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ETHICS TODAY

Stare Decisis versus Spider-Man Chapter 1, p. 9

Is It Ethical (and Legal) to Brew “Imported” Beer Brands Domestically? Chapter 11, p. 217

Forced Arbitration: Right or Wrong? Chaper 13, p. 267

Should There Be More Relief for Student Loan Defaults? Chapter 15, p. 337

Is It Fair to Classify Uber and Lyft Drivers as Independent Contractors? Chapter 19, p. 418

Is It Fair to Dock Employees’ Pay for Bathroom Breaks? Chapter 20, p. 442

Should Eminent Domain Be Used to Promote Private Development? Chapter 26, p. 562

MANAGERIAL STRATEGY

Should You Consent to Have Your Business Case Decided by a U.S. Magistrate Judge? Chapter 2, p. 38

Marriage Equality and the Constitution Chapter 4, p. 72

When Is a Warning Legally Bulletproof? Chapter 7, p. 142

The Criminalization of American Business Chapter 10, p. 191

Creating Liability Waivers That Are Not Unconscionable Chapter 12, p. 257

Commercial Use of Drones Chapter 14, p. 295

Can a Person Who Is Not a Member of a Protected Class Sue for Discrimination? Chapter 17, p. 376

Union Organizing Using a Company’s E-Mail System Chapter 22, p. 483

The SEC’s New Pay-Ratio Disclosure Rule Chapter 28, p. 590

Frank B. Cross Herbert D. Kelleher

Centennial Professor in Business Law University of Texas at Austin

Roger LeRoy Miller Institute for University Studies

Arlington, Texas

T h e L E G A L

E N V I RO N M E N T o f BB U S I N E S S

T E X T A N D C A S E S

Tenth Edition

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The Legal Environment of Business TEXT AND CASES

Tenth Edition

Frank B. Cross Roger LeRoy Miller

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Unit One THE FOUNDATIONS 1 Chapter 1 Law and Legal Reasoning 2 Chapter 2 Courts and Alternative Dispute Resolution 26 Chapter 3 Court Procedures 48 Chapter 4 Business and the Constitution 70 Chapter 5 Business Ethics 89

Unit Two THE PUBLIC AND INTERNATIONAL ENVIRONMENT 111 Chapter 6 Tort Law 112 Chapter 7 Strict Liability and Product Liability 134 Chapter 8 Intellectual Property Rights 150 Chapter 9 Internet Law, Social Media, and Privacy 170 Chapter 10 Criminal Law and Cyber Crime 187 Chapter 11 International and Space Law 211

Unit Three THE COMMERCIAL ENVIRONMENT 233 Chapter 12 Formation of Traditional and E-Contracts 234 Chapter 13 Contract Performance, Breach, and Remedies 262 Chapter 14 Sales and Lease Contracts 284 Chapter 15 Creditor-Debtor Relations and Bankruptcy 318

Unit Four THE BUSINESS AND EMPLOYMENT ENVIRONMENT 349 Chapter 16 Small Businesses and Franchises 350 Chapter 17 Limited Liability Business Forms 371 Chapter 18 Corporations 388 Chapter 19 Agency Relationships 416 Chapter 20 Employment Law 438 Chapter 21 Employment Discrimination 453 Chapter 22 Immigration and Labor Law 474

Unit Five THE REGULATORY ENVIRONMENT 495 Chapter 23 Administrative Agencies 496 Chapter 24 Consumer Protection 515 Chapter 25 Environmental Law 532 Chapter 26 Real Property and Land-Use Control 548 Chapter 27 Antitrust Law 568 Chapter 28 Investor Protection and Corporate Governance 588

Brief Contents

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

APPENDICES A How to Brief Cases and Analyze Case Problems A-1 B �e Constitution of the United States A-5 C Articles 2 and 2A of the A of the A Uniform Commercial Code A-13 D Answers to the Issue Spotters A-51 E Sample Answers for Business Case Problems with Sample Answer A-57

GLOSSARY G-1 TABLE OF CASES TC-1 INDEX I-1

Unit One THE FOUNDATIONS 1

Chapter 1 Law and Legal Reasoning 2 Business Activities and the Legal Environment 2 Sources of American Law 3 �e Common Law Tradition 6 Schools of Legal �ought 12 Classi�cations of Law 13 How to Find Primary Sources of Law 14 How to Read and Understand Case Law 19

Chapter 2 Courts and Alternative Dispute Resolution 26 �e Judiciary’s Role in American Government 26 Basic Judicial Requirements 27 Case Analysis 2.1 Mala v. Crown Bay Marina, Inc. (2013) 29 Spotlight on Gucci

Case 2.2 Gucci America, Inc. v. Wang Huoqing (2011) 32 �e State and Federal Court Systems 35 Case 2.3 Johnson v. Oxy USA, Inc. (2016) 36 Alternative Dispute Resolution 40 International Dispute Resolution 44

Chapter 3 Court Procedures 48 Procedural Rules 48 Pretrial Procedures 50 Case Analysis 3.1 Espresso Disposition Corp. 1 v. Santana Sales

& Marketing Group, Inc. (2013) 54 Case 3.2 Lewis v. Twenty-First Century Bean

Processing (2016) 56 Case 3.3 Brothers v. Winstead (2014) 58 �e Trial 61 Posttrial Motions 64 �e Appeal 65 Enforcing the Judgment 66

Chapter 4 Business and the Constitution 70 �e Constitutional Powers of Government 70 Classic Case 4.1 Heart of Atlanta Motel v. United

States (1964) 73 Business and the Bill of Rights 75 Spotlight on Beer Labels

Case 4.2 Bad Frog Brewery, Inc. v. New York State Liquor Authority (1998) 78

Case Analysis 4.3 Thompson v. Holm (2016) 81 Due Process and Equal Protection 83 Privacy Rights 84

Chapter 5 Business Ethics 89 Business Ethics 89 Case 5.1 Scott v. Carpanzano (2014) 91 Business Ethics and Social Media 93 Ethical Principles and Philosophies 94 Making Ethical Business Decisions 97 Case 5.2 Al-Dabagh v. Case Western Reserve

University (2015) 99 Case Analysis 5.3 Moseley v. Pepco Energy Services,

Inc. (2011) 100 Global Business Ethics 102 Unit One Application and Ethics:

“Arbitration, No Class Actions” 107

Unit Two THE PUBLIC AND INTERNATIONAL ENVIRONMENT 111

Chapter 6 Tort Law 112 �e Basis of Tort Law 112 Intentional Torts against Persons 113 Case Analysis 6.1 Blake v. Giustibelli (2016) 115 Case 6.2 Revell v. Guido (2015) 120 Intentional Torts against Property 123 Unintentional Torts—Negligence 125 Defenses to Negligence 129 Spotlight on the Seattle Mariners

Case 6.3 Taylor v. Baseball Club of Seattle, LP (2006) 129

Contents

vi C O N T E N T S

Chapter 7 Strict Liability and Product Liability 134 Strict Liability 134 Product Liability 135 Case Analysis 7.1 Schwarck v. Arctic Cat, Inc. (2016) 136 Strict Product Liability 137 Spotlight on Injuries from Vaccines

Case 7.2 Bruesewitz v. Wyeth, LLC (2011) 138 Defenses to Product Liability 144 Case 7.3 VeRost v. Mitsubishi Caterpillar Forklift America,

Inc. (2015) 144

Chapter 8 Intellectual Property Rights 150 Trademarks and Related Property 150 Classic Case 8.1 The Coca-Cola Co. v. The Koke Co.

of America (1920) 150 Case 8.2 LFP IP, LLC v. Hustler Cincinnati, Inc. (2016) 153 Patents 157 Copyrights 160 Case Analysis 8.3 Winstead v. Jackson (2013) 161 Trade Secrets 164 International Protection for Intellectual Property 166

Chapter 9 Internet Law, Social Media, and Privacy 170 Internet Law 170 Spotlight on Internet Porn

Case 9.1 Hasbro, Inc. v. Internet Entertainment Group, Ltd. (1996) 173

Copyrights in Digital Information 174 Social Media 176 Online Defamation 178 Other Actions Involving Online Posts 180 Case Analysis 9.2 David v. Textor (2016) 181 Privacy 182 Case 9.3 Nucci v. Target Corp. (2015) 182

Chapter 10 Criminal Law and Cyber Crime 187 Civil Law and Criminal Law 187 Criminal Liability 189 Types of Crimes 192 Case 10.1 State of Minnesota v. Smith (2015) 193 Spotlight on White-Collar Crime

Case 10.2 People v. Sisuphan (2010) 195 Defenses to Criminal Liability 198 Criminal Procedures 201 Cyber Crime 204 Case Analysis 10.3 United States v. Warner (2016) 205

Chapter 11 International and Space Law 211 International Law 211 Case Analysis 11.1 Bennett v. Islamic Republic of Iran

(2016) 215 Doing Business Internationally 216 Regulation of Speci�c Business Activities 219 International Dispute Resolution 221 Case 11.2 Carlyle Investment Management, LLC v. Moonmouth

Co. SA (2015) 222 U.S. Laws in a Global Context 223 Spotlight on International Torts

Case 11.3 Daimler AG v. Bauman (2014) 223 Space Law 225 Unit Two Application and Ethics:

The Biggest Data Breach of All Time 230

Unit Three THE COMMERCIAL ENVIRONMENT 233

Chapter 12 Formation of Traditional and E-Contracts 234 An Overview of Contract Law 234 Agreement 238 Classic Case 12.1 Lucy v. Zehmer (1954) 238 Case Analysis 12.2 Hinkal v. Pardoe (2016) 243 E-Contracts 245 Consideration 248 Spotlight on Nike

Case 12.3 Already, LLC v. Nike, Inc. (2013) 251 Contractual Capacity 253 Legality 254 Form 256 �ird Party Rights 256

Chapter 13 Contract Performance, Breach, and Remedies 262 Voluntary ConsentVoluntary ConsentV 262 Case 13.1 Schneiderman v. Trump Entrepreneur Initiative, LLC

(2016) 264 Performance and Discharge 267 Case Analysis 13.2 Kohel v. Bergen Auto Enterprises, L.L.C.

(2013) 270 Damages 274

C O N T E N T S vii

Spotlight on Liquidated Damages Case 13.3 Kent State University v. Ford (2015) 277

Equitable Remedies 278 Waiver of Breach 280 Contract Provisions Limiting Remedies 281

Chapter 14 Sales and Lease Contracts 284 �e Scope of Articles 2 (Sales) and 2A (A (A Leases) 284 �e Formation of Sales and Lease Contracts 286 Classic Case 14.1 Jones v. Star Credit Corp. (1969) 291 Title, Risk, and Insurable Interest 292 Case Analysis 14.2 BMW Group, LLC v. Castle Oil Corp.

(2016) 293 Performance and Breach of Sales and Lease Contracts 298 Remedies for Breach of Sales and Lease Contracts 302 Spotlight on Baseball Cards

Case 14.3 Fitl v. Strek (2005) 306 Warranties 307 Contracts for the International Sale of Goods 309

Chapter 15 Creditor-Debtor Relations and Bankruptcy 318 Laws Assisting Creditors 318 Case Analysis 15.1 Picerne Construction Corp. v. Villas

(2016) 319 Mortgages 324 Protection for Debtors 325 Bankruptcy Law 326 Liquidation Proceedings 326 Case 15.2 In re Anderson (2016) 332 Case 15.3 In re Cummings (2015) 336 Reorganizations 338 Bankruptcy Relief under Chapter 12 and Chapter 13 339 Unit Three Application and Ethics:

Fantasy Sports—Legal Gambling? 346

Unit Four THE BUSINESS AND EMPLOYMENT ENVIRONMENT 349

Chapter 16 Small Businesses and Franchises 350 General Considerations for Small Businesses 350 Sole Proprietorships 351

Case Analysis 16.1 A. Gadley Enterprises, Inc. v. Department of Labor and Industry Office of Unemployment Compensation Tax Services (2016) 352

Partnerships 355 Classic Case 16.2 Meinhard v. Salmon (1928) 358 Franchises 362 Spotlight on Holiday Inns

Case 16.3 Holiday Inn Franchising, Inc. v. Hotel Associates, Inc. (2011) 367

Chapter 17 Limited Liability Business Forms 371 �e Limited Liability Company 371 Case 17.1 Hodge v. Strong Built International, LLC (2015) 373 LLC Management and Operation 375 Dissociation and Dissolution of an LLC 377 Case Analysis 17.2 Reese v. Newman (2016) 378 Limited Liability Partnerships 379 Limited Partnerships 381 Case 17.3 DeWine v. Valley View Enterprises, Inc. (2015) 381

Chapter 18 Corporations 388 Nature and Classi�cation 388 Case 18.1 Drake Manufacturing Co. v. Polyflow, Inc.

(2015) 390 Case Analysis 18.2 Pantano v. Newark Museum (2016) 391 Formation and Powers 394 Piercing the Corporate VeilVeilV 399 Directors and O�cers 400 Classic Case 18.3 Guth v. Loft, Inc. (1939) 404 Shareholders 405 Major Business Forms Compared 411

Chapter 19 Agency Relationships 416 Agency Law 416 Formation of the Agency Relationship 419 Duties of Agents and Principals 420 Spotlight on Taser International

Case 19.1 Taser International, Inc. v. Ward (2010) 422 Case Analysis 19.2 NRT New England, LLC v. Jones (2016) 425 Agent’s Authority 426 Liability in Agency Relationships 428 Case 19.3 Asphalt & Concrete Services, Inc. v. Perry (2015) 431 Termination of an Agency 433

viii C O N T E N T S

Chapter 20 Employment Law 438 Employment at Will 438 Case Analysis 20.1 Caterpillar, Inc. v. Sudlow (2016) 439 Wages, Hours, and Layo�s 441 Case 20.2 Bailey v. TitleMax of Georgia, Inc. (2015) 443 Family and Medical Leave 444 Case 20.3 Ballard v. Chicago Park District (2014) 445 Health, Safety, and Income Security 446 Employee Privacy Rights 449

Chapter 21 Employment Discrimination 453 Title VII of the Civil Rights Act 453 Case Analysis 21.1 Bauer v. Lynch (2016) 458 Case 21.2 Young v. United Parcel Service, Inc. (2015) 459 Case 21.3 Roberts v. Mike’s Trucking, Ltd. (2014) 462 Discrimination Based on Age 464 Discrimination Based on Disability 466 Discrimination Based on Military Status 469 Defenses to Employment Discrimination 469 A�rmative Action 470

Chapter 22 Immigration and Labor Law 474 Immigration Law 474 Federal Labor Laws 477 Case 22.1 Services Employees International Union v.

National Union of Healthcare Workers (2013) 478 Union Organization 479 Case Analysis 22.2 Contemporary Cars, Inc. v. National Labor

Relations Board (2016) 481 Collective Bargaining 482 Strikes and Lockouts 483 Unfair Labor Practices 485 Case 22.3 Staffing Network Holdings, LLC v.

National Labor Relations Board (2016) 486 Unit Four Application and Ethics:

Health Insurance and Small Business 492

Unit Five THE REGULATORY ENVIRONMENT 495

Chapter 23 Administrative Agencies 496 �e Practical Signi�cance of Administrative Law 496 Agency Creation and Powers 497

Case 23.1 Loving v. Internal Revenue Service (2014) 500 �e Administrative Process 502 Case 23.2 Craker v. Drug Enforcement Administration

(2013) 506 Judicial Deference to Agency Decisions 507 Case Analysis 23.3 Olivares v. Transportation Security

Administration (2016) 508 Public Accountability 510

Chapter 24 Consumer Protection 515 Advertising, Marketing, and Sales 515 Case 24.1 POM Wonderful, LLC v. Federal Trade Commission

(2015) 516 Case 24.2 Lexmark International, Inc. v. Static Control

Components, Inc. (2014) 520 Labeling and Packaging Laws 522 Protection of Health and Safety 523 Credit Protection 524 Case Analysis 24.3 Santangelo v. Comcast Corporation

(2016) 526

Chapter 25 Environmental Law 532 Common Law Actions 532 Federal, State, and Local Regulations 533 Case Analysis 25.1 Friends of Animals v. Clay (2016) 533 Air Pollution 536 Case 25.2 United States v. O’Malley (2014) 538 Water Pollution 539 Case 25.3 Entergy Corp. v. Riverkeeper, Inc. (2009) 540 Toxic Chemicals and Hazardous Waste 543

Chapter 26 Real Property and Land-Use Control 548 �e Nature of Real Property 548 Ownership and Other Interests in Real Property 550 Case 26.1 Main Omni Realty Corp. v. Matus (2015) 551 Transfer of Ownership 555 Spotlight on Sales of Haunted Houses

Case 26.2 Stambovsky v. Ackley (1991) 556 Case Analysis 26.3 Montgomery County v. Bhatt (2016) 559 Limitations on the Rights of Property Owners 561 Land-Use Control and Zoning 563

Chapter 27 Antitrust Law 568 �e Sherman Antitrust Act 568 Section 1 of the Sherman Act 569 Section 2 of the Sherman Act 572

C O N T E N T S ix

Case Analysis 27.1 McWane, Inc. v. Federal Trade Commission (2015) 574

Spotlight on Weyerhaeuser Case 27.2 Weyerhaeuser Co. v. Ross-Simmons Hardwood Lumber Co. (2007) 576

�e Clayton Act 577 Enforcement and Exemptions 580 Case 27.3 TransWeb, LLC v. 3M Innovative Properties Co.

(2016) 580 U.S. Antitrust Laws in the Global Context 583

Chapter 28 Investor Protection and Corporate Governance 588 �e Securities Act of 1933 588 Case 28.1 Omnicare, Inc. v. Laborers District

Council Construction Industry Pension Fund (2015) 594 �e Securities Exchange Act of 1934 595 Classic Case 28.2 SEC v. Texas Gulf Sulphur Co. (1968) 596

Case Analysis 28.3 Rand-Heart of New York, Inc. v. Dolan (2016) 600

State Securities Laws 603 Corporate Governance 603 Unit Five Application and Ethics:

Climate Change 610

Appendices A How to Brief Cases and Analyze Case Problems A-1 B �e Constitution of the United States A-5 C Articles 2 and 2A of the A of the A Uniform Commercial Code A-13 D Answers to the Issue Spotters A-51 E Sample Answers for Business Case Problems with Sample

Answer A-57

Glossary G-1 Table of Cases TC-1 Index I-1

Concept Summaries

1.1 Sources of American Law 5 1.2 �e Common Law Tradition 11 1.3 Schools of Jurisprudential �ought 13 2.1 Jurisdiction 34 2.2 Types of Courts 4l 3.1 Pretrial Procedures 62 3.2 Trial Procedures 64 3.3 Posttrial Options 66 6.1 Intentional Torts against Persons 122

6.2 Intentional Torts against Property 126 7.1 Defenses to Product Liability 147

10.1 Types of Crimes 199 12.1 Types of Contracts 237 12.2 Methods byWhich

an O�er Can Be Terminated 242 14.1 O�er, Acceptance, and Consideration

under the UCC 289 15.1 Forms of Bankruptcy Relief Compared 342

xii

1–1 Areas of the Law That Can Affect Business Decision Making 3

1–2 Equitable Maxims 7 1–3 Procedural Differences between

Actions at Law and Actions in Equity 8 1–4 National Reporter Reporter R System—Regional/FederalRegional/FederalR 16 1–5 How to Read CitationsRead CitationsR 17 1–6 A Sample Court Case 21 2–1 Exclusive and Concurrent Jurisdiction 31 2–2 The State and Federal Court Systems 35 2–3 Geographic Boundaries of the

U.S. Courts of Appeals and Appeals and A U.S. District Courts 39 2–4 Basic Differences in the Traditional Forms of ADR 42 3–1 Stages in a Typical Lawsuit 49 3–2 A Typical Complaint A Typical Complaint A 51 3–3 A Typical A Typical A Summons 52 3–4 Pretrial Motions 54 4–1 Protections Guaranteed by the Bill of RightsRightsR 76 4–2 Federal Legislation Relating to PrivacyRelating to PrivacyR 85 8–1 Forms of Intellectual Property 165

10–1 Key Differences between Civil Law and Criminal Law 188

10–2 Civil (Tort) Lawsuit and Criminal Prosecution for the Same Act 189

10–3 Major Procedural Steps in a Criminal Case 203 11–1 The Legal Systems of Selected Nations 213 11–2 Examples of International Principles

and Doctrines 216 12–1 Examples of Agreements That Lack Consideration 250 13–1 Mistakes of Fact 263 13–2 Discharge by Performance 271 13–3 Remedies for Remedies for R Breach of Contract 280 14–1 The Law Governing Contracts 285 14–2 Major Differences between

Contract Law and Sales Law 292 15–1 Suretyship and Guaranty Parties 322

15–2 Collection and Distribution of Property in Most Voluntary Voluntary V Bankruptcies 334

16–1 The FTC’s Franchise Rule Rule R RequirementsRequirementsR 364 17–1 Management of an LLC 375 17–2 A Comparison of A Comparison of A General Partnerships

and Limited Partnerships 383 18–1 Results of Cumulative Results of Cumulative R VotingVotingV 408 18–2 Major Forms of Business Compared 411 19–1 Duties of the Agent 421 19–2 Duties of the Principal 423 19–3 Termination by Act of the Parties 433 21–1 Coverage of Employment Discrimination Laws 468 22–1 Good Faith versus Bad Faith

in Collective Bargaining 484 22–2 Basic Unfair Labor Practices 485 23–1 Executive Departments

and Important Subagencies 498 23–2 Selected Independent Regulatory Regulatory R Agencies 499 23–3 The Formal Administrative

Agency Adjudication Process 505 24–1 Selected Areas of Consumer Law

Regulated by Regulated by R Statutes 516 25–1 Major Federal Environmental Statutes 535 25–2 Environmental Impact Statements 536 25–3 Pollution-Control Equipment Standards under

the Clean Air Act and the Clean Water Act 540 26–1 Interests in Real PropertyReal PropertyR 555 27–1 Required Required R Elements of a Sherman Act ViolationViolationV 569 27–2 Exemptions to Antitrust Enforcement 582 28–1 Exemptions for Securities Offerings

under the 1933 Securities Act 592 28–2 Comparison of Coverage, Application, Application, A

and Liability under SEC Rule 10b-5 and Rule 10b-5 and R Section 16(b) 599

28–3 Some Key Provisions of the Sarbanes-Oxley Act Relating to Corporate Relating to Corporate R Accountability 606

Exhibits

xiii

The study of the legal environment of business has universal applicability. A student entering any field of A student entering any field of A business must have at least a passing understanding of business law in order to function in the real world. The Legal Environment of Business, Tenth Edition, provides the information that students need in an interesting and contemporary way.

Additionally, students preparing for a career in accounting, government and political science, econom- ics, and even medicine can use much of the information they learn in a legal environment course. In fact, every individual throughout his or her lifetime can bene�t from knowledge of environmental law, intellectual and real property, agency and employment relationships, and other legal environment topics. Consequently, we have fashioned this text as a useful “tool for living” for all of your students (including those taking the revised 2017 CPA2017 CPA2017 CP exam). A exam). A

For the Tenth Edition, we have spent a great deal of e�ort making this book more modern, exciting, and visu- ally appealing than ever before. We have added twenty- seven new features, �fty-two new cases, and seventeen new exhibits. �e text also contains more than one hundred new highlighted and numbered Cases in Point and Examples, and eighty-�ve new case problems. Spe- cial pedagogical elements within the text focus on legal, ethical, global, and corporate issues while addressing core curriculum requirements.

Highlights of the Tenth Edition Instructors have come to rely on the coverage, accuracy, and applicability of The Legal Environment of Business. To make sure that our text engages your students, solidifies their understanding of legal concepts, and provides the best teaching tools available, we now offer the following.

A Variety of New and Exciting Features The Tenth Edition of The Legal Environment of Business is filled with many new features specifically designed to cover current legal topics of high interest. Each feature is related to a topic discussed in the text and ends with Crit-Crit-Crit ical �inking or Business Questions. Suggested answers

to all the Critical �inking and Business Questions are included in the Solutions Manual for this text.

1. Ethics Today These features focus on the ethical aspects of a topic discussed in the text to empha- size that ethics is an integral part of a business law course. Examples include: • Stare Decisis versus Spiderman (Chapter 1) • Is It Ethical (and Legal) to Brew “Imported” Beer

Brands Domestically? (Chapter 11) • Forced Arbitration: Right or Wrong? (Chapter 13) • Should There Be More Relief for Student Loan

Defaults? (Chapter 15) • Is It Fair to Classify Uber and Lyft Drivers as Lyft Drivers as L

Independent Contractors? (Chapter 19) 2. Global Insight These features illustrate how other

nations deal with specific legal concepts to give stu- dents a sense of the global legal environment. Sub- jects include: • Does Cloud Computing Have a Nationality?

(Chapter 18) 3. NEW Digital Update These features are designed

to examine cutting-edge cyberlaw topics, such as the following: • Using Social Media for Service of Process

(Chapter 3) • Should Employees Have a “Right of Disconnect-

ing”? (Chapter 5) • Revenge Porn and Invasion of Privacy (Chapter 6) • Monitoring Employees’ Social Media—Right or

Wrong? (Chapter 9) • Hiring Discrimination Based on Social Media

Posts (Chapter 21) 4. Managerial Strategy These features emphasize the

management aspects of business law and the legal environment. Topics include: • Should You Consent to Have Your Business Case

Decided by a U.S. Magistrate Judge? (Chapter 2) • Marriage Equality and the Constitution (Chapter 4) • When Is a Warning Legally Bulletproof?

(Chapter 7) • The Criminalization of American Business

(Chapter 10) • Commercial Use of Drones (Chapter 14) • The SEC’s New CEO Pay-Ratio Disclosure

Rule (Chapter 28)

Preface

xiv P R E FA C E

Entire Chapter on Internet Law, Social Media, and Privacy For the Tenth Edition, we include a whole chapter (Chapter 9) on Internet Law, Social Media, and Privacy. Social media have entered the mainstream and become a part of everyday life for many businesspersons. In this special chapter, we give particular emphasis to the legal issues surrounding the Internet, social media, and pri- vacy. We also recognize this trend throughout the text by incorporating the Internet and social media as they relate to the topics under discussion.

Highlighted and Numbered Examples and Case in Point Illustrations Many instructors use cases and examples to illustrate how the law applies to business. Students understand legal concepts better in the context of their real-world applica- tion. Therefore, for this edition of The Legal Environment of Business, we have expanded the number of highlighted numbered Examples and Examples and Examples Cases in Point in every chap- ter. We have added 102 new Cases in Point and 35 new Examples.

Examples illustrate how the law applies in a speci�c Examples illustrate how the law applies in a speci�c Examples situation. Cases in Point present the facts and issues of an actual case and then describe the court’s decision and rationale. �ese two features are uniquely designed and consecutively numbered throughout each chapter for easy reference. �e Examples and Examples and Examples Cases in Point are inte- grated throughout the text to help students better under-grated throughout the text to help students better under-grated throughout the text to help students better under stand how courts apply legal principles in the real world.

New Unit-Ending Application and Ethics Features For the Tenth Edition, we have created an entirely new feature that concludes each of the five units in the text. Each of these Application and Ethics features provides additional analysis on a topic related to that unit and explores its ethics ramifications. Each of the features ends with two questions—a Critical Thinking and an Ethics Question. Some topics covered by these features include the following:

• The Biggest Data Breach of All Time (Unit 2) • Fantasy Sports—Legal Gambling? (Unit 3) • Health Insurance and Small Business (Unit 4) • Climate Change (Unit 5)

Suggested answers to the questions in Application and Ethics features are included in the Solutions Manual for this text.

New Cases and Case Problems For the Tenth Edition of The Legal Environment of Busi- ness, we have added fifty-two new cases and eighty-five new case problems, most from 2016 and 2015. The new cases and problems have been carefully selected to illus- trate important points of law and to be of high interest to students and instructors. We have made it a point to find recent cases that enhance learning and are relatively easy to understand.

1. Spotlight Cases and Classic Cases. Certain cases and case problems that are exceptionally good teaching cases are labeled as Spotlight Cases and Spotlight Case Problems. Examples include Spotlight on Beer Labels, Spotlight on Gucci, Spotlight on Nike, and Spotlight on the Seattle Mariners. Instructors will find these Spotlight Cases useful to illustrate the legal concepts under discussion, and students will enjoy studying the cases because they involve inter- esting and memorable facts. Other cases have been chosen as Classic Cases because they establish a legal precedent in a particular area of law.

2. Critical Thinking Section. Each case concludes with a Critical Thinking section, which normally includes two questions. The questions may address Legal Environment, E-Commerce, Economic, Envi- ronmental, Ethical, Global, Political, or Technological issues, or they may ask What If the Facts Were Differ- ent? Each Classic Case has a section titled Impact of This Case on Today’s Law and one Critical Thinking question.

3. Longer Excerpts for Case Analysis. We have also included one longer case excerpt in every chap- ter—labeled Case Analysis—followed by three Legal Reasoning Questions. The questions are designed to guide students’ analysis of the case and develop their legal reasoning skills. These Case Analysis cases may be used for case-briefing assignments and are also tied to the Special Case Analysis questions found in every unit of the text (one per unit).

Suggested answers to all case-ending questions and case problems are included in the Solutions Manual for this text.

P R E FA C E xv

Business Case Problem with Sample Answer in Each Chapter In response to those instructors who would like students to have sample answers available for some of the ques- tions and case problems, we include a Business Case Prob- lem with Sample Answer in each chapter. The Business Case Problem with Sample Answer is based on an actual case, and students can find a sample answer at the end of the text. Suggested answers to the Business Case Prob- lems with Sample Answers are provided in Appendix Appendix A E at the end of the text and in the Solutions Manual for this text.

New Exhibits and Concept Summaries For this edition, we have spent considerable effort reworking and redesigning all of the exhibits and Concept Summaries in the text to achieve better clarity and more Summaries in the text to achieve better clarity and more Summaries visual appeal. In addition, we have added seventeen new exhibits and three new Concept Summaries.

Special Case Analysis Questions For one chapter in every unit of the text, we provide a Special Case Analysis question that is based on the Case Analysis excerpt in that chapter. These special ques- tions appear in the Business Case Problems at the ends of selected chapters.

�e Special Case Analysis questions are designed to build students’ analytical skills. �ey test students’ ability to perform IR AC (IR AC (IR A Issue, Rule, Application, and Conclusion) case analysis. Students must identify the le- gal issue presented in the chapter’s Case Analysis Case, understand the rule of law, determine how the rule ap- plies to the facts of the case, and describe the court’s conclusion. Instructors can assign these questions as homework or use them in class to elicit student partici- pation and teach case analysis. Suggested answers to the Special Case Analysis questions can be found in the Solutions Manual for this text.

Reviewing Features in Every Chapter In the Tenth Edition of The Legal Environment of Busi- ness, we continue to offer a Reviewing feature at the end Reviewing feature at the end Reviewing of every chapter to help solidify students’ understanding of the chapter materials. Each Reviewing feature presents Reviewing feature presents Reviewing a hypothetical scenario and then asks a series of questions

that require students to identify the issues and apply the legal concepts discussed in the chapter.

�ese features are designed to help students review the chapter topics in a simple and interesting way and see how the legal principles discussed in the chapter af-see how the legal principles discussed in the chapter af-see how the legal principles discussed in the chapter af fect the world in which they live. An instructor can use these features as the basis for in-class discussion or en- courage students to use them for self-study prior to com- pleting homework assignments. Suggested answers to the questions posed in the Reviewing features can be found in the Solutions Manual for this text.

Two Issue Spotters At the conclusion of each chapter, we have included a special section with two Issue Spotters related to the chap- ter’s topics. These questions facilitate student learning and review of the chapter materials. Suggested answers to the Issue Spotters in every chapter are provided in Appendix Appendix A D at the end of the text and in the Solutions Manual for this text.

Legal Reasoning Group Activities For instructors who want their students to engage in group projects, each chapter of the Tenth Edition includes a special Legal Reasoning Group Activity. Each activity begins by describing a business scenario and then poses several specific questions pertaining to the scenario. Each question is to be answered by a different group of students based on the information in the chapter. These projects may be used in class to spur discussion or as homework assignments. Suggested answers to the Legal Reasoning Group Activities are included in the Solu- tions Manual for this text.

Supplements/Digital Learning Systems The Legal Environment of Business, Tenth Edition, pro- vides a comprehensive supplements package designed to make the tasks of teaching and learning more enjoyable and efficient. The following supplements and exciting new digital products are offered in conjunction with the text.

xvi P R E FA C E

MindTap MindTap for The Legal Environment of Business, Tenth Edition, is a fully online, highly personalized learning experience built upon Cengage Learning content. Mind- Tap combines student learning tools—such as readings, multimedia, activities, and assessments from Cengage- NOW—into a singular NOW—into a singular NO Learning Path that intuitively guides students through their course.

Instructors can personalize the experience by cus- tomizing authoritative Cengage Learning content and learning tools. MindTap o�ers instructors the ability to add their own content in the Learning Path with apps that integrate into the MindTap framework seamlessly with Learning Management Systems (LMS).

MindTap includes:

• An Interactive book with Whiteboard Videos Videos V and Interactive Cases.

• Automatically graded homework with the folutomatically graded homework with the folutomatically graded homework - lowing consistent question types: • Worksheets—Interactive Worksheets prepare

students for class by ensuring reading and comprehension.

• Video Video V Activities—Real-world video exercises make business law engaging and relevant.

• Brief Hypotheticals—These applications pro- vide students practice in spotting the issue and applying the law in the context of a short, fac- tual scenario.

• Case Problem Analyses—These promote deeper critical thinking and legal reasoning by guiding students step-by-step through a case problem and then adding in a critical thinking section based on “What If the Facts Were Dif-f the Facts Were Dif-f the Facts Were Dif ferent?” These now include a third section, a writing component, which requires students to demonstrate their ability to forecast the legal implications of real-world business scenarios.

• Personalized Student Plan with multimedia study tools and videos.

• New Adaptive Test Prep helps students study for exams.

• Test Bank. • Reporting and Assessment options.

By using the MindTap system, students can com- plete the assignments online and can receive instant feedback on their answers. Instructors can utilize Mind- Tap to upload their course syllabi, create and customize

homework assignments, and keep track of their students’ progress. By hiding, rearranging, or adding content, in- structors control what students see and when they see it to match the Learning Path to their course syllabus exactly. Instructors can also communicate with their students about assignments and due dates, and create re- ports summarizing the data for an individual student or for the whole class.

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

• Author, edit, and manage Test Bank content from multiple Cengage Learning solutions.

• Create multiple test versions in an instant. • Deliver tests from your LMS, your classroom, or

wherever you want.

Start Right Away! Cengage Learning Testing Powered by Cognero works on any operating system or browser.

• No special installs or downloads are needed. • Create tests from school, home, the coffee shop—

anywhere with Internet access.

What Will You Find?

• Simplicity at every step. A desktop-inspired interA desktop-inspired interA - desktop-inspired inter- desktop-inspired inter face features drop-down menus and familiar intu- itive tools that take you through content creation and management with ease.

• Full-featured test generator. Create ideal assess- ments with your choice of fifteen question types—including true/false, multiple choice, opinion scale/Likert, and essay). Multi-language support, an equation editor, and unlimited meta- data help ensure your tests are complete and compliant.

• Cross-compatible capability. Import and export content to and from other systems.

Instructor’s Companion Web Site The Web site for the Tenth Edition of The Legal Envi- ronment of Business can be found by going to www. cengagebrain.com and entering ISBN 9781305967304. The Instructor’s Companion Web Site contains the fol- lowing supplements:

P R E FA C E xvii

• Instructor’s Manual. Includes sections entitled “A“A“ dditional Cases Addressing This Issue” at the end of selected case synopses.

• Solutions Manual. Provides answers to all ques- tions presented in the text, including the ques- tions in each case and feature, the Issue Spotters, the Business Scenarios and Business Case Problems, and the unit-ending features.

• Test Bank. A comprehensive test bank that conA comprehensive test bank that conA - tains multiple-choice, true/false, and short essay questions.

• Case-Problem Cases. • Case Printouts. • PowerPoint Slides. • Lecture Outlines.

For Users of the Ninth Edition First of all, we want to thank you for helping make The Legal Environment of Business one of the best-selling legal environment texts in America today. Second, we want to make you aware of the numerous additions and changes that we have made in this edition—many in response to comments from reviewers.

Every chapter of the Tenth Every chapter of the Tenth E Edition has been revised as necessary to incorporate new developments in the law or to streamline the presentations. We have reorganized the chapters somewhat for better �ow and clarity and now divide the materials into �ve rather than six units. Each unit concludes with a new Application and Ethics feature. Other major changes and additions for this edi- tion include the following:

• Chapter 4 (Business and the Constitution)—The chapter has been revised and updated to be more business oriented. It has two new cases, four new Cases in Point, a new exhibit, and three new case problems. A Managerial Strategy feature on marriage equality and the constitution dis- cusses United States Supreme Court decisions on this issue.

• Chapter 5 (Business Ethics)—This chapter con- tains two new cases, two new Issue Spotters, three new Cases in Point (including a case involving Tom Brady’s suspension from the NFL as a result of “deflategate”), and three new case problems. The chapter includes a section on business ethics and social media, and discusses stakeholders and corporate social responsibility. The chapter also provides step-by-step guidance on making ethical

business decisions and includes materials on global business ethics. A new A new A Digital Update fea- ture examines whether employees should have the right to disconnect from their electronic devices after work hours.

• Chapter 8 (Intellectual Property Rights)—The materials on intellectual property rights have been thoroughly revised and updated to reflect the most current laws and trends. The 2016 case involves the Hustler Club and a trademark infringement claim between brothers. A Digital Update feature examines the problem of pat- ent trolls. There are eleven new Cases in Point, including cases involving FedEx’s color and logo, Google’s digitalization of books, and how the Sherlock Holmes copyright fell into the public domain.

• Chapter 9 (Internet Law, Social Media, and Pri- vacy)—This chapter, which was new to the last edition and covers legal issues that are unique to the Internet, has been thoroughly revised and updated for the Tenth Edition. It includes a new section on cyberstalking, two new cases, and a new Digital Update feature on whether employers can monitor employees’ social media use.

• Chapter 10 (Criminal Law and Cyber Crime)— This chapter includes three new cases, five new Cases in Point, three new examples, and three new case problems. A new A new A Managerial Strategy feature discusses the criminalization of American business.

• Chapter 11 (International and Space Law)—The chapter has been expanded to include a new sec- tion on space law—international and domestic. All three cases presented are new to this edition, including a Spotlight Case on a United States Supreme Court decision concerning the Alien Tort Claims Act. The chapter also now covers the Trans-Pacific Partnership (TPP) and includes an Ethics Today feature on the domestic brewing of imported beer brands.

• Chapters 12 through 15 (the Commercial Envi- ronment unit)—In this unit, we have added ten new cases (including two Spotlight Cases, a Classic Case, and several Case Analysis cases), and twenty new case problems. We have also added new Cases in Point, Examples, exhibits, graphic Concept Sum- maries, numbered lists, and a new Reviewing fea- ture. A new A new A Managerial Strategy feature discusses the commercial use of drones, and an Ethics Today feature examines whether there should be more relief for student loan debt.

xviii P R E FA C E

• Chapter 19 (Agency Relationships)—This chapter has been updated to reflect the realities of the gig economy in which many people are working as independent contractors. A new A new A Ethics Today feature continues that emphasis with a discus- sion of whether Uber and Lyft drivers should be Lyft drivers should be L considered employees rather than independent contractors. In addition, new Examples, Cases in Point, and case problems have been added to help students comprehend the important issues and liability in agency relationships.

• Chapter 20 (Employment Law)—The chapter covering employment law has been thoroughly updated to include discussions of legal issues fac- ing employers today. It has three new cases, three new Cases in Point, three new Examples (including one involving wage claims of the Oakland Raiders cheerleaders), and three new case problems. An

Ethics Today feature examines whether employees should receive paid bathroom breaks.

• Chapter 21 (Employment Discrimination)—This chapter has a new section discussing discrimina- tion based on military status and new coverage of same-sex discrimination and discrimination against transgender persons. All three cases are new. There are seven new Cases in Point, five new Examples, a new exhibit, and three new case problems. A Digi- tal Update feature discusses hiring discrimination based on social media posts. We discuss relevant United States Supreme Court decisions affecting employment issues throughout the chapter.

• Chapter 24 (Consumer Protection)—This chapter includes all new cases, and has been significantly updated with new coverage, Examples, and Cases in Point. A Digital Update feature deals with “native” ads on the Internet.

P R E FA C E xix

Acknowledgments for Previous Editions Since we began this project many years ago, a sizable number of legal environment of business professors and others have helped us in revising the book and it’s supplements, including the following:

Peter W. Allan Victor Valley College

William Dennis Ames Indiana University of Pennsylvania

Thomas M. Apke California State University, Fullerton

Linda Axelrod Metropolitan State University

Jane Bennett Orange Coast College

Robert C. Bird University of Connecticut

Dean Bredeson University of Texas at Austin

Sam Cassidy University of Denver

Thomas D. Cavenagh North Central College– Naperville, Illinois

Angela Cerino Villanova University

Corey Ciocchetti University of Denver

David Cooper Fullerton College

Steven R. Donley Cypress College

Paul F. Dwyer Siena College

Nena Ellison Florida Atlantic University

Joan Gabel Florida State University

Gamewell Gant Idaho State University

Jacqueline Hagerott Franklin University

Arlene M. Hibschweiler SUNY Fredonia

Barbara W. Kincaid Southern Methodist University

Marty P. Ludlum Oklahoma City Community College

Diane May Winona State University

Marty Salley McGee South Carolina State University

Robert Mitchum Arkansas State University, Beebe

Melanie Morris Raritan Valley Community College

Kathleen A. Phillips University of Houston

David Redle University of Akron

Larry A. Strate University of Nevada–Las Vegas

Dawn Swink Minnesota State University, Mankato

Brian Terry Johnson and Wales University

John Theis Mesa State College

William H. Volz Wayne State University

Michael G. Walsh Villanova University

Glynda White Community College of Southern Nevada

LeVon E. Wilson Western Carolina University

John A. Wrieden Florida International University

Eric D. Yordy Northern Arizona University

Mary-Kathryn Zachary State University of West Georgia

As in all past editions, we owe a debt of extreme grati- tude to the numerous individuals who worked directly with us or at Cengage Learning. In particular, we wish to thank Vicky True-Vicky True-V Baker, senior product manager; Su- zanne Wilder, managing content developer; Sarah Hu- ber, content developer; and Ann Borman, senior content project manager. We also thank Katie Jergens in market- ing and Michelle Kunkler, art director. We are indebted as well to the sta� at Lachina, our compositor, for accu-

rately generating pages for this text and making it pos- sible for us to meet our ambitious printing schedule.

We especially wish to thank Katherine Marie Silsbee for her management of the entire project, as well as for the application of her superb research and editorial skills. We also wish to thank William Eric Hollowell, who co- authored the Instructor’s Manual and the Test Bank, for his excellent research e�orts. We were fortunate enough to have the copyediting and proofreading services of

xx P R E FA C E

Beverly Peavler and Kristi Wiswell. We are grateful for the e�orts of Vickie Vickie V Reierson and Roxanna Lee for their proofreading and other assistance, which helped to en- sure an error-free text. Finally, we thank Suzanne Jasin of K & M Consulting for her many special e�orts on this project.

�rough the years, we have enjoyed an ongoing cor-�rough the years, we have enjoyed an ongoing cor-�rough the years, we have enjoyed an ongoing cor respondence with many of you who have found points

on which you wish to comment. We continue to wel- come all comments and promise to respond promptly. By incorporating your ideas, we can continue to write a legal environment text that is best for you and best for your students.

F.B.C. R.L.M.

To my parents and sisters. F.B.C.

To Ian Gowrie-Smith, Your amazingly high

energy level never ceases to amaze me.

Keep it up!

R.L.M.

Unit One

�e Foundations

1. Law and Legal Reasoning

2. Courts and Alternative Dispute Resolution

3. Court Procedures

4. Business and the Constitution

5. Business Ethics

1–1a Many Different Laws May Affect a Single Business Decision

As you will note, each chapter in this text covers specific areas of the law and shows how the legal rules in each area affect business activities. Although compartmental- izing the law in this fashion promotes conceptual clarity, it does not indicate the extent to which a number of dif-it does not indicate the extent to which a number of dif-it does not indicate the extent to which a number of dif ferent laws may apply to just one decision. Exhibit 1–1 illustrates the various areas of the law that may influence business decision making.business decision making.business decision making.business decision making.business decision making.

■ EXAMPLE 1.1 When Mark Zuckerberg started Facebook as a Harvard student, he probably did not imagine all the legal challenges his company would face as a result of his business decisions. • Shortly after Facebook was launched, others claimed

that Zuckerberg had stolen their ideas for a social net- working site. Their claims involved alleged theft of intellectual property, fraudulent misrepresentation, and

C H A P T E R 1

O ne of the most important func- tions of law in any society is to provide stability, predictability,

and continuity so that people can know how to order their affairs. If any society is to survive, its citizens must be able to determine what is legally right and legally wrong. They must know what sanctions will be imposed on them if they commit wrongful acts. If they suf- fer harm as a result of others’ wrong- ful acts, they must know how they can seek compensation. By setting forth the rights, obligations, and privileges of citi- zens, the law enables individuals to go about their business with confidence and a certain degree of predictability.

Although law has various defi- nitions, they all are based on the

general observation that law con- sists of enforceable rules governing relationships among individuals and between individuals and their society. These “enforceable rules” may con- sist of unwritten principles of behav- ior established by a nomadic tribe. They may be set forth in a law code, such as the Code of Hammurabi in ancient Babylon (c. 1780 B.C.E.) or the law code of one of today’s European nations. They may consist of written laws and court decisions created by modern legislative and judicial bod- ies, as in the United States. Regardless of how such rules are created, they all have one thing in common: they establish rights, duties, and privileges that are consistent with the values

and beliefs of their society or its rul- ing group.

In this introductory chapter, we first look at an important question for any student reading this text: How does the legal environment affect business decision making? We next describe the major sources of American law, the common law tradi- tion, and some basic schools of legal thought. We conclude the chapter with sections offering practical guid- ance on several topics, including how to find the sources of law discussed in this chapter (and referred to through- out the text) and how to read and understand court opinions.

1–1 Business Activities and the Legal Environment

Laws and government regulations affect almost all business activities—from hiring and firing decisions to workplace safety, the manufacturing and marketing of products, business financing, and more. To make good business decisions, a basic knowledge of the laws and regulations governing these activities is beneficial—if not essential.

Realize also that in today’s business world, a knowl- edge of “black-letter” law and what conduct can lead to legal liability is not enough. Businesspersons must develop critical thinking and legal reasoning skills so that they can evaluate how various laws might apply to a given situation and determine the best course of action. Busi- nesspersons are also expected to make ethical decisions. Thus, the study of business law necessarily involves an ethical dimension.

222

Law and Legal Reasoning

C H A P T E R 1 Law and Legal Reasoning 3

violations of partnership law and securities law. Face- book ultimately paid $65 million to settle those claims out of court.

• Facebook has been sued repeatedly for violating users’ privacy (and federal laws) by tracking their Web site usage and by scanning private messages for purposes of data mining and user profiling. A class-action suit filed in Europe alleges that Facebook’s data-use poli- cies violate the law of the European Union. Facebook might have to pay millions in damages in this case.

• Facebook’s business decisions have also come under scrutiny by federal regulators, such as the Federal Trade Commission (FTC). The company settled a complaint filed by the FTC alleging that Facebook had failed to keep “friends” lists and other user information private. ■

1–1b Ethics and Business Decision Making Merely knowing the areas of law that may affect a busi- ness decision is not sufficient in today’s business world. Today, business decision makers need to consider not just whether a decision is legal, but also whether it is ethical.

Ethics generally is defined as the principles governing Ethics generally is defined as the principles governing Ethics what constitutes right or wrong behavior. Often, as in several of the claims against Facebook discussed above, disputes arise in business because one party feels that he or she has been treated unfairly. Thus, the underlying reason for bringing some lawsuits is a breach of ethical duties (such as when a partner or employee attempts to secretly take advantage of a business opportunity).

Throughout this text, you will learn about the rela- tionship between the law and ethics, as well as about some of the types of ethical questions that arise in business. For instance, all of the new unit-ending Application and Eth- ics features include an ics features include an ics Ethical Connection section that explores the ethical dimensions of a topic treated within the unit. We have also included Ethical Questions for Ethical Questions for Ethical Questions each unit, as well as within the critical thinking sections of many of the cases presented in this text. Ethics Today features, which focus on ethical considerations in today’s business climate, appear in selected chapters, including this chapter. A Question of Ethics case problem is included Question of Ethics case problem is included Question of Ethics at the end of every chapter to introduce you to the ethical aspects of specific cases involving real-life situations.

1–2 Sources of American Law American law has numerous sources. Often, these sources of law are classified as either primary or secondary.

Primary sources of law, or sources that establish the law, include the following: 1. The U.S. Constitution and the constitutions of the

various states. 2. Statutory law—including laws passed by Congress,

state legislatures, or local governing bodies. 3. Regulations created by administrative agencies, such

as the Federal Trade Commission. 4. Case law and common law doctrines.

E X H I B I T 1 – 1 Areas of the Law That Can Affect Business Decision Making

Business Decision Making

Intellectual Property

Contracts

Environmental Law and Sustainability

Internet Law, Internet Law, Internet Law Social Media, and Privacy

Product Liability

Torts

Sales

4 U N I T O N E The Foundations

We describe each of these important sources of law in the following pages.

Secondary sources of law are books and articles that Secondary sources of law are books and articles that Secondary sources of law summarize and clarify the primary sources of law. Exam- ples include legal encyclopedias, treatises, articles in law reviews, and compilations of law, such as the Restatements of the Law (which will be discussed later). Courts often refer to secondary sources of law for guidance in interpret- ing and applying the primary sources of law discussed here.

1–2a Constitutional Law The federal government and the states have separate writ- ten constitutions that set forth the general organization, powers, and limits of their respective governments. Consti- tutional law is the law as expressed in these constitutions.

According to Article VI of the U.S. Constitution, the Constitution is the supreme law of the land. As such, it is the basis of all law in the United States. A law in viola- tion of the Constitution, if challenged, will be declared unconstitutional and will not be enforced, no matter what its source. Because of its importance in the Ameri- can legal system, we present the complete text of the U.S. Constitution in Appendix B.

The Tenth Amendment to the U.S. Constitution reserves to the states all powers not granted to the federal govern- ment. Each state in the union has its own constitution. Unless it conflicts with the U.S. Constitution or a federal law, a state constitution is supreme within the state’s borders.

1–2b Statutory Law Laws enacted by legislative bodies at any level of gov- ernment, such as statutes passed by Congress or by state legislatures, make up the body of law known as statutory law. When a legislature passes a statute, that statute ulti- mately is included in the federal code of laws or the rel- evant state code of laws.

Statutory law also includes local ordinances—regu- lations passed by municipal or county governing units to deal with matters not covered by federal or state law. Ordinances commonly have to do with city or county land use (zoning ordinances), building and safety codes, and other matters affecting the local community.

A federal statute, of course, applies to all states. A state statute, in contrast, applies only within the state’s bor- ders. State laws thus may vary from state to state. No federal statute may violate the U.S. Constitution, and no state statute or local ordinance may violate the U.S. Con- stitution or the relevant state constitution.

Uniform Laws During the 1800s, the differences among state laws frequently created difficulties for

businesspersons conducting trade and commerce among the states. To counter these problems, a group of legal scholars and lawyers formed the National Conference of Commissioners on Uniform State Laws, or NCCUSL (www.uniformlaws.org), in 1892. The NCCUSL still exists today. Its object is to draft uniform laws (model statutes) for the states to consider adopting.

Each state has the option of adopting or rejecting a uniform law. Only if a state legislature adopts a uniform law does that law become part of the statutory law of that state. Note that a state legislature may adopt all or part of a uniform law as it is written, or the legislature may rewrite the law however the legislature wishes. Hence, even though many states may have adopted a uniform law, those states’ laws may not be entirely “uniform.”

The earliest uniform law, the Uniform Negotiable Instruments Law, was completed by 1896 and adopted in every state by the 1920s (although not all states used exactly the same wording). Over the following decades, other acts were drawn up in a similar manner. In all, more than two hundred uniform acts have been issued by the NCCUSL since its inception. The most ambitious uniform act of all, however, was the Uniform Commercial Code.

The Uniform Commercial Code One of the most important uniform acts is the Uniform Commercial Code (UCC), which was created through the joint efforts of the NCCUSL and the American Law Institute.1 The UCC was first issued in 1952 and has been adopted in all fifty states,2 the District of Columbia, and the Virgin Islands.

The UCC facilitates commerce among the states by providing a uniform, yet flexible, set of rules governing commercial transactions. Because of its importance in the area of commercial law, we cite the UCC frequently in this text. We also present Article 2 of the UCC in Appendix C. From time to time, the NCCUSL revises the articles contained in the UCC and submits the revised versions to the states for adoption.

1–2c Administrative Law Another important source of American law is administra- tive law, which consists of the rules, orders, and decisions of administrative agencies. An administrative agency is a federal, state, or local government agency established to perform a specific function. Administrative law and pro- cedures constitute a dominant element in the regulatory environment of business.

1. This institute was formed in the 1920s and consists of practicing attorneys, legal scholars, and judges.

2. Louisiana has not adopted Articles 2 and 2A (covering contracts for the sale and lease of goods), however.

C H A P T E R 1 Law and Legal Reasoning 5

Rules issued by various administrative agencies now affect almost every aspect of a business’s operations. Reg- ulations govern a business’s capital structure and financ- ing, its hiring and firing procedures, its relations with employees and unions, and the way it manufactures and markets its products. Regulations enacted to protect the environment also often play a significant role in business operations.

Federal Agencies At the national level, the cabinet departments of the executive branch include numerous executive agencies. The U.S. Food and Drug Admin- istration, for instance, is an agency within the U.S. Department of Health and Human Services. Execu- tive agencies are subject to the authority of the presi- dent, who has the power to appoint and remove their officers.

There are also major independent regulatory agencies at the federal level, such as the Federal Trade Commission, the Securities and Exchange Commission, and the Federal Communications Commission. The president’s power is less pronounced in regard to inde- pendent agencies, whose officers serve for fixed terms and cannot be removed without just cause.

State and Local Agencies There are administrative agencies at the state and local levels as well. Commonly, a state agency (such as a state pollution-control agency) is created as a parallel to a federal agency (such as the Envi- ronmental Protection Agency). Just as federal statutes take precedence over conflicting state statutes, federal agency reg- ulations take precedence over conflicting state regulations.

1–2d Case Law and Common Law Doctrines

The rules of law announced in court decisions consti- tute another basic source of American law. These rules include interpretations of constitutional provisions, of statutes enacted by legislatures, and of regulations cre- ated by administrative agencies.

Today, this body of judge-made law is referred to as case law. Case law—the doctrines and principles announced in cases—governs all areas not covered by statutory law or administrative law and is part of our common law tradi- tion. We look at the origins and characteristics of the com- mon law tradition in some detail in the pages that follow.

See Concept Summary 1.1 for a review of the sources of American law.

ETHICS TODAY

Law as expressed in the U.S. Constitution or state constitutions. The U.S. Constitution is the supreme law of the land. State constitutions are supreme within state borders to the extent that they do not conflict with the U.S. Constitution.

Sources of American Law

●

The rules, orders, and decisions of federal, state, and local administrative agencies.

Administrative Law

Judge-made law, including interpretations of constitutional provisions, of statutes enacted by legislatures, and of regulations created by administrative agencies.

Case Law and Common Law Doctrines

Constitutional Law

Statutory Law Statutes (including uniform laws) and ordinances enacted by federal, state, and local legislatures. Federal statutes may not violate the U.S. Constitution. State statutes and local ordinances may not violate the U.S. Constitution or the relevant state constitution.

Concept SuETHICS TODAConcept SuETHICS TODAmmarETHICS TODAmmarETHICS TODAy ETHICS TODAy ETHICS TODAETHICS TODAYETHICS TODAy ETHICS TODAYETHICS TODA 1.1

6 U N I T O N E The Foundations

1–3 The Common Law Tradition Because of our colonial heritage, much of American law is based on the English legal system. Knowledge of this tradition is crucial to understanding our legal system today because judges in the United States still apply com- mon law principles when deciding cases.

1–3a Early English Courts After the Normans conquered England in 1066, William the Conqueror and his successors began the process of unifying the country under their rule. One of the means they used to do this was the establishment of the king’s courts, or curiae regis.

Before the Norman Conquest, disputes had been set- tled according to the local legal customs and traditions in various regions of the country. The king’s courts sought to establish a uniform set of customs for the country as a whole. What evolved in these courts was the begin- ning of the common law—a body of general rules that common law—a body of general rules that common law applied throughout the entire English realm. Eventually, the common law tradition became part of the heritage of all nations that were once British colonies, including the United States.

Courts of Law and Remedies at Law The early English king’s courts could grant only very limited kinds of remedies (the legal means to enforce a right or redress a wrong). If one person wronged another in some way, the king’s courts could award as compensation one or more of the following: (1) land, (2) items of value, or (3) money.

The courts that awarded this compensation became known as courts of law, and the three remedies were called remedies at law. (Today, the remedy at law normally takes the form of monetary damages—an amount given to a party whose legal interests have been injured.) This system made the procedure for settling disputes more uniform. When a complaining party wanted a remedy other than economic compensation, however, the courts of law could do nothing, so “no remedy, no right.”

Courts of Equity When individuals could not obtain an adequate remedy in a court of law, they petitioned the king for relief. Most of these petitions were decided by an adviser to the king, called a chancellor, who had the power to grant new and unique remedies. Eventually, formal chancery courts, or courts of equity, were established. Equity is a branch of law—founded on notions of justice Equity is a branch of law—founded on notions of justice Equity

and fair dealing—that seeks to supply a remedy when no adequate remedy at law is available.

Remedies in Equity The remedies granted by the equity courts became known as remedies in equity, or equitable remedies. These remedies include specific per- formance, injunction, and rescission. Specific performance involves ordering a party to perform an agreement as promised. An injunction is an order to a party to cease engaging in a specific activity or to undo some wrong or injury. Rescission is the cancellation of a contractual obli- gation. We will discuss these and other equitable remedies in more detail in later chapters.

As a general rule, today’s courts, like the early Eng- lish courts, will not grant equitable remedies unless the remedy at law—monetary damages—is inadethe remedy at law—monetary damages—is inadethe remedy at law—monetary damages—is inadethe remedy at law—monetary damages—is inade- quate. ■ EXAMPLE 1.2 Ted forms a contract (a legally Ted forms a contract (a legally binding agreement) to purchase a parcel of land that he thinks will be perfect for his future home. The seller breaches (fails to fulfill) this agreement. Ted could sue the seller for the return of any deposits or down payment he might have made on the land, but this is not the remedy he really wants. What Ted wants is to have a court order the seller to perform the contract. In other words, Ted will seek the equitable remedy of specific performance because monetary damages are inadequate in this situation. ■

Equitable Maxims In fashioning appropriate rem- edies, judges often were (and continue to be) guided by so-called equitable maxims—propositions or general statements of equitable rules. Exhibit 1–2 lists some important equitable maxims.

The last maxim listed in the exhibit—“Equity aids the vigilant, not those who rest on their rights”—merits special attention. It has become known as the equitable doctrine of laches (a term derived from the Latin laxus, meaning “lax” or “negligent”), and it can be used as a defense. A defense is an argument raised by the defen- dant (the party being sued) indicating why the plaintiff (the suing party) should not obtain the remedy sought. (Note that in equity proceedings, the party bringing a lawsuit is called the petitioner, and the party being sued is referred to as the respondent.)

The doctrine of laches arose to encourage people to bring lawsuits while the evidence was fresh. What consti- tutes a reasonable time, of course, varies according to the circumstances of the case. Time periods for different types of cases are now usually fixed by statutes of limitations. After the time allowed under a statute of limitations has expired, no action (lawsuit) can be brought, no matter how strong the case was originally.

C H A P T E R 1 Law and Legal Reasoning 7

1–3b Legal and Equitable Remedies Today The establishment of courts of equity in medieval Eng- land resulted in two distinct court systems: courts of law and courts of equity. The courts had different sets of judges and granted different types of remedies. Dur- ing the nineteenth century, however, most states in the United States adopted rules of procedure that resulted in the combining of courts of law and equity. A party now may request both legal and equitable remedies in the same action, and the trial court judge may grant either or both forms of relief.

The distinction between legal and equitable remedies remains relevant to students of business law, however, because these remedies differ. To seek the proper remedy for a wrong, you must know what remedies are avail- able. Additionally, certain vestiges of the procedures used when there were separate courts of law and equity still exist. For instance, a party has the right to demand a jury trial in an action at law, but not in an action in equity. Exhibit 1–3 summarizes the procedural differ- ences (applicable in most states) between an action at law and an action in equity.

1–3c The Doctrine of Stare Decisis One of the unique features of the common law is that it is judge-made law. The body of principles and doctrines judge-made law. The body of principles and doctrines judge-made that form the common law emerged over time as judges decided legal controversies.

Case Precedents and Case Reporters When possible, judges attempted to be consistent and to base their decisions on the principles suggested by earlier cases. They sought to decide similar cases in a similar way, and they considered new cases with care because they knew that their decisions would make new law. Each interpreta- tion became part of the law on the subject and thus served as a legal precedent. A precedent is a decision that fur- nishes an example or authority for deciding subsequent cases involving identical or similar legal principles or facts.

In the early years of the common law, there was no sin- gle place or publication where court opinions, or written decisions, could be found. By the fourteenth century, por- tions of the most important decisions from each year were being gathered together and recorded in Year Books, which became useful references for lawyers and judges. In the

E X H I B I T 1 – 2 Equitable Maxims

Equity will not suffer a wrong to be without

a remedy (equitable relief will be awarded when there is no legal remedy)

Equity regards substance rather than form

(fairness and justice are more important than legal

technicalities)

Equity aids the vigilant, not those who

rest on their rights (neglect their rights for an

unreasonable period of time)

One seeking the aid of an equity court must come to the court with clean hands

(have acted fairly and honestly)

Where there is equal equity, e is equal equity, e is equal equity the law must prevail (the law will determine

the outcome)

Whoever seeks equity must do equity (treat others fairly)

8 U N I T O N E The Foundations

sixteenth century, the Year Books were discontinued, and Year Books were discontinued, and Year Books other forms of case publication became available. Today, cases are published, or “reported,” in volumes called reportcases are published, or “reported,” in volumes called reportcases are published, or “reported,” in volumes called - ers, or reports—and are also posted online. We describe reports—and are also posted online. We describe reports— today’s case reporting system in detail later in this chapter.

Stare Decisis and the Common Law Tradition The practice of deciding new cases with reference to for- mer decisions, or precedents, became a cornerstone of the English and American judicial systems. The practice formed a doctrine known as stare decisis,3 a Latin phrase meaning “to stand on decided cases.”

Under the doctrine of stare decisis, judges are obli- gated to follow the precedents established within their jurisdictions. The term jurisdiction refers to a geographic area in which a court or courts have the power to apply the law. Once a court has set forth a principle of law as being applicable to a certain set of facts, that court must apply the principle in future cases involving similar facts. Courts of lower rank (within the same jurisdiction) must do likewise. Thus, stare decisis has two aspects:stare decisis has two aspects:stare decisis 1. A court should not overturn its own precedents

unless there is a compelling reason to do so. 2. Decisions made by a higher court are binding on

lower courts.

Controlling Precedents Precedents that must be followed within a jurisdiction are called controlling

precedents. Controlling precedents are a type of binding authority. A binding authority is any source of law that a binding authority is any source of law that a binding authority court must follow when deciding a case. Binding authori- ties include constitutions, statutes, and regulations that govern the issue being decided, as well as court decisions that are controlling precedents within the jurisdiction. United States Supreme Court case decisions, no matter how old, remain controlling until they are overruled by a subsequent decision of the Supreme Court or changed by further legislation or a constitutional amendment.

Stare Decisis and Legal Stability The doctrine of stare decisis helps the courts to be more efficient because, stare decisis helps the courts to be more efficient because, stare decisis if other courts have analyzed a similar case, their legal rea- soning and opinions can serve as guides. Stare decisis also Stare decisis also Stare decisis makes the law more stable and predictable. If the law on a subject is well settled, someone bringing a case can usu- ally rely on the court to rule based on what the law has been in the past. See this chapter’s Ethics Today feature for a discussion of how courts often defer to case precedent even when they disagree with the reasoning in the case.

Although courts are obligated to follow precedents, sometimes a court will depart from the rule of precedent if it decides that the precedent should no longer be fol- lowed. If a court decides that a ruling precedent is sim- ply incorrect or that technological or social changes have rendered the precedent inapplicable, the court might rule contrary to the precedent. Cases that overturn precedent often receive a great deal of publicity.often receive a great deal of publicity.often receive a great deal of publicity.often receive a great deal of publicity.

■ CASE IN POINT 1.3 The United States Supreme The United States Supreme Court expressly overturned precedent in the case of

E X H I B I T 1 – 3 Procedural Differences between Actions at Law and Actions in Equity

Monetary damages

Initiation of lawsuit

Parties

Result

Remedy

By filing a petition

Petitioner and respondent

Decree

Injunction, specific performance, or rescission

By filing a complaint

Plaintiff and defendant

Decision By judge (no jury)By jury or judge

Judgment

PROCEDURE

ACTION IN EQUITYACTION AT LAW

C H A P T E R 1 Law and Legal Reasoning 9

were inherently unequal. The Supreme Court’s depar- ture from precedent in this case received a tremendous amount of publicity as people began to realize the rami- fications of this change in the law. ■

Note that a lower court will sometimes avoid apply-Note that a lower court will sometimes avoid apply-Note that a lower court will sometimes avoid apply ing a precedent set by a higher court in its jurisdiction by

Brown v. Board of Education of Topeka.4 The Court con- cluded that separate educational facilities for whites and blacks, which it had previously upheld as constitutional,5

Stare Decisis versus Spider-Man

Supreme Court Justice Elena Kagan, in a recent decision involving Marvel Comics’ Spider- Man, ruled that, “What we can decide, we can undecide. But stare decisis teaches that we stare decisis teaches that we stare decisis should exercise that authority sparingly.” Cit- ing a Spider-Man comic book, she went on to say that “in this world, with great power there must also come—great responsibility.”a In its decision in the case—Kimble v. Marvel Entertainment, LLC—the Supreme Court applied LLC—the Supreme Court applied LLC stare decisis and ruled stare decisis and ruled stare decisis against Stephen Kimble, the creator of a toy related to the Spider-Man figure.b

Can a Patent Involving Spider-Man Last Super Long? A patent is an exclusive right granted to the creator of an invention. Under U.S. law, patent owners gener- ally possess that right for twenty years. Patent holders can license the use of their patents as they see fit dur- ing that period. In other words, they can allow others (called licensees) to use their invention in return for a fee (called royalties).

More than fifty years ago, the Supreme Court ruled in its Brulotte decision that a licensee cannot be forced Brulotte decision that a licensee cannot be forced Brulotte to pay royalties to a patent holder after the patent has expired.c So if a licensee signs a contract to continue to pay royalties after the patent has expired, the contract is invalid and thus unenforceable.

At issue in the Kimble case was a contract signed between Marvel Entertainment and Kimble, who had invented a toy made up of a glove equipped with a valve and a canister of pressurized foam. The patented toy allowed people to shoot fake webs intended to look like Spider-Man’s. In 1990, Kimble tried to cut a deal with Marvel Entertainment concerning his toy, but he was unsuccessful. Then Marvel started selling its own version of the toy.

When Kimble sued Marvel for patent infringement, he won. The result was a settle- ment that involved a licensing agreement between Kimble and Marvel with a lump-sum payment plus a royalty to Kimble of 3 percent of all sales of the toy. The agreement did not specify an end date for royalty payments to Kimble, and Marvel later sued to have the pay-

ments stop after the patent expired, consistent with the Court’s earlier Brulotte decision.

A majority of the Supreme Court justices agreed with Marvel. As Justice Kagan said in the opinion, “Patents endow their holders with certain super powers, but only for a limited time.” The court further noted that the fifty- year-old Brulotte decision was perhaps based on what Brulotte decision was perhaps based on what Brulotte today is an outmoded understanding of economics. That decision, according to some, may even hinder competi- tion and innovation. But “respecting stare decisis means stare decisis means stare decisis sticking to some wrong decisions.”

The Ethical Side In a dissenting opinion, Supreme Court Justice Samuel A. Alito, Jr., said, “The decision interferes with the abil- ity of parties to negotiate licensing agreements that reflect the true value of a patent, and it disrupts con- tractual expectations. Stare decisis does not require us Stare decisis does not require us Stare decisis to retain this baseless and damaging precedent. . . . Stare decisis is important to the rule of law, but so are Stare decisis is important to the rule of law, but so are Stare decisis correct judicial decisions.”

In other words, stare decisis holds that courts should stare decisis holds that courts should stare decisis adhere to precedent in order to promote predictability and consistency. But in the business world, shouldn’t parties to contracts be able to, for example, allow a patent licensee to make smaller royalty payments that exceed the life of the patent? Isn’t that a way to reduce the yearly costs to the licensee? After all, the licensee may be cash-strapped in its initial use of the patent. Shouldn’t the parties to a contract be the ones to decide how long the contract should last?

Critical Thinking When is the Supreme Court justified in not following the doctrine of stare decisis?

ETHICS TODAY

a. “Spider-Man,” Amazing Fantasy No. 15 (1962), p. 13. b. 576 U.S. __, 135 S.Ct. 2401, 192 L.Ed.2d 463 (2015). c. Brulotte v. Thys Co., 379 U.S. 29, 85 S.Ct. 176 (1964).

4. 347 U.S. 483, 74 S.Ct. 686, 98 L.Ed. 873 (1954). 5. See Plessy v. Ferguson, 163 U.S. 537, 16 S.Ct. 1138, 41 L.Ed. 256 (1896).Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

10 U N I T O N E The Foundations

distinguishing the two cases based on their facts. When this happens, the lower court’s ruling stands unless it is appealed to a higher court and that court overturns the decision.

When There Is No Precedent Occasionally, courts must decide cases for which no precedents exist, called cases of first impression. For instance, as you will read throughout this text, the Internet and certain other tech- nologies have presented many new and challenging issues for the courts to decide.

■ EXAMPLE 1.4 Google Glass is a Bluetooth-enabled, hands-free, wearable computer. A person using Google Glass can take photos and videos, surf the Internet, and do other things through voice commands. Many people expressed concerns about this new technology. Privacy advocates claimed that it is much easier to secretly film or photograph others with wearable video technology than with a camera or a smartphone. Indeed, numerous bars and restaurants, among others, banned the use of Google Glass to protect their patrons’ privacy. Police officers were concerned about driver safety. A California woman was ticketed for wearing Google Glass while driving. But the court dismissed this case of first impression because it was not clear whether the device had been in operation at the time of the offense. ■

In deciding cases of first impression, courts often look at persuasive authorities—legal authorities that a court may consult for guidance but that are not binding on the court. A court may consider precedents from other jurisdictions, for instance, although those precedents are not binding. A court may also consider legal principles and policies underlying previous court decisions or exist- ing statutes. Additionally, a court might look at issues of fairness, social values and customs, and public policy (governmental policy based on widely held societal val- ues). Today, federal courts can also look at unpublished opinions (those not intended for publication in a printed legal reporter) as sources of persuasive authority.6

1–3d Stare Decisis and Legal Reasoning In deciding what law applies to a given dispute and then applying that law to the facts or circumstances of the case, judges rely on the process of legal reasoning. Through the use of legal reasoning, judges harmonize their decisions with those that have been made before, as the doctrine of stare decisis requires.

Students of business law and the legal environment also engage in legal reasoning. For instance, you may be asked to provide answers for some of the case problems

that appear at the end of every chapter in this text. Each problem describes the facts of a particular dispute and the legal question at issue. If you are assigned a case problem, you will be asked to determine how a court would answer that question, and why. In other words, you will need to give legal reasons for whatever conclusion you reach.7 We look next at the basic steps involved in legal reasoning and then describe some forms of reasoning commonly used by the courts in making their decisions.

Basic Steps in Legal Reasoning At times, the legal arguments set forth in court opinions are rela- tively simple and brief. At other times, the arguments are complex and lengthy. Regardless of the length of a legal argument, however, the basic steps of the legal rea- soning process remain the same. These steps, which you can also follow when analyzing cases and case problems, form what is commonly referred to as the IRAC method of legal reasoning. IRAC is an acronym formed from the first letters of the words Issue, Rule, Application, and Con- clusion. To apply the IRAC method, you ask the follow- ing questions: 1. Issue—What are the key facts and issues? Suppose that

a plaintiff comes before the court claiming assault (words or acts that wrongfully and intentionally make another person fearful of immediate physi- cal harm). The plaintiff claims that the defendant threatened her while she was sleeping. Although the plaintiff was unaware that she was being threatened, her roommate heard the defendant make the threat. The legal issue is whether the defendant’s action constitutes the tort of assault, given that the plaintiff was unaware of that action at the time it occurred. (A tort is a wrongful act. As you will see later, torts fall under the governance of civil law rather than criminal law.)

2. Rule—What rule of law applies to the case? A rule of law may be a rule stated by the courts in previous decisions, a state or federal statute, or a state or federal administrative agency regulation. In our hypothetical case, the plaintiff alleges (claims) that the defendant committed a tort. Therefore, the applicable law is the common law of torts—specifically, tort law govern- ing assault. Case precedents involving similar facts and issues thus would be relevant. Often, more than one rule of law will be applicable to a case.

3. Application—How does the rule of law apply to the particular facts and circumstances of this case? This step is often the most difficult because each case presents a unique set of facts, circumstances, and parties.

6. See Rule 32.1 of the Federal Rules of Appellate Procedure. 7. See Appendix A for further instructions on how to analyze case problems.Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 1 Law and Legal Reasoning 11

Although cases may be similar, no two cases are ever identical in all respects. Normally, judges (and law- yers and law students) try to find cases on point— cases on point— cases on point previously decided cases that are as similar as possible to the one under consideration.

4. Conclusion—What conclusion should be drawn? This step normally presents few problems. Usually, the conclusion is evident if the previous three steps have been followed carefully.

There Is No One “Right” Answer Many people believe that there is one “right” answer to every legal question. In most legal controversies, however, there is no single correct result. Good arguments can usually be made to support either side of a legal controversy. Quite often, a case does not involve a “good” person suing a “bad” person. In many cases, both parties have acted in good faith in some measure or in bad faith to some degree. Additionally, each judge has her or his own per- sonal beliefs and philosophy. At least to some extent, these personal factors shape the legal reasoning process. In short, the outcome of a particular lawsuit before a court cannot be predicted with certainty.

1–3e The Common Law Today Today, the common law derived from judicial decisions continues to be applied throughout the United States. Common law doctrines and principles, however, govern only areas not covered by statutory or administrative law. In not covered by statutory or administrative law. In not a dispute concerning a particular employment practice, for instance, if a statute regulates that practice, the statute will apply rather than the common law doctrine that applied before the statute was enacted. The common law tradition and its application are reviewed in Concept Summary 1.2.

Courts Interpret Statutes Even in areas governed by statutory law, judge-made law continues to be impor- tant because there is a significant interplay between statu- tory law and the common law. For instance, many statutes essentially codify existing common law rules, and regula- tions issued by various administrative agencies usually are based, at least in part, on common law principles. Addi- tionally, the courts, in interpreting statutory law, often rely on the common law as a guide to what the legislators intended. Frequently, the applicability of a newly enacted statute does not become clear until a body of case law devel- ops to clarify how, when, and to whom the statute applies.

ETHICS TODAY

The Common Law Tradition

The American legal system is based on the common law tradition, which originated in medieval England.

Remedies at law (land, items of value, or money) and remedies in equity (including specific performance, injunction, and rescission of a contractual obligation) originated in the early English courts of law and courts of equity, respectively.

Case Precedents and the Doctrine of Stare DecisisStare DecisisStar

In the king’s courts, judges attempted to make their decisions consistent with previous decisions, called precedents. This practice gave rise to the doctrine of stare decisis. This doctrine, which became a cornerstone of the common law tradition, obligates judges to abide by precedents established in their jurisdictions.

Concept SuETHICS TODAConcept SuETHICS TODAmmarETHICS TODAmmarETHICS TODAy ETHICS TODAy ETHICS TODAETHICS TODAYETHICS TODAy ETHICS TODAYETHICS TODA 1.2

Origins of Common Law

The common law governs all areas not covered by statutory law or administrative laws. Courts interpret statutes and regulations.

Common Law TodayCommon Law TodayCommon Law T

Legal and Equitable Remedies

12 U N I T O N E The Foundations

Clearly, a judge’s function is not to make the laws—that make the laws—that make is the function of the legislative branch of government— but to interpret and apply them. From a practical point of view, however, the courts play a significant role in defining the laws enacted by legislative bodies, which tend to be expressed in general terms. Judges thus have some flexibility in interpreting and applying the law. It is because of this flexibility that different courts can, and often do, arrive at different conclusions in cases that involve nearly identical issues, facts, and applicable laws.

Restatements of the Law Clarify and Illus- trate the Common Law The American Law Insti- tute (ALI) has published compilations of the common law called Restatements of the Law, which generally summarize the common law rules followed by most states. There are Restatements of the Law in the areas of contracts, torts, Restatements of the Law in the areas of contracts, torts, Restatements of the Law agency, trusts, property, restitution, security, judgments, and conflict of laws. The Restatements, like other secondary sources of law, do not in themselves have the force of law, but they are an important source of legal analysis and opin- ion. Hence, judges often rely on them in making decisions.

Many of the Restatements are now in their second, third, Restatements are now in their second, third, Restatements or fourth editions. We refer to the Restatements frequently Restatements frequently Restatements in subsequent chapters of this text, indicating in parenthe- ses the edition to which we are referring. For instance, we refer to the third edition of the Restatement of the Law of Contracts as simply the Contracts as simply the Contracts Restatement (Third) of Contracts.

1–4 Schools of Legal Thought How judges apply the law to specific cases, including dis- putes relating to the business world, depends in part on their philosophical approaches to law. Thus, the study of law, or jurisprudence, involves learning about different schools of legal thought and how the approaches to law characteristic of each school can affect judicial decision making.

1–4a The Natural Law School An age-old question about the nature of law has to do with the finality of a nation’s laws. What if a particular law is deemed to be a “bad” law by a substantial number of the nation’s citizens? Must they obey that law? According to the natural law theory, a higher, or universal, law exists that applies to all human beings. Each written law should reflect the principles inherent in natural law. If it does not, then it loses its legitimacy and need not be obeyed.

The natural law tradition is one of the oldest and most significant schools of jurisprudence. It dates back to the days of the Greek philosopher Aristotle (384–322

b.c.e.), who distinguished between natural law and the laws governing a particular nation. According to Aristo- tle, natural law applies universally to all humankind.

The notion that people have “natural rights” stems from the natural law tradition. Those who claim that a specific foreign government is depriving certain citizens of their human rights, for instance, are implicitly appeal- ing to a higher law that has universal applicability.

The question of the universality of basic human rights also comes into play in the context of international busi- ness operations. U.S. companies that have operations abroad often hire foreign workers as employees. Should the same laws that protect U.S. employees apply to these foreign employees? This question is rooted implicitly in a concept of universal rights that has its origins in the natural law tradition.

1–4b The Positivist School Positive law, or national law, is the written law of a given society at a particular time. In contrast to natural law, it applies only to the citizens of that nation or society. Those who adhere to legal positivism believe that there can be no higher law than a nation’s positive law.

According to the positivist school, there are no “natu- ral rights.” Rather, human rights exist solely because of laws. If the laws are not enforced, anarchy will result. Thus, whether a law is “bad” or “good” is irrelevant. The law is the law and must be obeyed until it is changed—in an orderly manner through a legitimate lawmaking pro- cess. A judge who takes this view will probably be more inclined to defer to an existing law than would a judge who adheres to the natural law tradition.

1–4c The Historical School The historical school of legal thought emphasizes the evo- lutionary process of law by concentrating on the origin and history of the legal system. This school looks to the past to discover what the principles of contemporary law should be. The legal doctrines that have withstood the passage of time—those that have worked in the past—are deemed best suited for shaping present laws. Hence, law derives its legitimacy and authority from adhering to the standards that historical development has shown to be workable. Fol- lowers of the historical school are more likely than those of other schools to strictly follow decisions made in past cases.

1–4d Legal Realism In the 1920s and 1930s, a number of jurists and scholars, known as legal realists, rebelled against the historical approach

C H A P T E R 1 Law and Legal Reasoning 13

to law. Legal realism is based on the idea that law is just one of many institutions in society and that it is shaped by social forces and needs. Because the law is a human enterprise, this school reasons that judges should take social and economic realities into account when deciding cases.

Legal realists also believe that the law can never be applied with total uniformity. Given that judges are human beings with unique personalities, value systems, and intellects, different judges will obviously bring differ- ent reasoning processes to the same case. Female judges, for instance, might be more inclined than male judges to consider whether a decision might have a negative impact on the employment of women or minorities.

Legal realism strongly influenced the growth of what is sometimes called the sociological school, which views law as a tool for promoting justice in society. In the 1960s, for instance, the justices of the United States Supreme Court helped advance the civil rights movement by upholding long-neglected laws calling for equal treatment for all Americans, including African Americans and other minor- ities. Generally, jurists who adhere to this philosophy of law are more likely to depart from past decisions than are jurists who adhere to other schools of legal thought.

Concept Summary 1.3 reviews the schools of juris- prudential thought.

1–5 Classifications of Law The law may be broken down according to several clas- sification systems. One system, for instance, divides law into substantive law and procedural law. Substantive law consists of all laws that define, describe, regulate, and create legal rights and obligations. Procedural law consists of all laws that outline the methods of enforcing the rights established by substantive law.

Note that many statutes contain both substantive and procedural provisions. ■ EXAMPLE 1.5 A state law that A state law that provides employees with the right to workers’ compensa- tion benefits for on-the-job injuries is a substantive law tion benefits for on-the-job injuries is a substantive law tion benefits because it creates legal rights. Procedural laws estab- lish the method by which an employee must notify the employer about an on-the-job injury, prove the injury, and periodically submit additional proof to continue receiving workers’ compensation benefits. ■

Other classification systems divide law into federal law and state law, private law (dealing with relationships between private entities) and public law (addressing the relationship between persons and their governments), and national law and international law. Here we look at still another classification system, which divides law into

ETHICS TODAY

Schools of Jurisprudential Thought

One of the oldest and most significant schools of legal thought. Those who believe in natural law hold that there is a universal law applicable to all human beings.

Concept SuETHICS TODAConcept SuETHICS TODAmmarETHICS TODAmmarETHICS TODAy ETHICS TODAy ETHICS TODAETHICS TODAYETHICS TODAy ETHICS TODAYETHICS TODA 1.3

Natural Law School

A school of legal thought that stresses the evolutionary nature of law and looks to doctrines that have withstood the passage of time for guidance in shaping present laws.

Historical School

A school of legal thought that advocates a less abstract and more realistic and pragmatic approach to the law and takes into account customary practices and the circumstances surrounding the particular transaction.

Legal Realism

A school of legal thought centered on the assumption that there is no law higher than the laws created by the government.

Positivist School

14 U N I T O N E The Foundations

civil law and criminal law. We also explain what is meant by the term cyberlaw.

1–5a Civil Law and Criminal Law Civil law spells out the rights and duties that exist between persons and between persons and their govern- ments, as well as the relief available when a person’s rights are violated. Typically, in a civil case, a private party sues another private party who has failed to comply with a duty. (Note that the government can also sue a party for a civil law violation.) Much of the law that we discuss in this text is civil law, including contract law and tort law.

Criminal law, in contrast, is concerned with wrongs committed against the public as a whole. Criminal acts are defined and prohibited by local, state, or federal govern- ment statutes. Criminal defendants are thus prosecuted by public officials, such as a district attorney (D.A.), on behalf of the state, not by their victims or other private parties. Some statutes, such as those protecting the environment or investors, have both civil and criminal provisions.

1–5b Cyberlaw The use of the Internet to conduct business has led to new types of legal issues. In response, courts have had to adapt traditional laws to situations that are unique to our age. Additionally, legislatures at both the federal and the state levels have created laws to deal specifically with such issues.

Frequently, people use the term cyberlaw to refer to the emerging body of law that governs transactions con- ducted via the Internet. Cyberlaw is not really a classifica- tion of law, though, nor is it a new type of law. Rather, it type of law. Rather, it type is an informal term used to refer to both new laws and modifications of traditional laws that relate to the online environment. Throughout this book, you will read how the law in a given area is evolving to govern specific legal issues that arise in the online context.

1–6 How to Find Primary Sources of Law

This text includes numerous references, or citations, to primary sources of law—federal and state statutes, the U.S. Constitution and state constitutions, regula- tions issued by administrative agencies, and court cases. A citation identifies the publication in which a legal authority—such as a statute or a court decision or other source—can be found. In this section, we explain how you can use citations to find primary sources of law. Note

that in addition to being published in sets of books, as described next, most federal and state laws and case deci- sions are available online.

1–6a Finding Statutory and Administrative Law

When Congress passes laws, they are collected in a pub- lication titled United States Statutes at Large. When state legislatures pass laws, they are collected in similar state publications. Most frequently, however, laws are referred to in their codified form—that is, the form in which they appear in the federal and state codes. In these codes, laws are compiled by subject.

United States Code The United States Code (U.S.C.) United States Code (U.S.C.) United States Code arranges all existing federal laws by broad subject. Each of the fifty-two subjects is given a title and a title number. For instance, laws relating to commerce and trade are col- lected in Title 15, “Commerce and Trade.” Each title is subdivided by sections. A citation to the U.S.C. includes both title and section numbers. Thus, a reference to “15 U.S.C. Section 1” means that the statute can be found in Section 1 of Title 15. (“Section” may be designated by the symbol §, and “Sections,” by §§.)

In addition to the print publication, the federal gov- ernment provides a searchable online database at www .gpo.gov. It includes the United States Code, the U.S. Constitution, and many other federal resources. (Click on “Libraries” and then “Core Documents of Our Democracy” to find these resources.)

Commercial publications of federal laws and regula- tions are also available. For instance, Thomson Reuters publishes the United States Code Annotated (U.S.C.A.). United States Code Annotated (U.S.C.A.). United States Code Annotated The U.S.C.A. contains the official text of the U.S.C., plus notes (annotations) on court decisions that interpret and apply specific sections of the statutes. The U.S.C.A. also includes additional research aids, such as cross- references to related statutes, historical notes, and library references. A citation to the U.S.C.A. is similar to a cita- tion to the U.S.C.: “15 U.S.C.A. Section 1.”

State Codes State codes follow the U.S.C. pattern of arranging law by subject. They may be called codes, revi- sions, compilations, consolidations, general statutes, or statutes, depending on the preferences of the states.

In some codes, subjects are designated by number. In some codes, subjects are designated by number. In some codes, subjects are designated by number. In others, they are designated by name. ■ EXAMPLE 1.6 “13 Pennsylvania Consolidated Statutes Section 1101” means that the statute can be found in Title 13, Section 1101, of the Pennsylvania code. “California Commercial Code Section 1101” means that the statute can be found

C H A P T E R 1 Law and Legal Reasoning 15

under the subject heading “Commercial Code” of the California code in Section 1101. Abbreviations are often used. For example, “13 Pennsylvania Consolidated Stat- utes Section 1101” is abbreviated “13 Pa. C.S. § 1101,” and “California Commercial Code Section 1101” is abbreviated “Cal. Com. Code § 1101.” ■

Administrative Rules Rules and regulations adopted by federal administrative agencies are initially published in the Federal Register, a daily publication of the U.S. gov- ernment. Later, they are incorporated into the Code of Federal Regulations (C.F.R.). The C.F.R. is available online Federal Regulations (C.F.R.). The C.F.R. is available online Federal Regulations on the government database (www.gpo.gov).

Like the U.S.C., the C.F.R. is divided into titles. Rules within each title are assigned section numbers. A full citation to the C.F.R. includes title and section num- bers. ■ EXAMPLE 1.7 A reference to “17 C.F.R. Section 230.504” means that the rule can be found in Section 230.504 of Title 17. ■

1–6b Finding Case Law Before discussing the case reporting system, we need to look briefly at the court system. There are two types of courts in the United States, federal courts and state courts. Both systems consist of several levels, or tiers, of courts. Trial courts, in which evidence is presented and testimony given, are on the bottom tier. Decisions from a trial court can be appealed to a higher court, which commonly is an intermediate court of appeals, or appellate court. Decisions from these intermediate courts of appeals may be appealed to an even higher court, such as a state supreme court or the United States Supreme Court.

State Court Decisions Most state trial court deci- sions are not published in books (except in New York and a few other states, which publish selected trial court opin- ions). Decisions from state trial courts are typically filed in the office of the clerk of the court, where the decisions are available for public inspection. (Increasingly, they can be found online as well.)

Written decisions of the appellate, or reviewing, courts, however, are published and distributed (in print and online). As you will note, most of the state court cases presented in this textbook are from state appellate courts. The reported appellate decisions are published in volumes called reports or reports or reports reporters, which are numbered consecutively. State appellate court decisions are found in the state reporters of that particular state. Official reports are published by the state, whereas unofficial reports are published by nongovernment entities.

Regional Reporters. State court opinions appear in regional units of the West’s National Reporter System, published by �omson Reuters. Most lawyers and librar- ies have these reporters because they report cases more quickly and are distributed more widely than the state- published reporters. In fact, many states have eliminated their own reporters in favor of the National Reporter System.

The National Reporter System divides the states into the following geographic areas: Atlantic (A., A.2d, Atlantic (A., A.2d, Atlantic or A.3d), North Eastern (N.E. or N.E.2d), North West-North West-North West ern (N.W. or N.W.2d), Pacific (P., P.2d, or P.3d), Pacific (P., P.2d, or P.3d), Pacific South Eastern (S.E. or S.E.2d), South Western (S.W., S.W.2d, or S.W.3d), and Southern (So., So.2d, or So.3d). (The 2d and 2d and 2d 3d in the preceding abbreviations refer to 3d in the preceding abbreviations refer to 3d Sec- ond Series and ond Series and ond Series Third Series, respectively.) The states included in each of these regional divisions are indi- cated in Exhibit 1–4, which illustrates the National Reporter System.

Case Citations. After appellate decisions have been pub- lished, they are normally referred to (cited) by the name of the case and the volume, name, and page number of the reporter(s) in which the opinion can be found. �e citation �rst lists the state’s o�cial reporter (if di�erent from the National Reporter System), then the National Reporter, and then any other selected reporter. (Citing a reporter by volume number, name, and page number, in that order, is common to all citations. �e year that the decision was issued is often included at the end in parentheses.) When more than one reporter is cited for the same case, each reference is called a parallel citation.

Note that some states have adopted a “public domain citation system” that uses a somewhat different format for the citation. For instance, in Wisconsin, a Wiscon- sin Supreme Court decision might be designated “2016 WI 40,” meaning that the case was decided in the year 2016 by the Wisconsin Supreme Court and was the forti- eth decision issued by that court during that year. Parallel citations to the Wisconsin Reports and the Wisconsin Reports and the Wisconsin Reports North Western Reporter Reporter Reporter are still included after the public domain citation.

■ EXAMPLE 1.8 Consider the following case citation: Summerhill, LLC v. City of Meridan, 162 Conn.App. 469, 131 A.3d. 1225 (2016). We see that the opinion in this case can be found in Volume 162 of the official Con- necticut Appellate Court Reports, on page 469. The paral- lel citation is to Volume 131 of the Atlantic Reporter, Third Series, page 1225. ■

When we present opinions in this text, in addition to the reporter, we give the name of the court hearing the case and the year of the court’s decision. Sample citations to state court decisions are explained in Exhibit 1–5.

16 U N I T O N E The Foundations

E X H I B I T 1 – 4 National Reporter System—Regional/Federal

NATIONAL REPORTER SYSTEM MAP

Coverage Connecticut, Delaware, District of Columbia, Maine, Maryland, New Hampshire, New Jersey, Pennsylvania, Rhode Island, and Ve, New Jersey, Pennsylvania, Rhode Island, and Ve, New Jersey er, Pennsylvania, Rhode Island, and Ver, Pennsylvania, Rhode Island, and V mont. Illinois, Indiana, Massachusetts, New York, and Ohio.Illinois, Indiana, Massachusetts, New York, and Ohio.Illinois, Indiana, Massachusetts, New Y Iowa, Michigan, Minnesota, Nebraska, North Dakota, South Dakota, and Wisconsin. Alaska, Arizona, California, Colorado, Hawaii, Idaho, Kansas, Montana, Nevada, New Mexico, Oklahoma, Oregon, Utah, Washington, and Wyoming. Georgia, North Carolina, South Carolina, Virginia, and West Virginia. Arkansas, Kentucky, Missouri, TArkansas, Kentucky, Missouri, TArkansas, Kentucky ennessee, and T, Missouri, Tennessee, and T, Missouri, T exas.ennessee, and Texas.ennessee, and T

Alabama, Florida, Louisiana, and Mississippi.

U.S. Circuit Courts from 1880 to 1912; U.S. Commerce Court from 1911 to 1913; U.S. District Courts from 1880 to 1932; U.S. Court of Claims (now called U.S. Court of Federal Claims) from 1929 to 1932 and since 1960; U.S. Courts of Appeals since 1891; U.S. Court of Customs and Patent Appeals since 1929; U.S. Emergency Court of Appeals since 1943. U.S. Court of Claims from 1932 to 1960; U.S. District Courts since 1932; U.S. Customs Court since 1956. U.S. District Courts involving the Federal Rules of Civil Procedure since 1939 and Federal Rules of Criminal Procedure since 1946. United States Supreme Court since the October term of 1882. Bankruptcy decisions of U.S. Bankruptcy Courts, U.S. District Courts, U.S. Courts of Appeals, and the United States Supreme Court. U.S. Court of Military Appeals and Courts of Military Review for the Army, Navy, Air ForNavy, Air ForNavy ce, and Coast Guard.

1885

1885 1879

1883

1887 1886

1887

1880

1932

1939

1882 1980

1978

Atlantic Reporter (A., A.2d, or A.3d)

North Eastern Reporth Eastern Reporth Easter ter (N.E. or N.E.2d) North Westerth Westerth W n Reporestern Reporester ter (N.W. or N.W.2d)

Pacific Reporter (P., P (P., P (P .2d, or P., P.2d, or P., P .3d).2d, or P.3d).2d, or P

South Eastern ReporSouth Eastern ReporSouth Easter ter (S.E. or S.E.2d) South WesterSouth WesterSouth W n Reporestern Reporester ter (S.W., S.W.2d, or S.W.3d) Southern ReporSouthern ReporSouther ter (So., So.2d, or So.3d)

Federal Reporters Federal Reporter (F., F.2d, or F.3d)

Federal Supplement (F.Supp., F.Supp.2d, or F.Supp.3d)

Federal Rules Decisions (F.R.D.)

Supreme CourSupreme CourSupr t Reporter (S.Ct.) Bankruptcy Reporter (Bankr.)

Military Justice ReporMilitary Justice ReporMilitar ter (M.J.)

Regional Reporters Coverage Beginning

TENN.

VT.VT.

ALASKA

HAWAIIHAWAIIHAWAIIHAWAIIHAWAIIHAWAIIHAWAIIHAWAIIHAWAIIHAWAIIHAWAII

WASH.

OREGON

CALIF.

NEVADA

IDAHO

MONTANA

WYOMING

UTAH

ARIZONA N. MEXICO

COLORADO

NEBR.

S. DAK.

N. DAK.

KANSAS

OKLA.

TEXAS

ARK.

MO.

IOWA

MINN.

WIS.

ILL. IND.

MICH.

OHIO

KY.

MISS. ALA.

LA.

GA.

FLA.

S. CAR.

N. CAR.

VA. W.VA.

PA.

N.Y.

ME.

DEL.DEL.DEL.DEL.DEL.DEL.DEL.DEL.DEL.DEL.DEL.DEL.DEL.DEL.DEL. MD.MD.MD.MD.MD.MD.

N.J. CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.CONN.

R.I.R.I.R.I.R.I.

MASS.MASS.MASS.MASS.MASS.MASS. N.H.N.H.N.H.N.H.N.H.N.H.N.H.N.H.N.H.N.H.

PacificPacificPacificPacific North WesterNorth WesterNorth WesterNorth Western South WesteSouth WesteSouth WesteSouth Western North EasterNorth EasterNorth EasterNorth Eastern AtlanticAtlanticAtlantic South EasteSouth EasteSouth Eastern SoutherSoutherSouthern

C H A P T E R 1 Law and Legal Reasoning 17

E X H I B I T 1 – 5 How to Read Citations

292 Neb. 681, 874 N.W.2d 681 (2016)292 Neb. 681, 874 N.W.2d 681 (2016)292 Neb. 681, 874 N.W a

243 Cal.App.4th 1366, 197 Cal.Rptr.3d 647 (2016) 243 Cal.App.4th 1366, 197 Cal.Rptr.3d 647 (2016) 243 Cal.App.4th 1366, 197 Cal.Rptr

136 A.D.3d 1094, 24 N.Y.S.3d 448 (2016) 136 A.D.3d 1094, 24 N.Y.S.3d 448 (2016) 136 A.D.3d 1094, 24 N.Y

298 Ga.App. 324, 781 S.E.2d 772 (2016)

___ U.S. ___, 136 S.Ct. 651, 193 L.Ed.2d 556 (2016)

a. The case names have been deleted from these citations to emphasize the publications. It should be kept in mind, however, that om these citations to emphasize the publications. It should be kept in mind, however, that om these citations to emphasize the publications. It should be kept in mind, however the name of a case is as important as the specific page numbers in the volumes in which it is found. If a citation is incorrect, the correct citation may be found in a publication’s index of case names. In addition to providing a check on errors in citations, the date of a case is important because the value of a recent case as an authority is likely to be greater than that of older cases from the same court.

136 A.D.3d 1094, 24 N.Y.S.3d 448 (2016)

___ U.S. ___, 136 S.Ct. 651, 193 L.Ed.2d 556 (2016)

243 Cal.App.4th 1366, 197 Cal.Rptr

136 A.D.3d 1094, 24 N.Y136 A.D.3d 1094, 24 N.Y

STATE COURTS

FEDERAL COURTS

N.WN.W.N.W is the abbreviation for the publication of state court decisions rendered in the North Western Reporter North Western Reporter North W of West’s National Reporter System. est’s National Reporter System. est’ 2d indicates that this case was included in the 2d indicates that this case was included in the 2d Second Series of that Second Series of that Second Series reporter.

Neb. is an abbreviation for Nebraska Reports, Nebraska’s of Nebraska’s of Nebraska’ ficial rs official rs of eports of the decisions of its highest court, the Nebraska Supreme Court.

Cal.RptrCal.Rptr.Cal.Rptr is the abbreviation for the unofficial reviation for the unofficial reviation for the unof eports—titled California Reporter—California Reporter—California Reporter of the decisions of California courts.

N.Y.S. is the abbreviation for the unofficial reviation for the unofficial reviation for the unof eports—titled New YoNew YoNew Y rk Supplement—of the decisions of New Yt—of the decisions of New Yt ork courts.—of the decisions of New York courts.—of the decisions of New Y

A.D. is the abbreviation for the New York Appellate Division ReportsNew York Appellate Division ReportsNew Y , which hears appeals from the New York Suprom the New York Suprom the New Y eme Court—the state’s general trial court. The New Yeme Court—the state’s general trial court. The New Yeme Court—the state’ ork Court s general trial court. The New York Court s general trial court. The New Y of Appeals is the state’s highest court, analogous to other states’ suprof Appeals is the state’s highest court, analogous to other states’ suprof Appeals is the state’ eme courts.

Ga.App. is the abbreviation for Georgia Appeals Reports, Georgia’s of Georgia’s of Georgia’ ficial rs official rs of eports of the decisions of its court of appeals.

L.Ed. is an abbreviation for Lawyers’ Edition of the Supreme Court Reports, an unofficial edition of decisions of the , an unofficial edition of decisions of the , an unof United States Supreme Court.

S.Ct. is the abbreviation for West’s unofest’s unofest’ ficial rs unofficial rs unof eports—titled Supreme Court Reporter—of decisions of the United States SuprCourt Reporter—of decisions of the United States SuprCourt Reporter eme Court.

U.S. is the abbreviation for United States Reports, the official edition of the , the official edition of the , the of decisions of the United States Supreme Court. The blank lines in this citation (or any other citation) indicate that the appropriate volume of the case reporter has not yet been published and no page number is available.

Continued

18 U N I T O N E The Foundations

E X H I B I T 1 – 5 How to Read Citations—Continued

809 F.3d 376 (7th Cir809 F.3d 376 (7th Cir809 F . 2016) .3d 376 (7th Cir. 2016) .3d 376 (7th Cir

___ F.Supp.3d ___ (E.D.Cal. 2016) ___ F.Supp.3d ___ (E.D.Cal. 2016) ___ F

18 U.S.C. Section 1961(1)(A)

UCC 2–206(1)(b)

Restatement (Third) of TRestatement (Third) of TRestatement (Thir orts, d) of Torts, d) of T Section 6

17 C.F.R. Section 230.50517 C.F.R. Section 230.50517 C.F

.3d 376 (7th Cir

18 U.S.C. Section 1961(1)(A)

2016 WL 66334

b. Many court decisions that are not yet published or that are not intended for publication can be accessed through Westlaw, an online legal database.

FEDERAL COURTS (Continued)

WESTLAW® CITATIONSb

STATUTORY AND OTHER CITATIONS

7th Cir7th Cir.7th Cir is an abbreviation denoting that this case was decided in the U.S. Court of Appeals for the Seventh Circuit.

E.D.Cal. is an abbreviation indicating that the U.S. District Court for the Eastern District of California decided this case.

U.S.C. denotes United States Code, the codification of United States Statutes at Large. The number 18 refers to the statute’s U.S.C. title numberefers to the statute’s U.S.C. title numberefers to the statute’ and 1961 to its section number within that title. The number 1 in parentheses refers to a subsection within the section, and the letter A in parentheses to a subsection within the subsection.

UCC is an abbrUCC is an abbrUCC eviation for Uniform Commercial Code. The first number 2 is a reference to an article of the UCC, and 206 to a section within that article. The number 1 in parentheses refers to a subsection within the section, and the letter b in parentheses to a subsection within the subsection.

Restatement (Third) of TortsRestatement (Third) of TortsRestatement (Third) of T rorts rorts efers to the third edition of the American Law Institute’s Law Institute’s Law Institute’ Restatement of the Law of TortsRestatement of the Law of TortsRestatement of the Law of T . The number 6 refers to a specific section.

C.F.R.C.F.R.C.F is an abbreviation for Code of Federal Regulations, a compilation of federal administrative regulations. The number 17 designates the regulation’s egulation’s egulation’ title number, and 230.505 designates a specific section within that title.title number, and 230.505 designates a specific section within that title.title number

WL is an abbreviation for Westlaw. The number 2016 is the year of the document that can be found with this citation in the Westlaw database. The number 66334 is a number assigned to a specific document. A higher number indicates that a document was added to the Westlaw database later in the year.

C H A P T E R 1 Law and Legal Reasoning 19

Federal Court Decisions Federal district (trial) court decisions are published unofficially in the Federal Supple- ment (F.Supp. or F.Supp.2d), and opinions from the cirment (F.Supp. or F.Supp.2d), and opinions from the cirment - cuit courts of appeals (reviewing courts) are reported unofficially in the Federal Reporter (F., F.2d, or F.3d). Federal Reporter (F., F.2d, or F.3d). Federal Reporter Cases concerning federal bankruptcy law are published unofficially in the Bankruptcy Reporter (Bankr. or B.R.).Bankruptcy Reporter (Bankr. or B.R.).Bankruptcy Reporter

The official edition of the United States Supreme Court decisions is the United States Reports (U.S.), which is pubUnited States Reports (U.S.), which is pubUnited States Reports - lished by the federal government. Unofficial editions of Supreme Court cases include the Supreme Court Reporter (S.Ct.) and the Lawyers’ Edition of the Supreme Court Reports (L.Ed. or L.Ed.2d). Sample citations for federal court deci- sions are also listed and explained in Exhibit 1–5.

Unpublished Opinions Many court opinions that are not yet published or that are not intended for publi- cation can be accessed through Thomson Reuters West- law® (abbreviated in citations as “WL”), an online legal database. When no citation to a published reporter is available for cases cited in this text, we give the WL cita- tion (such as 2016 WL 145734, which means it was case number 145734 decided in the year 2016). In addition, federal appellate court decisions that are designated as unpublished may appear in the Federal Appendix (Fed.Federal Appendix (Fed.Federal Appendix Appx.) of the National Reporter System.

Old Case Law On a few occasions, this text cites opin- ions from old, classic cases dating to the nineteenth cen- tury or earlier. Some of these are from the English courts. The citations to these cases may not conform to the descriptions just presented because the reporters in which they were originally published were often known by the names of the persons who compiled the reporters.

1–7 How to Read and Understand Case Law

The decisions made by the courts establish the boundar- ies of the law as it applies to almost all business relation- ships. It thus is essential that businesspersons know how to read and understand case law.

The cases that we present in this text have been con- densed from the full text of the courts’ opinions and are presented in a special format. In approximately two-thirds of the cases (including the cases designated as Classic and Classic and Classic Spotlight), we have summarized the backSpotlight), we have summarized the backSpotlight - ground and facts, as well as the court’s decision and rem- edy, in our own words. In those cases, we have included only selected excerpts from the court’s opinion (“In the

Language of the Court”). In the remaining one-third of the cases (labeled “Case Analysis”), we have provided a longer excerpt from the court’s opinion without summa- rizing the background and facts or decision and remedy.

The following sections provide useful insights into how to read and understand case law.

1–7a Case Titles and Terminology The title of a case, such as Adams v. Jones, indicates the names of the parties to the lawsuit. The v. in the case title stands for versus, which means “against.” In the trial court, Adams was the plaintiff—the person who filed the suit. Jones was the defendant.

If the case is appealed, however, the appellate court will sometimes place the name of the party appealing the decision first, so the case may be called Jones v. Adams if Jones appealed. Because some appellate courts retain the trial court order of names, it is often impossible to distinguish the plaintiff from the defendant in the title of a reported appellate court decision. You must carefully read the facts of each case to identify the parties.

The following terms, phrases, and abbreviations are frequently encountered in court opinions and legal publications.

Parties to Lawsuits The party initiating a lawsuit is referred to as the plaintiff or plaintiff or plaintiff petitioner, depending on the petitioner, depending on the petitioner nature of the action. The party against whom a lawsuit is brought is the defendant or defendant or defendant respondent. Lawsuits frerespondent. Lawsuits frerespondent - quently involve more than one plaintiff and/or defendant.

When a case is appealed from the original court or jurisdiction to another court or jurisdiction, the party appealing the case is called the appellant. The appellee is the party against whom the appeal is taken. (In some appellate courts, the party appealing a case is referred to as the petitioner, and the party against whom the suit is brought or appealed is called the respondent.)

Judges and Justices The terms judge and judge and judge justice are justice are justice usually synonymous and represent two designations given to judges in various courts. All members of the United States Supreme Court, for instance, are referred to as justices. Justice is the formal title often given to judges of appellate courts, although this is not always true. In New York, a justice is a judge of the trial court (called the Supreme Court), and a member of the Court of Appeals (the state’s highest court) is called a judge.

The term justice is commonly abbreviated to J., and justice is commonly abbreviated to J., and justice justices, to JJ. A United States Supreme Court case might refer to Justice Sotomayor as Sotomayor, J., or to Chief Justice Roberts as Roberts, C.J.

20 U N I T O N E The Foundations

Decisions and Opinions Most decisions reached by reviewing, or appellate, courts are explained in written opinions. The opinion contains the court’s reasons for its decision, the rules of law that apply, and the judgment. You may encounter several types of opinions as you read appellate cases, including the following: • When all the judges (or justices) agree, a unanimous

opinion is written for the entire court. • When there is not unanimous agreement, a majority

opinion is generally written. It outlines the views of the majority of the judges deciding the case.

• A judge who agrees (concurs) with the majority opin- ion as to the result but not as to the legal reasoning often writes a concurring opinion. In it, the judge sets out the reasoning that he or she considers correct.

• A dissenting opinion presents the views of one or more judges who disagree with the majority view.

• Sometimes, no single position is fully supported by a majority of the judges deciding a case. In this situ- ation, we may have a plurality opinion. This is the opinion that has the support of the largest number of judges, but the group in agreement is less than a majority.

• Finally, a court occasionally issues a per curiam opin- ion (per curiamion (per curiamion ( is Latin for “of the court”), which does not indicate which judge wrote the opinion.

1–7b Sample Court Case To illustrate the various elements contained in a court opinion, we present an annotated court opinion in Exhibit 1–6. The opinion is from an actual case that the United States Court of Appeals for the Eleventh Circuit decided in 2016.

Background of the Case In December 1955, on a bus in Montgomery, Alabama, Rosa Parks refused to give up her seat to a white man in violation of the city’s seg- regation law. This “courageous act” sparked the modern civil rights movement. Parks’s role in “the most signifi- cant social movement in the history of the United States” has been chronicled in books and movies, and featured on mementoes, some of which are offered for sale by

Target Corp. The Rosa and Raymond Parks Institute for Self Development is a Michigan firm that owns the right to use Parks’s name and likeness for commercial pur- poses. The Institute filed a suit in a federal district court against Target, alleging misappropriation in violation of the Institute’s right of publicity. The court dismissed the complaint. The Institute appealed to the U.S. Court of Appeals for the Eleventh Circuit, arguing that Target’s sales of books, movies, and other items that depict or dis- cuss Rosa Parks and the modern civil rights movement violated Michigan law.

Editorial Practice You will note that triple asterisks (* * *) and quadruple asterisks (* * * *) frequently appear in the opinion. The triple asterisks indicate that we have deleted a few words or sentences from the opinion for the sake of readability or brevity. Quadruple asterisks mean that an entire paragraph (or more) has been omitted.

Additionally, when the opinion cites another case or legal source, the citation to the case or source has been omitted, again for the sake of readability and brevity. These editorial practices are continued in the other court opinions presented in this book. In addition, whenever we present a court opinion that includes a term or phrase that may not be readily understandable, a bracketed defi- nition or paraphrase has been added.

Briefing Cases Knowing how to read and understand court opinions and the legal reasoning used by the courts is an essential step in undertaking accurate legal research. A further step is “briefing,” or summarizing, the case.

Legal researchers routinely brief cases by reducing the texts of the opinions to their essential elements. Gener- ally, when you brief a case, you first summarize the back- ground and facts of the case, as the authors have done for most of the cases presented in this text. You then indicate the issue (or issues) before the court. An important ele- ment in the case brief is, of course, the court’s decision on the issue and the legal reasoning used by the court in reaching that decision.

Detailed instructions on how to brief a case are given in Appendix A, which also includes a briefed version of the sample court case presented in Exhibit 1–6.

C H A P T E R 1 Law and Legal Reasoning 21

E X H I B I T 1 – 6 A Sample Court Case

Rosa and Raymond Parks Institute for Self Development v. Target Corporation

United States Court of Appeals, Eleventh Circuit,

812 F.3d 824 (2016).

ROSENBAUM, Circuit Judge:ROSENBAUM, Circuit Judge:ROSENBAUM

* * * *

[Rosa] Parks’s courageous act inspired the Montgomery Bus Boycott and served Parks’s courageous act inspired the Montgomery Bus Boycott and served Parks’s courageous act

as the impetus for the modern Civil Rights Movement, transforming the nation.

In response to Parks’s arrest, for 381 days, 42,000 African–Americans boycotted

Montgomery buses, until the United States Supreme Court held the Montgomery

segregation law unconstitutional and ordered desegregation of the buses.

Parks’s refusal to cede ground in the face of continued injustice has made her

among the most revered heroines of our national story; her role in American his-

tory cannot be over-emphasized. Indeed, the United States Congress * * * has cred-

ited Parks with “igniting the most significant social movement in the history of the

United States.”

So it is not surprising that authors would write about Parks’s story and artists

would celebrate it with their works. The commemoration and dissemination of

Parks’s journey continues to entrench and embolden our pursuit of justice. And it is

in the general public interest to relentlessly preserve, spotlight, and recount the story

of Rosa Parks and the Civil Rights Movement—even when that interest allegedly

conflicts with an individual right of publicity.

The Rosa and Raymond Parks Institute for Self Development (the “Institute”) is a

Michigan * * * corporation that owns the name and likeness of the late Rosa Parks * * * .

The court divides the opinion into three sections. The first section summarizes the factual background of the case.

This line provides the name of the judge (or justice) who authored the court’s opinion.

This section contains the cita- tion—the name of the case, the name of the court that heard the case, the year of the deci- sion, and reporters in which the court’s opinion can be found.

A right of publicity is a person’s right of publicity is a person’s right of publicity right to the use of his or her name and likeness for a commer- cial purpose.

To cede is to yield or surrender.

The modern civil rights move- ment (1954–1964) included mass ment (1954–1964) included mass ment demonstrations in which partici- pants sought equality in public and private life at national, state, and local levels, as well as an end to state and local segregation and discrimination in schools, in the workplace and at the polls. The movement culminated in the enactment of two federal Civil Rights acts in 1957 and 1964.

An impetus is a stimulus or a spark.

In December 1955, on a bus in Montgomery, Alabama, Parks refused to give up her seat to a white man in violation of the city’s segregation law.

Continued

22 U N I T O N E The Foundations

E X H I B I T 1 – 6 A Sample Court Case—Continued

Target Corporation (“Target”), a national retail corporation headquartered in Min-

neapolis, Minnesota, operates more than 1,800 retail stores across the United States.

Target offered [for sale] seven books about Parks * * * , the * * * movie The Rosa

Parks Story, and a * * * plaque that included * * * a picture of Parks.

* * * *

* * * The Institute filed the underlying complaint in [a federal district court]. The

Institute alleged claims for * * * misappropriation * * * for Target’s sales of all items

using the name and likeness of Rosa Parks.

Generally, the Institute complained that * * * Target had unfairly and “without

the Institute’s prior knowledge, or consent, used Parks’s name, likeness, and image

to sell products * * * for Target’s own commercial advantage.” * * * The district court

dismissed the complaint, and this appeal followed.

II.

* * * In this case we apply * * * the substantive law of Michigan. substantive law of Michigan. substantive law

* * * *

Michigan’s common-law right of publicity is founded upon the interest of the

individual in the exclusive use of his own identity, in so far as it is represented by his

name or likeness, and in so far as the use may be of benefit to him or to others. This

* * * privacy right guards against the appropriation of the commercial value of a per-

son’s identity by using without consent the person’s name, likeness, or other indicia

of identity for the purpose of trade.

Privacy rights, however, are not absolute. * * * Individual rights must yield to the

qualified privilege to communicate on matters of public interest.

* * * *

* * * The privilege attaches to matters of general public interest and extends

to all communications made bona fide upon any subject matter where the party bona fide upon any subject matter where the party bona fide

Indicia is a synonym for indica- tions or signs.

The second major section of the opinion responds to the plain- tiff’s appeal.

Substantive law is law that Substantive law is law that Substantive law defines the rights and duties of persons with respect to each other. A federal court exercising jurisdiction based on diversity of citizenship—as in this case, where the two corporate parties are “citizens” of different states— applies the substantive law of the state in which the court sits (except in cases governed by federal law or the United States Constitution).

Misappropriation is the use of a person’s name or likeness without his or her consent for a commercial purpose. This is commonly referred to as a viola- tion of the individual’s right of publicity.

Qualified privilege gives some- one a limited right to act con- trary to another person’s right without the other person’s hav- ing legal recourse for the act.

In this context, bona fide means sincerely and honestly.

C H A P T E R 1 Law and Legal Reasoning 23

E X H I B I T 1 – 6 A Sample Court Case—Continued

communicating has an interest or a [legal, moral, or social] duty to a person having

a corresponding interest or duty.

* * * *

Of course, it is beyond dispute that Rosa Parks is a figure of great historical

significance and the Civil Rights Movement a matter of legitimate and important

public interest. And it is uncontested that * * * the * * * books * * * and the movie are uncontested that * * * the * * * books * * * and the movie are uncontested

all bona fide works * * * discussing Parks and her role in the Civil Rights Movement.bona fide works * * * discussing Parks and her role in the Civil Rights Movement.bona fide

Similarly, the plaque depicts images and mentions dates and statements related

to Parks and the Civil Rights Movement, in an effort to convey a message concern-

ing Parks, her courage, and the results of her strength. Indeed, all of the works in

question communicate information, express opinions, recite grievances, and protest

claimed abuses on behalf of a movement whose existence and objectives continue to

be of the highest public interest and concern.

* * * *

* * * The Institute has not articulated any argument as to why Michigan’s quali-

fied privilege for matters of public concern would not apply to these works, in light

of the conspicuous historical importance of Rosa Parks. Nor can we conceive of any.

* * * Indeed, it is difficult to conceive of a discussion of the Civil Rights Move-

ment without reference to Parks and her role in it. And Michigan law does not make

discussion of these topics of public concern contingent on paying a fee. As a result,

[the] books, the movie, and the plaque find protection in Michigan’s qualified privi-

lege protecting matters of public interest.

[III.]

In short, the district court did not err in dismissing the Institute’s complaint. The

district court’s order is AFFIRMED. To affirm is to validate, to give legal force to.

Here, uncontested can mean uncontested can mean uncontested unchallenged or accepted, as well as evident or obvious.

In the third major section of the opinion, the court states its decision.

24 U N I T O N E The Foundations

Terms and Concepts administrative agency 4 administrative law 4 allege 10 appellant 19 appellee 19 binding authority 8 breach 6 case law 5 case on point 11 citation 14 civil law 14 common law 6 concurring opinion 20 constitutional law 4 court of equity 6 court of law 6 criminal law 14 cyberlaw 14 damages 6

defendant 6 defense 6 dissenting opinion 20 equitable maxims 6 executive agency 5 historical school 12 independent regulatory agency 5 jurisprudence 12 laches 6 law 2 legal positivism 12 legal realism 13 legal reasoning 10 liability 2 majority opinion 20 natural law 12 opinion 20 ordinance 4 persuasive authority 10

per curiam opinion 20 petitioner 6 plainti� 6 plurality opinion 20 precedent 7 procedural law 13 remedy 6 remedy at law 6 remedy in equity 6 reporter 8 respondent 6 sociological school 13 stare decisis 8stare decisis 8stare decisis statute of limitations 6 statutory law 4 substantive law 13 uniform law 4

Debate This . . . Under the doctrine of stare decisis, courts are obligated to follow the precedents established in their jurisdiction unless there is a compelling reason not to. Should U.S. courts continue to adhere to this common law principle, given that our government now regulates so many areas by statute?

Reviewing: Law and Legal Reasoning

Suppose that the California legislature passes a law that severely restricts carbon dioxide emissions from automobiles in that state. A group of automobile manufacturers files suit against the state of California to prevent the enforcement of the law. The automakers claim that a federal law already sets fuel economy standards nationwide and that fuel economy standards are essentially the same as carbon dioxide emission standards. According to the automobile manufacturers, it is unfair to allow California to impose more stringent regulations than those set by the federal law. Using the informa- tion presented in the chapter, answer the following questions. 1. Who are the parties (the plaintiffs and the defendant) in this lawsuit? 2. Are the plaintiffs seeking a legal remedy or an equitable remedy? 3. What is the primary source of the law that is at issue here? 4. Where would you look to find the relevant California and federal laws?

Issue Spotters 1. Under what circumstances might a judge rely on case law

to determine the intent and purpose of a statute? (See Sources of American Law.)

2. After World War II, several Nazis were convicted of “crimes against humanity” by an international court. Assuming that these convicted war criminals had not

disobeyed any law of their country and had merely been following their government’s orders, what law had they violated? Explain. (See Schools of Legal Thought.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

C H A P T E R 1 Law and Legal Reasoning 25

Business Scenarios 1–1. Binding versus Persuasive Authority. A county court in Illinois is deciding a case involving an issue that has never been addressed before in that state’s courts. The Iowa Supreme Court, however, recently decided a case involving a very similar fact pattern. Is the Illinois court obligated to follow the Iowa Supreme Court’s decision on the issue? If the United States Supreme Court had decided a similar case, would that decision be binding on the Illinois court? Explain. (See The Common Law Tradition.) 1–2. Sources of Law. This chapter discussed a number of sources of American law. Which source of law takes priority in the following situations, and why? (See Sources of American Law.)

(a) A federal statute conflicts with the U.S. Constitution. (b) A federal statute conflicts with a state constitutional

provision. (c) A state statute conflicts with the common law of that

state. (d) A state constitutional amendment conflicts with the U.S.

Constitution. 1–3. Stare Decisis. In this chapter, we stated that the doc- trine of stare decisis “became a cornerstone of the English and stare decisis “became a cornerstone of the English and stare decisis American judicial systems.” What does stare decisis mean, and stare decisis mean, and stare decisis why has this doctrine been so fundamental to the develop- ment of our legal tradition? (See The Common Law Tradition.)

Business Case Problems 1–4. Spotlight on AOL—Common Law. AOL, LLC,

mistakenly made public the personal informa- tion of 650,000 of its members. �e members �led a suit, alleging violations of California law. AOL asked the court to dismiss the suit on the

basis of a “forum-selection clause” in its member agreement that designates Virginia courts as the place where member disputes will be tried. Under a decision of the United States Supreme Court, a forum-selection clause is unenforceable “if enforcement would contravene a strong public policy of the forum in which suit is brought.” California courts have declared in other cases that the AOL clause contravenes a strong public policy. If the court applies the doctrine of stare decisis, will it dismiss the suit? Explain. [Doe 1 v. AOL LLC, Doe 1 v. AOL LLC, Doe 1 v. AOL LLC 552 F.3d 1077 (9th Cir. 2009)] (See �e Common Law Tradition.) 1–5. Business Case Problem with Sample Answer— Reading Citations. Assume that you want to read the entire

court opinion in the case of Equal Employment Opportunity Commission v. Autozone, Inc., 809 F.3d 916 (7th Cir. 2016). Refer to the subsection enti- tled “Finding Case Law” in this chapter, and then

explain speci�cally where you would �nd the court’s opinion. (See How to Find Primary Sources of Law.) • For a sample answer to Problem 1–5, go to Appendix E at

the end of this text.

1–6. A Question of Ethics—The Common Law Tradition. On July 5, 1884, Dudley, Stephens, and Brooks—

”all able-bodied English seamen”—and a teenage English boy were cast adrift in a lifeboat following a storm at sea. �ey had no water with them in the boat, and all they had for sustenance were two one-

pound tins of turnips. On July 24, Dudley proposed that one of the four in the lifeboat be sacri�ced to save the others. Stephens agreed with Dudley, but Brooks refused to consent—and the boy was never asked for his opinion. On July 25, Dudley killed the boy, and the three men then fed on the boy’s body and blood. Four days later, a passing vessel rescued the men. �ey were taken to England and tried for the murder of the boy. If the men had not fed on the boy’s body, they would probably have died of starvation within the four-day period. �e boy, who was in a much weaker condition, would likely have died before the rest. [Regina v. Dudcondition, would likely have died before the rest. [Regina v. Dudcondition, would likely have died before the rest. [ - ley and Stephens, 14 Q.B.D. (Queen’s Bench Division, Eng-. (Queen’s Bench Division, Eng-. (Queen’s Bench Division, Eng land) 273 (1884)] (See �e Common Law Tradition.) (a) The basic question in this case is whether the survivors

should be subject to penalties under English criminal law, given the men’s unusual circumstances. Were the defen- dants’ actions necessary but unethical? Explain your rea- soning. What ethical issues might be involved here?

(b) Should judges ever have the power to look beyond the written “letter of the law” in making their decisions? Why or why not?

Legal Reasoning Group Activity 1–7. Court Opinions. Read through the subsection in this chapter entitled “Decisions and Opinions.” (See How to Read and Understand Case Law.) (a) One group will explain the difference between a concur-

ring opinion and a majority opinion. (b) Another group will outline the difference between a con-

curring opinion and a dissenting opinion.

(c) A third group will explain why judges and justices write concurring and dissenting opinions, given that these opinions will not affect the outcome of the case at hand, which has already been decided by majority vote.

C H A P T E R 2

2–1 The Judiciary’s Role in American Government

The body of American law includes the federal and state constitutions, statutes passed by legislative bod- ies, administrative law, and the case decisions and legal principles that form the common law. These laws would be meaningless, however, without the courts to interpret and apply them. The essential role of the judiciary— the courts—in the American governmental system is to interpret the laws and apply them to specific situations.

2–1a Judicial Review As the branch of government entrusted with interpreting the laws, the judiciary can decide, among other things, whether the laws or actions of the other two branches are constitutional. The process for making such a determina- tion is known as judicial review. The power of judicial review enables the judicial branch to act as a check on the other two branches of government, in line with the

system of checks and balances established by the U.S. Constitution.2

2–1b The Origins of Judicial Review in the United States

The power of judicial review is not mentioned in the U.S. Constitution (although many constitutional schol- ars believe that the founders intended the judiciary to have this power). The United States Supreme Court explicitly established this power in 1803 in the case Mar- bury v. Madison.3 In that decision, the Court stated, “It is emphatically the province [authority] and duty of the Judicial Department to say what the law is. . . . If two laws conflict with each other, the courts must decide

2. In a broad sense, judicial review occurs whenever a court “reviews” a case or legal proceeding—as when an appellate court reviews a lower court’s decision. When discussing the judiciary’s role in American government, however, the term judicial review refers to the power of the judiciary to judicial review refers to the power of the judiciary to judicial review decide whether the actions of the other two branches of government vio- late the U.S. Constitution.

3. 5 U.S. (1 Cranch) 137, 2 L.Ed. 60 (1803).

T he United States has fifty-two court systems—one for each of the fifty states, one for the District Tthe fifty states, one for the District T

of Columbia, and a federal system. Keep in mind that the federal courts are not superior to the state courts. They are simply an independent system of courts, which derives its authority from Article III, Section 2, of the U.S. Constitution. By the power given to it under the U.S. Constitution, Congress has extended the federal court system to U.S. territories such as Guam, Puerto Rico, and the Virgin Islands.1

1. In Guam and the Virgin Islands, territorial courts serve as both federal courts and state courts. In Puerto Rico, they serve only as federal courts.

As we shall see, the United States Supreme Court is the final control- ling voice over all of these fifty-two systems, at least when questions of federal law are involved. The Supreme Court’s decisions—whether on free speech and social media, health-care subsidies, environmental regulation, or same-sex marriage—represent the last word in the most controversial legal debates in our society. Never- theless, many of the legal issues that arise in our daily lives, such as the use of social media by courts, employ- ers, and law enforcement, have not yet come before the nation’s highest court. The lower courts usually resolve

such pressing matters, making these courts equally important in our legal system.

Although an understanding of our nation’s court systems is beneficial for anyone, it is particularly crucial for businesspersons, who will likely face a lawsuit at some time during their careers. Anyone involved in busi- ness should be familiar with the basic requirements that must be met before a party can bring a lawsuit before a particular court.

Courts and Alternative Dispute Resolution

C H A P T E R 2 Courts and Alternative Dispute Resolution 27

on the operation of each. . . . [I]f both [a] law and the Constitution apply to a particular case, . . . the Court must determine which of these conflicting rules governs the case. This is of the very essence of judicial duty.” Since the Marbury v. Madison decision, the power of judicial review has remained unchallenged. Today, this power is exercised by both federal and state courts.

2–2 Basic Judicial Requirements Before a lawsuit can be brought before a court, certain requirements must be met. These requirements relate to jurisdiction, venue, and standing to sue. We examine each of these important concepts here.

2–2a Jurisdiction In Latin, juris means “law,” and juris means “law,” and juris diction means “to speak.” Thus, “the power to speak the law” is the literal meaning of the term jurisdiction. Before any court can hear a case, it must have jurisdiction over the person (or company) against whom the suit is brought (the defendant) or over the property involved in the suit. The court must also have jurisdiction over the subject matter of the dispute.

Jurisdiction over Persons or Property Generally, a particular court can exercise in personam jurisdiction (personal jurisdiction) over any person or business that resides in a certain geographic area. A state trial court, for instance, normally has jurisdictional authority over residents (including businesses) of a particular area of the state, such as a county or district. A state’s highest court (often called the state supreme court4) has jurisdictional authority over all residents within the state.

A court can also exercise jurisdiction over property that is located within its boundaries. This kind of juris- diction is known as in rem jurisdiction jurisdiction, or “jurisdiction over the thing.” ■ EXAMPLE 2.1 A dispute arises over A dispute arises over the ownership of a boat in dry dock in Fort Lauderdale, Florida. The boat is owned by an Ohio resident, over whom a Florida court normally cannot exercise personal jurisdiction. The other party to the dispute is a resident of Nebraska. In this situation, a lawsuit concerning the boat could be brought in a Florida state court on the basis of the court’s in rem jurisdiction. ■

4. As will be discussed shortly, a state’s highest court is often referred to as the state supreme court, but there are exceptions. For instance, in New York the supreme court is a trial court.

Long Arm Statutes and Minimum Contacts. Under the authority of a state long arm statute, a court can exer- cise personal jurisdiction over certain out-of-state defen- dants based on activities that took place within the state. Before a court can exercise jurisdiction, though, it must be demonstrated that the defendant had su�cient con- tacts, or minimum contacts, with the state to justify the jurisdiction.5

Generally, the minimum-contacts requirement means that the defendant must have sufficient connection to the state for the judge to conclude that it is fair for the state to exercise power over the defendant. For instance, if an out-of-state defendant caused an automobile accident within the state or breached a contract formed there, a court will usually find that minimum contacts exist to exercise jurisdiction over that defendant. Similarly, a state may exercise personal jurisdiction over a nonresident defendant that is sued for selling defective goods within the state.

■ CASE IN POINT 2.2 An Xbox game system caught fire in Bonnie Broquet’s home in Texas and caused sub- stantial personal injuries. Broquet filed a lawsuit in a Texas court against Ji-Haw Industrial Company, a non- resident company that made the Xbox components. Bro- quet alleged that Ji-Haw’s components were defective and had caused the fire. Ji-Haw argued that the Texas court lacked jurisdiction over it, but a state appellate court held that the Texas long arm statute authorized the exercise of jurisdiction over the out-of-state defendant.6 ■

Corporate Contacts. Because corporations are con- sidered legal persons, courts use the same principles to determine whether it is fair to exercise jurisdiction over a corporation. A corporation normally is subject to per- sonal jurisdiction in the state in which it is incorporated, has its principal o�ce, and/or is doing business.

Courts apply the minimum-contacts test to determine if they can exercise jurisdiction over out-of-state corpo- rations. The minimum-contacts requirement is usually met if the corporation advertises or sells its products within the state, or places its goods into the “stream of commerce” with the intent that the goods be sold in the commerce” with the intent that the goods be sold in the commerce” with the intent that the goods be sold in the commerce” with the intent that the goods be sold in the state. ■ EXAMPLE 2.3 A business is incorporated under A business is incorporated under the laws of Maine but has a branch office and manufac- turing plant in Georgia. The corporation also advertises and sells its products in Georgia. These activities would likely constitute sufficient contacts with the state of

5. The minimum-contacts standard was first established in International Shoe Co. v. State of Washington, 326 U.S. 310, 66 S.Ct. 154, 90 L.Ed. 95 (1945).

6. Ji-Haw Industrial Co. v. Broquet, 2008 WL 441822 (Tex.App.—San Ji-Haw Industrial Co. v. Broquet, 2008 WL 441822 (Tex.App.—San Ji-Haw Industrial Co. v. Broquet Antonio 2008).

28 U N I T O N E The Foundations

Georgia to allow a Georgia court to exercise jurisdiction over the corporation. ■

Some corporations do not sell or advertise their products in the general marketplace. Determining what constitutes minimum contacts in these situations can be more difficult. ■ CASE IN POINT 2.4 Independence Plating Corporation is a New Jersey corporation that provides metal-coating services. Its only office and all of its personnel are located in New Jersey, and it does not advertise out of state. Independence had a long-standing business relationship with Southern Prestige Industries, Inc., a North Carolina company. Eventually, Southern Prestige filed suit in North Carolina against Indepen- dence for defective workmanship. Independence argued that North Carolina did not have jurisdiction over it, but the court held that Independence had sufficient mini- mum contacts with the state to justify jurisdiction. The two parties had exchanged thirty-two separate purchase orders in a period of less than twelve months.7 ■

Jurisdiction over Subject Matter Subject-matter jurisdiction refers to the limitations on the types of cases a court can hear. Certain courts are empowered to hear certain kinds of disputes. In both the federal and the state court systems, there are courts of general (unlimited) jurisdiction and courts of limited jurisdiction.

A court of general jurisdiction can decide cases involv- ing a broad array of issues. An example of a court of gen- eral jurisdiction is a state trial court or a federal district court.

In contrast, a court of limited jurisdiction can hear only specific types of cases. An example of a state court of lim- ited jurisdiction is a probate court. Probate courts are state courts that handle only the disposition of a person’s assets and obligations after that person’s death, including issues relating to the custody and guardianship of chil- dren. An example of a federal court of limited subject- matter jurisdiction is a bankruptcy court. Bankruptcy courts handle only bankruptcy proceedings, which are governed by federal bankruptcy law.

A court’s jurisdiction over subject matter is usually defined in the statute or constitution that created the court. In both the federal and the state court systems, a court’s subject-matter jurisdiction can be limited by any of the following: 1. The subject of the lawsuit. 2. The sum in controversy.

7. Southern Prestige Industries, Inc. v. Independence Plating Corp., 690 S.E.2d 768 (N.C. 2010).

3. Whether the case involves a felony (a serious type of crime) or a misdemeanor (a less serious type of crime).

4. Whether the proceeding is a trial or an appeal.

Original and Appellate Jurisdiction The distinc- tion between courts of original jurisdiction and courts of appellate jurisdiction normally lies in whether the case is being heard for the first time. Courts having original jurisdiction are courts of the first instance, or trial courts. These are courts in which lawsuits begin, trials take place, and evidence is presented. In the federal court system, the district courts are trial courts. In the various state court district courts are trial courts. In the various state court district courts systems, the trial courts are known by various names, as will be discussed shortly.

The key point here is that any court having original jurisdiction normally serves as a trial court. Courts hav- ing appellate jurisdiction act as reviewing, or appellate, courts. In general, cases can be brought before appellate courts only on appeal from an order or a judgment of a trial court or other lower courts.

Jurisdiction of the Federal Courts Because the federal government is a government of limited powers, the jurisdiction of the federal courts is limited. Federal courts have subject-matter jurisdiction in two situations: when a federal question is involved and when there is diversity of citizenship.

Federal Questions. Article III of the U.S. Constitution establishes the boundaries of federal judicial power. Sec- tion 2 of Article III states that “the judicial Power shall extend to all Cases, in Law and Equity, arising under this Constitution, the Laws of the United States, and Treaties made, or which shall be made, under their Authority.”

In effect, this clause means that whenever a plaintiff ’s cause of action is based, at least in part, on the U.S. Con- stitution, a treaty, or a federal law, a federal question arises. Any lawsuit involving a federal question, such as a person’s rights under the U.S. Constitution, can originate in a federal court. Note that in a case based on a federal question, a federal court will apply federal law.

Diversity of Citizenship. Federal district courts can also exercise original jurisdiction over cases involving diversity of citizenship. �e most common type of diversity juris- diction8 requires both of the following:both of the following:both

8. Diversity jurisdiction also exists in cases between (1) a foreign country and citizens of a state or of different states and (2) citizens of a state and citizens or subjects of a foreign country. Cases based on these types of diversity jurisdiction occur infrequently.

C H A P T E R 2 Courts and Alternative Dispute Resolution 29

1. The plaintiff and defendant must be residents of dif-The plaintiff and defendant must be residents of dif-The plaintiff and defendant must be residents of dif ferent states.

2. The dollar amount in controversy must exceed $75,000.

For purposes of diversity jurisdiction, a corporation is a citizen of both the state in which it is incorporated and the state in which its principal place of business is located.

A case involving diversity of citizenship can be filed in the appropriate federal district court. (If the case starts in a state court, it can sometimes be transferred, or “removed,” to a federal court.) A large percentage of the cases filed in federal courts each year are based on diversity of citizenship. As noted before, a federal court will apply federal law in cases involving federal questions.

In a case based on diversity of citizenship, in contrast, a federal court will apply the relevant state law (which is often the law of the state in which the court sits).

The following case focused on whether diversity jurisdiction existed. A boat owner was severely burned when his boat exploded after being overfilled with fuel at a marina in the U.S. Virgin Islands. The owner filed a suit in a federal district court against the marina and sought a jury trial. The defendant argued that a plain- tiff in an admiralty, or maritime, case (a case based on something that happened at sea) does not have a right to a jury trial unless the court has diversity jurisdiction. The defendant claimed that because both parties were citizens of the Virgin Islands, the court had no such jurisdiction.

In the Language of the Court SMITH, Circuit Judge.SMITH, Circuit Judge.SMITH

* * * * Kelley Mala is a citizen of the United

States Virgin Islands. * * * He went for a cruise in his powerboat near St. Thomas, Virgin Islands. When his boat ran low on gas, he entered Crown Bay Marina to refuel. Mala tied the boat to one of Crown Bay’s eight fueling stations and began filling his tank with an automatic gas pump. Before walking to the cash register to buy oil, Mala asked a Crown Bay attendant to watch his boat.

By the time Mala returned, the boat’s tank was overflowing and fuel was spilling into the boat and into the water. The attendant manually shut off the pump and acknowledged that the pump had been malfunctioning in recent days. Mala began cleaning up the fuel, and at some point, the attendant provided soap and water. Mala eventu- ally departed the marina, but as he did so, the engine caught fire and exploded. Mala was thrown into the water and was severely burned. His boat was unsalvageable.

* * * Mala sued Crown Bay in the District Court of the Virgin Islands.

Mala’s * * * complaint asserted * * * that Crown Bay negligently maintained its gas pump. [Negligence is the failure to exercise the standard of care that a rea- sonable person would exercise in similar circumstances. Negligence can form the basis for a legal claim.] The complaint also alleged that the District Court had admiralty and diversity jurisdiction over the case, and it requested a jury trial.

* * * * * * * Crown Bay filed a motion

to strike Mala’s jury demand. Crown Bay argued that plaintiffs generally do not have a jury-trial right in admiralty cases—only when the court also has diversity jurisdiction. And Crown Bay asserted that the parties were not diverse in this case * * * . In response to this motion, the District Court ruled that both Mala and Crown Bay were citizens of the Virgin Islands. The court therefore struck Mala’s jury demand, but neverthe- less opted to empanel an advisory jury. [The court could accept or reject the advisory jury’s verdict.]

* * * At the end of the trial, the advi- sory jury returned a verdict of $460,000 for Mala—$400,000 for pain and suf-for Mala—$400,000 for pain and suf-for Mala—$400,000 for pain and suf fering and $60,000 in compensatory

damages. It con- cluded that Mala was 25 percent at fault and that Crown Bay was 75 percent at fault. The District Court ultimately rejected the verdict and entered judg- ment for Crown Bay.

* * * * This appeal followed. * * * * Mala * * * argues that the District

Court improperly refused to conduct a jury trial. This claim ultimately depends on whether the District Court had diver- sity jurisdiction.

The Seventh Amendment [to the U.S. Constitution] creates a right to civil jury trials in federal court: “In Suits at common law * * * the right of trial by jury shall be preserved.” Admiralty suits are not “Suits at common law,” which means that when a district court has only admiralty jurisdiction the plaintiff does not have a jury-trial right. But [a federal statute] allows plaintiffs to pursue state claims in admiralty cases as long as the district court also has diversity jurisdic- tion. In such cases [the statute] preserves whatever jury-trial right exists with respect to the underlying state claims.

Case Analysis 2.1 Mala v. Crown Bay Marina, Inc. United States Court of Appeals, Third Circuit, 704 F.3d 239 (2013).

30 U N I T O N E The Foundations

Legal Reasoning Questions

1. What is “diversity of citizenship”? 2. How does the presence—or lack—of diversity of citizenship affect a lawsuit? 3. What did the court conclude with respect to the parties’ diversity of citizenship in this case?

Mala argues that the District Court had both admiralty and diversity juris- diction. As a preliminary matter, the court certainly had admiralty jurisdic- tion. The alleged tort occurred on navigable water and bore a substantial connection to maritime activity.

The grounds for diversity jurisdiction are less certain. District courts have juris- diction only if the parties are completely diverse. This means that no plaintiff may have the same state or territorial citizen- ship as any defendant. The parties agree that Mala was a citizen of the Virgin Islands. [Emphasis added.]

Unfortunately for Mala, the District Court concluded that Crown Bay also

was a citizen of the Virgin Islands. Mala rejects this conclusion.

Mala bears the burden of proving that the District Court had diversity jurisdiction. Mala failed to meet that burden because he did not offer evidence that Crown Bay was anything other than a citizen of the Virgin Islands. Mala con- tends that Crown Bay admitted to being a citizen of Florida, but Crown Bay actu- ally denied Mala’s allegation.

Absent evidence that the parties were diverse, we are left with Mala’s allegations. Allegations are insufficient at trial. And they are especially insufficient on appeal, where we review the District on appeal, where we review the District on appeal Court’s underlying factual findings for

clear error. Under this standard, we will not reverse unless we are left with the definite and firm conviction that Crown Bay was in fact a citizen of Florida. Mala has not presented any credible evidence that Crown Bay was a citizen of Florida—much less evidence that would leave us with the requisite firm convic- tion. [Emphasis added.]

* * * Accordingly, the parties were not diverse and Mala does not have a jury- trial right.

* * * * * * * For these reasons we will affirm

the District Court’s judgment.

Case 2.1 Continued

Exclusive versus Concurrent Jurisdiction When both federal and state courts have the power to hear a case, as is true in lawsuits involving diversity of citizen- ship, concurrent jurisdiction exists. When cases can be tried only in federal courts or only in state courts, exclu- sive jurisdiction exists.

Federal courts have exclusive jurisdiction in cases involv- ing federal crimes, bankruptcy, most patent and copyright claims, suits against the United States, and some areas of admiralty law. State courts also have exclusive jurisdiction over certain subjects—for instance, divorce and adoption.

When concurrent jurisdiction exists, a party may choose to bring a suit in either a federal court or a state court. Many factors can affect a party’s decision to liti- gate in a federal versus a state court. Examples include the availability of different remedies, the distance to the respective courthouses, or the experience or reputation of a particular judge.

For instance, if the dispute involves a trade secret, a party might conclude that a federal court—which has exclusive jurisdiction over copyrights and patents— would have more expertise in the matter. In contrast, a plaintiff might choose to litigate in a state court if the court has a reputation for awarding substantial amounts of damages or if the judge is perceived as being

pro-plaintiff. The concepts of exclusive and concurrent jurisdiction are illustrated in Exhibit 2–1.

Jurisdiction in Cyberspace The Internet’s capacity to bypass political and geographic boundaries undercuts the traditional basis on which courts assert personal juris- diction. As discussed, for a court to compel a defendant to come before it, the defendant must have a sufficient connection—that is, minimum contacts—with the state. When a defendant’s only contacts with the state are through a Web site, however, it can be difficult to deter- mine whether these contacts are sufficient for a court to exercise jurisdiction.

The “Sliding-Scale” Standard. �e courts have developed a “sliding-scale” standard to determine when they can exer- cise personal jurisdiction over an out-of-state defendant based on the defendant’s Web activities. �e sliding-scale standard identi�es three types of Internet business contacts and outlines the following rules for jurisdiction: 1. When the defendant conducts substantial business

over the Internet (such as contracts and sales), juris- diction is proper.

2. When there is some interactivity through a Web site, jurisdiction may be proper, depending on the

C H A P T E R 2 Courts and Alternative Dispute Resolution 31

circumstances. Even a single contact can satisfy the minimum-contacts requirement in certain situations.

3. When a defendant merely engages in passive adver- tising on the Web, jurisdiction is never proper.9 An Internet communication is typically considered pas- sive if people have to voluntarily access it to read the message and active if it is sent to specific individuals. ■ CASE IN POINT 2.5 Samantha Guffey lives in

Oklahoma. She placed a winning bid on eBay for a used 2009 Volvo XC90 from Motorcars of Nashville, Inc. (MNI), a Tennessee corporation. Before she won the auction, she spoke with Otto Ostonakulov at the deal- ership. Later, Ostonakulov sent the necessary paper- work to Guffey in Oklahoma. She signed and returned it by mail, and he arranged for MNI to ship the Volvo to Oklahoma.

When the car was delivered to Guffey, she discov- ered it was not in the condition advertised. She filed a lawsuit in Oklahoma against MNI and Ostonakulov, alleging fraud and a violation of state consumer protec- tion laws. Guffey’s complaint alleged that the defen- dants were active “power sellers” on eBay, averaging twelve to twenty-five cars for sale every day. The sellers claimed that the Oklahoma court lacked jurisdiction over them, and a trial court dismissed the complaint. Guffey appealed. The reviewing court found that Okla- homa had jurisdiction because the sellers’ “use of eBay to make multiple sales is systemic and appears to be a

9. For a leading case on this issue, see Zippo Manufacturing Co. v. Zippo Dot Com, Inc., 952 F.Supp. 1119 (W.D.Pa. 1997).

core part of their business.” They had negotiated with Guffey directly to sell her a vehicle in Oklahoma and had regularly used eBay to sell vehicles to remote parties in the past.10 ■

International Jurisdictional Issues. Because the Inter- net is international in scope, it obviously raises interna- tional jurisdictional issues. �e world’s courts seem to be developing a standard that echoes the requirement of minimum contacts applied by the U.S. courts.

Most courts are indicating that minimum contacts— doing business within the jurisdiction, for instance— are enough to compel a defendant to appear and that a physical presence in the country is not necessary. The effect of this standard is that a business firm has to comply with the laws in any jurisdiction in which it targets customers for its products. This situation is complicated by the fact that many countries’ laws on particular issues—free speech, for instance—are very different from U.S. laws.

The following case illustrates how federal courts apply a sliding-scale standard to determine if they can exercise jurisdiction over a foreign defendant whose only contact with the United States is through a Web site.

10. Guffey v. Ostonakulov, 2014 OK 6, 321 P.3d 971 (Ok.Sup. 2014). Note that a single sale on eBay does not necessarily form the basis for jurisdic- tion. Jurisdiction depends on whether the seller regularly uses eBay as a means for doing business with remote buyers. See Hinners v. Robey, 336 S.W.3d 891 (Ky.Sup. 2008).

Exclusive Federal Jurisdiction

(cases involving federal crimes, federal antitrust law, bankruptcyfederal antitrust law, bankruptcyfederal antitrust law ,, bankruptcy,, bankruptcy patents, copyrights, trademarks, suits against the United States,

some areas of admiralty law, and certain other matters specified

in federal statutes)

Exclusive State Jurisdiction

(cases involving all matters not subject to federal jurisdiction— for example, divorce and adoption

cases)

Concurrent Jurisdiction

(most cases involving federal questions, diversity-of-

citizenship cases)

E X H I B I T 2 – 1 Exclusive and Concurrent Jurisdiction

32 U N I T O N E The Foundations

Company Profile Gucci America, Inc., a New York corporation headquartered in New York City, is part of Gucci Group, a global fashion firm with offices in China, France, Great Britain, Italy, and Japan. Gucci makes and sells high-quality luxury goods, including footwear, belts, sunglasses, handbags, wallets, jewelry, fragrances, and children’s clothing. In connection with its products, Gucci uses twenty-one federally regis- tered trademarks. Gucci also operates a number of boutiques, some of which are located in California.

Background and Facts Wang Huoqing, a resident of the People’s Republic of China, operates numerous Web sites. When Gucci discovered that Wang Huoqing’s Web sites offered for sale coun- terfeit goods—products bearing Gucci’s trademarks but not genuine Gucci articles—it hired a private investigator in San Jose, California, to buy goods from the Web sites. The investigator purchased a wallet that was labeled Gucci but was counterfeit.

Gucci filed a trademark infringement lawsuit against Wang Huoqing in a federal district court in California seeking damages and an injunction to prevent further infringement. Wang Huoqing was notified of the lawsuit via e-mail but did not appear in court. Gucci asked the court to enter a default judgment—that is, a judgment entered when the defendant fails to appear. First, however, the court had to determine whether it had personal jurisdiction over Wang Huoqing based on the Internet sales.

In the Language of the Court Joseph C. SPERO, United States Magistrate Judge.

* * * * * * * Under California’s long-arm statute, federal courts in California may exercise jurisdiction to the

extent permitted by the Due Process Clause of the Constitution. The Due Process Clause allows federal courts to exercise jurisdiction where * * * the defendant has had sufficient minimum contacts with the forum to subject him or her to the specific jurisdiction of the court. The courts apply a three-part test to determine whether specific jurisdiction exists:

(1) The nonresident defendant must do some act or consummate some transaction with the forum or perform some act by which he purposefully avails himself of the privilege of conduct- ing activities in the forum, thereby invoking the benefits and protections of its laws; (2) the claim must be one which arises out of or results from the defendant’s forum-related activities; and (3) exercise of jurisdiction must be reasonable.

* * * * In order to satisfy the first prong of the test for specific jurisdiction, a defendant must have either

purposefully availed itself of the privilege of conducting business activities within the forum or purpose- fully directed activities toward the forum. Purposeful availment typically consists of action taking place in the forum that invokes the benefits and protections of the laws of the forum, such as executing or performing a contract within the forum. To show purposeful availment, a plaintiff must show that the defendant “engage[d] in some form of affirmative conduct allowing or promoting the transaction of business within the forum state.” [Emphasis added.]

“In the Internet context, the Ninth Circuit utilizes a sliding scale analysis under which ‘passive’ websites do not create sufficient contacts to establish purposeful availment, whereas interactive websites may create sufficient contacts, depending on how interactive the website is.” * * * Personal jurisdiction is appropriate where an entity is conducting business over the Internet and has offered for sale and sold its prod-appropriate where an entity is conducting business over the Internet and has offered for sale and sold its prod-appropriate where an entity is conducting business over the Internet and has offered for sale and sold its prod ucts to forum [California] residents. [Emphasis added.]

Here, the allegations and evidence presented by Plaintiffs in support of the Motion are sufficient to show purposeful availment on the part of Defendant Wang Huoqing. Plaintiffs have alleged that Defen- dant operates “fully interactive Internet websites operating under the Subject Domain Names” and have presented evidence in the form of copies of web pages showing that the websites are, in fact, interactive.

Spotlight on Gucci

Case 2.2 Gucci America, Inc. v. Wang HuoqingCase 2.2 Gucci America, Inc. v. Wang HuoqingCase 2.2 Gucci America, Inc. v. Wang Huoqing United States District Court, Northern District of California, 2011 WL 30972 (2011).United States District Court, Northern District of California, 2011 WL 30972 (2011).United States District Court, Northern District of California, 2011 WL 30972 (2011).

C H A P T E R 2 Courts and Alternative Dispute Resolution 33

* * * Additionally, Plaintiffs allege Defendant is conducting counterfeiting and infringing activities within this Judicial District and has advertised and sold his counterfeit goods in the State of California. * * * Plaintiffs have also presented evidence of one actual sale within this district, made by investigator Robert Holmes from the website bag2do.cn.* * * Finally, Plaintiffs have presented evidence that Defendant Wang Huoqing owns or controls the twenty-eight websites listed in the Motion for Default Judgment. * * * Such commercial activity in the forum amounts to purposeful availment of the privilege of conducting activities within the forum, thus invoking the benefits and protections of its laws. Accordingly, the Court concludes that Defendant’s contacts with California are sufficient to show purposeful availment.

Decision and Remedy The U.S. District Court for the Northern District of California held that it had personal jurisdiction over the foreign defendant, Wang Huoqing. The court entered a default judgment against Wang Huoqing and granted Gucci an injunction.

Critical Thinking • What If the Facts Were Different? Suppose that Gucci had not presented evidence that Wang Huoqing

had made one actual sale through his Web site to a resident of the court’s district (the private investigator). Would the court still have found that it had personal jurisdiction over Wang Huoqing? Why or why not?

• Legal Environment Is it relevant to the analysis of jurisdiction that Gucci America’s principal place of business is in New York rather than California? Explain.

Case 2.2 Continued

Minimum Contacts and Smartphones. �e widespread use of cellular phones, particularly smartphones, also complicates the determination of personal jurisdiction. People use their smartphones while traveling to make purchases, negotiate business deals, enter contracts, and download applications (apps). If a person traveling in another state (or nation) uses a smartphone to form a contract, does that forum have jurisdiction over the per- son? Is the party that creates an app subject to jurisdic- tion anywhere the app is downloaded or used? Because an app di�ers from a Web page, what degree of interactivity is required for apps to confer jurisdiction in the sliding- scale analysis? �e courts will be addressing these ques- tions in coming years and adapting traditional notions of jurisdiction to ever-changing technology.

Concept Summary 2.1 reviews the various types of jurisdiction, including jurisdiction in cyberspace.

2–2b Venue Jurisdiction has to do with whether a court has author- ity to hear a case involving specific persons, property, or subject matter. Venue11 is concerned with the most appropriate location for a trial. For instance, two state courts (or two federal courts) may have the authority to exercise jurisdiction over a case. Nonetheless, it may be

11. Pronounced ven-yoo.

more appropriate or convenient to hear the case in one court than in the other.

The concept of venue reflects the policy that a court trying a case should be in the geographic neighborhood (usually the county) where the incident occurred or where the parties reside. Venue in a civil case typically is where the defendant resides or does business, whereas venue in a criminal case normally is where the crime occurred.

In some cases, pretrial publicity or other factors may require a change of venue to another community, espe- cially in criminal cases in which the defendant’s right to a fair and impartial jury has been impaired. Note, though, that venue has lost some significance in today’s world because of the Internet and 24/7 news reporting. Courts now rarely grant requests for a change of venue. Because everyone has instant access to all information about a pur- ported crime, courts reason that no community is more or less informed or prejudiced for or against a defendant.

2–2c Standing to Sue Before a party can bring a lawsuit to court, that party must have standing to sue, or a sufficient stake in a matter to justify seeking relief through the court system. Standing means that the party that filed the action in court has a legally protected interest at stake in the liti- gation. At times, a person can have standing to sue on behalf of another person, such as a minor (child) or a mentally incompetent person.

34 U N I T O N E The Foundations

Limits the court’s jurisdictional authority to particular types of cases.

Jurisdiction

●

● Is located in the court’s territorial boundaries. Qualifies under state long arm statutes. Is a corporation doing business within the state. Advertises, sells, or places goods into commerce within the state.

Concept Summary 2.1

Personal

●

● General jurisdiction—Exists when a court can hear cases involving aGeneral jurisdiction—Exists when a court can hear cases involving aGeneral jurisdiction broad array of issues. Limited jurisdiction—Exists when a court is limited to a specific subjectLimited jurisdiction—Exists when a court is limited to a specific subjectLimited jurisdiction matter, such as probate or divorce.

Subject Matter

●

● When the plaintiff’s cause of action involves a federal question (is based at least in part on the U.S. Constitution, a treaty, or a federal law). In cases between citizens of different states (or cases involving U.S. citizens and foreign countries or their citizens) when the amount in controversy exceeds $75,000 (diversity-of-citizenship jurisdiction).

Federal

● Exists when the property that is subject to a lawsuit is located within the court’s territorial boundaries.

Property

● Exists with courts that have the authority to hear a case for the first time (trial courts, district courts).

Original

● Exists with courts of appeal and review. Generally, appellate courts do not have original jurisdiction.

Appellate

● Exists when both federal and state courts have authority to hear the same case.ConcurrentConcurrentConcurr

● Exists when only state courts or only federal courts have authority to hear a case.Exclusive

● The courts have developed a sliding-scale standard to use in determining when jurisdiction over a Web site owner or operator in another state is proper.

Cyberspace

Exists when a defendant:

A federal court can exercise jurisdiction:

C H A P T E R 2 Courts and Alternative Dispute Resolution 35

Standing can be broken down into three elements: 1. Harm. The party bringing the action must have

suffered harm—an invasion of a legally protected interest—or must face imminent harm. The con- troversy must be real and substantial rather than hypothetical.

2. Causation. There must be a causal connection between the conduct complained of and the injury.

3. Remedy. It must be likely, as opposed to merely specu- lative, that a favorable court decision will remedy the injury suffered. ■ CASE IN POINT 2.6 Harold Wagner obtained a Harold Wagner obtained a

loan through M.S.T. Mortgage Group to buy a house in Texas. After the sale, M.S.T. transferred its interest in the loan to another lender, which, in turn, assigned it to another lender (a common practice in the mortgage industry). Eventually, when Wagner failed to make the loan payments, CitiMortgage, Inc., notified him that it was going to foreclose on the property and sell the house.

Wagner filed a lawsuit, claiming that the lenders had improperly assigned the mortgage loan. In 2014, a fed- eral district court ruled that Wagner lacked standing to contest the assignment. Under Texas law, only the parties directly involved in an assignment can challenge its valid- ity. In this case, the assignment was between two lenders and did not directly involve Wagner.12 ■

12. Wagner v. CitiMortgage, Inc., 995 F.Supp.2d 621 (N.D.Tex. 2014).

2–3 The State and Federal Court Systems

Each state has its own court system. Additionally, there is a system of federal courts. The right-hand side of Exhibit 2–2 illustrates the basic organizational framework char- acteristic of the court systems in many states. The exhibit also shows how the federal court system is structured. We turn now to an examination of these court systems, beginning with the state courts.

2–3a The State Court Systems No two state court systems are exactly the same. Typi- cally, though, a state court system includes several lev- els, or tiers, of courts, as shown in Exhibit 2–2. State courts may include (1) trial courts of limited jurisdic- tion, (2) trial courts of general jurisdiction, (3) appellate courts (intermediate appellate courts), and (4) the state’s highest court (often called the state supreme court).

Generally, any person who is a party to a lawsuit has the opportunity to plead the case before a trial court and then, if he or she loses, before at least one level of appellate court. If the case involves a federal statute or a federal constitutional issue, the decision of the state supreme court may be further appealed to the United States Supreme Court. Note that lawsuits can take years to resolve through the courts, especially since many states have experienced large cuts in court funding in recent years. In fact, the United States Supreme Court decided a

Supreme Court of the United States

Specialized U.S. Courts

• Bankruptcy Courts • Court of Federal Claims

• Court of International Trade

• Tax Court• Tax Court• T

Highest State Courts

State Courts of Appeals

State Trial CourtsState Trial CourtsState T of General Jurisdiction

Local Trial Courts ofLocal Trial Courts ofLocal T Limited Jurisdiction

State Administrative Agencies

U.S. Courts of Appeals

Federal Administrative

Agencies

U.S. District Courts

E X H I B I T 2 – 2 The State and Federal Court Systems

36 U N I T O N E The Foundations

case in 2015 involving a trademark dispute that had been in the courts for more than sixteen years.13

The states use various methods to select judges for their courts. Usually, voters elect judges, but in some states judges are appointed. For instance, in Iowa, the governor appoints judges, and then the general popula- tion decides whether to confirm their appointment in the next general election. The states usually specify the number of years that judges will serve.

Trial Courts Trial courts are exactly what their name implies—courts in which trials are held and testimony is taken. State trial courts have either general or limited jurisdiction, as defined earlier.

General Jurisdiction. Trial courts that have general juris- diction as to subject matter may be called county, district, superior, or circuit courts.14 State trial courts of general jurisdiction have jurisdiction over a wide variety of sub- jects, including both civil disputes and criminal prosecu- tions. In some states, trial courts of general jurisdiction may hear appeals from courts of limited jurisdiction.

Limited Jurisdiction. Courts of limited jurisdiction as to subject matter are generally inferior trial courts or minor judiciary courts. Limited jurisdiction courts might include local municipal courts (which could include sepa- rate tra�c courts and drug courts) and domestic relations courts (which handle divorce and child-custody disputes).

Small claims courts are inferior trial courts that hear only civil cases involving claims of less than a certain amount, such as $5,000 (the amount varies from state to state). Procedures in small claims courts are generally informal, and lawyers are not required (in a few states, lawyers are not even allowed). Decisions of small claims

13. B&B Hardware, Inc. v. Hargis Industries, Inc., ___ U.S. ___, 135 S.Ct. 1293, 191 L.Ed.2d 222 (2015).

14. The name in Ohio and Pennsylvania is Court of Common Pleas. The name in New York is Supreme Court, Trial Division.

courts and municipal courts may sometimes be appealed to a state trial court of general jurisdiction.

A few states have also established Islamic law courts, which are courts of limited jurisdiction that serve the American Muslim community. These courts decide cases with reference to the sharia, a system of law used in most Islamic countries that is derived from the Qur’an and the sayings and doings of Muhammad and his followers.

Appellate, or Reviewing, Courts Every state has at least one court of appeals (appellate court, or reviewing court), which may be an intermediate appellate court or the state’s highest court. About three-fourths of the states have intermediate appellate courts.

Generally, courts of appeals do not conduct new trials, in which evidence is submitted to the court and witnesses are examined. Rather, an appellate court panel of three or more judges reviews the record of the case on appeal, which includes a transcript of the trial proceedings. The appellate court hears arguments from attorneys and determines whether the trial court committed an error.

Reviewing courts focus on questions of law, not ques- tions of fact. A question of fact deals with what really question of fact deals with what really question of fact happened in regard to the dispute being tried—such as whether a party actually burned a flag. A question of law concerns the application or interpretation of the law— such as whether flag-burning is a form of speech pro- tected by the First Amendment to the U.S. Constitution. Only a judge, not a jury, can rule on questions of law.

Appellate courts normally defer (give significant weight) to the trial court’s findings on questions of fact because the trial court judge and jury were in a better position to evalu- ate testimony. The trial court judge and jury can directly observe witnesses’ gestures, demeanor, and other nonver- bal behavior during the trial. An appellate court cannot.

In the following case, neither the administrative agency that initially ruled on the dispute nor the trial court to which the agency’s decision was appealed made a finding on a crucial question of fact. Faced with that circumstance, what should a state appellate court do?

Background and Facts Jennifer Johnson was working as a finance analyst for Oxy USA, Inc., when Oxy changed the job’s requirements. To meet the new standards, Johnson took courses to become a certified public accountant. Oxy’s “Educational Assistance Policy” was to reimburse employees for the

Johnson v. Oxy USA, Inc. Court of Appeals of Texas, Houston—14th District, __ S.W.3d __ , 2016 WL 93559 (2016).

Case 2.3

C H A P T E R 2 Courts and Alternative Dispute Resolution 37

cost of such courses. Johnson further agreed that Oxy could withhold the reimbursed amount from her final paycheck if she quit Oxy within a year. When she resigned less than a year later, Oxy with- held that amount from her last check. Johnson filed a claim for the amount with the Texas Workforce Commission (TWC). The TWC ruled that she was not entitled to the unpaid wages. She filed a suit in a Texas state court against Oxy, alleging breach of contract. The court affirmed the TWC’s ruling. Johnson appealed.

In the Language of the Court Ken WISE, Justice WISE, Justice WISE

* * * * * * * The trial court * * * held that Johnson’s [claim for breach of contract was] barred by res judicata

[“a matter judged”]. In a court of law, a claimant typically cannot pursue one remedy to an unfavorable outcome and then seek the same remedy in another proceeding before the same or a different tribunal. Res judicata bars the relitigation of claims that have been finally adjudicated or that could have been litigated Res judicata bars the relitigation of claims that have been finally adjudicated or that could have been litigated Res judicata in the prior action. [Emphasis added.]

Johnson argues that res judicata does not apply here because the TWC did not render a final judgres judicata does not apply here because the TWC did not render a final judgres judicata - ment on the merits of her claim that Oxy misinterpreted its Educational Assistance Policy. Specifically, Johnson claims she was “denied the right of full adjudication of her claim because the TWC refused to consider her arguments at the administrative level as beyond its jurisdiction.” To support this contention, Johnson points to the following excerpt from the * * * decision:

* * * The TWC does not interpret contracts between employers and employee but only enforces the Texas Payday Law [the Texas state law that governs the timing of employees’ paychecks]. * * * The question of whether the employer properly interpreted their policy on reimbursed educa- tional expenses versus a business expense is a question for a different forum.

According to Johnson, this language shows that the TWC refused to consider the merits of the issue she raised as “beyond its reach.” In contrast, the defendants contend that Johnson’s claims are barred by res judicata because they are based on claims previously decided by the TWC.res judicata because they are based on claims previously decided by the TWC.res judicata

* * * * In Johnson’s case, however, the TWC did not decide the key question of fact in dispute—whether Oxy

violated its own Educational Assistance Policy when it withheld Johnson’s final wages as reimbursement for the CPA courses. In fact, the TWC explicitly refused to do so, stating that the agency “does not interpret contracts between employers and employee.” * * * Because this question goes to the heart of Johnson’s breach of contract * * * claim, we hold that res judicata does not bar [that] claim. [Emphasis added.]res judicata does not bar [that] claim. [Emphasis added.]res judicata

The defendants argue that because Johnson seeks to recover the same wages in this suit as she did in her claim with the TWC, res judicata must bar her common law cause of action. However, * * * res judicata must bar her common law cause of action. However, * * * res judicata res judicata would only bar a claim if TWC’s order is considered final. * * * Here, the order in Johnson’s case judicata would only bar a claim if TWC’s order is considered final. * * * Here, the order in Johnson’s case judicata made no such findings with regard to the Educational Assistance Policy. The order expressly declined to address that issue. Therefore, * * * res judicata will not bar Johnson’s breach of contract * * * claim.res judicata will not bar Johnson’s breach of contract * * * claim.res judicata

Decision and Remedy A state intermediate appellate court reversed the lower court’s decision. “The TWC did not decide the key question of fact in dispute—whether Oxy violated its own Educational Assis- tance Policy when it withheld Johnson’s final wages. In fact, the TWC explicitly refused to do so, stating that the agency ‘does not interpret contracts between employers and employee.’“ The appellate court remanded the case for a trial on the merits.

Critical Thinking • Legal Environment Who can decide questions of fact? Who can rule on questions of law? Why? • Global In some cases, a court may be asked to determine and interpret the law of a foreign country. Some

states consider the issue of what the law of a foreign country requires to be a question of fact. Federal rules of procedure provide that this issue is a question of law. Which position seems more appropriate? Why?

Case 2.3 Continued

38 U N I T O N E The Foundations

Should You Consent to Have Your Business Case Decided by a U.S. Magistrate Judge?

You have a strong case in a contract dispute with one of your business’s suppliers. The sup- plier is located in another state. Your attorney did everything necessary to obtain your “day in court.” The court in question is a federal district court. But you have just found out that your case may not be heard for several years— or even longer. Your attorney tells you that the case can be heard in just a few months if you consent to place it in the hands of a U.S. magistrate judge.a

Should you consent?

A Short History of U.S. Magistrate Judges

Congress authorized the creation of a new federal judicial officer, the U.S. magistrate, in 1968 to help reduce delays in the U.S. district courts.b These junior federal officers were to conduct a wide range of judicial proceedings as set out by statute and as assigned by the district judges under whom they served. In 1979, Congress gave U.S. magistrates consent jurisdiction, which authorized them to conduct all civil trials as long as the parties consent.c Currently, magistrate judges dispose of over one million civil and criminal district court matters, which include motions and hearings.

The Selection and Quality of Magistrate Judges

As mentioned, federal district judges are nominated by the president, confirmed by the Senate, and appointed for life. In contrast, U.S. magistrate judges are selected by federal district court judges based on the recommenda-

tions of a merit screening committee. They serve an eight-year term (which can be renewed).

By statute, magistrate judges must be chosen through a merit selection process. Applicants are interviewed by a screening committee of lawyers and others from the dis- trict in which the position will be filled.d Politi- cal party affiliation plays no part in the process.

A variety of experienced attorneys, administrative law judges, state court judges, and others apply for magistrate judge positions. A typical opening receives about a hundred applicants. The merit selection panel selects the five most qualified, who are then voted on by federal district court judges.

Because the selection process for a magistrate judge is not the same as for a district judge, some critics have expressed concerns about the quality of magistrate judges. Some groups, such as People for the American Way, are not in favor of allowing magistrate judges the power to decide cases. These critics believe that because of their limited terms, they are not completely immune from outside pressure.

Business Questions 1. If you were facing an especially complex legal dispute—

one involving many facets and several different types of law—would you consent to allowing a U.S. magistrate judge to decide the case? Why or why not?

2. If you had to decide whether to allow a U.S. magistrate judge to hear your case, what information might you ask your attorney to provide concerning that individual?

d. 28 U.S.C. Section 631(b)(5).

MANAGERIAL STRATEGY

a. 28 U.S.C. Sec 636(c); Roell v, Withrow, 538 U.S. 580, 123 S.Ct. 1698, 155 L.Ed.2d 775 (2003).

b. Federal Magistrates Act, 82 Stat. 1107, October 17, 1968. c. U.S.C. Section 636(c)(1).

Highest State Courts The highest appellate court in a state is usually called the supreme court but may be des- ignated by some other name. For instance, in both New York and Maryland, the highest state court is called the Court of Appeals. The highest state court in Maine and Massachusetts is the Supreme Judicial Court. In West Vir- ginia, it is the Supreme Court of Appeals.

The decisions of each state’s highest court on all questions of state law are final. Only when issues of federal law are involved can the United States Supreme Court overrule a decision made by a state’s highCourt overrule a decision made by a state’s highCourt overrule a decision made by a state’s high- est court. ■ EXAMPLE 2.7 A city enacts an ordinance that prohibits citizens from engaging in door-to-door

advocacy without first registering with the mayor’s office and receiving a permit. A religious group then sues the city, arguing that the law violates the freedoms of speech and religion guaranteed by the First Amendment. If the state supreme court upholds the law, the group could appeal the decision to the United States Supreme Court, because a constitutional (federal) issue is involved. ■

2–3b The Federal Court System The federal court system is basically a three-tiered model consisting of (1) U.S. district courts (trial courts of general jurisdiction) and various courts of limited

C H A P T E R 2 Courts and Alternative Dispute Resolution 39

jurisdiction, (2) U.S. courts of appeals (intermediate courts of appeals), and (3) the United States Supreme Court.

Unlike state court judges, who are usually elected, fed- eral court judges—including the justices of the Supreme Court—are appointed by the president of the United States, subject to confirmation by the U.S. Senate. Fed- eral judges receive lifetime appointments under Article III of the U.S. Constitution, which states that federal judges “hold their offices during good Behaviour.” In the entire history of the United States, only seven federal judges have been removed from office through impeach- ment proceedings.

Certain federal court officers are not chosen in the way just described. This chapter’s Managerial Strategy feature describes how U.S. magistrate judges are selected.

U.S. District Courts At the federal level, the equiva- lent of a state trial court of general jurisdiction is the dis- trict court. U.S. district courts have original jurisdiction in matters involving a federal question and concurrent

jurisdiction with state courts when diversity jurisdiction exists. Federal cases typically originate in district courts. There are other federal courts with original, but special (or limited), jurisdiction, such as the federal bankruptcy courts and tax courts.

Every state has at least one federal district court. The number of judicial districts can vary over time, primarily owing to population changes and corresponding changes in caseloads. Today, there are ninety-four federal judicial districts. Exhibit 2–3 shows the boundaries of both the U.S. district courts and the U.S. courts of appeals.

U.S. Courts of Appeals In the federal court system, there are thirteen U.S. courts of appeals—referred to as U.S. circuit courts of appeals. Twelve of these courts (including the Court of Appeals for the D.C. Circuit) hear appeals from the federal district courts located within their respective judicial circuits (shown in Exhibit 2–3).15

15. Historically, judges were required to “ride the circuit” and hear appeals in different courts around the country, which is how the name “circuit court” came about.

W E

E N

E W

W E

S W

N N

MMS

W S

N W

W N

NNNNNN

3 6

Atlanta

Maine

VeVermontrmont

Puerto RicoPuerto Rico

Virgin Islands

D.C. Circuit

Federal Circuit

HawaiiHawaiiHawaiiHawaii

Michigan

Washington, D.C.

Legend Circuit boundaries

State boundaries

District boundaries

Location of U.S. Court of Appeals

Florida

MarylandMarylandMaryland DelawareDelawareDelaware

NewNew JerseyJerseyJersey

PennsylvaniaPennsylvania

ConnecticutConnecticut Rhode IslandRhode Island MassachusettsMassachusetts

New HampshireHampshire

New York

GuamGuam

Northern Mariana IslandsIslands

Boston

NewNewNewNew Y Yorkork York Y York Y

PhiladelphiaPhiladelphiaPhiladelphia

District of ColumbiDistrict of Columbia WWashington, D.C. RichmondRichmond

New OrleansNew OrleansNew Orleans

CincinnatiCincinnatiCincinnatiCincinnatiCincinnati

Chicago

St. LouisSt. Louis

Denver SanSan

FranciscoFranciscoFrancisco

Source: Source: Administrative OfAdministrative Office of the United States Courts.

Texas

MississippiMississippiMississippi

Alaska

California

Nevada

Oregon

Washington

Idaho

Montana

Wyoming

Utah

Arizona

New Mexico

Colorado

Kansas

Oklahoma

Nebraska

So. Dakota

No. Dakota Minnesota

Iowa

Missouri

Arkansas

Georgia Alabama

So. Carolina

No. Carolina

Virginia W. Va.

Ohio

Kentucky

Tennessee

Michigan

Indiana Illinois

Wisconsin

irginia

Chicago

Louisiana

E X H I B I T 2 – 3 Geographic Boundaries of the U.S. Courts of Appeals and U.S. District Courts

40 U N I T O N E The Foundations

The Court of Appeals for the Thirteenth Circuit, called the Federal Circuit, has national appellate jurisdiction over certain types of cases, including those involving patent law and those in which the U.S. government is a defendant.

The decisions of a circuit court of appeals are binding on all courts within the circuit court’s jurisdiction. These decisions are final in most cases, but appeal to the United States Supreme Court is possible.

The United States Supreme Court The highest level of the three-tiered federal court system is the United States Supreme Court. According to the U.S. Constitu- tion, there is only one national Supreme Court. All other courts in the federal system are considered “inferior.” Congress is empowered to create inferior courts as it deems necessary. The inferior courts that Congress has created include the second tier in our model—the U.S. circuit courts of appeals—as well as the district courts and the various federal courts of limited, or specialized, jurisdiction.

The United States Supreme Court consists of nine justices. Although the Supreme Court has original, or trial, jurisdiction in rare instances (set forth in Article III, Sections 1 and 2), most of its work is as an appeals court. The Supreme Court can review any case decided by any of the federal courts of appeals. It also has appellate authority over cases involving federal questions that have been decided in the state courts. The Supreme Court is the final authority on the Constitution and federal law.

Appeals to the Supreme Court. To bring a case before the Supreme Court, a party requests the Court to issue a writ of certiorari.16 A writ of certiorari is an order issued certiorari is an order issued certiorari by the Supreme Court to a lower court requiring the lat- ter to send it the record of the case for review. �e Court will not issue a writ unless at least four of the nine justices approve of it. �is is called the rule of four.

Whether the Court will issue a writ of certiorari is certiorari is certiorari entirely within its discretion, and most petitions for writs are denied. (Although thousands of cases are filed with the Supreme Court each year, it hears, on average, fewer than one hundred of these cases.)17 A denial of the request to issue a writ of certiorari is not a decision on the certiorari is not a decision on the certiorari merits of the case, nor does it indicate agreement with the lower court’s opinion. Also, denial of the writ has no

16. Pronounced sur-shee-uh-rah-ree. 17. From the mid-1950s through the early 1990s, the Supreme Court

reviewed more cases per year than it has since then. In the Court’s 1982–1983 term, for example, the Court issued written opinions in 151 cases. In contrast, during the Court’s 2015–2016 term, the Court issued written opinions in only 81 cases.

value as a precedent. Denial simply means that the lower court’s decision remains the law in that jurisdiction.

Petitions Granted by the Court. Typically, the Court grants petitions when cases raise important constitutional questions or when the lower courts have issued con�ict- ing decisions on a signi�cant issue. �e justices, however, never explain their reasons for hearing certain cases and not others, so it is di�cult to predict which type of case the Court might select.

Concept Summary 2.2 reviews the courts in the fed- eral and state court systems.

2–4 Alternative Dispute Resolution Litigation—the process of resolving a dispute through the court system—is expensive and time consuming. Lit- igating even the simplest complaint is costly, and because of the backlog of cases pending in many courts, several years may pass before a case is actually tried. For these and other reasons, more and more businesspersons are turning to alternative dispute resolution (ADR) as a means of settling their disputes.

The great advantage of ADR is its flexibility. Methods of ADR range from the parties sitting down together and attempting to work out their differences to multinational corporations agreeing to resolve a dispute through a for- mal hearing before a panel of experts. Normally, the par- ties themselves can control how they will attempt to settle their dispute. They can decide what procedures will be used, whether a neutral third party will be present or make a deci- sion, and whether that decision will be legally binding or nonbinding. ADR also offers more privacy than court pro- ceedings and allows disputes to be resolved relatively quickly.

Today, more than 90 percent of civil lawsuits are set- tled before trial using some form of ADR. Indeed, most states either require or encourage parties to undertake ADR prior to trial. Many federal courts have instituted ADR programs as well. In this section, we examine the basic forms of ADR.

2–4a Negotiation The simplest form of ADR is negotiation, a process in which the parties attempt to settle their dispute infor- mally, with or without attorneys to represent them. Attorneys frequently advise their clients to negotiate a settlement voluntarily before they proceed to trial. Par- ties may even try to negotiate a settlement during a trial or after the trial but before an appeal.

C H A P T E R 2 Courts and Alternative Dispute Resolution 41

Courts of appeals are reviewing courts. Generally, appellate courts do not have original jurisdiction.

The highest state court is that state’s supreme court, although it may be called by some other name.

Types of Courts

Concept Summary 2.2

●

● State courts —Courts of general jurisdiction can hear any case that has not been specifically designated for another court. Courts of limited jurisdiction include, among others, domestic relations courts, probate courts, municipal courts, and small claims courts. Federal courts —The federal district court is the equivalent of the state trial court. Federal courts of limited jurisdiction include the bankruptcy courts and others shown in Exhibit 2–2.

Trial CourtsTrial CourtsT

●

● About three-fourths of the states have intermediate appellate courts. In the federal court system, the U.S. circuit courts of appeals are the intermediate appellate courts.

Intermediate Appellate Courts

●

● Appeal from state supreme courts to the United States Supreme Court is possible only if a federal question is involved. The United States Supreme Court is the highest court in the federal court system and the final authority on the Constitution and federal law.

Supreme Courts

Trial courts are courts of original jurisdiction in which actions are initiated.

Negotiation traditionally involves just the parties themselves and (typically) their attorneys. The attorneys, though, are advocates—they are obligated to put their clients’ interests first.

2–4b Mediation In mediation, a neutral third party acts as a mediator and works with both sides in the dispute to facilitate a resolution. The mediator, who need not be a lawyer, usu- ally charges a fee for his or her services (which can be split between the parties). States that require parties to undergo ADR before trial often offer mediation as one of the ADR options or (as in Florida) the only option.

During mediation, the mediator normally talks with the parties separately as well as jointly, emphasizes their points of agreement, and helps them to evaluate their options. Although the mediator may propose a solution

(called a mediator’s proposal), he or she does not make a decision resolving the matter.

One of the biggest advantages of mediation is that it is less adversarial than litigation. In mediation, the media- tor takes an active role and attempts to bring the parties together so that they can come to a mutually satisfac- tory resolution. The mediation process tends to reduce the antagonism between the disputants, allowing them to resume their former relationship while minimizing hostility. For this reason, mediation is often the preferred form of ADR for disputes between business partners, employers and employees, or other parties involved in long-term relationships.

2–4c Arbitration A more formal method of ADR is arbitration, in which an arbitrator (a neutral third party or a panel of experts)

42 U N I T O N E The Foundations

hears a dispute and imposes a resolution on the parties. Arbitration differs from other forms of ADR in that the third party hearing the dispute makes a decision for the parties. Exhibit 2–4 outlines the basic differences among the three traditional forms of ADR.

Usually, the parties in arbitration agree that the third party’s decision will be legally binding, although the parlegally binding, although the parlegally binding - ties can also agree to nonbinding arbitration. In nonbindnonbinding arbitration. In nonbindnonbinding - ing arbitration, the parties can go forward with a lawsuit if they do not agree with the arbitrator’s decision. Arbi- tration that is mandated by the courts often is not bind- ing on the parties.

In some respects, formal arbitration resembles a trial, although usually the procedural rules are much less restric- tive than those governing litigation. In a typical arbitration, the parties present opening arguments and ask for specific remedies. Both sides present evidence and may call and examine witnesses. The arbitrator then renders a decision.

The Arbitrator’s Decision The arbitrator’s decision is called an award. It is usually the final word on the mat- ter. Although the parties may appeal an arbitrator’s deci- sion, a court’s review of the decision will be much more restricted in scope than an appellate court’s review of a trial court’s decision. The general view is that because the parties were free to frame the issues and set the powers of the arbitrator at the outset, they cannot complain about

the results. A court will set aside an award only in the event of one of the following: 1. The arbitrator’s conduct or “bad faith” substantially

prejudiced the rights of one of the parties. 2. The award violates an established public policy. 3. The arbitrator exceeded her or his powers—that is,

arbitrated issues that the parties did not agree to sub- mit to arbitration.

Arbitration Clauses Almost any commercial mat- ter can be submitted to arbitration. Frequently, parties include an arbitration clause in a contract specifying that any dispute arising under the contract will be resolved through arbitration rather than through the court system. Parties can also agree to arbitrate a dispute after it arises.after it arises.after

Arbitration Statutes Most states have statutes (often based, in part, on the Uniform Arbitration Act) under which arbitration clauses will be enforced. Some state statutes compel arbitration of certain types of disputes, such as those involving public employees.

At the federal level, the Federal Arbitration Act (FAA), enacted in 1925, enforces arbitration clauses in contracts involving maritime activity and interstate com- merce. As you will see in later chapters, the courts have defined interstate commerce broadly, and so arbitration interstate commerce broadly, and so arbitration interstate commerce

Who Decides the Resolution?

Description

Neutral Third Party Present?

Type of ADRType of ADRT

The parties themselves reach a resolution.

The parties, but the mediator may suggest or propose a resolution.

The arbitrator imposes a resolution on the parties that may be either binding or nonbinding.

Negotiation Mediation Arbitration

Parties meet informally with or without their attorneys and attempt to agree on a resolution. This is the simplest and least expensive method of ADR.

A neutral third party meets with the parties and emphasizes points of agreement to bring them toward resolution of their dispute, reducing hostility between the parties.

The parties present their arguments and evidence before an arbitrator at a formal hearing. The arbitrator renders a decision to resolve the parties’ dispute.

No Yes Ys Ys Ys Ys Ys Ys Ys Ys Ys Ys Ys Yess Yess Y

E X H I B I T 2 – 4 Basic Differences in the Traditional Forms of ADR

C H A P T E R 2 Courts and Alternative Dispute Resolution 43

agreements involving transactions only slightly con- nected to the flow of interstate commerce may fall under the FAA. The FAA established a national policy favor- ing arbitration that the United States Supreme Court has continued to reinforce.18

■ CASE IN POINT 2.8 Cleveland Construction, Inc. (CCI), was the general contractor on a project to build a grocery store in Houston, Texas. CCI hired Levco Construction, Inc., as a subcontractor. Their contract included an arbitration provision stating that any dis- putes would be resolved by arbitration in Ohio. When a dispute arose between the parties, Levco filed a suit against CCI in a Texas state court. CCI sought to com- pel arbitration in Ohio under the Federal Arbitration Act (FAA), but a Texas statute allows a party to void a con- tractual provision that requires arbitration outside Texas. Ultimately, a Texas appellate court held that the FAA preempted (took priority over) the state law. CCI could compel arbitration in Ohio.19 ■

The Issue of Arbitrability The terms of an arbitra- tion agreement can limit the types of disputes that the parties agree to arbitrate. Disputes can arise, however, when the parties do not specify limits or when the parties disagree on whether a particular matter is covered by their arbitration agreement.

When one party files a lawsuit to compel arbitration, it is up to the court to resolve the issue of arbitrability. That is, the court must decide whether the matter is one that must be resolved through arbitration. If the court finds that the subject matter in controversy is covered by the agreement to arbitrate, then it may compel arbitration.

Usually, a court will allow a claim to be arbitrated if the court finds that the relevant statute (the state arbitra- tion statute or the FAA) does not exclude such claims. No party, however, will be ordered to submit a particular dispute to arbitration unless the court is convinced that the party has consented to do so. Additionally, the courts will not compel arbitration if it is clear that the arbitra- tion rules and procedures are inherently unfair to one of the parties.

Mandatory Arbitration in the Employment Context A significant question for businesspersons has concerned mandatory arbitration clauses in employment contracts. Many employees claim they are at a disadvan- tage when they are forced, as a condition of being hired,

18. See, for example, AT&AT&AT T Mobility LLC v. Concepcion, 563 U.S. 333, 131 S.Ct. 1740, 179 L.Ed.2d 742 (2011).

19. Cleveland Construction, Inc. v. Levco Construction, Inc., 359 S.W.3d 843 (Tex.App. 2012).

to agree to arbitrate all disputes and thus waive their rights under statutes designed to protect employees.

The United States Supreme Court, however, has held that mandatory arbitration clauses in employment con- tracts are generally enforceable. ■ CASE IN POINT 2.9 In a landmark decision, Gilmer v. Interstate Johnson Lane Corp.,20 the Supreme Court held that a claim brought under a federal statute prohibiting age discrimination could be subject to arbitration. The Court concluded that the employee had waived his right to sue when he agreed, as part of a required application to be a securities representative, to arbitrate “any dispute, claim, or contro- versy” relating to his employment. ■

Since the Gilmer decision, some courts have refused to enforce one-sided arbitration clauses.21 Nevertheless, the policy favoring enforcement of mandatory arbitration agreements in employment contracts remains strong.agreements in employment contracts remains strong.agreements in employment contracts remains strong.agreements in employment contracts remains strong.

■ CASE IN POINT 2.10 Stephanie Cruise was hired by Kroger Co. to work in its deli. Her job application had included a clause requiring arbitration of “employment- related disputes.” When Cruise was fired four years later, she filed a lawsuit claiming that Kroger had violated a number of laws prohibiting employment discrimina- tion. Kroger filed a motion to compel arbitration. A state appellate court concluded that the arbitration clause in the employment application established that the parties had agreed to arbitrate their “employment-related dis- putes.” Cruise’s claims fell within the meaning of that agreement, and therefore she was required to arbitrate.22 ■

2–4d Other Types of ADR The three forms of ADR just discussed are the oldest and traditionally the most commonly used forms. In addi- tion, a variety of newer types of ADR have emerged, including those described here. 1. In early neutral case evaluation, the parties select a

neutral third party (generally an expert in the subject matter of the dispute) and explain their respective positions to that person. The case evaluator assesses the strengths and weaknesses of each party’s claims.

2. In a mini-trial, each party’s attorney briefly argues the party’s case before the other party and a panel of representatives from each side who have the authority to settle the dispute. Typically, a neutral third party (usually an expert in the area being disputed) acts as

20. 500 U.S. 20, 111 S.Ct. 1647, 114 L.Ed.2d 26 (1991). 21. See, for example, Mohamed v. Uber Technologies, Inc., 2015 WL

3749716 (N.D.Cal. 2015); Macias v. Excel Building Services, LLC, 767 Macias v. Excel Building Services, LLC, 767 Macias v. Excel Building Services, LLC F.Supp.2d 1002 (N.D.Cal. 2011).

22. Cruise v. Kroger Co., 233 Cal.App.4th 390, 183 Cal.Rptr.3d 17 (2015). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

44 U N I T O N E The Foundations

an adviser. If the parties fail to reach an agreement, the adviser renders an opinion as to how a court would likely decide the issue.

3. Numerous federal courts hold summary jury trials, in which the parties present their arguments and evi- dence and the jury renders a verdict. The jury’s ver- dict is not binding, but it does act as a guide to both sides in reaching an agreement during the mandatory negotiations that immediately follow the trial.

4. Other alternatives being employed by the courts include summary proceedings, which dispense with some formal court procedures, and the appointment of special masters to assist judges in deciding complex issues.

2–4e Providers of ADR Services ADR services are provided by both government agen- cies and private organizations. A major provider of ADR services is the American Arbitration Association (AAA), which handles more than 200,000 claims a year in its numerous offices worldwide. Most of the largest U.S. law firms are members of this nonprofit association.

Cases brought before the AAA are heard by an expert or a panel of experts in the area relating to the dispute and are usually settled quickly. Generally, about half of the panel members are lawyers. To cover its costs, the AAA charges a fee, paid by the party filing the claim. In addi- tion, each party to the dispute pays a specified amount for each hearing day, as well as a special additional fee in cases involving personal injuries or property loss.

Hundreds of for-profit firms around the country also provide dispute-resolution services. Typically, these firms hire retired judges to conduct arbitration hearings or oth- erwise assist parties in settling their disputes. The judges follow procedures similar to those of the federal courts and use similar rules. Usually, each party to the dispute pays a filing fee and a designated fee for a hearing session or conference.

2–4f Online Dispute Resolution An increasing number of companies and organizations are offering dispute-resolution services using the Internet. The settlement of disputes in these forums is known as online dispute resolution (ODR). The disputes resolved have most commonly involved rights to domain names (Web site addresses) or the quality of goods sold via the Internet, including goods sold through Internet auction sites.

Rules being developed in online forums may ulti- mately become a code of conduct for everyone who

does business in cyberspace. Most online forums do not automatically apply the law of any specific jurisdiction. Instead, results are often based on general, universal legal principles. As with most offline methods of dispute reso- lution, any party may appeal to a court at any time.

ODR may be best for resolving small- to medium- sized business liability claims, which may not be worth the expense of litigation or traditional ADR methods. In addition, some cities use ODR as a means of resolving addition, some cities use ODR as a means of resolving addition, some cities use ODR as a means of resolving addition, some cities use ODR as a means of resolving claims against them. ■ EXAMPLE 2.11 New York City New York City uses Cybersettle.com to resolve auto accident, sidewalk, and other personal-injury claims made against the city. Parties with complaints submit their demands, and the city submits its offers confidentially online. If an offer exceeds a demand, the claimant keeps half the difference as a bonus, plus the original claim. ■

2–5 International Dispute Resolution

Businesspersons who engage in international business transactions normally take special precautions to pro- tect themselves in the event that a party with whom they are dealing in another country breaches an agreement. Often, parties to international contracts include special clauses in their contracts providing for how disputes arising under the contracts will be resolved. Sometimes, international treaties (formal agreements among several nations) even require parties to arbitrate any disputes.

2–5a Forum-Selection and Choice-of-Law Clauses

Parties to international transactions often include forum- selection and choice-of-law clauses in their contracts. These clauses designate the jurisdiction (court or coun- try) where any dispute arising under the contract will be litigated and which nation’s law will be applied.

When an international contract does not include such clauses, any legal proceedings arising under the contract will be more complex and attended by much more uncertainty. For instance, litigation may take place in two or more countries, with each country applying its own national law to the particular transactions.

Furthermore, even if a plaintiff wins a favorable judg- ment in a lawsuit litigated in the plaintiff ’s country, the defendant’s country could refuse to enforce the court’s judgment. The judgment may be enforced in the defen- dant’s country for reasons of courtesy. The United States,

C H A P T E R 2 Courts and Alternative Dispute Resolution 45

Terms and Concepts alternative dispute resolution

(ADR) 40 arbitration 41 arbitration clause 42 award 42 bankruptcy court 28 concurrent jurisdiction 30 diversity of citizenship 28 early neutral case evaluation 43 exclusive jurisdiction 30

federal question 28 in personam jurisdiction 27 in rem jurisdiction 27 judicial review 26 jurisdiction 27 litigation 40 long arm statute 27 mediation 41 mini-trial 43 negotiation 40

online dispute resolution (ODR) 44 probate court 28 question of fact 36 question of law 36 rule of four 40 small claims court 36 standing to sue 33 summary jury trial 44 venue 33 writ of certiorari 40certiorari 40certiorari

Debate This ... In this age of the Internet, when people communicate via e-mail, texts, tweets, Facebook, and Skype, is the concept of jurisdiction losing its meaning?

Reviewing: Courts and Alternative Dispute Resolution

Stan Garner resides in Illinois and promotes boxing matches for SuperSports, Inc., an Illinois corporation. Garner created the concept of “Ages” promotion—a three-fight series of boxing matches pitting an older fighter (George Foreman) against a younger fighter. The concept had titles for each of the three fights, including “Battle of the Ages.” Garner contacted Foreman and his manager, who both reside in Texas, to sell the idea, and they arranged a meeting in Las Vegas, Nevada. During negotiations, Foreman’s manager signed a nondisclosure agreement prohibiting him from disclosing Garner’s promotional concepts unless the parties signed a contract. Nevertheless, after negotiations fell through, Foreman used Garner’s “Battle of the Ages” concept to promote a subsequent fight. Garner filed a suit against Foreman and his manager in a federal district court located in Illinois, alleging breach of contract. Using the informa- tion presented in the chapter, answer the following questions. 1. On what basis might the federal district court in Illinois exercise jurisdiction in this case? 2. Does the federal district court have original or appellate jurisdiction? 3. Suppose that Garner had filed his action in an Illinois state court. Could an Illinois state court have exercised per-

sonal jurisdiction over Foreman or his manager? Why or why not? 4. Now suppose that Garner had filed his action in a Nevada state court. Would that court have had personal jurisdic-

tion over Foreman or his manager? Explain.

for instance, will generally enforce a foreign court’s deci- sion if it is consistent with U.S. national law and policy. Other nations, however, may not be as accommodat- ing as the United States, and the plaintiff may be left empty-handed.

2–5b Arbitration Clauses International contracts also often include arbitration clauses that require a neutral third party to decide any contract disputes. Many of the institutions that offer arbitration, such as the International Chamber of Com- merce or the Hong Kong International Arbitration Cen- tre, have formulated model clauses for parties to use. In

international arbitration proceedings, the third party may be a neutral entity, a panel of individuals representing both parties’ interests, or some other group or organization.

The United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards23 has been implemented in more than 145 countries, including the United States. This convention assists in the enforcement of arbitration clauses, as do provisions in specific treaties among nations. The American Arbitration Association provides arbitration services for international as well as domestic disputes.

23. June 10, 1958, 21 U.S.T. 2517, T.I.A.S. No. 6997 (the “New York Convention”).

46 U N I T O N E The Foundations

Issue Spotters 1. Sue uses her smartphone to purchase a video security

system for her architectural firm from Tipton, Inc., a company located in a different state. The system arrives a month after the projected delivery date, is of poor quality, and does not function as advertised. Sue files a suit against Tipton in a state court. Does the court in Sue’s state have jurisdiction over Tipton? What factors will the court consider in determining jurisdiction? (See Basic Judicial Requirements.)

2. The state in which Sue resides requires that her dispute with Tipton be submitted to mediation or nonbinding arbitration. If the dispute is not resolved, or if either party disagrees with the decision of the mediator or arbitrator, will a court hear the case? Explain. (See Alternative Dispute Resolution.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 2–1. Standing. Jack and Maggie Turton bought a house in Jefferson County, Idaho, located directly across the street from a gravel pit. A few years later, the county converted the pit to a landfill. The landfill accepted many kinds of trash that cause harm to the environment, including major appliances, animal carcasses, containers with hazardous content warnings,

leaking car batteries, and waste oil. The Turtons complained to the county, but the county did nothing. The Turtons then filed a lawsuit against the county alleging violations of federal environmental laws pertaining to groundwater contamination and other pollution. Do the Turtons have standing to sue? Why or why not? (See Basic Judicial Requirements.)

Business Case Problems 2–2. Venue. Brandy Austin used powdered infant for- mula manufactured by Nestlé USA, Inc., to feed her infant daughter. Austin claimed that a can of the formula was con- taminated with Enterobacter sakazakii bacteria, causing severe Enterobacter sakazakii bacteria, causing severe Enterobacter sakazakii injury to the infant. �e bacteria can cause infections of the bloodstream and central nervous system—in particular, men- ingitis (in�ammation of the tissue surrounding the brain or spinal cord). Austin �led an action against Nestlé in Henne- pin County District Court in Minnesota. Nestlé argued for a change of venue because the alleged harm had occurred in South Carolina. Austin is a South Carolina resident and had given birth to her daughter in that state. Should the case be transferred to a South Carolina venue? Why or why not? [Austransferred to a South Carolina venue? Why or why not? [Austransferred to a South Carolina venue? Why or why not? [ - tin v. Nestlé USA, Inc., 677 F.Supp.2d 1134 (D.Minn. 2009)] (See Basic Judicial Requirements.) 2–3. Arbitration. PRM Energy Systems owned patents licensed to Primenergy to use in the United States. �eir contract stated that “all disputes” would be settled by arbitra- tion. Kobe Steel of Japan was interested in using the technol- ogy represented by PRM’s patents. Primenergy agreed to let Kobe use the technology in Japan without telling PRM. When PRM learned about the secret deal, the �rm �led a suit against Primenergy for fraud and theft. Does this dispute go to arbitra- tion or to trial? Why? [PRM Energy Systems v. Primenergy, 592 F.3d 830 (8th Cir. 2010)] (See Alternative Dispute Resolution.) 2–4. Spotlight on the National Football League— Arbitration. Bruce Matthews played football for the Tennes-

see Titans. As part of his contract, he agreed to submit any dispute to arbitration. He also agreed that Tennessee law would determine all matters related to workers’ compensation. After Matthews

retired, he �led a workers’ compensation claim in California. �e arbitrator ruled that Matthews could pursue his claim in California but only under Tennessee law. Should this award be set aside? Explain. [National Football League Players Association v. National Football League Management Council, 2011 WL 1137334 (S.D.Cal. 2011)] (See Alternative Dispute Resolution.) 2–5. Minimum Contacts. Seal Polymer Industries sold two freight containers of latex gloves to Med-Express, Inc., a company based in North Carolina. When Med-Express failed to pay the $104,000 owed for the gloves, Seal Polymer sued in an Illinois court and obtained a judgment against Med- Express. Med-Express argued that it did not have minimum contacts with Illinois because it was incorporated under North Carolina law and had its principal place of business in North Carolina. �erefore, the Illinois judgment based on personal jurisdiction was invalid. Was this argument alone su�cient to prevent the Illinois judgment from being collected against Med-Express in North Carolina? Why or why not? [Seal Poly- mer Industries v. Med-Express, Inc., 725 S.E.2d 5 (N.C.App. 2012)] (See Basic Judicial Requirements.) 2–6. Arbitration. Horton Automatics and the Industrial Division of the Communications Workers of America, the union that represented Horton’s workers, negotiated a col- lective bargaining agreement. If an employee’s discharge for a workplace-rule violation was submitted to arbitration, the agreement limited the arbitrator to determining whether the rule was reasonable and whether the employee had violated it. When Horton discharged employee Ruben de la Garza, the union appealed to arbitration. �e arbitrator found that de la Garza had violated a reasonable safety rule, but “was not totally convinced” that Horton should have treated the

C H A P T E R 2 Courts and Alternative Dispute Resolution 47

violation more seriously than other rule violations. �e arbi- trator ordered de la Garza reinstated. Can a court set aside this order? Explain. [Horton Automatics v. �e Industrial Division of the Communications Workers of America, AFL-CIO, 2013 WL 59204 (5th Cir. 2013)] (See Alternative Dispute Resolution.) 2–7. Business Case Problem with Sample Answer— Corporate Contacts. LG Electronics, Inc., a South Korean

company, and nineteen other foreign companies participated in the global market for cathode ray tube (CRT) products. CRTs were integrated as components in consumer goods, including televi-

sion sets, and were sold for many years in high volume in the United States, including the state of Washington. �e state �led a suit in a Washington state court against LG and the others, alleging a conspiracy to raise prices and set production levels in the market for CRTs in violation of a state consumer protection statute. �e defendants �led a motion to dismiss the suit for lack of personal jurisdiction. Should this motion be granted? Explain. [State of Washington v. LG Electronics, Inc., 341 P.3d 346 (Wash.App., Div. 1 2015)] (See Basic Judi- cial Requirements.) • For a sample answer to Problem 2–7, go to Appendix E at

the end of this text.

2–8. Appellate, or Reviewing, Courts. Angelica West- brook was employed as a collector for Franklin Collection Service, Inc. During a collection call, Westbrook told a debtor that a $15 processing fee was an “interest” charge. �is vio- lated company policy. Westbrook was �red. She �led a claim for unemployment bene�ts, which the Mississippi Depart- ment of Employment Security (MDES) approved. Franklin objected. At an MDES hearing, a Franklin supervisor testi- �ed that she had heard Westbrook make the false statement, although she admitted that there had been no similar incidents

with Westbrook. Westbrook denied making the statement, but added that if she had said it, she did not remember it. �e agency found that Franklin’s reason for terminating West- brook did not amount to the misconduct required to disqual- ify her for bene�ts and upheld the approval. Franklin appealed to a state intermediate appellate court. Is the court likely to uphold the agency’s �ndings of fact? Explain. [Franklin Col-Franklin Col-Franklin Col lection Service, Inc. v. Mississippi Department of Employment Security, 184 So.3d 330 (Miss.App. 2016)] (See �e State and Federal Court Systems.) 2–9. A Question of Ethics—Agreement to Arbitrate.

Nellie Lumpkin, who su�ered from various illnesses, including dementia, was admitted to the Picayune Convalescent Center, a nursing home. Because of her mental condition, her daughter, Beverly

McDaniel, �lled out the admissions paperwork and signed the admissions agreement. It included a clause requiring parties to submit to arbitration any disputes that arose. After Lumpkin left the center two years later, she sued, through her husband, for negligent treatment and malpractice during her stay. �e center moved to force the matter to arbitration. �e trial court held that the arbitration agreement was not enforceable. �e center appealed. [Covenant Health [Covenant Health [ & Rehabilitation of Picayune, LP v. Lumpkin, 23 So.3d 1092 (Miss.App. 2009)] (See Alter- native Dispute Resolution.) (a) Should a dispute involving medical malpractice be forced

into arbitration? This is a claim of negligent care, not a breach of a commercial contract. Is it ethical for medical facilities to impose such a requirement? Is there really any bargaining over such terms? Discuss fully.

(b) Should a person with limited mental capacity be held to an arbitration clause agreed to by the next of kin who signed on behalf of that person? Why or why not?

Legal Reasoning Group Activity 2–10. Access to Courts. Assume that a statute in your state requires that all civil lawsuits involving damages of less than $50,000 be arbitrated. Such a case can be tried in court only if a party is dissatis�ed with the arbitrator’s decision. �e stat- ute also provides that if a trial does not result in an improve- ment of more than 10 percent in the position of the party who demanded the trial, that party must pay the entire cost of the arbitration proceeding. (See Alternative Dispute Resolution.)

(a) One group will argue that the state statute violates liti- gants’ rights of access to the courts and trial by jury.

(b) Another group will argue that the statute does not violate litigants’ right of access to the courts.

(c) A third group will evaluate how the determination on right of access would be changed if the statute was part of a pilot program that affected only a few judicial districts in the state.

C H A P T E R 3

3–1 Procedural Rules The parties to a lawsuit must comply with the procedural rules of the court in which the lawsuit is filed. Although people often think that substantive law determines the outcome of a case, procedural law can have a significant impact on a person’s ability to pursue a legal claim. Pro- cedural rules provide a framework for every dispute and specify what must be done at each stage of the litigation process.

Procedural rules are complex, and they vary from court to court and from state to state. There is a set of federal rules of procedure as well as various sets of rules for state courts. Additionally, the applicable procedures will depend on whether the case is a civil or criminal proceed- ing. All civil trials held in federal district courts are gov- erned by the Federal Rules of Civil Procedure (FRCP).2

3–1a Stages of Litigation Broadly speaking, the litigation process has three phases: pretrial, trial, and posttrial. Each phase involves spe- cific procedures, as discussed throughout this chapter. Although civil lawsuits may vary greatly in terms of com- plexity, cost, and detail, they typically progress through the stages charted in Exhibit 3–1.

2. The United States Supreme Court has authority to establish these rules, as spelled out in 28 U.S.C. Sections 2071–2077. Generally, though, the federal judiciary appoints committees that make recommendations to the Supreme Court. The Court then publishes any proposed changes in the rules and allows for public comment before finalizing the rules.

To illustrate the procedures involved in a civil lawsuit, we will use a simple hypothetical case. The case arose from an automobile accident, which occurred when a car driven by Antonio Carvello, a resident of New Jer- sey, collided with a car driven by Jill Kirby, a resident of New York. The accident took place at an intersection in New York City. Kirby suffered personal injuries, which caused her to incur medical and hospital expenses as well as lost wages for four months. In all, she calculated that the cost to her of the accident was $500,000.3 Carvello and Kirby have been unable to agree on a settlement, and Kirby now must decide whether to sue Carvello for the $500,000 compensation she feels she deserves.

3–1b Hire an Attorney As mentioned, rules of procedure often affect the out- come of a dispute—a fact that highlights the importance of obtaining the advice of counsel. The first step taken by almost anyone contemplating a lawsuit is to seek the guidance of a licensed attorney.

In the hypothetical Kirby-Carvello case, assume that Kirby consults with a lawyer. The attorney will advise her regarding what she can expect in a lawsuit, her prob- ability of success at trial, and the procedures that will be involved. If more than one court would have jurisdiction over the matter, the attorney will also discuss the advan- tages and disadvantages of filing in a particular court. In addition, the attorney will indicate how long it will take

3. For simplicity, we are ignoring damages for pain and suffering and for per- manent disabilities, which plaintiffs in personal-injury cases often seek.

A merican and English courts fol- low the adversarial system of justiceAjusticeA . Although parties are

allowed to represent themselves in court (called pro se representation),1

1. This right was definitively established in Faretta v. California, 422 U.S. 806, 95 S.Ct. 2525, 45 L.Ed.2d 562 (1975).

most parties to lawsuits hire attorneys to represent them. Each lawyer acts as his or her client’s advocate. Each law- yer presents his or her client’s version of the facts in such a way as to con- vince the judge (or the judge and jury, in a jury trial) that this version is cor-in a jury trial) that this version is cor-in a jury trial) that this version is cor rect. Most of the judicial procedures

that you will read about are rooted in the adversarial framework of the American legal system.

Court Procedures

C H A P T E R 3 Court Procedures 49

to resolve the dispute through litigation in a particular court and provide an estimate of the costs involved.

The attorney will also inform Kirby of the legal fees that she will have to pay in an attempt to collect damages from the defendant, Carvello. Attorneys base their fees on such factors as the difficulty of the matter at issue, the attorney’s experience and skill, and the amount of time involved. In the United States, legal fees range from $200 to $700 per hour or even higher (the average fee is between $200 and $450 per hour). The client normally must also pay various expenses related to the case (called “out-of- pocket” costs), such as court filing fees, travel expenses, and the costs of expert witnesses and investigators.

Types of Attorneys’ Fees For a particular legal mat- ter, an attorney may charge one type of fee or a combina- tion of several types. 1. Fixed fees may be charged for the performance of such Fixed fees may be charged for the performance of such Fixed fees

services as drafting a simple will. 2. Hourly fees may be charged for matters that will Hourly fees may be charged for matters that will Hourly fees

involve an indeterminate period of time. The amount of time required to bring a case to trial, for instance, probably cannot be precisely estimated in advance.

3. Contingency fees are fixed as a percentage (usually 33 percent) of a client’s recovery in certain types of lawsuits, such as a personal-injury lawsuit.4 If the

4. Contingency-fee arrangements are typically prohibited in criminal cases, divorce cases, and cases involving the distribution of assets after death.

lawsuit is unsuccessful, the attorney receives no fee, but the client will have to reimburse the attorney for all out-of-pocket costs incurred.

Because Kirby’s claim involves a personal injury, her lawyer will likely take the case on a contingency-fee basis. In some cases, the winning party may be able to recover at least some portion of her or his attorneys’ fees from the losing party.

Settlement Considerations Once an attorney has been retained, the attorney is required to pursue a resolu- tion of the matter on the client’s behalf. Nevertheless, the amount of resources an attorney will spend on a given case is affected by the time and funds the client wishes to devote to the process.

If the client is willing to pay for a lengthy trial and one or more appeals, the attorney may pursue those actions. Often, however, after learning of the substantial costs that litigation entails, a client may decide to pursue a settlement of the claim. Attempts to settle the case may be ongoing throughout the litigation process.

Another important consideration in deciding whether to pursue litigation is the defendant’s ability to pay the damages sought. Even if Kirby is awarded damages, it may be difficult to enforce the court’s judgment if the amount exceeds the limits of Carvello’s automobile insur- ance policy. (We will discuss the problems involved in enforcing a judgment later in this chapter.)

Trial and perhaps posttrial motions and/or an appeal

Defendant's attorney files an answer or a motion to dismiss

Pretrial discovery and more motions, pretrial

conference

The party hires a lawyer, lawyer, lawyer who files a

complaint and notifies (serves) the defendant

Accident, breach of contract, or other event

E X H I B I T 3 – 1 Stages in a Typical Lawsuit

50 U N I T O N E The Foundations

3–2 Pretrial Procedures The pretrial litigation process involves the filing of the pleadings, the gathering of evidence (called discovery), and discovery), and discovery possibly other procedures, such as a pretrial conference and jury selection.

3–2a The Pleadings The complaint and complaint and complaint answer (and other legal documents disanswer (and other legal documents disanswer - cussed below) are known as the pleadings. The pleadings inform each party of the other’s claims, reveal the facts, and specify the issues (disputed questions) involved in the case. Because the rules of procedure vary depending on the jurisdiction of the court, the style and form of the plead- ings may be different from those shown in this chapter.

The Plaintiff’s Complaint Kirby’s action against Carvello commences when her lawyer files a complaint5 with the clerk of the appropriate court. Complaints can be lengthy or brief, depending on the complexity of the case and the rules of the jurisdiction. The complaint con- tains statements or allegations concerning the following: 1. Jurisdiction. Facts showing that the particular court

has subject-matter and personal jurisdiction. 2. Legal theory. The facts establishing the plaintiff ’s

claim and basis for relief. 3. Remedy. The remedy (such as an amount of damages)

that the plaintiff is seeking. Exhibit 3–2 illustrates how a complaint in the Kirby-

Carvello case might appear. The complaint asserts facts indicating that the federal district court has subject- matter jurisdiction because of diversity of citizenship. It then gives a brief statement of the facts of the accident and alleges that Carvello negligently drove his vehicle through a red light, striking Kirby’s car. The complaint alleges that Carvello’s actions caused Kirby serious per- sonal injury and property damage. The complaint goes on to state that Kirby is seeking $500,000 in damages. (In some state civil actions, the plaintiff need not specify the amount of damages sought.)

Service of Process. Before the court can exercise personal jurisdiction over the defendant (Carvello)—in e�ect, before the lawsuit can begin—the court must have proof that the defendant was noti�ed of the lawsuit. Formally notifying the defendant of a lawsuit is called service of process.

5. Sometimes, the document filed with the court is called a petition or a declaration instead of a complaint.

The plaintiff must deliver, or serve, a copy of the complaint and a summons (a notice requiring the defen- dant to appear in court and answer the complaint) to the defendant. The summons notifies Carvello that he must file an answer to the complaint within a specified time period (twenty days in the federal courts) or suf-time period (twenty days in the federal courts) or suf-time period (twenty days in the federal courts) or suf fer a default judgment against him. A default judgment in Kirby’s favor would mean that she would be awarded the damages alleged in her complaint because Carvello failed to respond to the allegations. A typical summons is shown in Exhibit 3–3.

Method of Service. How service of process occurs depends on the rules of the court or jurisdiction in which the lawsuit is brought. Under the Federal Rules of Civil Procedure, anyone who is at least eighteen years of age and is not a party to the lawsuit can serve process in fed- eral court cases. In state courts, the process server is often a county sheri� or an employee of an independent com- pany that provides process service in the local area.

Usually, the server hands the summons and complaint to the defendant personally or leaves it at the defendant’s residence or place of business. In some states, process can be served by mail if the defendant consents (accepts service). When the defendant cannot be reached, special rules provide for alternative means of service, such as publishing a notice in the local newspaper.

In some situations, courts allow service of process via e-mail, as long as it is reasonably calculated to pro- vide notice and an opportunity to respond. Today, some judges have even allowed defendants to be served legal documents via social media, as discussed in this chapter’s Digital Update feature.

In cases involving corporate defendants, the summons and complaint may be served on an officer or on a regis- tered agent (representative) of the corporation. The name tered agent (representative) of the corporation. The name tered agent of a corporation’s registered agent can usually be obtained from the secretary of state’s office in the state where the company incorporated its business (and, frequently, from the secretary of state’s office in any state where the corpo- ration does business).

Waiver of Formal Service of Process. In many instances, the defendant is already aware that a lawsuit is being �led and is willing to waive (give up) her or his right to be served personally. �e Federal Rules of Civil Procedure (FRCP) and many states’ rules allow defen- dants to waive formal service of process, provided that certain procedures are followed.

In the Kirby case, for example, Kirby’s attorney could mail to defendant Carvello a copy of the complaint, along with “Waiver of Service of Summons” forms for

C H A P T E R 3 Court Procedures 51

IN THE UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK

JILL KIRBY

ANTONIO CARVELLO

COMPLAINT Plaintiff,

Defendant.

The plaintiff brings this cause of action against the defendant, alleging as follows:

WHEREFORE, the plaintiff demands judgment against the defendant for the sum of $500,000 plus interest at the maximum legal rate and the costs of this action.

1/3/18

Joseph RoeJoseph RoeJoseph Roe Attorney for Plaintiff 100 Main Street New York, New York

CIVIL NO. 9-1047

1. This action is between the plaintiff, who is a resident of the State of New York, and the defendant, who is a resident of the State of New Jersey. There is diversity of citizenship between the parties.

2. The amount in controversy, exclusive of interest and costs, exceeds the sum of $75,000.

3. On September 10th, 2017, the plaintiff, Jill Kirby, was exercising good driving habits and reasonable care in driving her car through the intersection of Boardwalk and Pennsylvania Avenue, New York City, New York, when the defendant, Antonio Carvello, negligently drove his vehicle through a red light at the intersection and collided with the plaintiff’s vehicle.

4. As a result of the collision, the plaintiff suffered severe physical injury, which prevented her from working, and property damage to her car.

E X H I B I T 3 – 2 A Typical Complaint

Carvello to sign. If Carvello signs and returns the forms within thirty days, formal service of process is waived.

Moreover, under the FRCP, defendants who agree to waive formal service of process receive additional time to respond to the complaint (sixty days, instead of twenty days). Some states provide similar incentives to encour- age defendants to waive formal service of process and thereby reduce associated costs and foster cooperation between the parties.

The Defendant’s Response Typically, the defen- dant’s response to the complaint takes the form of an answer. In an answer, the defendant either admits or denies each of the allegations in the plaintiff ’s complaint and may also set forth defenses to those allegations.

Under the federal rules, any allegations that are not denied by the defendant will be deemed by the court to have been admitted. If Carvello admits to all of Kirby’s allegations in his answer, a judgment will be entered for

52 U N I T O N E The Foundations

Kirby. If Carvello denies Kirby’s allegations, the matter will proceed further.

Affirmative Defenses. Carvello can also admit the truth of Kirby’s complaint but raise new facts to show that he should not be held liable for Kirby’s damages. �is is called raising an a�rmative defense.

Defendants in both civil and criminal cases can raise affirmative defenses. For example, Carvello could assert Kirby’s own negligence as a defense by alleging that Kirby was driving negligently at the time of the accident. In some states, a plaintiff ’s contributory negligence operates as a complete defense. In most states, however, the plain- tiff ’s own negligence constitutes only a partial defense.

Counterclaims. Carvello could also deny Kirby’s alle- gations and set forth his own claim that the accident occurred as a result of Kirby’s negligence and therefore she

owes Carvello for damage to his car. �is is appropriately called a counterclaim. If Carvello �les a counterclaim, Kirby will have to submit an answer to the counterclaim.

3–2b Dismissals and Judgments before Trial

Many actions for which pleadings have been filed never come to trial. The parties may, for instance, negotiate a settlement of the dispute at any stage of the litigation process. There are also numerous procedural avenues for disposing of a case without a trial. Many of them involve one or the other party’s attempts to get the case dismissed through the use of various motions.

A motion is a procedural request submitted to the court by an attorney on behalf of her or his client. When a motion is filed with the court, the filing party must also send to, or personally serve, the opposing party a notice of

UNITED STATES DISTRICT COURT FOR THE SOUTHERN DISTRICT OF NEW YORK

JILL KIRBY

ANTONIO CARVELLO

SUMMONS Plaintiff,

Defendant.

To the above-named Defendant:

You are hereby summoned and required to serve upon Joseph Roe, plaintiff’s attorney, whose address is 100 Main Street, New York, NY, an answer to the complaint which is herewith served upon you, within 20 days after service of this summons upon you, exclusive of the day of service. If you fail to do so, judgment by default will be taken against you for the relief demanded in the complaint.

C. H. Hynek

CLERK

BY DEPUTY CLERK

January 3, 2018

DATE

CIVIL ACTION, FILE NO. 9-1047

E X H I B I T 3 – 3 A Typical Summons

C H A P T E R 3 Court Procedures 53

motion. The notice of motion informs the opposing party that the motion has been filed. Pretrial motions include the motion to dismiss, the motion for judgment on the pleadings, and the motion for summary judgment, as well as the other motions listed in Exhibit 3–4.

Motion to Dismiss Either party can file a motion to dismiss asking the court to dismiss the case for the reasons stated in the motion. Normally, though, it is the defendant who requests dismissal.

A defendant can file a motion to dismiss if the plain- tiff ’s complaint fails to state a claim for which relief (a remedy) can be granted. Such a motion asserts that even if the facts alleged in the complaint are true, they

do not give rise to any legal claim against the defendant. For example, if the allegations in Kirby’s complaint do not constitute negligence on Carvello’s part, Carvello can move to dismiss the case for failure to state a claim. Defendant Carvello could also file a motion to dismiss on the grounds that he was not properly served, that the court lacked jurisdiction, or that the venue was improper.

If the judge grants the motion to dismiss, the plain- tiff generally is given time to file an amended com- plaint. If the judge denies the motion, the suit will go forward, and the defendant must then file an answer. Note that if Carvello wishes to discontinue the suit because, for example, an out-of-court settlement has been reached, he can likewise move for dismissal. The

Using Social Media for Service of Process

Historically, when process servers failed to reach a defendant at home, they attempted to serve process at the defendant’s workplace, by mail, and by publication. In our digital age, does publication via social media qualify as legitimate service of process?

Can You Serve a Divorce Summons Through a Private Message on a Facebook Account?

Facebook has well over 1.6 billion active users per month. Assume that a man has a Facebook account and so does his spouse. He has moved out and is inten- tionally avoiding service of a divorce summons. Even a private investigator has not been able to deliver that summons. What to do? According to a New York state court ruling, the lawyer for the woman can serve the divorce summons through a private message from her Facebook account. “The past decade has . . . seen the advent and ascendancy of social media. . . . Thus, it would appear that the next frontier in the developing law of the service of process over the Internet is the use of social media sites as forums through which a sum- mons can be delivered.”a

An Increasing Use of Social Media for Service of Process

More and more courts are allowing service of process via Facebook and other social media. One New York City family court judge ruled that a divorced man could

serve his ex-wife through her active Facebook account. She had moved out of the house and provided no forwarding address. A Dallas district judge authorized service of process via social media, and other judges in that state have agreed with the ruling. A bill pending in the Texas state legislature would allow ser- vice via social media whenever a plaintiff can

authenticate the social media account. Other states are considering similar legislation.

Not All Courts Agree, Though

In spite of these examples, the courts have not uni- formly approved of using social media to serve process. In one federal district court case, the court pointed out the relative simplicity of creating a fake Facebook account and the court’s resulting inability to verify the true owner of that account.b In another case, involv- ing the Federal Trade Commission (FTC), the court did allow service of process via Facebook, but noted that “if the FTC were proposing to serve the defendants only by means of Facebook, as opposed to using Facebook as a supplemental means of service, a substantial ques- tion would arise whether that service comports with due process.”c

Critical Thinking In our connected world, is there any way a defendant could avoid service of process via social media?

DIGITAL UPDATE

a. Baido v. Blood-Dzraqu, 48 Misc.3d 309, 5 N.Y.S.3d 709 (2015).

b. Fortunato v. Chase Bank USA, 2011 WL 5574884 (S.D.N.Y. 2011) and 2012 WL 2086950 (S.D.N.Y. 2012).

c. FTC v. PCCare247, Inc., 2013 WL 841037 (S.D.N.Y. 2013).

54 U N I T O N E The Foundations

Motion to Strike A defendant's motion asking the court to strike (delete or remove) certain paragraphs from the complaint to better clarify the issues in dispute

Motion to Make More Definite or Certain

A motion by the defendant when the complaint is vague that asks the court to compel the plaintiff to clarify the cause of action

Motion for Judgment on the Pleadings

A motion by either party asking the court to enter judgment in his or her favor based on the pleadings because there are no facts in dispute

Motion to Compel Discovery

A motion asking the court to force the nonmoving party to comply with a discovery request

Motion for Summary Judgment

A motion asking the court to enter a judgment in his or her favor without a trial

A motion (normally filed by the defendant) that asks the court to dismiss the case for a specified reason, such as lack of personal jurisdiction or failure to state a claim

Motion to Dismiss

E X H I B I T 3 – 4 Pretrial Motions

court can also dismiss a case on its own motion. In the following case, one party filed a complaint against two others, alleging a breach of contract. The defendants

filed a motion to dismiss on the ground that the venue was improper. The court denied the motion, and the defendants appealed.

In the Language of the Court CORTIÑAS, J. [Judge]

* * * * Espresso Disposition Corporation

1 and Rowland Coffee Roasters, Inc. (collectively “Appellants”) seek review of the trial court’s order denying their motions to dismiss [Santana Sales & Marketing Group, Inc.’s (“Appellee’s”)]

third amended complaint. Appellants claim that the trial court erred in deny- ing their motions to dismiss because the plain and unambiguous language in the parties’ * * * agreement contains a man- datory forum selection clause [a provi- sion in a contract designating the court, jurisdiction, or tribunal that will decide any disputes arising under the contract]

requiring that all law- suits brought under the agreement shall be in Illinois.

Espresso Disposition Corporation 1 and Santana and Associates entered into the * * * agreement in 2002. The agree- ment provides for a mandatory forum selection clause in paragraph 8. The pro- vision states:

Case Analysis 3.1 Espresso Disposition Corp. 1 v. Santana Sales & Marketing Group, Inc. Espresso Disposition Corp. 1 v. Santana Sales & Marketing Group, Inc. Espresso Disposition Corp. 1 v.

Florida Court of Appeal, Third District, 105 So.3d 592 (2013).

C H A P T E R 3 Court Procedures 55

The venue with respect to any action pertaining to this Agree- ment shall be the State of Illinois. The laws of the State of Illinois shall govern the application and interpretation of this Agreement.

However, Appellee filed a lawsuit against Appellants alleging a breach of the agreement in Miami–Dade County, Florida. In fact, Appellee filed four subsequent complaints—an initial complaint, amended complaint, second amended complaint, and third amended complaint—after each and every previ- ous pleading’s dismissal was based upon venue as provided for in the agreement’s mandatory forum selection clause. Appellee’s third amended complaint alleges the forum selection clause was a mistake that was made at the time the agreement was drafted. Additionally, Appellee attached an affidavit [a sworn statement] which states that, in drafting the agreement, Appellee * * * copied a form version of an agreement between different parties, and by mistake, forgot to change the venue provision from Illi- nois to Florida. In response, Appellants filed their motions to dismiss the third amended complaint, which the trial court denied.

Florida appellate courts interpret a contractual forum selection clause under a de novo standard of review. [The courts review the issue anew, as if the lower courts had not ruled on the issue.] Likewise, as the trial court’s order denying appellant’s motion to dismiss is based on the interpretation of the contractual forum selection clause, this court’s standard of review is de novo. Therefore, the narrow issue before this court is whether the * * *

agreement provides for a mandatory forum selection clause that is enforce- able under Florida law.

Florida courts have long recognized that forum selection clauses such as the one at issue here are presumptively valid. This is because forum selection clauses provide a degree of certainty to business contracts by obviating [preventing] juris- dictional struggles and by allowing parties to tailor the dispute resolution mechanism to their particular situation. Moreover, forum selection clauses reduce litigation over venue, thereby conserving judicial resources, reducing business expenses, and lowering consumer prices. [Emphasis added.]

Because Florida law presumes that forum selection clauses are valid and enforceable, the party seeking to avoid enforcement of such a clause must estab- lish that enforcement would be unjust or unreasonable. Under Florida law, the clause is only considered unjust or unreasonable if the party seeking avoid- ance establishes that enforcement would result in no forum at all. There is abso- lutely no set of facts that Appellee could plead and prove to demonstrate that Illinois state courts do not exist. Illinois became the twenty-first state in 1818, and has since established an extensive system of state trial and appellate courts. Clearly, Appellee failed to establish that enforcement would be unreasonable since the designated forum—Illinois— does not result in Appellee’s having “no forum at all.”

Further, as we have said on a number of occasions, if a forum selection clause unambiguously mandates that litigation be subject to an agreed upon forum, then it is error for the trial court to ignore the clause. Generally, the clause

is mandatory where the plain language used by the parties indicates exclusiv- ity. Importantly, if the forum selection clause states or clearly indicates that any litigation must or shall be initiated in a specified forum, then it is mandatory. Here, the agreement’s plain language provides that the venue for any action relating to a controversy under the agreement * * * “shall be the State of Illinois.” The clear language unequivo- cally renders the forum selection clause mandatory.

Appellee would have us create an exception to our jurisprudence on mandatory forum selection clauses based on their error in cutting and pasting the clause from another agree- ment. Of course, the origin of “cutting and pasting” comes from the tradi- tional practice of manuscript-editing whereby writers used to cut paragraphs from a page with editing scissors, that had blades long enough to cut an 811⁄⁄1⁄11⁄1⁄2⁄2⁄2⁄2⁄ inch-wide page, and then physically pasted them onto another page. Today, the cut, copy, and paste functions contained in word processing software render unnecessary the use of scissors or glue. However, what has not been eliminated is the need to actually read and analyze the text being pasted, especially where it is to have legal sig- nificance. Thus, in reviewing the man- datory selection clause which Appellant seeks to enforce, we apply the legal maxim “be careful what you ask for” and enforce the pasted forum.

Accordingly, we reverse [the] trial court’s denial of the motions to dismiss Appellee’s third amended complaint on the basis of improper venue, and remand for entry of an order of dismissal.

Case 3.1 Continued

Legal Reasoning Questions

1. Compare and contrast a motion to dismiss with other pretrial motions. Identify their chief differences. 2. Why did the appellants in this case file a motion to dismiss? 3. What is the effect of granting a motion to dismiss?

56 U N I T O N E The Foundations

Background and Facts Twenty-First Century Bean Processing hired Anthony Lewis, a forty-seven- year-old African American male, for a warehouse position, subject to a thirty-day probationary period. At the end of the period, Twenty-First Century evaluated Lewis’s performance to determine whether he would remain an employee. The employer decided not to retain Lewis, who then filed a suit in a federal district court against Twenty-First Century. Lewis alleged discrimination on the basis of race and age in violation of Title VII of the Civil Rights Act and the Age Discrimination in Employment Act. Twenty-First Century filed a motion for summary judgment. As evidence, the employer presented proof concerning Lewis’s job performance during the probationary period. The court granted the motion. Lewis appealed.

In the Language of the Court Robert E. BACHARACH, Circuit Judge.BACHARACH, Circuit Judge.BACHARACH

* * * * When a plaintiff alleges discrimination but offers no direct evidence of discrimination, the plaintiff bears

the initial burden to establish a prima facie case of discrimination. [This requires a showing that (1) the plaintiff is a member of a protected class—a person defined by certain criteria, including race or age; (2) the plaintiff applied and was qualified for the job at issue; (3) the plaintiff was rejected by the employer; and (4) the employer filled the position with someone not in a protected class.] If a plaintiff

Lewis v. Twenty-First Century Bean Processing United States Court of Appeals, Tenth Circuit, __ F.3d __, 2016 WL 66334 (2016).

Case 3.2

Motion for Judgment on the Pleadings At the close of the pleadings, either party may make a motion for judgment on the pleadings. This motion asks the court to decide the issue solely on the pleadings without proceeding to trial.

The judge will grant the motion only when there is no dispute over the facts of the case and the sole issue to be resolved is a question of law. For example, in the Kirby- Carvello case, if Carvello had admitted to all of Kirby’s allegations in his answer and had raised no affirmative defenses, Kirby could file a motion for judgment on the pleadings.

In deciding a motion for judgment on the pleadings, the judge may consider only the evidence contained in the pleadings. In contrast, in a motion for summary judg- ment, discussed next, the court may consider evidence outside the pleadings, such as sworn statements and other materials that would be admissible as evidence at trial.

Motion for Summary Judgment Either party can file a motion for summary judgment, which asks the court to grant a judgment in that party’s favor without a trial. The motion can be made before or during the trial. As with a motion for judgment on the pleadings, a court

will grant a motion for summary judgment only if no facts are in dispute and the only question is how the law applies to the facts. In determining whether no facts are in contention, the court considers the evidence in the light most favorable to the other party.

To support a motion for summary judgment, a party can submit evidence obtained at any point before the trial that refutes the other party’s factual claim. The evidence may consist of affidavits (sworn statements by parties or witnesses) or copies of documents, such as contracts, e-mails, and letters obtained through the course of dis- covery (discussed next).

Of course, the evidence must be admissible evidence—that is, evidence that the court would allow to be presented during the trial. As mentioned, the use of additional evidence is one feature that distinguishes the motion for summary judgment from the motion to dismiss and the motion for judgment on the pleadings.

On appeal of a court’s grant or denial of a motion for summary judgment, the appellate court engages in de novo review—that is, it applies the same standard that the trial court applied. In the following case, an appellate court took a fresh look at the evidence that had been presented with a motion for summary judgment granted by the lower court.

C H A P T E R 3 Court Procedures 57

establishes a prima facie case, the burden shifts to the defendant to articulate a * * * nondiscriminatory reason for its actions. If the defendant satisfies that burden, the employee would bear the burden to prove the defendant’s actions were discriminatory, which the employee could do by showing defendant’s proffered reason is a pretext for illegal discrimination. [Emphasis added.]

* * * * Mr. Lewis alleges age discrimination under the Age Discrimination in Employment Act. * * * Mr.

Lewis had not presented any direct evidence of discrimination [and] the court determined that Mr. Lewis had not established a prima facie case because he had failed to provide evidence that his work was prima facie case because he had failed to provide evidence that his work was prima facie satisfactory. In our view, that conclusion was proper. Therefore, we affirm the district court’s grant of summary judgment to Twenty-First Century on the age discrimination claim.

* * * * Mr. Lewis also alleges race discrimination under Title VII of the Civil Rights Act. Again finding no

direct evidence of discrimination, * * * the court assumed without deciding that Mr. Lewis had estab- lished a prima facie case of race discrimination. Thus, the burden shifted to Twenty-First Century to prima facie case of race discrimination. Thus, the burden shifted to Twenty-First Century to prima facie show a nondiscriminatory reason for terminating Mr. Lewis.

As evidence of a non-discriminatory purpose, Twenty-First Century pointed out that Mr. Lewis had missed too many work days, slept at work, used his personal cellphone at work, and reacted argumenta- tively when warned about his cellphone usage. After finding that any one of these policy violations could serve as a nondiscriminatory reason for the firing, the court placed the burden on Mr. Lewis to show * * * that Twenty-First Century’s explanation was pretextual [not legitimate]. The district court con- cluded that Mr. Lewis was unable to meet this burden, and we agree.

Decision and Remedy The U.S. Court of Appeals for the Tenth Circuit affirmed the lower court’s sum- mary judgment. Of the twenty-five work days in the probationary period, Lewis was absent for four days, found sleeping twice, and seen several times texting and talking on his personal phone. When informed that this use of a phone was against company policy, Lewis argued with his superior.

Critical Thinking • Legal Environment Should motions for summary judgment and other pretrial motions be abolished so

that all lawsuits proceed to trial? Why or why not? • What If the Facts Were Different? Suppose that at this stage of the litigation, Twenty-First Century

had not been able to provide evidence in support of its asserted reason for Lewis’s firing. What would have been the result? Why?

Case 3.2 Continued

3–2c Discovery Before a trial begins, the parties can use a number of procedural devices to obtain information and gather evi- dence about the case. Kirby, for example, will want to know how fast Carvello was driving. She will also want to learn whether he had been drinking, was under the influ- ence of medication, and was wearing corrective lenses if required by law to do so while driving.

The process of obtaining information from the opposing party or from witnesses prior to trial is known as discovery. Discovery includes gaining access to wit- nesses, documents, records, and other types of evidence.

In federal courts, the parties are required to make initial disclosures of relevant evidence to the opposing party. A court can impose sanctions on a party who fails to respond to discovery requests.

Discovery prevents surprises at trial by giving both parties access to evidence that might otherwise be hid- den. This allows the litigants to learn as much as they can about what to expect at a trial before they reach the courtroom. Discovery also serves to narrow the issues so that trial time is spent on the main questions in the case. The following case shows how vital discovery can be to the outcome of litigation.

58 U N I T O N E The Foundations

Background and Facts Phillips Brothers, LP (limited partnership), Harry Simmons, and Ray Win- stead were the owners of Kilby Brake Fisheries, LLC (limited liability company), a catfish farm in Missis- sippi. For nearly eight years, Winstead operated a hatchery for the firm. During this time, the hatchery had only two profitable years. Consequently, Winstead was fired. He filed a suit in a Mississippi state court against Kilby Brake and its other owners, alleging a “freeze-out.” (A freeze-out occurs when a majority of the owners of a firm exclude other owners from certain benefits of participating in the firm.)

The defendants filed a counterclaim of theft. To support this claim, the defendants asked the court to allow them to obtain documents from Winstead regarding his finances, particularly income from his Winstead Cattle Company. The court refused this request. A jury awarded Winstead more than $1.7 million, and the defendants appealed.

In the Language of the Court WALLER, Chief Justice for the Court.

* * * * During discovery, Winstead produced his tax returns from 2006 to 2009, which showed substantial

income as coming from the Winstead Cattle Company. The only other income listed on Winstead’s tax returns was from Kilby Brake * * * . Winstead had also produced [other documents showing income] from a fish farmer named Scott Kiker, which did not appear on his tax returns. [The documents suppos- edly involved income from sales of cattle.] Kilby Brake’s theory was the entries for “cattle” represented income from sales of Kilby Brake fish Winstead was brokering and thus, it sought to compel [discovery] of all of the Winstead Cattle Company’s financial records. Winstead [testified] in his deposition and again at trial that the Winstead Cattle Company did no actual business, and it was simply his hunting camp. The trial court denied Kilby Brake’s motion to compel discovery into Winstead’s finances.

* * * [Winstead was questioned about the forms he] had produced in discovery showing income from Kiker. Winstead testified that he would often act as a middle man if he knew of a farmer who was in need of fish and another who had fish for sale, taking a commission for brokering the deal.

* * * * * * * Kiker testified that he had received a load of fish from Kilby Brake [but that] there was no

paperwork on the transaction [and] that he sold this load of fish, gave Winstead a commission and did not pay Kilby Brake for the sales.

From the evidence noted above, we find the trial court’s refusal to allow both discovery into the finances of Winstead and questions concerning Winstead Cattle Company on his tax return prevented Kilby Brake and the jury from finding out whether Winstead was selling fish from Kilby Brake and disguising it on his income tax returns * * * . Importantly, the decisions by the trial court denied Kilby Brake the ability to present tax returns * * * . Importantly, the decisions by the trial court denied Kilby Brake the ability to present tax returns its case as to what happened to the fish. The record shows there were years in which Winstead received substantial income from brokering fish sales, almost $20,000 in one year. He [testified] that Winstead Cattle Company did no business and was simply his hunting camp, yet it made significant amounts of money. [Emphasis added.]

Decision and Remedy The Mississippi Supreme Court reversed the lower court’s decision to deny dis- covery of information concerning Winstead’s outside finances, especially regarding income from Winstead Cattle Company. The state supreme court remanded the case for a new trial.

Critical Thinking • Ethical Does Winstead have an ethical duty to comply with the defendants’ discovery request? Discuss. • Legal Environment Did the defendants have a legitimate basis to make a discovery request for infor-

mation regarding Winstead’s outside income? Explain.

Brothers v. Winstead Supreme Court of Mississippi, 129 So.3d 906 (2014).

Case 3.3

C H A P T E R 3 Court Procedures 59

Discovery Rules The FRCP and similar state rules set forth the guidelines for discovery activity. Generally, discovery is allowed regarding any matter that is relevant to the claim or defense of any party. Discovery rules also attempt to protect witnesses and parties from undue harassment, and to prevent privileged or confidential material from being disclosed. Only information that is relevant to the case at hand—or likely to lead to the dis- covery of relevant information—is discoverable.

If a discovery request involves privileged or confiden- tial business information, a court can deny the request and can limit the scope of discovery in a number of ways. For instance, a court can require the party to submit the materials to the judge in a sealed envelope so that the judge can decide if they should be disclosed to the oppos- ing party.

Depositions Discovery can involve the use of deposi- tions. A deposition is sworn testimony by a party to the lawsuit or by any witness, recorded by an authorized court official. The person deposed gives testimony and answers questions asked by the attorneys from both sides. The questions and answers are recorded, sworn to, and signed. These answers, of course, will help the attorneys prepare their cases.

Depositions also give attorneys the opportunity to ask immediate follow-up questions and to evaluate how their witnesses will conduct themselves at trial. In addi- tion, depositions can be employed in court to impeach (challenge the credibility of ) a party or a witness who changes his or her testimony at the trial. Finally, a depo- sition can be used as testimony if the witness is not avail- able at trial.

Interrogatories Discovery can also involve inter- rogatories—written questions for which written answers rogatories—written questions for which written answers rogatories— are prepared and then signed under oath. The main dif-are prepared and then signed under oath. The main dif-are prepared and then signed under oath. The main dif ference between interrogatories and written depositions is that interrogatories are directed to a party to the law- suit (the plaintiff or the defendant), not to a witness. The party usually has thirty days to prepare answers.

The party’s attorney often drafts the answers to inter- rogatories in a manner calculated to give away as little information as possible. Whereas depositions elicit can- did answers not prepared in advance, interrogatories are designed to obtain accurate information about spe- cific topics, such as how many contracts were signed and when. The scope of interrogatories is also broader because parties are obligated to answer questions, even if that means disclosing information from their records and files. As with discovery requests, a court can impose sanctions on a party who fails to answer interrogatories.

■ CASE IN POINT 3.1 Ronald J. Hass (doing business as Valley Corp. and R. J. Hass Corp.) was a contractor who built a home for Ty and Karen Levine. Probuild- ers Specialty Insurance Co. provided commercial liabil- ity insurance for the contractor. Later, when the Levines sued Hass and his company for shoddy and incomplete work, Hass blamed the subcontractors. Probuilders pro- vided Hass with legal representation, but the Levines won a judgment for more than $2 million. Then Probuilders sued Hass and his company, claiming that he had made misrepresentations to them regarding the facts of the case and seeking to avoid paying the judgment. Hass filed a counterclaim against Probuilders.

A dispute arose between Probuilders and Hass con- cerning discovery. Hass refused to respond fully to inter- rogatories and other discovery requests, and refused to give a deposition. Probuilders filed a motion to compel, and the court ordered Hass to respond to the discovery requests. Although Probuilders sent letters specifying what was needed, Hass continued to be evasive. The court imposed sanctions on Hass more than once. Ulti- mately, the court found that Hass had acted willfully and in bad faith, and recommended that his answers and counterclaim against Probuilders be dismissed.6 ■

Requests for Admissions One party can serve the other party with a written request for an admission of the truth of matters relating to the trial. Any fact admitted under such a request is conclusively established as true for the trial. For example, Kirby can ask Carvello to admit that his driver’s license was suspended at the time of the accident. A request for admission shortens the trial because the parties will not have to spend time proving facts on which they already agree.

Requests for Documents, Objects, and Entry upon Land A party can gain access to documents and other items not in her or his possession in order to inspect and examine them. Carvello, for example, can gain permission to inspect and copy Kirby’s car repair bills. Likewise, a party can gain “entry upon land” to inspect the premises.

Requests for Examinations When the physical or mental condition of one party is in question, the oppos- ing party can ask the court to order a physical or mental examination by an independent examiner. If the court agrees to make the order, the opposing party can obtain the results of the examination. Note that the court will

6. Probuilders Specialty Insurance Co. v. Valley Corp., 2012 WL 6045753 (N.D.Cal. 2012).

60 U N I T O N E The Foundations

make such an order only when the need for the informa- tion outweighs the right to privacy of the person to be examined.

Electronic Discovery Any relevant material, includ- ing information stored electronically, can be the object of a discovery request. The federal rules and most state rules (as well as court decisions) specifically allow indi- viduals to obtain discovery of electronic “data compila- tions.” Electronic evidence, or e-evidence, consists of all computer-generated or electronically recorded infor- mation, such as e-mail, voice mail, tweets, blogs, social media posts, spreadsheets, documents, and other data stored electronically.

E-evidence can reveal significant facts that are not discoverable by other means. Computers, smartphones, cameras, and other devices automatically record certain information about files—such as who created the file and when, and who accessed, modified, or transmit- ted it—on their hard drives. This information is called metadata, which can be thought of as “data about data.” Metadata can be obtained only from the file in its elec- tronic format—not from printed-out versions.

■ EXAMPLE 3.2 In 2012, John McAfee, the program- mer responsible for creating McAfee antivirus software, was wanted for questioning in the murder of his neigh- bor in Belize. McAfee left Belize and was on the run from police, but he allowed a journalist to come with him and photograph him. When the journalist posted photos of McAfee online, some metadata were attached to a photo. The police used the metadata to pinpoint the latitude and longitude of the image and subsequently arrested McAfee in Guatemala. ■

E-Discovery Procedures. �e Federal Rules of Civil Pro- cedure deal speci�cally with the preservation, retrieval, and production of electronic data. Although traditional interrogatories and depositions are still used to �nd out whether e-evidence exists, a party usually must hire an expert to retrieve the evidence in its electronic format. �e expert uses software to reconstruct e-mail, text, and other exchanges to establish who knew what and when they knew it. �e expert can even recover computer �les that the user thought had been deleted.

Advantages and Disadvantages. Electronic discovery has signi�cant advantages over paper discovery. Electronic versions of documents, e-mail, and text messages can pro- vide useful—and often quite damaging—information about how a particular matter progressed over several weeks or months. E-discovery can uncover the prover- bial smoking gun that will win the lawsuit. But it is also

time consuming and expensive, especially when lawsuits involve large �rms with multiple o�ces. Indeed, many �rms are �nding it di�cult to ful�ll their duty to preserve electronic evidence from a vast number of sources.

A party that fails to preserve e-evidence may find itself at such a disadvantage that it will settle a dispute rather at such a disadvantage that it will settle a dispute rather at such a disadvantage that it will settle a dispute rather at such a disadvantage that it will settle a dispute rather than continue litigation. ■ CASE IN POINT 3.3 Advanced Micro Devices, Inc. (AMD), sued Intel Corporation, one of the world’s largest microprocessor suppliers, for vio- lating antitrust laws. Immediately after the lawsuit was filed, Intel began collecting and preserving the electronic evidence on its servers and instructed its employees to retain documents and e-mails related to competition with AMD. Nevertheless, many employees saved only copies of the e-mails that they had received and not e-mails that they had sent. In addition, Intel did not stop its automatic e-mail deletion system, causing other infor- mation to be lost. In the end, although Intel produced data equivalent to “somewhere in the neighborhood of a pile 137 miles high” in paper, its failure to preserve e-discovery led it to settle the dispute.7 ■

3–2d Pretrial Conference After discovery has taken place and before the trial begins, the attorneys may meet with the trial judge in a pretrial conference, or hearing. Usually, the confer- ence consists of an informal discussion between the judge and the opposing attorneys after discovery has taken place. The purpose is to explore the possibility of a settlement without trial and, if this is not possible, to identify the matters in dispute and to plan the course of the trial. In particular, the parties may attempt to establish ground rules to restrict the number of expert witnesses or discuss the admissibility or costs of certain types of evidence.

3–2e The Right to a Jury Trial The Seventh Amendment to the U.S. Constitution guar- antees the right to a jury trial for cases at law in federal courts when the amount in controversy exceeds $20. Most states have similar guarantees in their own consti- tutions (although the threshold dollar amount is higher than $20).

The right to a trial by jury need not be exercised, and many cases are tried without a jury. In most states and in federal courts, one of the parties must request a jury, or the judge presumes the parties waive this right. If there

7. In re Intel Corp. Microprocessor Antitrust Litigation, 2008 WL 2310288 (D.Del. 2008).

C H A P T E R 3 Court Procedures 61

is no jury, the judge determines the truth of the facts alleged in the case.

3–2f Jury Selection Before a jury trial commences, a panel of jurors must be selected. Although some types of trials require twelve- person juries, most civil matters can be heard by six- person juries. The jury selection process is known as voir dire.8 In most jurisdictions, attorneys for the plaintiff and the defendant ask prospective jurors oral questions to determine whether they are biased or have any connec- tion with a party to the action or with a prospective wit- ness. In some jurisdictions, the judge may do all or part of the questioning based on written questions submitted by counsel for the parties.

During voir dire, a party may challenge a certain num- ber of prospective jurors peremptorily—that is, ask that an peremptorily—that is, ask that an peremptorily individual not be sworn in as a juror without providing any reason. Alternatively, a party may challenge a pro- spective juror for cause—that is, provide a reason why an for cause—that is, provide a reason why an for cause individual should not be sworn in as a juror. If the judge grants the challenge, the individual is asked to step down. A prospective juror, however, may not be excluded by the use of discriminatory challenges, such as those based on racial criteria or gender.

See Concept Summary 3.1 for a review of pretrial procedures.

3–3 The Trial Various rules and procedures govern the trial phase of the litigation process. There are rules governing what kind of evidence will or will not be admitted during the trial, as well as specific procedures that the participants in the lawsuit must follow. For instance, a trial judge may instruct jurors not to communicate with anyone about the case or order reporters not to use social media to comment on the case while in the courtroom.

3–3a Opening Statements At the beginning of the trial, both attorneys are allowed to make opening statements setting forth the facts that they expect to prove during the trial. The opening state- ment provides an opportunity for each lawyer to give a

8. Pronounced vwahr deehr. These verbs, based on Old French, mean “to speak the truth.” In legal language, the phrase refers to the process of questioning jurors to learn about their backgrounds, attitudes, and simi- lar attributes.

brief version of the facts and the supporting evidence that will be used during the trial. Then the plaintiff ’s case is presented. In our hypothetical case, Kirby’s lawyer would introduce evidence (relevant documents, exhibits, and the testimony of witnesses) to support Kirby’s position.

3–3b Rules of Evidence Whether evidence will be admitted in court is deter- mined by the rules of evidence. These are a series of rules that the courts have created to ensure that any evidence presented during a trial is fair and reliable. The Federal Rules of Evidence govern the admissibility of evidence in federal courts.

Evidence Must Be Relevant to the Issues Evi- dence will not be admitted in court unless it is relevant to the matter in question. Relevant evidence is evidence that tends to prove or disprove a fact in question or to establish the degree of probability of a fact or action. For instance, evidence that the defendant was in another per- son’s home when the victim was shot would be relevant, because it would tend to prove that the defendant was not the shooter.

Hearsay Evidence Is Not Admissible Generally, hearsay is not admissible as evidence. Hearsay is testi- mony someone gives in court about a statement made by someone else who was not under oath at the time of the statement. Literally, it is what someone heard someone else say. If a witness in the Kirby-Carvello case testified in court concerning what he or she heard another observer say about the accident, for example, that testimony would be hearsay. Admitting hearsay into evidence carries many risks because, even though it may be relevant, there is no way to test its reliability.

3–3c Examination of Witnesses and Potential Motions

Because Kirby is the plaintiff, she has the burden of prov- ing that her allegations are true. Her attorney begins the presentation of Kirby’s case by calling the first witness for the plaintiff and examining, or questioning, the witness. (For both attorneys, the types of questions and the man- ner of asking them are governed by the rules of evidence.) This questioning is called direct examination.

After Kirby’s attorney is finished, the witness is subject to cross-examination by Carvello’s attorney. Then Kirby’s attorney has another opportunity to ques- tion the witness in redirect examination, and Carvello’s

62 U N I T O N E The Foundations

ETHICS TODAY

Pretrial Procedures

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The Pleadings The plaintiff’s complaint—The plaintiff’s statement of the cause of action andThe plaintiff’s complaint—The plaintiff’s statement of the cause of action andThe plaintiff’s complaint the parties involved, filed with the court by the plaintiff’s attorney. After the filing, the defendant is notified of the suit through service of process. The defendant’s response—The defendant’s response to the plaintiff’sThe defendant’s response—The defendant’s response to the plaintiff’sThe defendant’s response complaint may take the form of an answer, in which the defendant admits or denies the plaintiff’s allegations. The defendant may also raise an affirmative defense and/or assert a counterclaim.

Concept SuETHICS TODAConcept SuETHICS TODAmmarETHICS TODAmmarETHICS TODAy ETHICS TODAy ETHICS TODAETHICS TODAYETHICS TODAy ETHICS TODAYETHICS TODA 3.1

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Pretrial Motions Motion to dismiss—See Exhibit 3–4Motion to dismiss—See Exhibit 3–4Motion to dismiss— . Motion for judgment on the pleadings—May be made by either party and will—May be made by either party and will— be granted only if no facts are in dispute and only questions of law are at issue. Motion for summary judgment—See Exhibit 3–4.Motion for summary judgment—See Exhibit 3–4.Motion for summary judgment

Pretrial Conference A pretrial hearing, at the request of either party or the court, to identify the matters in dispute after discovery has taken place and to explore the possibility of settling the dispute without a trial. If no settlement is possible, the parties plan the course of the trial.

Jury Selection In a jury trial, the selection of members of the jury from a pool of prospective jurors. During a process known as voir dire, the attorneys for both sides may challenge prospective jurors either for cause or peremptorily (for no cause).

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Discovery

Depositions (sworn testimony by either party or any witness). Interrogatories (in which parties to the action write answers to questions with the aid of their attorneys). Requests for admissions, documents, examinations, or other information relating to the case. Requests for electronically recorded information, such as e-mail, text messages, voice mail, and other data.

The process of gathering evidence concerning the case, which may involve the following:

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attorney may follow the redirect examination with a recross-examination. When both attorneys have finished with the first witness, Kirby’s attorney calls the succeed- ing witnesses in the plaintiff ’s case. Each witness is sub- ject to examination by the attorneys in the manner just described.

Expert Witnesses As part of their cases, both the plaintiff and the defendant may present testimony from one or more expert witnesses, such as forensic scientists, physicians, and psychologists. An expert witness is a person expert witness is a person expert witness who, by virtue of education, training, skill, or experience, has scientific, technical, or other specialized knowledge

C H A P T E R 3 Court Procedures 63

in a particular area beyond that of an average person. In Kirby’s case, her attorney might hire an accident recon- struction specialist to establish Carvello’s negligence or a physician to testify to the extent of Kirby’s injuries.

Normally, witnesses can testify only about the facts of a case—that is, what they personally observed. When wit- nesses are qualified as experts in a particular field, however, they can offer their opinions and conclusions about the evidence in that field. Because numerous experts are avail- able for hire and expert testimony is powerful and effective with juries, there is tremendous potential for abuse. There- fore, judges act as gatekeepers to ensure that the experts are qualified. If a party believes that the opponent’s expert wit- ness is not a qualified expert in the relevant field, that party can make a motion to prevent the witness from testifying.can make a motion to prevent the witness from testifying.can make a motion to prevent the witness from testifying.can make a motion to prevent the witness from testifying.9

■ CASE IN POINT 3.4 Yvette Downey bought a children’s bedroom set from Bob’s Discount Furniture Holdings, Inc. She later discovered that it was infested with bed bugs, which had spread throughout her home. Downey spoke with Edward Gordinier, a licensed and experienced exterminator, who identified the bedroom set as the source of the problem. Although Bob’s retrieved the bedroom set and refunded the purchase price, it refused to pay for the costs of extermination or any other damages. Downey sued.

Before the trial, Downey’s attorney named Gordinier as a witness but did not submit a written report describ- ing his anticipated testimony or specifying his qualifi- cations. The defendants filed a motion to prevent his testimony. The district court refused to allow Gordinier to testify, but that decision was reversed on appeal. The appellate court concluded that Gordinier was not the type of expert who regularly was hired by plaintiffs to testify in court, in which case a report would have been required. Gordinier was simply an expert on bugs, and he was allowed to give his opinion on the infestation.10 ■

Possible Motion and Judgment At the conclusion of the plaintiff ’s case, the defendant’s attorney may ask the judge to direct a verdict for the defendant on the ground that the plaintiff has presented no evidence to support her or his claim. This is called a motion for a judgment as a matter of law (or a matter of law (or a matter of law motion for a directed verdict in state motion for a directed verdict in state motion for a directed verdict courts). In considering the motion, the judge looks at the evidence in the light most favorable to the plaintiff and grants the motion only if there is insufficient evidence to raise an issue of fact. (Motions for directed verdicts at this stage of a trial are seldom granted.)

9. See Edward J. Imwinkelried, The Methods of Attacking Scientific Evi- dence, 5th ed. (2014).

10. Downey v. Bob’s Discount Furniture Holdings, Inc., 633 F.3d 1 (1st Cir. 2011).

Defendant’s Evidence The defendant’s attorney then presents the evidence and witnesses for the defen- dant’s case. Witnesses are called and examined by the defendant’s attorney. The plaintiff ’s attorney has the right to cross-examine them, and there may be a redirect exami- nation and possibly a recross-examination.

At the end of the defendant’s case, either attorney can move for a directed verdict. Again, the test is whether the jury can, through any reasonable interpretation of the evidence, find for the party against whom the motion has been made. After the defendant’s attorney has finished introducing evidence, the plaintiff ’s attorney can present a rebuttal by offering additional evidence that refutes the defendant’s case. The defendant’s attorney can, in turn, refute that evidence in a rejoinder.

3–3d Closing Arguments, Jury Instructions, and Verdict

After both sides have rested their cases, each attorney presents a closing argument. In the closing argument, each attorney summarizes the facts and evidence pre- sented during the trial and indicates why the facts and evidence support his or her client’s claim. In addition to generally urging a verdict in favor of the client, the clos- ing argument typically reveals the shortcomings of the points made by the opposing party during the trial.

Jury Instructions Attorneys usually present closing arguments whether or not the trial was heard by a jury. If it was a jury trial, the attorneys will have met with the judge before the closing arguments to determine how the jury will be instructed on the law. The attorneys can refer to these instructions in their closing arguments. After closing arguments are completed, the judge instructs the jury in the law that applies to the case (these instructions are often called charges). The jury then retires to the jury charges). The jury then retires to the jury charges room to deliberate a verdict.

Juries are instructed on the standard of proof they must apply to the case. In most civil cases, the standard of proof is a preponderance of the evidence.11 In other words, the plaintiff (Kirby in our hypothetical case) need only show that her factual claim is more likely to be true than the defendant’s. (In a criminal trial, the prosecution has a higher standard of proof to meet—it must prove its case beyond a reasonable doubt.)

11. Note that some civil claims must be proved by “clear and convincing evidence,” meaning that the evidence must show that the truth of the party’s claim is highly probable. This standard is often applied in situa-highly probable. This standard is often applied in situa-highly tions that present a particular danger of deception, such as allegations of fraud.

64 U N I T O N E The Foundations

Verdict Once the jury has reached a decision, it issues a verdict in favor of one party. The verdict specifies the verdict in favor of one party. The verdict specifies the verdict jury’s factual findings. In some cases, the jury also decides on the amount of the award (the compensation to be award (the compensation to be award paid to the prevailing party). After the announcement of the verdict, which marks the end of the trial itself, the jurors are dismissed.

See Concept Summary 3.2 for a review of trial procedures.

3–4 Posttrial Motions After the jury has rendered its verdict, either party may make a posttrial motion. The prevailing party usually requests that the court enter a judgment in accordance with the verdict. The nonprevailing party frequently files one of the motions discussed next.

3–4a Motion for a New Trial At the end of the trial, the losing party may make a motion to set aside the adverse verdict and any judgment and to hold a new trial. After looking at all the evidence, the judge will grant the motion for a new trial only if she or he believes that the jury was in error and that it is not appropriate to grant judgment for the other side.

Usually, a new trial is granted only when the jury ver- dict is obviously the result of a misapplication of the law or a misunderstanding of the evidence presented at trial. A new trial can also be granted on the grounds of newly discovered evidence, misconduct by the participants dur- ing the trial (such as when a juror has made prejudicial and inflammatory remarks), or an error by the judge.

3–4b Motion for Judgment N.O.V. If Kirby wins and if Carvello’s attorney has previously moved for a judgment as a matter of law, then Carvello’s

Trial Procedure

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● Plaintiff’s introduction and direct examination of witnesses, cross-examination by defendant’s attorney, possible redirect examination by plaintiff’s attorney, and possible recross-examination by defendant’s attorney. Both the plaintiff and the defendant may present testimony from one or more expert witnesses. At the close of the plaintiff’s case, the defendant may make a motion for a directed verdict (or for judgment as a matter of law). If granted by the court, this motion will end the trial before the defendant presents witnesses. Defendant’s introduction and direct examination of witnesses, cross- examination by plaintiff’s attorney, possible redirect examination by defendant’s attorney, and possible recross-examination by plaintiff’s attorney. Possible rebuttal of defendant’s argument by plaintiff’s attorney, who presents more evidence. Possible rejoinder by defendant’s attorney to meet that evidence.

Concept Summary 3.2

Examination of Witnesses

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● The judge instructs (or charges) the jury as to how the law applies to the issue, and the jury retires to deliberate. When the jury renders its verdict, the trial comes to an end.

Closing Arguments, Jury Instructions, and Verand Verand V dict

● Each party’s attorney is allowed to present an opening statement indicating what the attorney will attempt to prove during the course of the trial.

Opening Statements

Each party’s attorney argues in favor of a verdict for his or her client.

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C H A P T E R 3 Court Procedures 65

attorney can make a second motion for a judgment as a matter of law (the terminology used in federal courts). State courts may use different terms for these motions.

In many state courts, if the defendant’s attorney moved earlier for a directed verdict, he or she may now make a motion for judgment n.o.v.—from the Latin non obstante veredicto, meaning “notwithstanding the verdict.” Such a motion will be granted only if the jury’s verdict was unreasonable and erroneous.

If the judge grants the motion, then the jury’s ver- dict will be set aside, and a judgment will be entered in favor of the opposing party (Carvello). If the motion is denied, Carvello may then appeal the case. (Kirby may also appeal the case, even though she won at trial. She might appeal, for example, if she received a smaller mon- etary award than she had sought.)

3–5 The Appeal Either party may appeal not only the jury’s verdict but also the judge’s ruling on any pretrial or posttrial motion. Many of the appellate court cases that appear in this text involve appeals of motions for summary judgment or other motions that were denied by trial court judges.

Note that a party must have legitimate grounds to file an appeal (some legal error) and that few trial court decisions are reversed on appeal. Moreover, the expenses associated with an appeal can be considerable.

3–5a Filing the Appeal If Carvello decides to appeal the verdict in Kirby’s favor, then his attorney must file a notice of appeal with the notice of appeal with the notice of appeal clerk of the trial court within a prescribed period of time. Carvello then becomes the appellant or appellant or appellant petitioner. The clerk of the trial court sends to the reviewing court (usu- ally an intermediate court of appeals) the record on appeal. record on appeal. record on appeal The record contains all the pleadings, motions, and other documents filed with the court and a complete written transcript of the proceedings, including testimony, argu- ments, jury instructions, and judicial rulings.

Carvello’s attorney will file an appellate brief with the brief with the brief reviewing court. The brief is a formal legal document out- lining the facts and issues of the case, the judge’s rulings or jury’s findings that should be reversed or modified, the applicable law, and arguments on Carvello’s behalf (cit- ing applicable statutes and relevant cases as precedents). The attorney for the appellee (Kirby, in our hypothetical appellee (Kirby, in our hypothetical appellee case) usually files an answering brief. Carvello’s attorney can file a reply, although it is not required. The reviewing court then considers the case.

3–5b Appellate Review A court of appeals does not hear any evidence. Rather, it reviews the record for errors of law. Its decision concern- ing a case is based on the record on appeal and the briefs and arguments. The attorneys present oral arguments, after which the case is taken under advisement. The court then issues a written opinion. In general, appellate courts do not reverse findings of fact unless the findings are unsupported or contradicted by the evidence.

An appellate court has the following options after reviewing a case:

1. The court can affirm the trial court’s decision. (Most decisions are affirmed.)

2. The court can reverse the trial court’s judgment if it reverse the trial court’s judgment if it reverse concludes that the trial court erred or that the jury did not receive proper instructions.

3. The appellate court can remand (send back) the case remand (send back) the case remand to the trial court for further proceedings consistent with its opinion on the matter.

4. The court might also affirm or reverse a decision in part. For example, the court might affirm the jury’s finding that Carvello was negligent but remand the case for further proceedings on another issue (such as the extent of Kirby’s damages).

5. An appellate court can also modify a lower court’s modify a lower court’s modify decision. If the appellate court decides that the jury awarded an excessive amount in damages, for exam- ple, the court might reduce the award to a more appropriate, or fairer, amount.

3–5c Higher Appellate Courts If the reviewing court is an intermediate appellate court, the losing party may decide to appeal the decision to the state’s highest court, usually called its supreme court. Although the losing party has a right to ask (petition) a higher court to review the case, the party does not have a right to have the case heard by the higher appellate court. Appellate courts normally have discretionary power and can accept or reject an appeal. Like the United States Supreme Court, state supreme courts generally deny most petitions for appeal.

If the petition for review is granted, new briefs must be filed before the state supreme court, and the attorneys may be allowed or requested to present oral arguments. Like the intermediate appellate courts, the state supreme court can reverse or affirm the lower appellate court’s decision or remand the case. At this point, the case typi- cally has reached its end (unless a federal question is at issue and one of the parties has legitimate grounds to seek review by a federal appellate court).

66 U N I T O N E The Foundations

Concept Summary 3.3 reviews the options that the parties may pursue after the trial.

3–6 Enforcing the Judgment The uncertainties of the litigation process are com- pounded by the lack of guarantees that any judgment will be enforceable. Even if the jury awards Kirby the full amount of damages requested ($500,000), for example, Carvello’s auto insurance coverage might have lapsed. If so, the company would not pay any of the damages. Alternatively, Carvello’s insurance policy might be lim- ited to $250,000, meaning that Carvello personally would have to pay the remaining $250,000.

3–6a Requesting Court Assistance in Collecting the Judgment

If the defendant does not have the funds available to pay the judgment, the plaintiff can go back to the court and request that the court issue a writ of execution. A writ

of execution is an order directing the sheriff to seize and sell the defendant’s nonexempt assets, or property (cer- tain assets are exempted by law from creditors’ actions). The proceeds of the sale are then used to pay the damages owed, and any excess proceeds are returned to the defen- dant. Alternatively, the nonexempt property itself could be transferred to the plaintiff in lieu of an outright pay- ment. (Creditors’ remedies, discussed elsewhere in this text, may also be available.)

3–6b Availability of Assets The problem of collecting a judgment is less pronounced when a party is seeking to satisfy a judgment against a defendant with substantial assets that can be easily located, such as a major corporation. Usually, one of the factors considered by the plaintiff and his or her attorney before a lawsuit is initiated is whether the defendant has sufficient assets to cover the amount of damages sought. In addition, during the discovery process, attorneys rou- tinely seek information about the location of the defen- dant’s assets that might potentially be used to satisfy a judgment.

Posttrial Options

●

● Filing the appeal—The appealing party must file a notice of appeal with theFiling the appeal—The appealing party must file a notice of appeal with theFiling the appeal clerk of the trial court, who forwards the record on appeal to the appellate court. Attorneys file appellate briefs. Appellate review—The appellate court does not hear evidence but bases itAppellate review—The appellate court does not hear evidence but bases itAppellate review s opinion, which it issues in writing, on the record on appeal and the attorneys’ briefs and oral arguments. The court may affirm or reverse all (or part) of the trial court’s judgment and/or remand the case for further proceedings consistent with its opinion. Most decisions are affirmed on appeal. Further review—In some cases, further review may be sought from a higherFurther review—In some cases, further review may be sought from a higherFurther review appellate court, such as a state supreme court. If a federal question is involved, the case may ultimately be appealed to the United States Supreme Court.

Concept Summary 3.3

The Appeal

●

●Posttrial Motions Motion for a new trial—If the judge believes that the jury was in error but is notMotion for a new trial—If the judge believes that the jury was in error but is notMotion for a new trial convinced that the losing party should have won, the motion normally is granted. It can also be granted on the basis of newly discovered evidence, misconduct by the participants during the trial, or error by the judge. Motion for judgment n.o.v. (“notwithstanding the verdict”)—The party making the motion must have filed a motion for a directed verdict at the close of the presentation of evidence during the trial. The motion will be granted if the judge is convinced that the jury was in error.

●

Either party can appeal the trial court’s judgment to an appropriate court of appeals.

C H A P T E R 3 Court Procedures 67

Terms and Concepts a�davit 56 a�rmative defense 52 answer 51 brief 65 closing argument 63 complaint 50 counterclaim 52 cross-examination 61 default judgment 50 deposition 59 direct examination 61 discovery 57 e-evidence 60 Federal Rules of Civil Procedure

(FRCP) 48

hearsay 61 impeach 59 interrogatories 59 metadata 60 motion 52 motion for a directed verdict 63 motion for a judgment as a matter

of law 63 motion for a new trial 64 motion for judgment n.o.v. 65 motion for judgment on the

pleadings 56 motion for summary judgment 56 motion to dismiss 53 opening statement 61

pleadings 50 pretrial conference 60 pretrial motion 53 rebuttal 63 rejoinder 63 relevant evidence 61 rules of evidence 61 service of process 50 summons 50 verdict 64 voir dire 61voir dire 61voir dire writ of execution 66

Debate This ... Some consumer advocates argue that attorneys’ high contingency fees—sometimes reaching 40 percent—unfairly deprive winning plaintiffs of too much of their awards. Should the government cap contingency fees at, say, 20 percent of the award? Why or why not?

Reviewing: Court Procedures

Ronald Metzgar placed his fifteen-month-old son, Matthew, awake and healthy, in his playpen. Ronald left the room for five minutes and on his return found Matthew lifeless. A toy block had lodged in the boy’s throat, causing him to choke to death. Ronald called 911, but efforts to revive Matthew were to no avail. There was no warning of a choking hazard on the box containing the block. Matthew’s parents hired an attorney and sued Playskool, Inc., the manufac- turer of the block, alleging that the manufacturer had been negligent in failing to warn of the block’s hazard. Playskool filed a motion for summary judgment, arguing that the danger of a young child’s choking on a small block was obvious. Using the information presented in the chapter, answer the following questions. 1. Suppose that the attorney the Metzgars hired agreed to represent them on a contingency-fee basis. What does that

mean? 2. How would the Metzgars’ attorney likely have served process (the summons and complaint) on Playskool, Inc.? 3. Should Playskool’s request for summary judgment be granted? Why or why not? 4. Suppose that the judge denied Playskool’s motion and the case proceeded to trial. After hearing all the evidence,

the jury found in favor of the defendant. What options do the plaintiffs have at this point if they are not satisfied with the verdict?

Issue Spotters 1. At the trial, after Sue calls her witnesses, offers her evi-

dence, and otherwise presents her side of the case, Tom has at least two choices between courses of actions. Tom can call his first witness. What else might he do? (See The Trial.)Trial.)Trial

2. After the trial, the judge issues a judgment that includes a grant of relief for Sue, but the relief is less than Sue wanted. Neither Sue nor Tom is satisfied with this result. Who can appeal to a higher court? (See The Appeal.)The Appeal.)The Appeal

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

68 U N I T O N E The Foundations

Business Scenarios 3–1. Discovery Rules. In the past, the rules of discovery were very restrictive, and trials often turned on elements of surprise. For example, a plaintiff would not necessarily know until the trial what the defendant’s defense was going to be. In the last several decades, however, new rules of discovery have substantially changed this situation. Now each attorney can access practically all of the evidence that the other side intends to present at trial, with the exception of certain information— namely, the opposing attorney’s work product. Work product is not a precise concept. Basically, it includes all of the attor- ney’s thoughts on the case. Can you see any reason why such information should not be made available to the opposing attorney? Discuss fully. (See Pretrial Procedures.)

3–2. Motions. When and for what purpose is each of the following motions made? Which of them would be appropri- ate if a defendant claimed that the only issue between the par- ties was a question of law and that the law was favorable to the defendant’s position? (See Pretrial Procedures.) (a) A motion for judgment on the pleadings. (b) A motion for a directed verdict. (c) A motion for summary judgment. (d) A motion for judgment n.o.v.

3–3. Motion for a New Trial. Washoe Medical Center, Inc., admitted Shirley Swisher for the treatment of a fractured pelvis. During her stay, Swisher suffered a fatal fall from her hospital bed. Gerald Parodi, the administrator of her estate, and others filed an action against Washoe seeking damages for the alleged lack of care in treating Swisher. During voir dire, when the plaintiffs’ attorney returned a few minutes late from

a break, the trial judge led the prospective jurors in a standing ovation. The judge joked with one of the prospective jurors, whom he had known in college, about his fitness to serve as a judge and personally endorsed another prospective juror’s business. After the trial, the jury returned a verdict in favor of Washoe. The plaintiffs moved for a new trial, but the judge denied the motion. The plaintiffs then appealed, arguing that the tone set by the judge during voir dire prejudiced their right voir dire prejudiced their right voir dire to a fair trial. Should the appellate court agree? Why or why not? (See Posttrial Motions.) 3–4. Discovery. Advance Technology Consultants, Inc. (ATC), contracted with RoadTrac, LLC, to provide soft- ware and client software systems for the products of global positioning satellite (GPS) technology being developed by RoadTrac. RoadTrac agreed to provide ATC with hardware with which ATC’s software would interface. Problems soon arose, however. ATC claimed that RoadTrac’s hardware was defective, making it difficult to develop the software. Road- Trac contended that its hardware was fully functional and that ATC had simply failed to provide supporting software.

ATC told RoadTrac that it considered their contract ter- minated. RoadTrac filed a suit in a Georgia state court against ATC alleging breach of contract. During discovery, RoadTrac requested ATC’s customer lists and marketing procedures. ATC objected to providing this information because Road- Trac and ATC had become competitors in the GPS industry. Should a party to a lawsuit have to hand over its confiden- tial business secrets as part of a discovery request? Why or why not? What limitations might a court consider imposing before requiring ATC to produce this material? (See Pretrial Procedures.)

Business Case Problems 3–5. Jury Misconduct. Michelle Fleshner worked for Pepose Vision Institute (PVI), a surgical practice. She was �red after she provided information to the U.S. Department of Labor about PVI’s overtime pay policy. She sued for wrong- ful termination, and the jury awarded her $125,000. After the trial, a juror told PVI’s attorneys that another juror had made anti-Semitic statements during jury deliberations. �e comments concerned a witness who testi�ed on PVI’s behalf. According to the juror, the other juror said, about the wit- ness: “She is a Jewish witch.” “She is a penny-pinching Jew.” “She was such a cheap Jew that she did not want to pay Plain- ti� unemployment compensation.” Another juror con�rmed the remarks. PVI �led a motion for a new trial on the basis of juror misconduct. �e trial judge held that the comments had not prevented a fair trial from occurring. PVI appealed. Do you think such comments are su�cient to require a new trial, or must a juror’s bias be discovered during voir dire for voir dire for voir dire it to matter? Explain. [Fleshner v. Pepose Vision Institute, 304 S.W.3d 81 (Mo. 2010)] (See �e Trial.)�e Trial.)�e Trial

3–6. Service of Process. Dr. Kevin Bardwell owns North- �eld Urgent Care, LLC, a Minnesota medical clinic. North�eld ordered �u vaccine from Clint Pharmaceuticals, a licensed dis- tributer of �u vaccine located in Tennessee. �e parties signed a credit agreement that speci�ed that any disputes would be litigated in the Tennessee state courts. When North�eld failed to pay what it owed for the vaccine, Clint Pharmaceuticals �led a lawsuit in Tennessee and served process on the clinic via reg- istered mail to Dr. Bardwell, the registered agent of North�eld.

Bardwell’s wife, who worked as a receptionist at the clinic and handled inquiries on the clinic’s Facebook site, signed for the letter. Bardwell did not appear on the trial date, however, and the Tennessee court entered a default judgment against Northfield. When Clint Pharmaceuticals attempted to col- lect on the judgment in Minnesota, Bardwell claimed that the judgment was unenforceable. He asserted that he had not been properly served because his wife was not a registered agent. Should the Minnesota court invalidate the Tennessee judgment? Was service of process proper when it was mailed

C H A P T E R 3 Court Procedures 69

to the defendant medical clinic and the wife of the physician who owned the clinic opened the letter? Explain. [Clint Phar- maceuticals v. Northfield Urgent Care, LLC, 2012 WL 3792546 maceuticals v. Northfield Urgent Care, LLC, 2012 WL 3792546 maceuticals v. Northfield Urgent Care, LLC (Minn.App. 2012).] (See Pretrial Procedures.) 3–7. Business Case Problem with Sample Answer— Discovery. Jessica Lester died from injuries su�ered in an

auto accident caused by the driver of a truck owned by Allied Concrete Co. Jessica’s widower, Isaiah, �led a suit against Allied for damages. �e defendant requested copies of all of Isaiah’s Face-

book photos and other postings. Before responding, Isaiah “cleaned up” his Facebook page. Allied suspected that some items had been deleted, including a photo of Isaiah holding a beer can while wearing a T-shirt that declared “I [heart] hot- moms.” Can this material be recovered? If so, how? What e�ect might Isaiah’s “postings” have on the result in this case? Discuss. [Allied Concrete Co. v. Lester,Discuss. [Allied Concrete Co. v. Lester,Discuss. [ 736 S.E.2d 699 (2013)] (See Pretrial Procedures.) • For a sample answer to Problem 3–7, go to Appendix E at

the end of this text.

3–8. Motion for Summary Judgment. Rebecca Nichols drove a truck for Tri-National Logistics, Inc. (TNI). On a delivery trip, Nichols’s fellow driver, James Paris, made unwel- come sexual advances. Paris continued to make advances dur- ing a subsequent mandatory layover. Nichols reported this behavior to their employer. TNI nevertheless left her with Paris in Pharr, Texas, for another seven days with no alternative form of transportation before sending a driver to pick her up. She �led a suit in a federal district court against TNI, alleging discrimination on the basis of sex in violation of Title VII of the Civil Rights Act. Disputed facts included whether Nichols subjectively felt abused by Paris and whether their employer was aware of his conduct and failed to take appropriate action.

Could TNI successfully �le a motion for summary judgment at this point? Explain. [Nichols v. Tri-National Logistics, Inc, 809 F.3d 981 (8th Cir. 2016)] (See Pretrial Procedures.) 3–9. A Question of Ethics—Service of Process. Narnia

Investments, Ltd., �led a suit in a Texas state court against several defendants, including Harvestons Secu- rities, Inc., a securities dealer. (Securities are invest-rities, Inc., a securities dealer. (Securities are invest-rities, Inc., a securities dealer. (Securities are invest ments that include stocks and bonds.) Harvestons is

registered with the state of Texas. �us, a party may serve a sum- mons and a copy of a complaint on Harvestons by serving the Texas Securities Commissioner. In this case, the return of service indicated that process had been served on the commissioner “by delivering to JoAnn Kocerek defendant, in person, a true copy of this [summons] together with the accompanying copy(ies) of the [complaint].”

Harvestons did not file an answer, and Narnia obtained a default judgment against the defendant for $365,000, plus attor- neys’ fees and interest. Five months after this judgment, Harvestons filed a motion for a new trial, which the court denied. Harvestons appealed to a state intermediate appellate court, claiming that it had not been served in strict compliance with the rules governing service of process. [ Harvestons Securities, Inc. v. Narnia Invest- ments, Ltd., 218 S.W.3d 126 (Tex.App.—Houston 2007)] (See 218 S.W.3d 126 (Tex.App.—Houston 2007)] (See 218 S.W.3d 126 (Tex.App.—Houston 2007)] Pretrial Procedures.) (a) Harvestons asserted that Narnia’s service was invalid, in

part, because “the return of service states that process was delivered to ‘JoAnn Kocerek’” and did not show that she “had the authority to accept process on behalf of Harvest- ons or the Texas Securities Commissioner.” Should such a detail, if it is required, be strictly construed and applied? Should it apply in this case? Explain.

(b) Who is responsible for ensuring that service of process is accomplished properly? Was it accomplished properly in this case? Why or why not?

Legal Reasoning Group Activity 3–10. Court Procedures. Bento Cuisine is a lunch-cart business. It occupies a street corner in Texarkana, a city that straddles the border of Arkansas and Texas. Across the street— and across the state line, which runs down the middle of the street—is Rico’s Tacos. �e two businesses compete for cus- tomers. Recently, Bento has begun to suspect that Rico’s is engaging in competitive behavior that is illegal. Bento’s man- ager overheard several of Rico’s employees discussing these competitive tactics while on a break at a nearby Starbucks. Bento �les a lawsuit against Rico’s in a federal court based on diversity jurisdiction. (See Pretrial Procedures.) (a) The first group will discuss whether Rico’s could file a

motion claiming that the federal court lacks jurisdiction over this dispute.

(b) The second group will assume that the case goes to trial. Bento’s manager believes that Bento’s has both the law and the facts on its side. Nevertheless, at the end of the trial, the jury decides against Bento, and the judge issues a rul- ing in favor of Rico’s. If Bento is unwilling to accept this result, what are its options?

(c) As discussed in this chapter, hearsay is literally what a witness says he or she heard another person say. A third group will decide whether Bento’s manager can testify about what he heard some of Rico’s employees say to one another while at a coffee shop. This group will also discuss what makes the admissibility of hearsay evidence poten- tially unethical.

C H A P T E R 4

4–1 The Constitutional Powers of Government

Following the Revolutionary War, the states adopted the Articles of Confederation. The Articles created a con- federal form of government in which the states had the federal form of government in which the states had the federal form of government authority to govern themselves and the national govern- ment could exercise only limited powers. Problems soon arose because the nation was facing an economic crisis and state laws interfered with the free flow of commerce. A national convention was called, and the delegates drafted the U.S. Constitution. This document, after its ratification by the states in 1789, became the basis for an entirely new form of government.

4–1a A Federal Form of Government The new government created by the U.S. Constitution reflected a series of compromises made by the convention delegates on various issues. Some delegates wanted sover- eign power to remain with the states. Others wanted the national government alone to exercise sovereign power. The end result was a compromise—a federal form of government in which the national government and the government in which the national government and the government states share sovereign power.share sovereign power.share

Federal Powers The Constitution sets forth specific powers that can be exercised by the national (federal)

government. It further provides that the national gov- ernment has the implied power to undertake actions necessary to carry out its expressly designated powers (or enumerated powers). All other powers are expressly enumerated powers). All other powers are expressly enumerated powers “reserved” to the states under the Tenth Amendment to the U.S. Constitution.

Regulatory Powers of the States As part of their inherent sovereignty (power to govern themselves), state sovereignty (power to govern themselves), state sovereignty governments have the authority to regulate certain affairs within their borders. As mentioned, this authority stems, in part, from the Tenth Amendment, which reserves all powers not delegated to the national government to the states or to the people.

State regulatory powers are often referred to as police powers. The term encompasses more than just the enforcement of criminal laws. Police powers also give state governments broad rights to regulate private activi- ties to protect or promote the public order, health, safety, morals, and general welfare. Fire and building codes, antidiscrimination laws, parking regulations, zoning restrictions, licensing requirements, and thousands of other state statutes have been enacted pursuant to states’ police powers. Local governments, such as cities, also exercise police powers.2 Generally, state laws enacted pur-

2. Local governments derive their authority to regulate their communities from the state, because they are creatures of the state. In other words, they cannot come into existence unless authorized by the state to do so.

L aws that govern business have their origin in the lawmaking authority granted by the U.S. Constitution,

which is the supreme law in this coun- try.1 Neither Congress nor any state

1. See Appendix B for the full text of the U.S. Constitution.

may pass a law that is in conflict with the Constitution.

Constitutional disputes frequently come before the courts. For instance, numerous states challenged the Obama administration’s Affordable Care Act on constitutional grounds. The United States Supreme Court

decided in 2012 that the provisions of this law, which required most Americans to have health insurance by 2014, did not exceed the consti- tutional authority of the federal gov- ernment. The Court’s decision in the matter continues to have a significant impact on the business environment.

Business and the Constitution

C H A P T E R 4 Business and the Constitution 71

suant to a state’s police powers carry a strong presump- tion of validity.

4–1b Relations among the States The U.S. Constitution also includes provisions concern- ing relations among the states in our federal system. Particularly important are the privileges and immunities clause and the clause and the clause full faith and credit clause.

The Privileges and Immunities Clause Article IV, Section 2, of the Constitution provides that the “Citi- zens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States.” This clause is often referred to as the interstate privileges and immu- nities clause.3 It prevents a state from imposing unrea- sonable burdens on citizens of another state—particularly with regard to means of livelihood or doing business.

When a citizen of one state engages in basic and essen- tial activities in another state (the “foreign state”), the foreign state must have a substantial reason for treating the nonresident differently than its own residents. Basic activities include transferring property, seeking employ- ment, and accessing the court system. The foreign state must also establish that its reason for the discrimination is substantially related to the state’s ultimate purpose in substantially related to the state’s ultimate purpose in substantially related adopting the legislation or regulating the activity.4

The Full Faith and Credit Clause Article IV, Sec- tion 1, of the U.S. Constitution provides that “Full Faith and Credit shall be given in each State to the public Acts, Records, and judicial Proceedings of every other State.” This clause, which is referred to as the full faith and credit clause, applies only to civil matters. It ensures that rights established under deeds, wills, contracts, and similar instruments in one state will be honored by other states. It also ensures that any judicial decision with respect to such property rights will be honored and enforced in all states.

The legal issues raised by same-sex marriage involve, among other things, the full faith and credit clause, because that clause requires each state to honor marriage decrees issued by another state. See this chapter’s Mana- gerial Strategy feature for a discussion of marriage equalgerial Strategy feature for a discussion of marriage equalgerial Strategy - ity laws.

The full faith and credit clause has contributed to the unity of American citizens because it protects their

3. Interpretations of this clause commonly use the terms privilege and privilege and privilege immunity synonymously. Generally, the terms refer to certain rights, ben-immunity synonymously. Generally, the terms refer to certain rights, ben-immunity efits, or advantages enjoyed by individuals.

4. This test was first announced in Supreme Court of New Hampshire v. Piper, 470 U.S. 274, 105 S.Ct. 1272, 84 L.Ed.2d 205 (1985). For another example, see Lee v. Miner, 369 F.Supp.2d 527 (D.Del. 2005).

legal rights as they move about from state to state. It also protects the rights of those to whom they owe obliga- tions, such as persons who have been awarded monetary damages by courts. The ability to enforce such rights is extremely important for the conduct of business in a country with a very mobile citizenry.

4–1c The Separation of Powers To make it more difficult for the national government to use its power arbitrarily, the Constitution provided for three branches of government. The legislative branch makes the laws, the executive branch enforces the laws, and the judicial branch interprets the laws. Each branch performs a separate function, and no branch may exercise the authority of another branch.

Additionally, a system of checks and balances allows each branch to limit the actions of the other two branches, thus preventing any one branch from exercis- ing too much power. Some examples of these checks and balances include the following: 1. The legislative branch (Congress) can enact a law, but

the executive branch (the president) has the constitu- tional authority to veto that law.

2. The executive branch is responsible for foreign affairs, but treaties with foreign governments require the advice and consent of the Senate.

3. Congress determines the jurisdiction of the federal courts, and the president appoints federal judges, with the advice and consent of the Senate. The judi- cial branch has the power to hold actions of the other two branches unconstitutional.5

4–1d The Commerce Clause To prevent states from establishing laws and regulations that would interfere with trade and commerce among the states, the Constitution expressly delegated to the national government the power to regulate interstate commerce. Article I, Section 8, of the U.S. Constitution explicitly permits Congress “[t]o regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” This clause, referred to as the commerce clause, has had a greater impact on business than any other provision in the Constitution. The com- merce clause provides the basis for the national govern- ment’s extensive regulation of state and even local affairs.

5. The power of judicial review was established by the United States Supreme Court in Marbury v. Madison, 5 U.S. (1 Cranch) 137, 2 L.Ed. 60 (1803).

72 U N I T O N E The Foundations

Initially, the courts interpreted the commerce clause to apply only to commerce between the states (interstate commerce) and not commerce within the states (intra- state commerce). That changed in 1824, however, when state commerce). That changed in 1824, however, when state the United States Supreme Court decided the landmark case of Gibbons v. Ogden.6 The Court held that commerce within the states could also be regulated by the national government as long as the commerce substantially affected commerce involving more than one state.

The Expansion of National Powers under the Commerce Clause As the nation grew and faced

6. 22 U.S. (9 Wheat.) 1, 6 L.Ed. 23 (1824).

new kinds of problems, the commerce clause became a vehicle for the additional expansion of the national gov- ernment’s regulatory powers. Even activities that seemed purely local in nature came under the regulatory reach of the national government if those activities were deemed to substantially affect interstate commerce. In 1942, the Supreme Court held that wheat production by an indi- vidual farmer intended wholly for consumption on his own farm was subject to federal regulation.7

The following Classic Case involved a challenge to the Classic Case involved a challenge to the Classic Case scope of the national government’s constitutional author- ity to regulate local activities.

7. Wickard v. Filburn, 317 U.S. 111, 63 S.Ct. 82, 87 L.Ed. 122 (1942).

Marriage Equality and the Constitution

The debate over same-sex marriage has been raging across the country for years. The legal issues raised by marriage equality involve pri- vacy rights and equal protection. Although marriage equality may not appear at first glance to be business related, it is an impor- tant legal issue for managers. Companies like Barilla Pasta, Chick-fil-A, Exxon Mobil, and Target Corporation have lost significant business for purportedly supporting anti-gay organizations and legislation.

The Definition of Marriage

Before 1996, federal law did not define marriage, and the U.S. government recognized any marriage that was recognized by a state. Then Congress passed the Defense of Marriage Act (DOMA), which explic- itly defined marriage as a union of one man and one woman. DOMA was later challenged, and a number of federal courts found it to be unconstitutional in the context of bankruptcy, public employee benefits, and estate taxes. In 2013, the United States Supreme Court struck down part of DOMA as unconstitutional.a Today, once again, no federal law defines marriage.

Bans on Same-Sex Marriage Eliminated by the Supreme Court

During this period, federal courts became increasingly likely to invalidate state bans on same-sex marriage. In 2013, a federal district court held that Utah’s same-sex marriage ban was unconstitutional.b In 2014, federal

district courts in Arkansas, Mississippi, and Oklahoma struck down state same-sex mar- riage bans.c Moreover, public sentiment on the issue had shifted, and more states recog- nized the rights of same-sex couples. By 2015, thirty-seven states, as well as the District of Columbia, had legalized same-sex marriage.

In 2015, the United States Supreme Court determined that the remaining state-level prohibi- tions on same-sex marriage were unconstitutional. In a landmark decision, the Court ruled that the Fourteenth Amendment requires individual states to (1) issue mar- riage licenses to same-sex couples and (2) recognize same-sex marriages performed in other states.d

The landmark Supreme Court decision requiring all states to recognize same-sex marriage means that busi- nesses must make adjustments. Company policies need to be revised to specify how same-sex partners will be treated in terms of family and medical leave, health- insurance coverage, pensions, and other benefits.

Business Questions 1. Can a business manager’s religious beliefs legally factor

into the business’s hiring and treatment of same-sex partners? Why or why not?

2. Must business owners in all states provide the same benefits to employees in a same-sex union as they do to heterosexual couples?

MANAGERIAL STRATEGY

a. Windsor v. United States, ___ U.S. ___, 133 S.Ct. 2675, 186 L.Ed.2d 808 (2013).

b. Kitchen v. Herbert, 961 F.Supp.2d 1181 (D.Utah 2013).

c. Campaign for Southern Equality v. Bryant, 64 F.Supp.3d 906 (S.D. Miss. 2014); Jernigan v. Crane, 64 F.Supp.3d 1260 (E.D.Ark. 2014); and Bishop v. U.S. ex rel. Holder, 962 F.Supp.2d 1252 (N.D. Okla. 2014).

d. Obergefell v. Hodges, ___ U.S. ___, 135 S.Ct. 2584, 192 L.Ed.2d 609 (2015).

C H A P T E R 4 Business and the Constitution 73

Background and Facts In the 1950s, the United States Supreme Court ruled that racial segrega- tion imposed by the states in school systems and other public facilities violated the Constitution. Privately owned facilities were not affected until Congress passed the Civil Rights Act of 1964, which prohibited racial discrimination in “establishments affecting interstate commerce.”

The owner of the Heart of Atlanta Motel, in violation of the Civil Rights Act of 1964, refused to rent rooms to African Americans. The motel owner brought an action in a federal district court to have the Civil Rights Act declared unconstitutional on the ground that Congress had exceeded its constitutional authority to regulate commerce by enacting the statute. The owner argued that his motel was not engaged in interstate commerce but was “of a purely

local character.” The motel, however, was accessible to state and interstate highways. The owner advertised nationally, maintained billboards throughout the state, and accepted convention trade from outside the state (75 percent of the guests were residents of other states).

The district court ruled that the act did not violate the Constitution and enjoined (prohibited) the owner from discriminating on the basis of race. The motel owner appealed. The case ultimately went to the United States Supreme Court.

In the Language of the Court Mr. Justice CLARKE delivered the opinion of the Court.CLARKE delivered the opinion of the Court.CLARKE

* * * * While the Act as adopted carried no congressional findings, the record of its passage through each

house is replete with evidence of the burdens that discrimination by race or color places upon interstate commerce * * * . This testimony included the fact that our people have become increasingly mobile with millions of all races traveling from State to State; that Negroes in particular have been the subject of discrimination in transient accommodations, having to travel great distances to secure the same; that often they have been unable to obtain accommodations and have had to call upon friends to put them up overnight. * * * These exclusionary practices were found to be nationwide, the Under Secretary of Commerce testifying that there is “no question that this discrimination in the North still exists to a large degree” and in the West and Midwest as well * * * . This testimony indicated a qualitative as well as quantitative effect on interstate travel by Negroes. The former was the obvious impairment of the Negro traveler’s pleasure and convenience that resulted when he continually was uncertain of finding lodging. As for the latter, there was evidence that this uncertainty stemming from racial discrimination had the effect of discouraging travel on the part of a substantial portion of the Negro community * * * . We shall not burden this opinion with further details since the voluminous testimony presents overwhelming evi- dence that discrimination by hotels and motels impedes interstate travel.

* * * * It is said that the operation of the motel here is of a purely local character. But, assuming this to be

true, “if it is interstate commerce that feels the pinch, it does not matter how local the operation that applies the squeeze.’’ * * * Thus the power of Congress to promote interstate commerce also includes the power to regulate the local incidents thereof, including local activities in both the States of origin and destination, which might have a substantial and harmful effect upon that commerce. [Emphasis added.]

Decision and Remedy The United States Supreme Court upheld the constitutionality of the Civil Rights Act of 1964. The power of Congress to regulate interstate commerce permitted the enactment of legislation that could halt local discriminatory practices.

Impact of This Case on Today’s Law If the United States Supreme Court had invalidated the Civil Rights Act of 1964, the legal landscape of the United States would be much different today. The act prohib- its discrimination based on race, color, national origin, religion, or gender in all “public accommodations,” including hotels and restaurants.

Classic Case 4.1 Heart of Atlanta Motel v. United States Supreme Court of the United States, 379 U.S. 241, 85 S.Ct. 348, 13 L.Ed.2d 258 (1964).

74 U N I T O N E The Foundations

The act also prohibits discrimination in employment based on these criteria. Although state laws now prohibit many of these forms of discrimination as well, the protections available vary from state to state—and it is not certain whether such laws would have been passed had the outcome in this case been different.

Critical Thinking • What If the Facts Were Different? If this case had involved a small, private retail business that did

not advertise nationally, would the result have been the same? Why or why not?

The Commerce Clause Today Today, at least theo- retically, the power over commerce authorizes the national government to regulate almost every commercial enter- prise in the United States. The breadth of the commerce clause permits the national government to legislate in areas in which Congress has not explicitly been granted power. Only occasionally has the Supreme Court curbed the national government’s regulatory authority under the commerce clause.8

The Supreme Court has, for instance, allowed the federal government to regulate noncommercial activi- ties relating to medical marijuana that take place wholly ties relating to medical marijuana that take place wholly ties relating to medical marijuana that take place wholly within a state’s borders. ■ CASE IN POINT 4.1 More than half the states, including California, have adopted laws that legalize marijuana for medical purposes (and a handful of states now permit the recreational use of mar- ijuana). Marijuana possession, however, is illegal under the federal Controlled Substances Act (CSA).9 After the federal government seized the marijuana that two seri- ously ill California women were using on the advice of their physicians, the women filed a lawsuit. They argued that it was unconstitutional for the federal statute to pro- hibit them from using marijuana for medical purposes that were legal within the state.

The Supreme Court, though, held that Congress has the authority to prohibit the intrastate possession and intrastate possession and intrastate noncommercial cultivation of marijuana as part of a larger regulatory scheme (the CSA).10 In other words, the federal government may still prosecute individuals for possession of marijuana regardless of whether they reside in a state that allows the medical or recreational use of marijuana. ■

8. See, for example, United States v. Morrison, 529 U.S. 598, 120 S.Ct. 1740, 146 L.Ed.2d 658 (2000), holding that the federal Violence Against Women Act violated Congress’s commerce clause authority.

9. 21 U.S.C. Sections 801 et seq. 10. Gonzales v. Raich, 545 U.S. 1, 125 S.Ct. 2195, 162 L.Ed.2d 1 (2005).

The “Dormant” Commerce Clause The Supreme Court has interpreted the commerce clause to mean that the national government has the exclusive authority to exclusive authority to exclusive regulate commerce that substantially affects trade and commerce among the states. This express grant of author- ity to the national government is often referred to as the “positive” aspect of the commerce clause. But this positive aspect also implies a negative aspect—that the states do not have the authority to regulate interstate commerce. not have the authority to regulate interstate commerce. not This negative aspect of the commerce clause is often referred to as the “dormant” (implied) commerce clause.

The dormant commerce clause comes into play when state regulations affect interstate commerce. In this situ- ation, the courts weigh the state’s interest in regulating a certain matter against the burden that the state’s regula- tion places on interstate commerce. Because courts bal- ance the interests involved, it is difficult to predict the outcome in a particular case. State laws that alter con- ditions of competition to favor in-state interests over out-of-state competitors in a market (such as wineries or construction workers) are usually invalidated, however.11

■ CASE IN POINT 4.2 Maryland imposed personal income taxes on its residents at the state level and the county level. Maryland residents who paid income tax in another state were allowed a credit against the state portion of their Maryland taxes, but not the county porcounty porcounty - tion. Several Maryland residents who had earned profits in and paid taxes to other states but had not received a credit against their county tax liability sued. They claimed that Maryland’s system discriminated against intrastate commerce because those who earned income in other states paid more taxes than residents whose only income came from within Maryland. When the case reached the United States Supreme Court in 2015, the

11. See Family Winemakers of California v. Jenkins, 592 F.3d 1 (1st Cir. 2010); and Tri-M Group, LLC v. Sharp, 638 F.3d 406 (3d Cir. 2011).

Case 4.1 Continued

C H A P T E R 4 Business and the Constitution 75

Court held that Maryland’s personal income tax scheme violated the dormant commerce clause.12 ■

4–1e The Supremacy Clause and Federal Preemption

Article VI of the U.S. Constitution, commonly referred to as the supremacy clause, provides that the Constitution, laws, and treaties of the United States are “the supreme Law of the Land.” When there is a direct conflict between a federal law and a state law, the state law is rendered invalid. Because some powers are concurrent (shared by the fed- eral government and the states), however, it is necessary to determine which law governs in a particular circumstance.

Preemption When Congress chooses to act exclusively in a concurrent area, preemption occurs. In this circum- stance, a valid federal statute or regulation will take prece- dence over a conflicting state or local law or regulation on the same general subject.

Congressional Intent Often, it is not clear whether Congress, in passing a law, intended to preempt an entire subject area. In these situations, the courts determine whether Congress intended to exercise exclusive power.

No single factor is decisive as to whether a court will find preemption. Generally, though, congressional intent to preempt will be found if a federal law regulating an activity is so pervasive, comprehensive, or detailed that the states have little or no room to regulate in that area. Also, when a federal statute creates an agency to enforce the law, matters that may come within the agency’s juris- diction will likely preempt state laws.

■ CASE IN POINT 4.3 A man who alleged that he had been injured by a faulty medical device (a balloon catheter that was inserted into his artery following a heart attack) sued the manufacturer. The case ultimately came before the United States Supreme Court. The Court noted that the relevant federal law (the Medical Device Amendments of 1976) had included a preemption provi- sion. Furthermore, the device had passed the U.S. Food and Drug Administration’s rigorous premarket approval process. Therefore, the Court ruled that the federal regu- lation of medical devices preempted the man’s state law claims.13 ■

12. Comptroller of Treasury of Maryland v. Wynne, ___ U.S. ___, 135 S.Ct. 1787, 191 L.Ed.2d 813 (2015).

13. Riegel v. Medtronic, Inc., 552 U.S. 312, 128 S.Ct. 999, 169 L.Ed.2d 892 (2008).

4–1f The Taxing and Spending Powers Article I, Section 8, of the U.S. Constitution provides that Congress has the “Power to lay and collect Taxes, Duties, Imposts, and Excises.” Section 8 further requires uniformity in taxation among the states, and thus Con- gress may not tax some states while exempting others.

In the distant past, if Congress attempted to regu- late indirectly, by taxation, an area over which it had no authority, the courts would invalidate the tax. Today, however, if a tax measure is reasonable, it generally is held to be within the national taxing power. Moreover, the expansive interpretation of the commerce clause almost always provides a basis for sustaining a federal tax.

Article I, Section 8, also gives Congress its spending power—the power “to pay the Debts and provide for the common Defence and general Welfare of the United States.” Congress can spend revenues not only to carry out its expressed powers but also to promote any objec- tive it deems worthwhile, so long as it does not violate the Bill of Rights. The spending power necessarily involves policy choices, with which taxpayers (and politicians) may disagree.

4–2 Business and the Bill of Rights The importance of a written declaration of the rights of individuals caused the first Congress of the United States to submit twelve amendments to the U.S. Con- stitution to the states for approval. Ten of these amend- ments, known as the Bill of Rights, were adopted in 1791 and embody a series of protections for the indi- vidual against various types of interference by the federal government.14

The protections guaranteed by these ten amendments are summarized in Exhibit 4–1.15 Some of these consti- tutional protections apply to business entities as well as individuals. For example, corporations exist as separate legal entities, or legal persons, and enjoy many of the same rights and privileges as natural persons do.natural persons do.natural persons

14. Another of these proposed amendments was ratified more than two hundred years later (in 1992) and became the Twenty-seventh Amend- ment to the Constitution. See Appendix B.

15. See the Constitution in Appendix B for the complete text of each amendment.

76 U N I T O N E The Foundations

First Amendment: Guarantees the freedoms of religion, speech, and the press and the rights to assemble peaceably and to petition the government.

Second Amendment: States that the right of the people to keep and bear arms shall not be infringed.

Third Amendment: Prohibits, in peacetime, the lodging of soldiers in any house without the owner’s consent.

Fourth Amendment: Prohibits unreasonable searches and seizures of persons or property.

Fifth Amendment: Guarantees the rights to indictment (formal accusation) by a grand jury, to due indictment (formal accusation) by a grand jury, to due indictment process of law, and to fair payment when private property is taken for public use. The Fifth Amendment also prohibits compulsory self-incrimination and double jeopardy (trial for the same crime twice).

Sixth Amendment: Guarantees the accused in a criminal case the right to a speedy and public trial by an impartial jury and with counsel. The accused has the right to cross-examine witnesses against him or her and to solicit testimony from witnesses in his or her favor.

Seventh Amendment: Guarantees the right to a trial by jury in a civil case involving at least twenty dollars.

Eighth Amendment: Prohibits excessive bail and fines, as well as cruel and unusual punishment.

Ninth Amendment: Establishes that the people have rights in addition to those specified in the Constitution.

Tenth Amendment: Establishes that those powers neither delegated to the federal government nor Establishes that those powers neither delegated to the federal government nor denied to the states are reserved to the states and to the people.

E X H I B I T 4 – 1 Protections Guaranteed by the Bill of Rights

4–2a Limits on Federal and State Governmental Actions

As originally intended, the Bill of Rights limited only the powers of the national government. Over time, however, the United States Supreme Court “incorporated” most of these rights into the protections against state actions afforded by the Fourteenth Amendment to the Constitution.

The Fourteenth Amendment The Fourteenth Amendment, passed in 1868 after the Civil War, pro- vides, in part, that “[n]o State shall . . . deprive any person of life, liberty, or property, without due process of law.” Starting in 1925, the Supreme Court began to define various rights and liberties guaranteed in the U.S. Con- stitution as constituting “due process of law,” which was required of state governments under that amendment.

Today, most of the rights and liberties set forth in the Bill of Rights apply to state governments as well as the national government. In other words, neither the federal government nor state governments can deprive persons of those rights and liberties.

Judicial Interpretation The rights secured by the Bill of Rights are not absolute. Many of the rights

guaranteed by the first ten amendments are set forth in very general terms. The Second Amendment states that people have a right to keep and bear arms, but it does not describe the extent of this right. As the Supreme Court has noted, this right does not mean that people can “keep and carry any weapon whatsoever in any manner what- soever and for whatever purpose.”16 Legislatures can pro- hibit the carrying of concealed weapons or certain types of weapons, such as machine guns.

Ultimately, the United States Supreme Court, as the final interpreter of the Constitution, gives mean- ing to these rights and determines their boundaries. Changing public views on controversial topics, such as privacy in an era of terrorist threats or the rights of gay men and lesbians, can affect the way the Supreme Court decides a case.

4–2b Freedom of Speech A democratic form of government cannot survive unless people can freely voice their political opinions and criti- cize government actions or policies. Freedom of speech,

16. District of Columbia v. Heller, 554 U.S. 570, 128 S.Ct. 2783, 171 L.Ed.2d 637 (2008).

C H A P T E R 4 Business and the Constitution 77

particularly political speech, is thus a prized right, and traditionally the courts have protected this right to the fullest extent possible.

Symbolic speech—gestures, movements, articles of clothing, and other forms of expressive conduct—is also given substantial protection by the courts. The Supreme Court has held that the burning of the American flag as part of a peaceful protest is a constitutionally protected form of expression.17 Similarly, wearing a T-shirt with a photo of a presidential candidate is a constitutionally protected form of expression. ■ EXAMPLE 4.4 As a form of expression, Nate has gang signs tattooed on his torso, arms, neck, and legs. If a reasonable person would inter- pret this conduct as conveying a message, then it might be a protected form of symbolic speech. ■

Reasonable Restrictions A balance must be struck between a government’s obligation to protect its citizens and those citizens’ exercise of their rights. Expression— oral, written, or symbolized by conduct—is therefore sub- ject to reasonable restrictions. Reasonableness is analyzed on a case-by-case basis.

Content-Neutral Laws. Laws that regulate the time, manner, and place, but not the content, of speech receive less scrutiny by the courts than do laws that restrict the content of expression. If a restriction imposed by the government is content neutral, then a court may allow it. To be content neutral, the restriction must be aimed at combatting some societal problem, such as crime or drug abuse, and not be aimed at suppressing the expres- sive conduct or its message.

Courts have often protected nude dancing as a form of symbolic expression but typically allow content-neutral laws that ban all public nudity. ■ CASE IN POINT 4.5 Ria Ora was charged with dancing nude at an annual “anti-Christmas” protest in Harvard Square in Cam- bridge, Massachusetts, under a statute banning public displays of open and gross lewdness. Ora argued that the statute was overbroad and unconstitutional, and a trial court agreed. On appeal, however, a state appellate court upheld the statute as constitutional in situations in which there was an unsuspecting or unwilling audience.18 ■

Laws That Restrict the Content of Speech. Any law that regulates the content of expression must serve a com- pelling state interest and must be narrowly written to achieve that interest. Under the compelling government

17. Texas v. Johnson, 491 U.S. 397, 109 S.Ct. 2533, 105 L.Ed.2d 342 (1989).

18. Commonwealth v. Ora, 451 Mass. 125, 883 N.E.2d 1217 (2008).

interest test, the government’s interest is balanced against the individual’s constitutional right to free expression. For the statute to be valid, there must be a compelling gov- ernment interest that can be furthered only by the law in question.

The United States Supreme Court has held that schools may restrict students’ speech at school events. ■ CASE IN POINT 4.6 Some high school stu- dents held up a banner saying “Bong Hits 4 Jesus” at an off-campus but school-sanctioned event. The Supreme Court ruled that the school did not violate the students’ free speech rights when school officials confiscated the banner and suspended the students for ten days. Because the banner could reasonably be interpreted as promot- ing drugs, the Court concluded that the school’s actions were justified. Several justices disagreed, however, noting that the majority’s holding creates an exception that will allow schools to censor any student speech that mentions drugs.19 ■

Corporate Political Speech Political speech by corporations also falls within the protection of the First Amendment. Many years ago, the United States Supreme Court struck down as unconstitutional a Massachusetts statute that prohibited corporations from making politi- cal contributions or expenditures that individuals were permitted to make.20 The Court has also held that a law forbidding a corporation from including inserts with its bills to express its views on controversial issues violates the First Amendment.21

Corporate political speech continues to be given significant protection under the First Amendsignificant protection under the First Amendsignificant protection under the First Amend- ment. ■ CASE IN POINT 4.7 In Citizens United v. Fed-Citizens United v. Fed-Citizens United v. Fed eral Election Commission,22 the Supreme Court issued a landmark decision that overturned a twenty-year-old precedent on campaign financing. The case involved Citizens United, a nonprofit corporation that runs a political action committee (an organization that regispolitical action committee (an organization that regispolitical action committee - ters with the government and campaigns for or against political candidates).

Citizens United had produced a film called Hillary: The Movie that was critical of Hillary Clinton, who was The Movie that was critical of Hillary Clinton, who was The Movie seeking the Democratic nomination for presidential can- didate. Campaign-finance law restricted Citizens United from broadcasting the movie. The Court ruled that these

19. Morse v. Frederick, 551 U.S. 393, 127 S.Ct. 2618, 168 L.Ed.2d 290 (2007).

20. First National Bank of Boston v. Bellotti, 435 U.S. 765, 98 S.Ct. 1407, 55 L.Ed.2d 707 (1978).

21. Consolidated Edison Co. v. Public Service Commission, 447 U.S. 530, 100 S.Ct. 2326, 65 L.Ed.2d 319 (1980).

78 U N I T O N E The Foundations

restrictions were unconstitutional and that the First Amendment prevents limits from being placed on inde- pendent political expenditures by corporations. ■

Commercial Speech The courts also give substan- tial protection to commercial speech, which consists of communications—primarily advertising and marketing— made by business firms that involve only their commer- cial interests. The protection given to commercial speech under the First Amendment is less extensive than that afforded to noncommercial speech, however.

A state may restrict certain kinds of advertising, for instance, in the interest of preventing consumers from being misled. States also have a legitimate interest in road- side beautification and therefore may impose restraints on billboard advertising. ■ EXAMPLE 4.8 Café Erotica, a nude dancing establishment, sues the state after being

denied a permit to erect a billboard along an interstate highway in Florida. Because the law directly advances a substantial government interest in highway beautification and safety, a court will likely find that it is not an uncon- stitutional restraint on commercial speech. ■

Generally, a restriction on commercial speech will be considered valid as long as it meets three criteria:

1. It must seek to implement a substantial government interest.

2. It must directly advance that interest. 3. It must go no further than necessary to accomplish

its objective.

At issue in the following case was whether a govern- ment agency had unconstitutionally restricted commer- cial speech when it prohibited the inclusion of a certain illustration on beer labels.

Background and Facts Bad Frog Brewery, Inc., makes and sells alcoholic beverages. Some of the beverages feature labels that display a drawing of a frog making the gesture generally known as “giv- ing the finger.” Bad Frog’s authorized New York distributor, Renaissance Beer Company, applied to the New York State Liquor Authority (NYSLA) for brand label approval, as required by state law before the beer could be sold in New York.

The NYSLA denied the application, in part, because “the label could appear in grocery and con- venience stores, with obvious exposure on the shelf to children of tender age.” Bad Frog filed a suit in a federal district court against the NYSLA, asking for, among other things, an injunction against the denial of the application. The court granted summary judgment in favor of the NYSLA. Bad Frog appealed to the U.S. Court of Appeals for the Second Circuit.

In the Language of the Court Jon O. NEWMAN, Circuit Judge:

* * * * * * * To support its asserted power to ban Bad Frog’s labels [NYSLA advances] * * * the State’s interest

in “protecting children from vulgar and profane advertising” * * * . [This interest is] substantial * * * . States have a compelling interest in protecting the physical and psycho-

logical wellbeing of minors * * * . [Emphasis added.]logical wellbeing of minors * * * . [Emphasis added.]logical wellbeing of minors * * * * * * * NYSLA endeavors to advance the state interest in preventing exposure of children to vulgar

displays by taking only the limited step of barring such displays from the labels of alcoholic beverages. In view of the wide currency of vulgar displays throughout contemporary society, including comic books targeted directly at children, barring such displays from labels for alcoholic beverages cannot realistically be expected to reduce children’s exposure to such displays to any significant degree. [Emphasis added.]

* * * If New York decides to make a substantial effort to insulate children from vulgar displays in some significant sphere of activity, at least with respect to materials likely to be seen by children, NYSLA’s label prohibition might well be found to make a justifiable contribution to the material

Spotlight on Beer Labels

Case 4.2 Bad Frog Brewery, Inc. v. Case 4.2 Bad Frog Brewery, Inc. v. New York State Liquor AuthorityNew York State Liquor Authority Case 4.2 Bad Frog Brewery, Inc. v. New York State Liquor Authority Case 4.2 Bad Frog Brewery, Inc. v. Case 4.2 Bad Frog Brewery, Inc. v. New York State Liquor Authority Case 4.2 Bad Frog Brewery, Inc. v.

United States Court of Appeals, Second Circuit, 134 F.3d 87 (1998).United States Court of Appeals, Second Circuit, 134 F.3d 87 (1998).

C H A P T E R 4 Business and the Constitution 79

advancement of such an effort, but its currently isolated response to the perceived problem, applicable only to labels on a product that children cannot purchase, does not suffice. * * * A state must demon- strate that its commercial speech limitation is part of a substantial effort to advance a valid state interest, not merely the removal of a few grains of offensive sand from a beach of vulgarity.

* * * * * * * Even if we were to assume that the state materially advances its asserted interest by shielding

children from viewing the Bad Frog labels, it is plainly excessive to prohibit the labels from all use, including placement on bottles displayed in bars and taverns where parental supervision of children is to be expected. Moreover, to whatever extent NYSLA is concerned that children will be harmfully exposed to the Bad Frog labels when wandering without parental supervision around grocery and convenience stores where beer is sold, that concern could be less intrusively dealt with by placing restrictions on the permissible locations where the appellant’s products may be displayed within such stores.

Decision and Remedy The U.S. Court of Appeals for the Second Circuit reversed the judgment of the district court and remanded the case for the entry of a judgment in favor of Bad Frog. The NYSLA’s ban on the use of the labels lacked a “reasonable fit” with the state’s interest in shielding minors from vulgarity. In addition, the NYSLA had not adequately considered alternatives to the ban.

Critical Thinking • What If the Facts Were Different? If Bad Frog had sought to use the offensive label to market toys

instead of beer, would the court’s ruling likely have been the same? Why or why not? • Legal Environment Whose interests are advanced by the banning of certain types of advertising?

Case 4.2 Continued

Unprotected Speech The United States Supreme Court has made it clear that certain types of speech will not be protected under the First Amendment. Unpro- tected speech includes fighting words, or words that are likely to incite others to respond violently. It also includes speech that harms the good reputation of another, or defamatory speech. In addition, speech that violates crim- inal laws (threatening speech or possession of child por- nography, for instance) is not constitutionally protected.

Threatening Speech. Note that in the case of threaten- ing speech, the speaker must have posed a “true threat”— that is, must have meant to communicate a serious intent to commit an unlawful, violent act against a particular to commit an unlawful, violent act against a particular to commit an unlawful, violent act against a particular person or group. ■ CASE IN POINT 4.9 After Anthony Elonis’s wife, Tara, left him and took their two children, Elonis was upset and experienced problems at work. A coworker �led �ve sexual harassment reports against him. When Elonis posted a photograph of himself in a Hallow- een costume holding a toy knife to the coworker’s neck, he was �red from his job. Elonis then began posting vio- lent statements on his Facebook page, mostly focusing on his former wife and talking about killing her.

Elonis continued to post statements about killing his wife and eventually was arrested and prosecuted for his online posts. Elonis was convicted by a jury of violating a statute and ordered to serve time in prison. He appealed

to the United States Supreme Court, which held that it is not enough that a reasonable person might view the defendant’s Facebook posts as threats. Elonis must have intended to issue threats or known that his statements would be viewed as threats to be convicted of a crime. The Court reversed Elonis’s conviction and remanded the case back to the lower court to determine if there was sufficient evidence of intent.23 ■

Obscene Speech. �e First Amendment, as interpreted by the Supreme Court, also does not protect obscene speech. Numerous state and federal statutes make it a crime to dis- seminate and possess obscene materials, including child por- nography. Objectively de�ning obscene speech has proved di�cult, however. It is even more di�cult to prohibit the dissemination of obscenity and pornography online.

Most of Congress’s attempts to pass legislation pro- tecting minors from pornographic materials on the Internet have been struck down on First Amendment grounds when challenged in court. One exception is a law that requires public schools and libraries to install filtering software on computers to keep children from accessing adult content.24 Such software is designed to

23. Elonis v. United States, ___ U.S. ___, 135 S.Ct. 2001, 192 L.Ed.2d 1 (2015).

24. Children’s Internet Protection Act (CIPA), 17 U.S.C. Sections 1701–1741.

80 U N I T O N E The Foundations

prevent persons from viewing certain Web sites based on a site’s Internet address or its meta tags, or key words. The Supreme Court held that the act does not uncon- stitutionally burden free speech because it is flexible and libraries can disable the filters for any patrons who ask.25

Another exception is a law that makes it a crime to intentionally distribute virtual child pornography—which virtual child pornography—which virtual child pornography uses computer-generated images, not actual people— without indicating that it is computer-generated.26 In a case challenging the law’s constitutionality, the Supreme Court held that the statute is valid because it does not prohibit a substantial amount of protected speech.27 Nevertheless, because of the difficulties of policing the Internet, as well as the constitutional complexities of prohibiting obscenity through legislation, online obscenity remains a legal issue.

4–2c Freedom of Religion The First Amendment states that the government may neither establish any religion nor prohibit the free exer- cise of religious practices. The first part of this consti- tutional provision is referred to as the establishment clause, and the second part is known as the free exercise clause. Government action, both federal and state, must be consistent with this constitutional mandate.

The Establishment Clause The establishment clause prohibits the government from establishing a state- sponsored religion, as well as from passing laws that pro- mote (aid or endorse) religion or show a preference for one religion over another. Although the establishment clause involves the separation of church and state, it does not require a complete separation.

Applicable Standard. Establishment clause cases often involve such issues as the legality of allowing or requiring school prayers, using state-issued vouchers to pay tuition at religious schools, and teaching creation theories versus evolution. Federal or state laws that do not promote or place a signi�cant burden on religion are constitutional even if they have some impact on religion. For a govern- ment law or policy to be constitutional, it must not have the primary e�ect of promoting or inhibiting religion.

Religious Displays. Religious displays on public prop- erty have often been challenged as violating the establish- ment clause, and the United States Supreme Court has

25. United States v. American Library Association, 539 U.S. 194, 123 S.Ct. 2297, 156 L.Ed.2d 221 (2003).

26. The Prosecutorial Remedies and Other Tools to End the Exploitation of Children Today Act (Protect Act), 18 U.S.C. Section 2252A(a)(5)(B).

27. United States v. Williams, 553 U.S. 285, 128 S.Ct. 1830, 170 L.Ed.2d 650 (2008).

ruled on a number of such cases. Generally, the Court has focused on the proximity of the religious display (such as a Christian Christmas symbol) to nonreligious symbols (such as reindeer and candy canes) or symbols from dif-(such as reindeer and candy canes) or symbols from dif-(such as reindeer and candy canes) or symbols from dif ferent religions (such as a menorah, a nine-branched can- delabrum used in celebrating Hanukkah).

The Supreme Court took a slightly different approach when it held that public displays having historical, as well as religious, significance do not necessarily violate the establishment clause.28 Still, historical significance must be carefully weighed against religious elements in establishment clause cases.

■ CASE IN POINT 4.10 Mount Soledad is a promi- nent hill near San Diego. There has been a forty-foot cross on top of Mount Soledad since 1913. In the 1990s, a war memorial with six walls listing the names of veter- ans was constructed next to the cross. The site was pri- vately owned until 2006, when Congress authorized the property’s transfer to the federal government “to preserve a historically significant war memorial.”

Steve Trunk and the Jewish War Veterans filed law- suits claiming that the cross violated the establishment clause because it endorsed the Christian religion. A federal appellate court agreed, finding that the primary effect of the memorial as a whole sent a strong message of endorsement of Christianity and exclusion of non- Christian veterans. The court noted that although not all cross displays at war memorials violate the establishment clause, the cross in this case physically dominated the site. Additionally, it was originally dedicated to religious purposes, had a long history of religious use, and was the only portion visible to drivers on the freeway below.29 ■

The Free Exercise Clause The free exercise clause guarantees that people can hold any religious beliefs they want or can hold no religious beliefs. The constitutional guarantee of personal freedom restricts only the actions of the government, however, and not those of individuals or private businesses.

Restrictions Must Be Necessary. �e government must have a compelling state interest for restricting the free exercise of religion, and the restriction must be the only exercise of religion, and the restriction must be the only exercise of religion, and the restriction must be the only way to further that interest. ■ CASE IN POINT 4.11 Greg- ory Holt, an inmate in an Arkansas state prison, was a devout Muslim who wished to grow a beard in accord with his religious beliefs. �e Arkansas Department of

28. Van Orden v. Perry, 545 U.S. 677, 125 S.Ct. 2854, 162 L.Ed.2d 607 (2005). The Court held that a six-foot-tall monument of the Ten Commandments on the Texas state capitol grounds did not violate the establishment clause because the Ten Commandments have historical significance.

C H A P T E R 4 Business and the Constitution 81

Correction prohibited inmates from growing beards (except for medical reasons). Holt asked for an exemp- tion to grow a half-inch beard on religious grounds, and prison o�cials denied his request. Holt �led a suit in a federal district court against Ray Hobbs, the director of the department, and others.

A federal statute prohibits the government from taking any action that substantially burdens the reli- gious exercise of an institutionalized person unless the action constitutes the least restrictive means of further- ing a compelling governmental interest. The defendants argued that beards compromise prison safety—a compel- ling government interest—because contraband can be hidden in them and because an inmate can quickly shave his beard to disguise his identity.

The district court dismissed Holt’s suit, and the dis- missal was affirmed on appeal. Holt then appealed to the United States Supreme Court. The Court noted that “an item of contraband would have to be very small indeed to

be concealed by a 1/2–inch beard.” Moreover, the Court reasoned that the department could satisfy its secu- rity concerns by simply searching the beard, the way it already searches prisoners’ hair and clothing. The Court concluded that the department’s grooming policy, which prevented Holt from growing a half-inch beard, violated his right to exercise his religious beliefs.30 ■

Restrictions Must Not Be a Substantial Burden. To comply with the free exercise clause, a government action must not place a substantial burden on religious practices. A burden is substantial if it pressures an individual to modify his or her behavior and to violate his or her beliefs.

At issue in the following case was whether forcing a state prison inmate to choose between daily nutrition and a religious practice is a substantial burden.

30. Holt v. Hobbs, ___ U.S. ___, 135 S.Ct. 853, 190 L.Ed.2d 747 (2015).

In the Language of the Court ROVNER, Circuit Judge.

Michael Thompson, a Muslim inmate incarcerated at Waupun Correctional Institution in Wisconsin, sued mem- bers of the prison staff for violating his right under the First Amendment to exercise his religion freely. The violation occurred, Thompson says, when for two days prison staff prevented him from fasting properly during Ramadan.

* * * A central religious practice of the Islamic faith is a sunrise-to-sunset fast during the month of Ramadan. The prison normally accommodates this practice by providing Ramadan “meal bags” at sunset to each Muslim prisoner listed as eligible. The prison’s chaplain determines eligibility. Each Ramadan meal bag contains two meals: the post- sunset dinner and the next morning’s pre-sunrise breakfast. A prisoner who eats at the prison cafeteria during Rama- dan forfeits his right to the meal bags for the rest of the month-long fast. Thomp- son, a practicing Muslim, began fasting for Ramadan after sunrise on August 11—the first day of Ramadan. He

received his daily meal bags until August 21, about one-third into the month.

* * * Thompson says that shortly before August 21, as he was on his way back to his cell, Randall Lashock, a prison guard, handed him a meal bag. When Thompson arrived at his cell, he found that a guard had already left a meal bag for him there. Thompson could not leave his cell to return the extra bag without risking a conduct violation, so he left one of the two bags unopened for Lashock to retrieve. Lashock asserts that when he later retrieved that extra meal bag from Thompson’s cell, he found Thompson eating from both bags.

Thompson received no meal bags on August 21 and 22. Lashock was sup- posed to deliver the Ramadan meal bags to every prisoner on the eligibility list. But on those two days, Lashock brought Thompson nothing, even though * * * he remained on the list. Receiving no meals, and learning from [prison guards] Bruce Bleich and Matthew Larson when he complained to them that he would have to go to the cafeteria if he wanted

to eat, Thompson felt pressure to break his fast by going to the cafeteria. But he knew that under the prison’s policy he could not do that without forfeiting meal bags for the rest of the month-long fast. He also had hunger pangs and felt tired and unwell. Because of his hunger, exhaustion, and anxiety, he missed one of his morning prayers and did not properly experience Ramadan, which is meant to be a time of peace and focus.

* * * * While he was receiving no meal

bags, Thompson asked other prison officials to explain why Lashock was not bringing him food * * * . Bleich and Larson told him that Captain William Holm had ordered his name removed from the list because he had stolen a meal bag; they too refused to bring him any meals. But Holm * * * did not remove Thompson from the list and had no authority to do so; only the chaplain could do that.

* * * On August 23, Thompson received a Ramadan meal bag at sunset

Case Analysis 4.3 Thompson v. Holm United States Court of Appeals, Seventh Circuit, 809 F.3d 376 (2016).

82 U N I T O N E The Foundations

and continued to receive a bag each day until the end of Ramadan.

Thompson [filed a suit in a federal district court against] Lashock, Holm, Bleich, and Larson * * * for violating his First Amendment rights, and the defen- dants moved for summary judgment. * * * They argued the lack of meal bags for two days did not substantially bur- den Thompson’s free-exercise rights.

Thompson responded that the defen- dants unlawfully withheld his meal bags. * * * By forcing him to choose between adequate nutrition and a central tenet of his religion, the defendants substantially burdened his free-exercise rights.

[The court] granted the defendants’ motion for summary judgment. The judge ruled that receiving no meal bags for just two days was not a substantial burden on Thompson’s free-exercise rights because he kept fasting, praying, and reading the Koran.

On appeal Thompson challenges the entry of summary judgment.

We begin our analysis by asking whether the denial of meal bags substan- tially burdened Thompson’s free exercise rights. The answer is yes. Without the meal bags, Thompson was forced to choose between foregoing adequate nutrition or violating a central tenet of his religion. Facing that choice for “only” two days was not, as defendants argue, a “de minimisnot, as defendants argue, a “de minimisnot, as defendants argue, a “ ” [minimal] burden. Not only did Thomp- son receive no proper meal for 55 hours, leaving him weak and tired, he did not know if he would ever be put back on the Ramadan list and get regular food. This uncertainty put pressure on him to resign himself to the cafeteria; the anxi- ety left him unable to practice Ramadan properly. [Emphasis added.]

* * * * We next consider whether Thompson

produced sufficient evidence that all the defendants were personally involved in imposing this burden. Once again, the answer is yes. We consider the defendants individually, beginning with

Lashock. He was responsible for deliver- ing the meal bags to all inmates on the eligibility list. Yet he personally denied them to Thompson for two days even though * * * Thompson remained on the list. As to Holm, * * * Holm lied about whether he had removed Thompson from the meal list. Finally, as to Bleich and Larson, they also bear responsibility for depriving Thompson of his food. By (falsely) telling Thompson that Holm had removed him from the religious meal list, refusing to bring him any meals, and warning him to go to the cafeteria if he wanted to eat, * * * they were involved in a joint effort to pressure Thompson to break his fast.

* * * * Accordingly, we VACATE the judg-

ment. This case is REMANDED for further proceedings consistent with this order.

Legal Reasoning Questions

1. What is the standard for determining whether a restriction on a religious practice is constitutional under the First Amendment? 2. How did that standard apply to the prison guards’ conduct in this case? 3. Were all of the guards personally involved in the alleged violation of the First Amendment? Explain.

Case 4.3 Continued

Public Welfare Exception. When religious practices work against public policy and the public welfare, the government can act. For instance, the government can require that a child receive certain types of vaccinations or medical treatment if his or her life is in danger— regardless of the child’s or parent’s religious beliefs. When public safety is an issue, an individual’s religious beliefs often have to give way to the government’s interest in protecting the public.protecting the public.protecting the public.

■ EXAMPLE 4.12 A woman of the Muslim faith may choose not to appear in public without a scarf, known as a hijab, over her head. Nevertheless, due to public safety concerns, many courts today do not allow the wearing of any headgear (hats or scarves) in courtrooms. ■

4–2d Searches and Seizures The Fourth Amendment protects the “right of the people to be secure in their persons, houses, papers, and effects.”

Before searching or seizing private property, law enforce- ment officers must usually obtain a search warrant—an search warrant—an search warrant order from a judge or other public official authorizing the search or seizure. Because of the strong government inter- est in protecting the public, however, a warrant normally is not required for seizures of spoiled or contaminated food. Nor are warrants required for searches of businesses in such highly regulated industries as liquor, guns, and strip mining.

To obtain a search warrant, law enforcement officers must convince a judge that they have reasonable grounds, or probable cause, to believe a search will reveal evi- dence of a specific illegality. To establish probable cause, the officers must have trustworthy evidence that would convince a reasonable person that the proposed search or seizure is more likely justified than not.seizure is more likely justified than not.seizure is more likely justified than not.

■ CASE IN POINT 4.13 Citlalli Flores was driving across the border into the United States from Tijuana, Mexico, when a border protection officer became suspicious because she was acting nervous and looking around inside her car.

C H A P T E R 4 Business and the Constitution 83

On further inspection, the officer found thirty-six pounds of marijuana hidden in the car’s quarter panels. Flores claimed that she had not known about the marijuana.

Flores was arrested for importing marijuana into the United States. She then made two jail-recorded phone calls in which she asked her cousin to delete whatever he felt needed to be removed from Flores’s Facebook page. The government got a warrant to search Flores’s Facebook messages, where they found references to her “carrying” or “bringing” marijuana into the United States that day. Flores’s Facebook posts were later used as evi- dence against her at trial, and she was convicted.

On appeal, the court held that the phone calls had given the officers probable cause to support a warrant to search Flores’s social networking site for incriminating statements. Her conviction was affirmed.31 ■

4–2e Self-Incrimination The Fifth Amendment guarantees that no person “shall be compelled in any criminal case to be a witness against himself.” Thus, in any court proceeding, an accused per- son cannot be forced to give testimony that might subject him or her to any criminal prosecution. The guarantee applies to both federal and state proceedings because the due process clause of the Fourteenth Amendment (dis- cussed shortly) extends the protection to state courts.

The Fifth Amendment’s guarantee against self- incrimination extends only to natural persons. Neither corporations nor partnerships receive Fifth Amendment protection. When a partnership is required to produce business records, it must therefore do so even if the infor- mation provided incriminates the individual partners of the firm. In contrast, sole proprietors and sole prac- titioners (those who individually own their businesses) cannot be compelled to produce their business records. These individuals have full protection against self- incrimination because they function in only one capac- ity, and there is no separate business entity.

4–3 Due Process and Equal Protection

Other constitutional guarantees of great significance to Americans are mandated by the due process clauses of the Fifth and Fourteenth Amendments and the equal protec- tion clause of the Fourteenth Amendment.tion clause of the Fourteenth Amendment.tion clause

31. United States v. Flores, 830 F.3d 1028 (9th Cir. 2015).

4–3a Due Process Both the Fifth and Fourteenth Amendments provide that no person shall be deprived “of life, liberty, or property, without due process of law.” The due pro- cess clause of these constitutional amendments has two aspects—procedural and substantive. Note that the due process clause applies to “legal persons” (that is, corpora- tions), as well as to individuals.

Procedural Due Process Procedural due process Procedural due process Procedural requires that any government decision to take life, liberty, or property must be made equitably. In other words, the government must give a person proper notice and an opportunity to be heard. Fair procedures must be used in determining whether a person will be subjected to punishment or have some burden imposed on her or him.

Fair procedure has been interpreted as requiring that the person have at least an opportunity to object to a pro- posed action before an impartial, neutral decision maker (who need not be a judge). ■ EXAMPLE 4.14 Doyle Doyle Burns, a nursing student in Kansas, poses for a photo- graph standing next to a placenta used as a lab specimen. Although she quickly deletes the photo from her library, it ends up on Facebook. When the director of nursing sees the photo, Burns is expelled. She sues for reinstate- ment and wins. The school violated Burns’s due process rights by expelling her from the nursing program for tak- ing a photo without giving her an opportunity to present her side to school authorities. ■

Substantive Due Process Substantive due process Substantive due process Substantive focuses on the content of legislation rather than the fair- ness of procedures. Substantive due process limits what the government may do in its legislative and executive capacities. Legislation must be fair and reasonable in content and must further a legitimate governmental objective.

If a law or other governmental action limits a fun- damental right, the state must have a legitimate and compelling interest to justify its action. Fundamental rights include interstate travel, privacy, voting, marriage and family, and all First Amendment rights. Thus, for instance, a state must have a substantial reason for tak- ing any action that infringes on a person’s free speech rights.

In situations not involving fundamental rights, a law or action does not violate substantive due process if it rationally relates to any legitimate government purpose. It is almost impossible for a law or action to fail the “rationality” test. Under this test, almost any business regulation will be upheld as reasonable.Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

84 U N I T O N E The Foundations

4–3b Equal Protection Under the Fourteenth Amendment, a state may not “deny to any person within its jurisdiction the equal protection of the laws.” The United States Supreme Court has inter- preted the due process clause of the Fifth Amendment to make the equal protection clause applicable to the federal government as well. Equal protection means that the government cannot enact laws that treat similarly situated individuals differently.

Equal protection, like substantive due process, relates to the substance of a law or other governmental action. When a law or action limits the liberty of all persons, it all persons, it all may violate substantive due process. When a law or action limits the liberty of some persons but not others, it may persons but not others, it may persons but not others, it may persons but not others, it may some persons but not others, it may some violate the equal protection clause. ■ EXAMPLE 4.15 If a law prohibits all advertising on the sides of trucks, it raises a substantive due process question. If the law makes an exception to allow truck owners to advertise their own businesses, it raises an equal protection issue. ■

In an equal protection inquiry, when a law or action distinguishes between or among individuals, the basis for the distinction—that is, the classification—is examined. Depending on the classification, the courts apply differ- ent levels of scrutiny, or “tests,” to determine whether the law or action violates the equal protection clause. The courts use one of three standards: strict scrutiny, interme- diate scrutiny, or the “rational basis” test.

Strict Scrutiny If a law or action prohibits or inhibits some persons from exercising a fundamental right, the law or action will be subject to “strict scrutiny” by the courts. Under this standard, the classification must be necessary to promote a compelling state interest.

Compelling state interests include remedying past unconstitutional or illegal discrimination but do not include correcting the general effects of “society’s disinclude correcting the general effects of “society’s disinclude correcting the general effects of “society’s disinclude correcting the general effects of “society’s dis- crimination.” ■ EXAMPLE 4.16 For a city to give pref-For a city to give pref-For a city to give pref erence to minority applicants in awarding construction contracts, it normally must identify past unconstitutional or illegal discrimination against minority construction firms. Because the policy is based on suspect traits (race and national origin), it will violate the equal protection clause unless it is necessary to promote a compelling state unless it is necessary to promote a compelling state unless interest. ■ Generally, few laws or actions survive strict- scrutiny analysis by the courts.

Intermediate Scrutiny Another standard, that of intermediate scrutiny, is applied in cases involving dis- crimination based on gender or legitimacy (children born out of wedlock). Laws using these classifications must be substantially related to important government

objectives. ■ EXAMPLE 4.17 An important government An important government objective is preventing illegitimate teenage pregnancies. Males and females are not similarly situated in this regard because only females can become pregnant. Therefore, a law that punishes men but not women for statutory rape will be upheld even though it treats men and women unequally. ■

The state also has an important objective in establish- ing time limits (called statutes of limitation) for how long after an event a particular type of action can be brought. Nevertheless, the limitation period must be substantially related to the important objective of preventing fraudulent related to the important objective of preventing fraudulent related to the important objective of preventing fraudulent related to the important objective of preventing fraudulent or outdated claims. ■ EXAMPLE 4.18 A state law requires illegitimate children to bring paternity suits within six years of their births in order to seek support from their fathers. A court will strike down this law if legitimate chil- dren are allowed to seek support from their parents at any time. Distinguishing between support claims on the basis of legitimacy is not related to the important government objective of preventing fraudulent or outdated claims. ■

The “Rational Basis” Test In matters of economic or social welfare, a classification will be considered valid if there is any conceivable rational basis on which the classification rational basis on which the classification rational basis might relate to a legitimate government interest. It is almost impossible for a law or action to fail the rational basis test.

■ CASE IN POINT 4.19 A Kentucky statute prohibits businesses that sell substantial amounts of staple grocer- ies or gasoline from applying for a license to sell wine and liquor. A local grocer (Maxwell’s Pic-Pac) filed a lawsuit against the state, alleging that the statute and the regu- lation were unconstitutional under the equal protection clause. The court applied the rational basis test and ruled that the statute and regulation were rationally related to a legitimate government interest in reducing access to products with high alcohol content.

The court cited the problems caused by alcohol, including drunk driving, and noted that the state’s inter- est in limiting access to such products extends to the gen- eral public. Grocery stores and gas stations pose a greater risk of exposing members of the public to alcohol. For these and other reasons, the state can restrict these places from selling wine and liquor.32 ■

4–4 Privacy Rights The U.S. Constitution does not explicitly mention a general right to privacy. In a 1928 Supreme Court case,

32. Maxwell’s Pic-Pac, Inc. v. Dehner, 739 F.3d 936 (6th Cir. 2014).

C H A P T E R 4 Business and the Constitution 85

Olmstead v. United States,33 Justice Louis Brandeis stated in his dissent that the right to privacy is “the most com- prehensive of rights and the right most valued by civilized men.” The majority of the justices at that time, however, did not agree with Brandeis.

It was not until the 1960s that the Supreme Court endorsed the view that the Constitution protects indi- vidual privacy rights. In a landmark 1965 case, Griswold v. Connecticut,34 the Supreme Court held that a consti- tutional right to privacy was implied by the First, Third, Fourth, Fifth, and Ninth Amendments.

Today, privacy rights receive protection under vari- ous federal statutes as well the U.S. Constitution. State constitutions and statutes also secure individuals’ privacy rights, often to a significant degree. Privacy rights are also protected to an extent under tort law, consumer law, and employment law.

4–4a Federal Privacy Legislation In the last several decades, Congress has enacted a num- ber of statutes that protect the privacy of individuals in

33. 277 U.S. 438, 48 S.Ct. 564, 72 L.Ed. 944 (1928). 34. 381 U.S. 479, 85 S.Ct. 1678, 14 L.Ed.2d 510 (1965).

various areas of concern. Most of these statutes deal with personal information collected by governments or pri- vate businesses.

In the 1960s, Americans were sufficiently alarmed by the accumulation of personal information in government files that they pressured Congress to pass laws permitting individuals to access their files. Congress responded by passing the Freedom of Information Act, which allows any person to request copies of any information on her or him contained in federal government files. Congress later enacted the Privacy Act, which also gives persons the right to access such information.

In the 1990s, responding to the growing need to protect the privacy of individuals’ health records— particularly computerized records—Congress passed the Health Insurance Portability and Accountability Act (HIPAA).35 This act defines and limits the circumstances in which an individual’s “protected health informa- tion” may be used or disclosed by health-care providers, health-care plans, and others. These and other major fed- eral laws protecting privacy rights are listed and briefly described in Exhibit 4–2.

35. HIPAA was enacted as Pub. L. No. 104-191 (1996) and is codified in 29 U.S.C.A. Sections 1181 et seq.

E X H I B I T 4 – 2 Federal Legislation Relating to Privacy

Provides that individuals have a right to obtain access to information about them collected in government files.

Freedom of Information Act (1966)

Privacy Act (1974) Protects the privacy of individuals about whom the federal government has information. Regulates agencies’ use and disclosure of data, and gives individuals access to and a means to correct inaccuracies.

Electronic Communications Privacy Act (1986)

Prohibits the interception of information communicated by electronic means.

Health Insurance Portability and Accountability Act (1996)

Requires health-care providers and health-care plans to inform patients of their privacy rights and of how their personal medical information may be used. States that medical records may not be used for purposes unrelated to health care or disclosed without permission.

Financial Services Modernization Act (Gramm-Leach-Bliley Act) (1999)

Prohibits the disclosure of nonpublic personal information about a consumer to an unaffiliated third party unless strict disclosure and opt-out requirements are met.

86 U N I T O N E The Foundations

Debate This . . . Legislation aimed at “protecting people from themselves” concerns the individual as well as the pub- lic in general. Protective helmet laws are just one example of such legislation. Should individuals be allowed to engage in unsafe activities if they choose to do so?

Reviewing: Business and the Constitution

A state legislature enacted a statute that required any motorcycle operator or passenger on the state’s highways to wear a protective helmet. Jim Alderman, a licensed motorcycle operator, sued the state to block enforcement of the law. Alder- man asserted that the statute violated the equal protection clause because it placed requirements on motorcyclists that were not imposed on other motorists. Using the information presented in the chapter, answer the following questions. 1. Why does this statute raise equal protection issues instead of substantive due process concerns? 2. What are the three levels of scrutiny that the courts use in determining whether a law violates the equal protection

clause? 3. Which standard of scrutiny, or test, would apply to this situation? Why? 4. Applying this standard, is the helmet statute constitutional? Why or why not?

Terms and Concepts Bill of Rights 75 checks and balances 71 commerce clause 71 compelling government interest 77 due process clause 83 equal protection clause 84 establishment clause 80

federal form of government 70 �ltering software 79 free exercise clause 80 full faith and credit clause 71 meta tag 80 police powers 70 preemption 75

privileges and immunities clause 71 probable cause 82 search warrant 82 sovereignty 70 supremacy clause 75 symbolic speech 77

4–4b The USA Patriot Act and the USA Freedom Act

The USA Patriot Act was passed by Congress in the wake of the terrorist attacks of September 11, 2001.36 The Patriot Act has given government officials increased authority to monitor Internet activities (such as e-mail and Web site visits) and to gain access to personal financial information and student information. Law enforcement officials can track the telephone and e-mail communications of one party to find out the identity of the other party or parties. Privacy advocates argue that

36. The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, also known as the USA Patriot Act, was enacted as Pub. L. No. 107-56 (2001) and last reauthorized by Pub. L. No. 112-114 (2011).

this law adversely affects the constitutional rights of all Americans, and it has been widely criticized in the media.

While the bulk of the Patriot Act is permanent law, its most controversial surveillance provisions had to be reau- thorized every four years and expired in June 2015. Most of the expired provisions were restored by the USA Free- dom Act, which extends surveillance authority through 2019.37 The Freedom Act did amend a portion of the Patriot Act in an attempt to stop the National Security Agency (NSA) from collecting mass phone data. (Note, however, that the act still allows the data to be collected by private phone companies, and the NSA can obtain data about targeted individuals through these companies.)

37. The full title of this statute is Uniting and Strengthening America by Fulfilling Rights and Ending Eavesdropping, Dragnet-collection and Online Monitoring, H.R. 3361.

C H A P T E R 4 Business and the Constitution 87

Issue Spotters 1. Can a state, in the interest of energy conservation, ban

all advertising by power utilities if conservation could be accomplished by less restrictive means? Why or why not? (See Business and the Bill of Rights.)

2. Suppose that a state imposes a higher tax on out-of-state companies doing business in the state than it imposes on

in-state companies. Is this a violation of equal protection if the only reason for the tax is to protect the local firms from out-of-state competition? Explain. (See The Consti- tutional Powers of Government.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 4–1. Commerce Clause. A Georgia state law requires the use of contoured rear-fender mudguards on trucks and trail- ers operating within Georgia state lines. The statute further makes it illegal for trucks and trailers to use straight mud- guards. In approximately thirty-five other states, straight mud- guards are legal. Moreover, in Florida, straight mudguards are explicitly required by law. There is some evidence suggesting that contoured mudguards might be a little safer than straight mudguards. Discuss whether this Georgia statute violates any constitutional provisions. (See The Constitutional Powers of Government.) 4–2. Equal Protection. With the objectives of prevent- ing crime, maintaining property values, and preserving the

quality of urban life, New York City enacted an ordinance to regulate the locations of adult entertainment establishments. The ordinance expressly applied to female, but not male, top- less entertainment. Adele Buzzetti owned the Cozy Cabin, a New York City cabaret that featured female topless danc- ers. Buzzetti and an anonymous dancer filed a suit in a fed- eral district court against the city, asking the court to block the enforcement of the ordinance. The plaintiffs argued, in part, that the ordinance violated the equal protection clause. Under the equal protection clause, what standard applies to the court’s consideration of this ordinance? Under this test, how should the court rule? Why? (See Due Process and Equal Protection.)

Business Case Problems 4–3. Spotlight on Plagiarism—Due Process. �e Russ

College of Engineering and Technology of Ohio University announced in a press conference that it had found “rampant and �agrant plagiarism” in the theses of mechanical engineering graduate stu-

dents. Faculty singled out for “ignoring their ethical responsi- bilities” included Jay Gunasekera, chair of the department. Gunasekera was prohibited from advising students. He �led a suit against Dennis Irwin, the dean of Russ College, for violat- ing his due process rights. What does due process require in these circumstances? Why? [Gunasekera v. Irwin, 551 F.3d 461 (6th Cir. 2009)] (See Due Process and Equal Protection.) 4–4. Business Case Problem with Sample Answer— The Dormant Commerce Clause. In 2001, Puerto Rico

enacted a law that requires speci�c labels on cement sold in Puerto Rico and imposes �nes for any violations of these requirements. �e law prohibits the sale or distribution of cement man-

ufactured outside Puerto Rico that does not carry a required label warning that the cement may not be used in government-�nanced construction projects. Antilles Cement Corp., a Puerto Rican �rm that imports foreign cement, �led a complaint in federal court, claiming that this law vio- lated the dormant commerce clause. (�e dormant com- merce clause doctrine applies not only to commerce among the states and U.S. territories, but also to international

commerce.) Did the 2001 Puerto Rican law violate the dor- mant commerce clause? Why or why not? [Antilles Cement mant commerce clause? Why or why not? [Antilles Cement mant commerce clause? Why or why not? [ Corp. v. Fortuno, 670 F.3d 310 (1st Cir. 2012)] (See �e Con- stitutional Powers of Government.) • For a sample answer to Problem 4–4, go to Appendix E at

the end of this text.

4–5. Freedom of Speech. Mark Wooden sent an e-mail to an alderwoman for the city of St. Louis. Attached was a nineteen-minute audio �le that compared her to the biblical character Jezebel. �e audio said she was a “bitch in the Sixth Ward,” spending too much time with the rich and powerful and too little time with the poor. In a menacing, maniacal tone, Wooden said that he was “dusting o� a sawed-o� shot- gun,” called himself a “domestic terrorist,” and referred to the assassination of President John Kennedy, the murder of federal judge John Roll, and the shooting of Representative Gabrielle Gi�ords. Feeling threatened, the alderwoman called the police. Wooden was convicted of harassment under a state criminal statute. Was this conviction unconstitutional under the First Amendment? Discuss. [State of Missouri v. Wooden, 388 S.W.3d 522 (Mo. 2013)] (See Business and the Bill of Rights.)

4–6. Equal Protection. Abbott Laboratories licensed SmithKline Beecham Corp. to market an Abbott human immunode�ciency virus (HIV) drug in conjunction with one of SmithKline’s drugs. Abbott then increased the price

88 U N I T O N E The Foundations

of its drug fourfold, forcing SmithKline to increase its prices and thereby driving business to Abbott’s own combination drug. SmithKline �led a suit in a federal district court against Abbott. During jury selection, Abbott struck the only self- identi�ed gay person among the potential jurors. (�e pricing of HIV drugs is of considerable concern in the gay commu- nity.) Could the equal protection clause be applied to prohibit discrimination based on sexual orientation in jury selection? Discuss. [SmithKline Beecham Corp. v. Abbott Laboratories, 740 F.3d 471 (9th Cir. 2014)] (See Due Process and Equal Protection.)

4–7. Procedural Due Process. Robert Brown applied for admission to the University of Kansas School of Law. Brown answered “no” to questions on the application asking if he had a criminal history and acknowledged that a false answer con- stituted “cause for . . . dismissal.” In fact, Brown had crimi- nal convictions for domestic battery and driving under the in�uence. He was accepted for admission to the school. When school o�cials discovered his history, however, he was noti- �ed of their intent to dismiss him and given an opportunity to respond in writing. He demanded a hearing. �e o�cials refused to grant Brown a hearing and then expelled him. Did the school’s actions deny Brown due process? Discuss. [Brown v. University of Kansas, 599 Fed.Appx. 833 (10th Cir. 2015)] (See Due Process and Equal Protection.) 4–8. The Commerce Clause. Regency Transportation, Inc., operates a freight business throughout the eastern United States. Regency maintains its corporate headquarters, four warehouses, and a maintenance facility and terminal location for repairing and storing vehicles in Massachusetts. All of the vehicles in Regency’s �eet were bought in other states. Massa- chusetts imposes a use tax on all taxpayers subject to its jurisdic- tion, including those that do business in interstate commerce, as Regency does. When Massachusetts imposed the tax on the purchase price of each tractor and trailer in Regency’s �eet, the trucking �rm challenged the assessment as discriminatory under the commerce clause. What is the chief consideration under the commerce clause when a state law a�ects interstate commerce?

Is Massachusetts’s use tax valid? Explain. [Regency Transporta- tion, Inc. v. Commissioner of Revenue, 473 Mass. 459, 42 N.E.3d 1133 (2016)] (See �e Constitutional Powers of Government.)�e Constitutional Powers of Government.)�e Constitutional Powers of Government 4–9. A Question of Ethics—Defamation. Aric Toll owns

and manages the Balboa Island Village Inn, a restau- rant and bar in Newport Beach, California. Anne Lemen lives across from the inn. Lemen complained to the authorities about the inn’s customers, whom

she called “drunks” and “whores.” She referred to Aric’s wife as “Madam Whore” and told neighbors that the owners were involved in illegal drugs and prostitution. Lemen told Ewa Cook, a bartender at the Inn, that Cook “worked for Satan.” She repeated her statements to potential customers, and the inn’s sales dropped more than 20 percent. �e inn �led a suit against Lemen. [ Balboa Island Village Inn, Inc. v. Lemen, 40 Cal.4th 1141, 156 P.3d 339 (2007)] (See 156 P.3d 339 (2007)] (See 156 P.3d 339 (2007)] Business and the Bill of Rights.) (a) Are Lemen’s statements about the inn’s owners, customers,

and activities protected by the U.S. Constitution? Should such statements be protected? In whose favor should the court rule? Why?

(b) Did Lemen behave unethically in the circumstances of this case? Explain.

4–10. Special Case Analysis—Freedom of Religion. Go to Case Analysis 4.3, �ompson v. Holm. Read the excerpt, and answer the following questions. (a) Issue: The focus in this case was on an allegation of the

violation of which clause of the U.S. Constitution, and by what means?

(b) Rule of Law: What is required to establish that this clause has been violated?

(d) Conclusion: What did the federal appellate court con- clude with respect to the plaintiff ’s claim, and what did the court order as the next step in the case?

Legal Reasoning Group Activity 4–11. Free Speech and Equal Protection. For many years, New York City has had to deal with the vandalism and defacement of public property caused by unauthorized graf-defacement of public property caused by unauthorized graf-defacement of public property caused by unauthorized graf �ti. In an e�ort to stop the damage, the city banned the sale of aerosol spray-paint cans and broad-tipped indelible markers to persons under twenty-one years of age. �e new rules also prohibited people from possessing these items on property other than their own. Within a year, �ve people under age twenty-one were cited for violations of these regulations, and 871 individuals were arrested for actually making gra�ti.

Lindsey Vincenty and other artists wished to create graf-Lindsey Vincenty and other artists wished to create graf-Lindsey Vincenty and other artists wished to create graf �ti on legal surfaces, such as canvas, wood, and clothing. Unable to buy supplies in the city or to carry them into the city from elsewhere, Vincenty and others �led a lawsuit on behalf of themselves and other young artists against Michael

Bloomberg, the city’s mayor, and others. �e plainti�s claimed that, among other things, the new rules violated their right to freedom of speech. (a) One group will argue in favor of the plaintiffs and provide

several reasons why the court should hold that the city’s new rules violate the plaintiffs’ freedom of speech. (See Business and the Bill of Rights.)

(b) Another group will develop a counterargument that out- lines the reasons why the new rules do not violate free speech rights. (See Business and the Bill of Rights.)

(c) A third group will argue that the city’s ban violates the equal protection clause because it applies only to per- sons under age twenty-one. (See Due Process and Equal Protection.)Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 5

5–1 Business Ethics At the most basic level, the study of ethics is the study of what constitutes right or wrong behavior. It is a branch of philosophy focusing on morality and the way moral prin- ciples are derived and implemented. Ethics has to do with the fairness, justness, rightness, or wrongness of an action.

The study of business ethics typically looks at the decisions businesses make or have to make and whether those decisions are right or wrong. It has to do with how businesspersons apply moral and ethical principles in making their decisions. Those who study business eth- ics also evaluate what duties and responsibilities exist or should exist for businesses.

In this book, we include an Application and Ethics fea- ture at the end of each unit to expand on the concepts of business ethics discussed in that unit. We also cover ethi- cal issues in Ethics Today features that appear in a number Ethics Today features that appear in a number Ethics Today of chapters.

5–1a Why Is Studying Business Ethics Important?

Over the last hundred years, the public perception of the corporation has changed from an entity that primarily generates revenues for its owners to an entity that partici- pates in society as a corporate citizen. Originally, the only

goal or duty of a corporation was to maximize profits. Although many people today may view this idea as greedy or inhumane, the rationale for the profit-maximization theory is still valid.

Profit Maximization In theory, if all firms strictly adhere to the goal of profit maximization, resources flow to where they are most highly valued by society. Corpora- tions can focus on their strengths, and other entities that are better suited to deal with social problems and perform charitable acts can specialize in those activities. The gov- ernment, through taxes and other financial allocations, can shift resources to those other entities to perform pub- lic services. Thus, in an ideal world, profit maximization leads to the most efficient allocation of scarce resources.

The Rise of Corporate Citizenship Over the years, as resources purportedly were not sufficiently reallocated to cover the costs of social needs, many people became dis- satisfied with the profit-maximization theory. Investors and others began to look beyond profits and dividends and to consider the triple bottom line—a corporation’s profits, its triple bottom line—a corporation’s profits, its triple bottom line impact on people, and its impact on the planet. Magazines and Web sites began to rank companies based on their envi- ronmental impacts and their ethical decisions. The corpo- ration came to be viewed as a “citizen” that was expected to participate in bettering communities and society.

O ne of the most complex issues businesspersons and corpo- rations face is ethics. It is not

as well defined as the law, and yet it can have substantial impacts on a firm’s finances and reputation, espe- cially when the firm is involved in a well-publicized scandal. Some scan- dals arise from activities that are legal, but are ethically questionable. Other

scandals arise from conduct that is both illegal and unethical.

Consider, for example, Volkswa- gen’s corporate executives, who were accused of cheating on the pollu- tion emissions tests of millions of vehicles that were sold in the United States. Volkswagen admitted in 2015 that it had installed “defeat device” software in its diesel models. The

software detected when the car was being tested and changed its perfor- mance to improve the test outcome. As a result, the diesel cars showed low emissions—a feature that made the cars more attractive to today’s consumers. Ultimately, millions of Volkswagen vehicles were recalled, and the company suffered its first quarterly loss in fifteen years.

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90 U N I T O N E The Foundations

Even so, many still believe that corporations are fun- damentally profit-making entities that should have no responsibility other than profit maximization.

5–1b The Importance of Ethics in Making Business Decisions

Whether one believes in profit maximization or corporate citizenship, ethics is important in making business deci- sions. When making decisions, a business should evaluate: 1. The legal implications of each decision. 2. The public relations impact. 3. The safety risks for consumers and employees. 4. The financial implications. This four-part analysis will assist the firm in making decisions that not only maximize profits but also reflect good corporate citizenship.

Long-Run Profit Maximization In attempting to maximize profits, corporate executives and employees have to distinguish between short-run and long-run profit maximization. In the short run, a company may increase its profits by continuing to sell a product even though it knows that the product is defective. In the long run, though, because of lawsuits, large settlements, and bad publicity, such unethical conduct will cause profits to suffer. Thus, business ethics is consistent only with long- run profit maximization. An overemphasis on short-term profit maximization is the most common reason that ethi- cal problems occur in business.

■ CASE IN POINT 5.1 When the powerful narcotic painkiller OxyContin was first marketed, its manufac- turer, Purdue Pharma, claimed that it was unlikely to lead to drug addiction or abuse. Internal company docu- ments later showed that the company’s executives knew that OxyContin could be addictive, but kept this risk a secret to boost sales and maximize short-term profits.

Subsequently, Purdue Pharma and three former exec- utives pleaded guilty to criminal charges that they had misled regulators, patients, and physicians about Oxy- Contin’s risks of addiction. Purdue Pharma agreed to pay $600 million in fines and other payments. The three for- mer executives agreed to pay $34.5 million in fines and were barred from federal health programs for a period of fifteen years. Thus, the company’s focus on maximizing profits in the short run led to unethical conduct that hurt profits in the long run.1 ■

1. United States v. Purdue Frederick Co., 495 F.Supp.2d 569 (W.D.Va. 2007).

The Internet Can Ruin Reputations In the past, negative information or opinions about a company might remain hidden. Now, however, cyberspace provides a forum where disgruntled employees, unhappy consum- ers, or special interest groups can post derogatory remarks. Thus, the Internet has increased the potential for a major corporation (or other business) to suffer damage to its reputation or loss of profits through negative publicity.

Wal-Mart and Nike in particular have been frequent targets for advocacy groups that believe those corporations exploit their workers. Although some of these assertions may be unfounded or exaggerated, the courts generally have refused to consider them defamatory (a tort giving defamatory (a tort giving defamatory rise to a civil lawsuit). Most courts regard online attacks as expressions of opinion protected by the First Amendment. Even so, corporations often incur considerable expense in running marketing campaigns to thwart bad publicity and may even face legal costs if the allegations lead to litigation.

Image Is Everything The study of business ethics is concerned with the purposes of a business and how that business achieves those purposes. Thus, business ethics is concerned not only with the image of the business, but also with the impact that the business has on the envi- ronment, customers, suppliers, employees, and the global economy.

Unethical corporate decision making can negatively affect suppliers, consumers, the community, and society as a whole. It can also have a negative impact on the repu- tation of the company and the individuals who run that company. Hence, an in-depth understanding of business ethics is important to the long-run viability of any cor- poration today.

5–1c The Relationship of Law and Ethics Because the law does not codify all ethical requirements, compliance with the law is not always sufficient to deter- mine “right” behavior. Laws have to be general enough to apply in a variety of circumstances. Laws are broad in their purpose and their scope. They prohibit or require certain actions to avoid significant harm to society.

When two competing companies secretly agree to set prices on products, for instance, society suffers harm— typically, the companies will charge higher prices than they could if they continued to compete. This harm inflicted on consumers has negative consequences for the economy, and so colluding to set prices is an illegal activ- ity. Similarly, when a company is preparing to issue stock, the law requires certain disclosures to potential investors. This requirement is meant to prevent harms that come

C H A P T E R 5 Business Ethics 91

with uninformed investing. Such harms occurred in the 1920s and may have contributed to the stock market crash and the Great Depression.

Moral Minimum Compliance with the law is some- times called the moral minimum. If people and entities

merely comply with the law, they are acting at the low- est ethical level society will tolerate. The study of ethics goes beyond those legal requirements to evaluate what is right for society. The following case illustrates some con- sequences of a businessperson’s failure to meet the moral minimum.

Background and Facts Rick Scott deposited $2 million into an escrow account maintained by a company owned by Salvatore Carpanzano. Immediately after the deposit was made, in violation of the escrow agreement, the funds were withdrawn. When Scott was unable to recover his money, he filed a suit against Salvatore Carpanzano and others, including Salvatore’s daughter Carmela Carpan- zano. In the complaint, Scott made no allegations of acts or knowledge on Carmela’s part.

Salvatore failed to cooperate with discovery and did not respond to attempts to contact him by certified mail, regular mail, or e-mail. Salvatore also refused to make an appearance in the court and did not finalize a settlement negotiated between the parties’ attorneys. Carmela denied that she was involved in her father’s business or the Scott transaction. The court found that the defendants had in- tentionally failed to respond to the litigation and issued a judgment for more than $6 million in Scott’s favor. The defendants appealed to the U.S. Court of Appeals for the Fifth Circuit.

In the Language of the Court PER CURIAM [By the Whole Court].PER CURIAM [By the Whole Court].PER CURIAM

* * * * A willful default is an intentional failure to respond to litigation. The district court found that [the]

Defendants willfully defaulted based on evidence that the Defendants were aware of the proceedings against them and that [their] attorneys were specifically instructed not to enter an appearance [partici- pate] in this case. [Emphasis added.]

The evidence substantially supports the district court’s finding as to Mr. Carpanzano. First, Mr. Carpanzano’s first attorney withdrew [from the case] because Mr. Carpanzano failed to cooperate with the discovery process and refused to appear as requested and ordered. Second, * * * Mr. Carpanzano instructed his second set of attorneys to negotiate settlement of this matter but not to enter an appear- ance in the district court. Significantly, Mr. Carpanzano never denies this allegation. Third, * * * Mr. Carpanzano and his attorneys were well aware that the case was proceeding toward default and * * * were in communication with each other during this time. Fourth, * * * once final execution of settle- ment papers was at hand, Mr. Carpanzano also ceased communication with his second set of attorneys and did not finalize the settlement. Finally, other than ambiguously suggesting that a health condition (unsupported by any evidence of what the condition was) and absence from the country (unsupported by any evidence that electronic communication was not possible from that country) prevented him from defending this action, Mr. Carpanzano offers no real reason why he did not answer the * * * complaint.

* * * * By contrast, the record does not support the district court’s finding that * * * Ms. [Carmela] Carpan-

zano also willfully defaulted. * * * Ms. Carpanzano repeatedly indicated that [she was] relying on Mr. Carpanzano * * * to make

sure [her] interests were protected. Nothing in the record contradicts this assertion. While [her] reliance on Mr. Carpanzano acting with the attorneys he retained may have been negligent, it does not amount to an intentional failure to respond to litigation.

Scott v. Carpanzano United States Court of Appeals, Fifth Circuit, 556 Fed.Appx. 288 (2014).

Case 5.1

92 U N I T O N E The Foundations

* * * * * * * [Furthermore] the * * * complaint * * * contains no factual allegations of acts or omissions on

the part of Ms. Carpanzano. It does not allege that she ever was in contact with Scott, that she was in control of the * * * escrow account, or that she wrongfully transferred any funds out of the account. Nor does it allege any intent or knowledge on the part of Ms. Carpanzano * * *. Indeed, an examination of the complaint reveals that there is not a sufficient basis in the pleadings for the judgment * * * entered against Ms. Carpanzano.

The defenses presented by Ms. Carpanzano to the district court assert that she had no knowledge of the details of her father’s business transactions, she did not personally enter into any contracts with Scott or seek to defraud him, and * * * she had limited involvement in the facts of this case.

* * * * * * * Even if Scott were able to prove the entirety of the * * * complaint, we fail to see how it would

justify a judgment * * * against Ms. Carpanzano.

Decision and Remedy The U.S. Court of Appeals for the Fifth Circuit affirmed the judgment against Salvatore, but reversed the decision against Carmela. Scott had made no allegations of acts on Carmela’s part.

Critical Thinking • Ethical Are Salvatore’s actions likely to affect his business’s ability to profit in the long run? Discuss. • Legal Environment Did Carmela Carpanzano meet the minimum acceptable standard for ethical

business behavior? Explain.

Case 5.1 Continued

Ethical Requirements The study of ethics goes beyond legal requirements to evaluate what is right for society. Businesspersons thus must remember that an action that is legal is not necessarily ethical. For instance, a company’s refusal to negotiate liability claims for alleged injuries because of a faulty product is legal. But it may not be ethical if the reason the business refuses to negotiate is to increase the injured party’s legal costs and force the person to drop a legitimate claim.

Private Company Codes of Ethics Most compa- nies attempt to link ethics and law through the creation of internal codes of ethics. Company codes are not law. Instead, they are rules that the company sets forth that it can also enforce (by terminating an employee who does not follow them, for instance). Codes of conduct typi- cally outline the company’s policies on particular issues and indicate how employees are expected to act.

■ EXAMPLE 5.2 Google’s code of conduct starts with the motto “Don’t be evil.” The code then makes general statements about how Google promotes integrity, mutual respect, and the highest standard of ethical business con- duct. Google’s code also provides specific rules on a num- ber of issues, such as privacy, drugs and alcohol, conflicts of interest, co-worker relationships, and confidentiality.

It even has a dog policy. The company takes a stand against employment discrimination that goes further than the law requires—it prohibits discrimination based on sexual orientation, gender identity or expression, and veteran status. ■

Industry Ethical Codes Numerous industries have also developed their own codes of ethics. The American Institute of Certified Public Accountants (AICPA) has a comprehensive Code of Professional Conduct for the ethical practice of accounting. The American Bar Associa- tion has model rules of professional conduct for attorneys, and the American Nurses Association has a code of ethics that applies to nurses. These codes can give guidance to decision makers facing ethical questions.

Violation of an industry code may result in discipline of an employee or sanctions against a company from the industry organization. Remember, though, that these internal codes are not laws, so their effectiveness is deter- mined by the commitment of the industry or company leadership to enforcing the codes.leadership to enforcing the codes.leadership to enforcing the codes.

■ CASE IN POINT 5.3 National Football League (NFL) rules require footballs to be inflated to a minimum air pressure (pounds per square inch, or psi) as measured by the referees. This rule gained attention when the New

C H A P T E R 5 Business Ethics 93

England Patriots played the Indianapolis Colts for the American Football Conference championship in early 2015. After Tom Brady, the Patriots quarterback, threw a pass that was intercepted, officials became suspicious that the football was underinflated. The game continued after NFL officials verified the psi in all the footballs, and the Patriots won.

Nevertheless, allegations continued that Brady and the Patriots had deflated balls during the game—a con- troversy popularly known as “deflategate.” The NFL performed an investigation, and after arbitration, the league announced that Brady would be suspended for four games. Brady appealed, and a federal district court vacated the arbitrator’s decision to suspend, but a federal appellate court reinstated Brady’s suspension in 2016. The reviewing court held that the arbitrator had grounds to suspend Brady for being generally aware that the team had intentionally released air from the game balls.2 ■

“Gray Areas” in the Law Because it is often highly subjective and subject to change over time without any sort of formal process, ethics is less certain than law. But the law can also be uncertain. Numerous “gray areas” in the law make it difficult to predict with certainty how a court will apply a given law to a particular action. In addi- tion, laws frequently change.

5–2 Business Ethics and Social Media

Most young people may think of social media—Facebook, Flickr, Instagram, Tumblr, Twitter, Pinterest, Google+, LinkedIn, VR, and the like—as simply ways to commu- nicate rapidly. Businesses, though, often face ethical issues with respect to these same social media platforms.

5–2a Hiring Procedures In the past, to learn about a prospective employee, an employer would ask the candidate’s former employers for references. Today, employers are likely to also conduct Internet searches to discover what job candidates have posted on their Facebook pages, blogs, and tweets.

On the one hand, job candidates may be judged by what they post on social media. On the other hand, though, they may be judged because they do not

2. National Football League Management Council v. National Football League Players Association, 820 F.3d 527 (2d Cir. 2016).

participate in social media. Given that the vast majority of younger people do use social media, some employers have decided that the failure to do so raises a red flag. In either case, many people believe that judging a job candidate based on what she or he does outside the work environment is unethical.

5–2b The Use of Social Media to Discuss Work-Related Issues

Because so many Americans use social media daily, they often discuss work-related issues there. Numerous com- panies have strict guidelines about what is appropriate and inappropriate for employees to say when making posts on their own or others’ social media accounts. A number of companies have fired employees for such activities as criticizing other employees or managers through social media outlets. Until recently, such disci- plinary measures were considered ethical and legal.

Responsibility of Employers Today, in con- trast, a ruling by the National Labor Relations Board (NLRB—the federal agency that investigates unfair labor practices) has changed the legality of such labor practices) has changed the legality of such labor practices) has changed the legality of such actions. ■ EXAMPLE 5.4 At one time, Costco’s social media policy specified that its employees should not make statements that would damage the company, harm another person’s reputation, or violate the com- pany’s policies. Employees who violated these rules were subject to discipline and could be fired.

The NLRB ruled that Costco’s social media policy violated federal labor law, which protects employees’ right to engage in “concerted activities.” Employees can freely associate with each other and have conversations about common workplace issues without employer inter- ference. This right extends to social media posts. There- fore, an employer cannot broadly prohibit its employees from criticizing the company or co-workers, supervisors, or managers via social media. ■

Responsibility of Employees While most of the discussion in this chapter concerns the ethics of business management, employee ethics is also an important issue. For instance, is it ethical for employees to make negative posts in social media about other employees or, more commonly, about managers? After all, negative comments about managers reflect badly on those managers, who often are reluctant to respond via social media to such criticism. Disgruntled employees may exaggerate the neg- ative qualities of managers whom they do not like.

94 U N I T O N E The Foundations

Some may consider the decision by the National Labor Relations Board outlined in Example 5.4 to be too Example 5.4 to be too Example 5.4 lenient toward employees and too stringent toward man- agement. There is likely to be an ongoing debate about how to balance employees’ right to free expression against employers’ right to prevent the spreading of inaccurate negative statements across the Internet.

5–3 Ethical Principles and Philosophies

As Dean Krehmeyer, executive director of the Business Roundtable’s Institute for Corporate Ethics, once said, “Evidence strongly suggests being ethical—doing the right thing—pays.” Even if ethics “pays,” though, instill- ing ethical business decision making into the fabric of a business organization is no small task.

How do business decision makers decide whether a given action is the “right” one for their firms? What ethi- cal standards should be applied? Broadly speaking, ethi- cal reasoning—the application of morals and ethics to cal reasoning—the application of morals and ethics to cal reasoning a situation—applies to businesses just as it does to indi- viduals. As businesses make decisions, they must analyze their alternatives in a variety of ways, one of which is the ethical implications of each alternative.

Generally, the study of ethics is divided into two major categories—duty-based ethics and outcome- based ethics. Duty-based ethics is rooted in the idea that every person has certain duties to others, including both humans and the planet. Outcome-based ethics focuses on the impacts of a decision on society or on key stakeholders.

5–3a Duty-Based Ethics Duty-based ethics focuses on the obligations of the cor- poration. It deals with standards for behavior that tra- ditionally were derived from revealed truths, religious authorities, or philosophical reasoning. These standards involve concepts of right and wrong, duties owed, and rights to be protected. Corporations today often describe these values or duties in their mission statements or stra- tegic plans. Some companies base their statements on a nonreligious rationale, while others derive their values from religious doctrine.

Religious Ethical Principles Nearly every religion has principles or beliefs about how one should treat others. In the Judeo-Christian tradition, which is the

dominant religious tradition in the United States, the Ten Commandments of the Old Testament establish these fundamental rules for moral action. The principles of the Muslim faith are set out in the Qur’an, and Hindus find their principles in the four Vedas.

Religious rules generally are absolute with respect to Religious rules generally are absolute with respect to Religious rules generally are absolute with respect to the behavior of their adherents. ■ EXAMPLE 5.5 The commandment “Thou shalt not steal” is an absolute mandate for a person who believes that the Ten Com- mandments reflect revealed truth. Even a benevolent motive for stealing (such as Robin Hood’s) cannot justify the act because the act itself is inherently immoral and thus wrong. ■

For businesses, religious principles can be a unify- ing force for employees or a rallying point to increase employee motivation. They can also present problems, however, because different owners, suppliers, employees, and customers may have different religious backgrounds. Taking an action based on religious principles, especially when those principles address socially or politically con- troversial topics, can lead to negative publicity and even to protests or boycotts.

Principles of Rights Another view of duty-based ethics focuses on basic rights. The principle that human beings have certain fundamental rights (to life, freedom, and the pursuit of happiness, for example) is deeply embedded in Western culture.

Those who adhere to this principle of rights, or “rights theory,” believe that a key factor in determining whether a business decision is ethical is how that decision affects the rights of others. These others include the firm’s owners, its employees, the consumers of its products or services, its suppliers, the community in which it does business, and society as a whole.

Conflicting Rights. A potential dilemma for those who support rights theory is that they may disagree on which rights are most important. When considering all those a�ected by a business decision to downsize a �rm, for example, how much weight should be given to employ- ees relative to shareholders? Which employees should be laid o� �rst—those with the highest salaries or those who have worked there for less time (and have less seniority)? How should the �rm weigh the rights of customers rela- tive to the community, or employees relative to society as a whole?

Resolving Conflicts. In general, rights theorists believe that whichever right is stronger in a particular cirthat whichever right is stronger in a particular cirthat whichever right is stronger in a particular cir- cumstance takes precedence. ■ EXAMPLE 5.6 Murray

C H A P T E R 5 Business Ethics 95

Chemical Corporation has to decide whether to keep a chemical plant in Utah open, thereby saving the jobs of a hundred and �fty workers, or shut it down. Closing the plant will avoid contaminating a river with pollut- ants that might endanger the health of tens of thousands of people. In this situation, a rights theorist can easily choose which group to favor because the value of the right to health and well-being is obviously stronger than the basic right to work. Not all choices are so clear-cut, however. ■

Kantian Ethical Principles Duty-based ethical standards may also be derived solely from philosophi- cal reasoning. The German philosopher Immanuel Kant (1724–1804) identified some general guiding principles for moral behavior based on what he thought to be the fundamental nature of human beings. Kant believed that human beings are qualitatively different from other physical objects and are endowed with moral integrity and the capacity to reason and conduct their affairs rationally.

People Are Not a Means to an End. Based on this view of human beings, Kant said that when people are treated merely as a means to an end, they are being treated as the equivalent of objects and are being denied their basic humanity. For instance, a manager who treats subordi- nates as mere pro�t-making tools is less likely to retain motivated and loyal employees than a manager who respects employees. Management research has shown that, in fact, employees who feel empowered to share their thoughts, opinions, and solutions to problems are happier and more productive.

Categorical Imperative. When a business makes uneth- ical decisions, it often rationalizes its action by saying that the company is “just one small part” of the problem or that its decision has had “only a small impact.” A cen- tral theme in Kantian ethics is that individuals should evaluate their actions in light of the consequences that would follow if everyone in society acted in the same way. �is categorical imperative can be applied to any action.

■ EXAMPLE 5.7 CHS Fertilizer is deciding whether to invest in expensive equipment that will decrease profits but will also reduce pollution from its factories. If CHS has adopted Kant’s categorical imperative, the decision makers will consider the consequences if every company invested in the equipment (or if no company did so). If the result would make the world a better place (less pol- luted), CHS’s decision would be clear. ■

5–3b Outcome-Based Ethics: Utilitarianism

In contrast to duty-based ethics, outcome-based ethics focuses on the consequences of an action, not on the nature of the action itself or on any set of preestablished moral values or religious beliefs. Outcome-based ethics looks at the impacts of a decision in an attempt to maxi- mize benefits and minimize harms.

The premier philosophical theory for outcome-based decision making is utilitarianism, a philosophical theory developed by Jeremy Bentham (1748–1832) and modi- fied by John Stuart Mill (1806–1873)—both British phi- losophers. “The greatest good for the greatest number” is a paraphrase of the major premise of the utilitarian approach to ethics.

Cost-Benefit Analysis Under a utilitarian model of ethics, an action is morally correct, or “right,” when, among the people it affects, it produces the greatest amount of good for the greatest number or creates the least amount of harm for the fewest people. When an action affects the majority adversely, it is morally wrong. Applying the utili- tarian theory thus requires the following steps:

1. A determination of which individuals will be affected by the action in question.

2. A cost-benefit analysis, which involves an assess- ment of the negative and positive effects of alterna- tive actions on these individuals.

3. A choice among alternative actions that will produce maximum societal utility (the greatest positive net benefits for the greatest number of individuals).

Thus, if expanding a factory would provide hundreds of jobs but generate pollution that could endanger the lives of thousands of people, a utilitarian analysis would find that saving the lives of thousands creates greater good than providing jobs for hundreds.

Problems with the Utilitarian Approach There are problems with a strict utilitarian analysis. In some situations, an action that produces the greatest good for the most people may not seem to be the most ethi- cal. ■ EXAMPLE 5.8 Phazim Company is producing a drug that will cure a disease in 85 percent of patients, but the other 15 percent will experience agonizing side effects and a horrible, painful death. A quick utilitarian analysis would suggest that the drug should be produced and mar- keted because the majority of patients will benefit. Many people, however, have significant concerns about manu- facturing a drug that will cause such harm to anyone. ■

96 U N I T O N E The Foundations

5–3c Corporate Social Responsibility In pairing duty-based concepts with outcome-based concepts, strategists and theorists developed the idea of the corporate citizen. Corporate social responsibility (CSR) combines a commitment to good citizenship with a commitment to making ethical decisions, improving society, and minimizing environmental impact.

CSR is a relatively new concept in the history of busi- ness, but a concept that becomes more important every year. Although CSR is not imposed on corporations by law, it does involve a commitment to self-regulation in a way that attends to the text and intent of the law as well as to ethical norms and global standards. A survey of U.S. executives undertaken by the Boston College Cen- ter for Corporate Citizenship found that more than 70 percent of those polled agreed that corporate citizenship must be treated as a priority. More than 60 percent said that good corporate citizenship added to their compa- nies’ profits.

CSR can be a successful strategy for companies, but corporate decision makers must not lose track of the two descriptors in the title: corporate and social. The com- pany must link the responsibility of citizenship with the strategy and key principles of the business. Incorporating both the social and the corporate components of CSR and making ethical decisions can help companies grow and prosper. CSR is most successful when a company undertakes activities that are significant and related to its business operations.

The Social Aspects of CSR Because business con- trols so much of the wealth and power in this country, business has a responsibility to use that wealth and power in socially beneficial ways. Thus, the social aspect requires that corporations demonstrate that they are promot- ing goals that society deems worthwhile and are moving toward solutions to social problems. Companies may be judged on how much they donate to social causes, as well as how they conduct their operations with respect to employment discrimination, human rights, environmen- tal concerns, and similar issues.

Some corporations publish annual social responsibil- ity reports, which may also be called corporate sustain- ability (referring to the capacity to endure) or citizenship ability (referring to the capacity to endure) or citizenship ability (referring to the capacity to endure) or citizenship reports. ■ EXAMPLE 5.9 The software company Syman- tec Corporation issues corporate responsibility reports to demonstrate its focus on critical environmental, social, and governance issues. In its 2014 report, Symantec

pointed out that 88 percent of facilities it owns or leases on a long-term basis are certified as environmentally friendly by the LEED program. LEED stands for Leader- ship in Energy and Environmental Design. Certification requires the achievement of high standards for energy efficiency, material usage in construction, and other envi- ronmental qualities. ■

The Corporate Aspects of CSR Arguably, any socially responsible activity will benefit a corporation. A corporation may see an increase in goodwill from the local community for creating a park, for instance. A corpora- tion that is viewed as a good citizen may see an increase in sales.

At times, the benefit may not be immediate. Con- structing a new plant that meets the high LEED stan- dards may cost more initially. Nevertheless, over the life of the building, the savings in maintenance and utilities may more than make up for the extra cost of construction.

Surveys of college students about to enter the job mar- ket confirm that young people are looking for socially responsible employers. Socially responsible activities may thus cost a corporation now, but may lead to more impressive and more committed employees. Corpora- tions that engage in meaningful social activities retain workers longer, particularly younger ones.workers longer, particularly younger ones.workers longer, particularly younger ones.

■ EXAMPLE 5.10 Pacific Gas and Electric (PG&E) Pacific Gas and Electric (PG&E) in California sends its employees out on Earth Day to help clean and restore state parks. PG&E also provides free solar panels for new Habitat for Humanity homes and donates food to the needy. LinkedIn employees participate in an “InDay” every month to donate time and resources to the community. Zappos donates large amounts of its goods to charities and pays its employees for time off if they are volunteering. ■

Stakeholders One view of CSR stresses that cor- porations have a duty not just to shareholders, but also to other groups affected by corporate decisions—called stakeholders. The rationale for this “stakeholder view” is that, in some circumstances, one or more of these other groups may have a greater stake in company decisions than the shareholders do.

Under this approach, a corporation considers the impact of its decisions on its employees, customers, cred- itors, suppliers, and the community in which it operates. Stakeholders could also include advocacy groups such as environmental groups and animal rights groups. To

C H A P T E R 5 Business Ethics 97

avoid making a decision that may be perceived as unethi- cal and result in negative publicity or protests, a corpora- tion should consider the impact of its decision on the stakeholders.

The most difficult aspect of the stakeholder analysis is determining which group’s interests should receive greater weight if the interests conflict. For instance, companies that are struggling financially sometimes lay off workers to reduce labor costs. But in recent years, some corpora- tions have given greater weight to employees’ interests and have found ways to avoid slashing their workforces. Companies finding alternatives to layoffs included Dell (extended unpaid holidays), Cisco Systems (four-day end-of-year shutdowns), Motorola (salary cuts), and Honda (voluntary unpaid vacation time).

5–4 Making Ethical Business Decisions

Even if officers, directors, and others in a company want to make ethical decisions, it is not always clear what is ethical in a given situation. Thinking beyond things that are easily measured, such as profits, can be challenging. Although profit projections are not always accurate, they are more objective than considering the personal impacts of decisions on employees, shareholders, customers, and the community. But this subjective component of deci- sion making potentially has a great potential influence on a company’s profits.

Companies once considered leaders in their indus- try, such as Enron and the worldwide accounting firm Arthur Andersen, were brought down by the unethical behavior of a few. A two-hundred-year-old British invest- ment banking firm, Barings Bank, was destroyed by the actions of one employee and a few of his friends. Clearly, ensuring that all employees get on the ethical business decision-making “bandwagon” is crucial in today’s fast- paced world.

Individuals entering the global corporate community, even in entry-level positions, must be prepared to make hard decisions. Sometimes, there is no “good” answer to the questions that arise. Therefore, it is important to have tools to help in the decision-making process and to create a framework for organizing those tools. Business deci- sions can be complex and may involve legal concerns, financial questions, possibly health and safety concerns, and ethical components.

5–4a A Systematic Approach Organizing the ethical concerns and issues and approach- ing them systematically can help a businessperson elimi- nate various alternatives and identify the strengths and weaknesses of the remaining alternatives. Ethics consul- tant Leonard H. Bucklin of Corporate-Ethics.US/ has devised a procedure that he calls Business Process Prag- matism/. It involves five steps: Step 1: Inquiry. First, the decision maker must under-

stand the problem. This step involves identifying the parties involved (the stakeholders) and collect- ing the relevant facts. Once the ethical problem or problems are clarified, the decision maker lists any relevant legal and ethical principles that will guide the decision.

Step 2: Discussion. In this step, the decision maker lists possible actions. The ultimate goals for the decision are determined, and each option is evaluated using the laws and ethical principles listed in Step 1.

Step 3: Decision. In this step, those participating in the decision making work together to craft a con- sensus decision or consensus plan of action for the corporation.

Step 4: Justification. In this step, the decision maker articulates the reasons for the proposed action or series of actions. Generally, these reasons should come from the analysis done in Step 3. This step essentially results in documentation to be shared with stakeholders explaining why the proposal is an ethical solution to the problem.

Step 5: Evaluation. This final step occurs once the deci- sion has been made and implemented. The solution should be analyzed to determine if it was effective. The results of this evaluation may be used in making future decisions.

5–4b The Importance of Ethical Leadership Talking about ethical business decision making is meaningless if management does not set standards. Fur- thermore, managers must apply the same standards to themselves as they do to the company’s employees. See this chapter’s Digital Update feature for a discussion of an ethical dilemma that has arisen from the increased use of digital technology by employees after work hours.

Attitude of Top Management One of the most important ways to create and maintain an ethical

98 U N I T O N E The Foundations

Should Employees Have a “Right of Disconnecting”?

Almost all jobs today involve digital technol- ogy, whether it be e-mail, Internet access, or smartphone use. Most employees, when inter- viewed, say that digital technology increases their productivity and flexibility.

The downside is what some call an “elec- tronic leash”—meaning that employees are constantly connected and end up working when they are not “at work.” Over one-third of full- time workers, for example, say that they frequently check e-mails outside normal working hours.

Do Workers Have the Right to Disconnect?

Because the boundaries between being “at work” and being “at leisure” can be so hazy, some labor unions in other countries have attempted to pass rules that allow employees to disconnect from e-mail and other work-related digital communication during nonworking hours. For instance, a French labor union representing high-tech workers signed an agreement with a large business association recognizing a “right of disconnect- ing.” In Germany, Volkswagen and BMW no longer for- ward e-mail to staff from company servers after the end of the workday. Other German firms have declared that workers are not expected to check e-mail on weekends and holidays. The government is considering legislating such restrictions nationwide.

The Thorny Issue of Overtime and the Fair Labor Standards Act

Payment for overtime work is strictly regulated under the Fair Labor Standards Act (FLSA). According to the United States Supreme Court, in this context, work is “physical work is “physical work or mental exertion (whether burdensome or not) con- trolled or required by the employer and pursued neces- sarily for the benefit of the employer and his business.”a

This definition was extended to off-duty work if such work is an “integral and indispensible part of [employees’] activities.”b

Today’s modern digital connectivity raises issues about the definition of work. Employees at several major companies, including Black & Decker, T-Mobile, and Verizon, have sued for unpaid overtime related to smartphone use.

In another case, a police sergeant has sued the city of Chicago, claiming that he should have been paid over- time for hours spent using his personal digital assistant (PDA).c The police department issues PDAs to officers and requires them to respond to work-related text mes- sages, e-mails, and voice mails not only while on duty, but also while off duty. Off-duty responses are not com- pensated by the city.

Not All Employees Demand the “Right to Disconnect”

According to a recent Gallup poll, 79 percent of full- time employees had either strongly positive or some- what positive views of using computers, e-mail, tablets, and smartphones to work remotely outside of normal business hours. According to the same poll, 17 percent of them report “better overall lives” because of con- stant online connectivity with their work. Finally, work- ing remotely after business hours apparently does not necessarily result in additional work-related stress.

Critical Thinking From an ethical point of view, is there any difference between calling subordinates during off hours for work-related questions and sending them e-mails or text messages?

DIGITAL UPDATE

a. Tennessee Coal, Iron & R. Co. v. Muscoda Local No. 123, 321 U.S. 590, 64 S.Ct. 698, 8 L.Ed. 949 (1944). Although Congress later passed a statute that superseded the holding in this case, the statute gave the courts broad authority to interpret the FLSA’s definition of work. 29 U.S.C. Section 251(a). See Integrity Staffing Solutions, Inc. v. Busk, ___ U.S. ___, 135 S.Ct. 513, 190 L.Ed.2d 410 (2014).

b. Steiner v. Mitchell, 350 U.S. 247, 76 S.Ct. 330, 100 L.Ed. 267 (1956).

c. Allen v. City of Chicago, 2014 WL 5461856 (N.D.Ill. 2014).

workplace is for top management to demonstrate its com- mitment to ethical decision making. A manager who is not totally committed to an ethical workplace rarely succeeds in creating one. Management’s behavior, more than any-in creating one. Management’s behavior, more than any-in creating one. Management’s behavior, more than any thing else, sets the ethical tone of a firm. Employees take their cues from management.

Managers have found that discharging even one employee for ethical reasons has a tremendous impact as

a deterrent to unethical behavior in the workplace. This is true even if the company has a written code of ethics. If management does not enforce the company code, the code is essentially nonexistent.

The administration of a university may have had a similar concept in mind in the following case when it applied the school’s professionalism standard to a student who had engaged in serious misconduct.Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 5 Business Ethics 99

Background and Facts The curriculum at Case Western Reserve University School of Medicine identifies nine “core competencies.” At the top of the list is professionalism, which includes “ethi- cal, honest, responsible and reliable behavior.” The university’s Committee on Students determines whether a student has met the professionalism requirements.

Amir Al-Dabagh enrolled at the school and did well academically. But he sexually harassed fellow students, often asked an instructor not to mark him late for class, received complaints from hospital staff about his demeanor, and was convicted of driving while intoxicated. The Committee on Students unanimously refused to certify him for graduation and dismissed him from the university.

He filed a suit in a federal district court against Case Western, alleging a breach of good faith and fair dealing. The court ordered the school to issue a diploma. Case Western appealed.

In the Language of the Court SUTTON, Circuit Judge.SUTTON, Circuit Judge.SUTTON

* * * * * * * Case Western’s student handbook * * * makes clear that the only thing standing between Al-

Dabagh and a diploma is the Committee on Students’ finding that he lacks professionalism. Unhappily for Al-Dabagh, that is an academic judgment. And we can no more substitute our personal views for the Committee’s when it comes to an academic judgment than the Committee can substitute its views for ours when it comes to a judicial decision. [Emphasis added.]

* * * * * * * The Committee’s professionalism determination is an academic judgment. That conclusion all but

resolves this case. We may overturn the Committee only if it substantially departed from accepted academic norms when it refused to approve Al-Dabagh for graduation. And given Al-Dabagh’s track record—one member of the Committee does not recall encountering another student with Al-Dabagh’s “repeated professionalism issues” in his quarter century of experience—we cannot see how it did. [Emphasis added.]

To the contrary, Al-Dabagh insists: The Committee’s decision was a “punitive disciplinary measure” that had nothing to do with academics. * * * His argument fails to wrestle with the prominent place of professionalism in the university’s academic curriculum—which itself is an academic decision courts may not lightly disturb.

Even if professionalism is an academic criterion, Al-Dabagh persists that the university defined it too broadly. As he sees it, the only professional lapses that matter are the ones linked to academic performance. That is not how we see it or for that matter how the medical school sees it. That many professionalism-related cases involve classroom incidents does not establish that only classroom incidents are relevant to the professionalism inquiry * * * . Our own standards indicate that professionalism does not end at the courtroom door. Why should hospitals operate any differently? As for the danger that an expansive view of professionalism might forgive, or provide a cloak for, arbitrary or discriminatory behavior, we see no such problem here. Nothing in the record suggests that the university had impermis- sible motives or acted in bad faith in this instance. And nothing in our deferential standard prevents us from invalidating genuinely objectionable actions when they occur.

Decision and Remedy The U.S. Court of Appeals for the Sixth Circuit reversed the lower court’s order to issue a diploma to Al-Dabagh. The federal appellate court found nothing to indicate that Case Western had “impermissible motives,” acted in bad faith, or dealt unfairly with Al-Dabagh.

Critical Thinking • What If the Facts Were Different? Suppose that Case Western had tolerated Al-Dabagh’s conduct

and awarded him a diploma. What impact might that had on other students at the school? Why?

Al-Dabagh v. Case Western Reserve University United States Court of Appeals, Sixth Circuit, 777 F.3d 355 (2015).

Case 5.2

100 U N I T O N E The Foundations

Behavior of Owners and Managers Certain types of behavior on the part of managers and owners contrib- ute to unethical behavior among employees. Managers who set unrealistic production or sales goals increase the probability that employees will act unethically. If a sales quota can be met only through high-pressure, unethical sales tactics, employees will try to act “in the best inter- est of the company” and will continue to behave unethi- cally. A manager who looks the other way when she or he knows about an employee’s unethical behavior also sets an example—one indicating that ethical transgressions will be accepted.

Business owners and managers sometimes take more active roles in fostering unethical and illegal conduct. This sort of misbehavior can have negative consequences for the owners and managers and their business. Not only can a court sanction them, but it can also issue an injunction that prevents them from engaging in similar patterns of conduct in the future.patterns of conduct in the future.patterns of conduct in the future.

■ CASE IN POINT 5.11 John Robert Johnson, Jr., took a truck that needed repair along with its fifteen-ton trailer to Bubba Shaffer, doing business as Shaffer’s Auto and Diesel Repair, LLC. The truck was supposedly fixed,

and Johnson paid the bill, but the truck continued to leak oil and water. Johnson returned the truck to Shaffer, who again claimed to have fixed the problem. Johnson paid the second bill. The problems with the truck contin- ued, however, so Johnson returned the truck and trailer to Shaffer a third time.

Johnson was given a verbal estimate of $1,000 for the repairs, but Shaffer ultimately sent an invoice for $5,863. Johnson offered to settle for $2,480, the amount of the initial estimate ($1,000), plus the costs of parts and shipping. Shaffer refused the offer and would not return Johnson’s truck or trailer until full payment was made. Shaffer retained possession for almost four years and also charged Johnson a storage fee of $50 a day and 18 percent interest on the $5,863. Johnson sued for unfair trade practices and won. The court awarded him $3,500 in damages plus attorneys’ fees and awarded Shaf-$3,500 in damages plus attorneys’ fees and awarded Shaf-$3,500 in damages plus attorneys’ fees and awarded Shaf fer $1,000 (the amount of his estimate).3 ■

The following case further demonstrates the types of situations that can occur when management demon- strates a lack of concern about ethics.

3. Johnson Construction Co. v. Shaffer, 87 So.3d 203 (La.App. 2012).

In the Language of the Court Joseph H. RODRIGUEZ, District Judge.RODRIGUEZ, District Judge.RODRIGUEZ

* * * Plaintiff Moseley is an employee of Defendant Pepco Energy Services, Inc. (“PES”). He has been employed by PES or its corporate predecessors for over twenty-five years. PES, a subsidiary of Defendant Pepco Holdings, Inc. (“PHI”), provides deregulated energy and energy- related services for residential, small busi- ness, and large commercial customers.

* * * * In 1998, Thomas Herzog held the

position of Vice President of CTS. * * * In or around 2002, CTS merged with Potomic Electric Power Company, Inc., and each company became a subsidiary of PHI. Following the merger, according to Plaintiff, he continued to work for

PHI, still as Maintenance Manager at Midtown Thermal, until December 31, 2009.

* * * * Following the 2002 merger with

PHI, employees were required to com- plete an annual ethics survey. By March of 2007, Plaintiff and two co-workers had discussed their respective observa- tions of Herzog’s conduct, which they deemed questionable and possibly unethical. Specifically, they felt that Herzog improperly used company assets and improperly hired immediate fam- ily members and friends who did not appear on the payroll. The three decided to disclose this information on PHI’s annual “Ethics Survey.”

The three planned to reveal that Her- zog employed his daughter, Laurie, as his

secretary in the sum- mer of 2005 and the beginning of 2006 without posting the position first and in violation of PHI’s anti-nepotism policy.

* * * * Next, Herzog hired his girlfriend’s

daughter as his secretary after his daugh- ter had gone back to school. Plaintiff believed this was in violation of Com- pany policy because the position again was not posted. Herzog also hired his son as a project manager, again through a third party independent contractor, Walter Ratai. Plaintiff thought this was wrong because (1) Herzog circumvented the Company’s hiring process, (2) it vio- lated Company policy, and (3) Herzog’s son was being paid $75.00/hr, which was more than Plaintiff was making. * * *

Case Analysis 5.3 Moseley v. Pepco Energy Services, Inc. United States District Court, District of New Jersey, 2011 WL 1584166 (2011).

C H A P T E R 5 Business Ethics 101

In addition, Plaintiff had learned that Herzog was improperly using the Com- pany’s Eagles’ tickets for personal use. Finally, Herzog had leased a new SUV with Company funds, but which was not approved by the Company.

* * * * [After the surveys were completed,

an] investigation ensued. Following the investigation, effective on or about May 10, 2007, Herzog was escorted out of the building. * * * On March 8, 2008, Plaintiff received his annual performance evaluation * * * ; for the first time in twenty-three years, Plaintiff ’s perfor- mance review was negative. Plaintiff feels that this negative performance review was a further act of retaliation for his disclosure of Herzog’s conduct.

* * * * On or about June 11, 2008 the

Plant/Operations Manager position was posted * * * . Plaintiff applied for the position, but it was offered to [another person]. Plaintiff alleges that he “was not promoted to the position of Plant/ Operations Manager despite his experi- ence performing the job for the previ- ous two and a half years, qualifications for same and seniority, as a direct and proximate result of his prior complaints and/or disclosures regarding the Herzog illegal conduct and activities.”

* * * * The New Jersey Legislature enacted

the Conscientious Employee Protection Act (CEPA) to “protect and encourage employees to report illegal or unethical workplace activities.” * * * CEPA prohib- its a New Jersey employer from taking “retaliatory action” against an employee who objects to “any activity, policy or practice which the employee reasonably believes” is in violation of applicable law. * * * “To prevail on a claim under

this provision, a plaintiff must establish that: (1) he reasonably believed that [the complained-of ] conduct was violating a law or rule or regulation promulgated pursuant to law; (2) he objected to the conduct; (3) an adverse employment action was taken against him; and (4) a causal connection exists between the whistleblowing activity and the adverse employment action.

* * * * The first element of the prima

facie case [a case sufficient to be sent facie case [a case sufficient to be sent facie to the jury] under CEPA is that the Plaintiff reasonably believed that the complained-of conduct (1) was violat- ing a “law, rule, or regulation promul- gated pursuant to law, including any violation involving deception of, or misrepresentation to, any shareholder, investor, client, patient, customer, employee, former employee, retiree or pensioner of the employer or any governmental entity”; or “(2) is fraudu- lent or criminal, including any activ- ity, policy or practice of deception or misrepresentation which the employee reasonably believes may defraud any shareholder, investor, client, patient, customer, employee, former employee, retiree or pensioner of the employer or any governmental entity.”

Although Defendants have argued that Plaintiff merely disclosed a violation of Company policy, Moseley has testified that in March 2007, he reported what he believed to be “unethical conduct, misappropriation of company funds, and theft” by his direct supervisor. * * * Moreover, a plaintiff need not demonstrate that there was a violation of the law or fraud, but instead that he “reasonably believed” that to be the case. The facts in this case support an objectively reason- able belief that a violation of law or

fraudulent conduct was being commit- ted by Plaintiff ’s supervisor. [Emphasis added.]

Regarding the causal connection between Plaintiff ’s whistleblow- ing activity and the negative adverse employment actions taken against him, Plaintiff stresses that he was employed by the Defendants for twenty-five years without a negative employment evalu- ation or any form of discipline until immediately after he disclosed the wrongful conduct of his supervisor. Not only did Plaintiff then receive a nega- tive performance evaluation, but the posted position of Plant Manager was given to [another], despite [the other’s] alleged past negative history and despite that Plaintiff asserts he had been acting in that job for over two years. Plaintiff contends that this is sufficient evidence of pretext.

The Court is unable to find as a matter of law that Defendants’ inferences prevail or that a jury could not reasonably adopt a contrary inference of retaliation. There are questions of fact as to how much the individuals responsible for Plaintiff ’s negative performance evaluations knew about Plaintiff ’s complaints. “[A] finding of the required causal connection may be based solely on circumstantial evidence that the person ultimately responsible for an adverse employment action was aware of an employee’s whistle-blowing activity.” Because jurors may infer a causal connection from the surrounding circumstances, as well as temporal prox- imity, the Court will not grant summary judgment. [Emphasis added.]

* * * * IT IS ORDERED on this 26th

day of April, 2011 that Defendants’ motion for summary judgment is hereby DENIED.

Legal Reasoning Questions

1. Using duty-based ethical principles, what facts or circumstances in this case would lead Moseley to disclose Herzog’s behavior? 2. Using outcome-based ethical principles, what issues would Moseley have to analyze in making the decision to report Herzog’s

behavior? What would be the risks to Moseley? The benefits? 3. Under the Business Process Pragmatism/ steps, what alternatives might Moseley have had in this situation?

Case 5.3 Continued

102 U N I T O N E The Foundations

The Sarbanes-Oxley Act Congress enacted the Sarbanes-Oxley Act4 to help reduce corporate fraud and unethical management decisions. The act requires com- panies to set up confidential systems so that employees and others can “raise red flags” about suspected illegal or unethical auditing and accounting practices.

Some companies have implemented online report- ing systems to accomplish this goal. In one such system, employees can click on an on-screen icon that anony- mously links them with NAVEX Global, an organization based in Oregon. Through NAVEX Global, employees can report suspicious accounting practices, sexual harass- ment, and other possibly unethical behavior. NAVEX, in turn, alerts management personnel or the audit commit- tee at the designated company to the possible problem.

5–5 Global Business Ethics Just as different religions have different moral codes, dif-Just as different religions have different moral codes, dif-Just as different religions have different moral codes, dif ferent countries, regions, and even states have different ethical expectations and priorities. Some of these dif-ethical expectations and priorities. Some of these dif-ethical expectations and priorities. Some of these dif ferences are based in religious values, whereas others are cultural in nature. Such differences make it even more difficult to determine what is ethical in a particular situ- ation. For instance, in certain countries the consumption of alcohol is forbidden for religious reasons. It would be considered unethical for a U.S. business to produce alco- hol in those countries and employ local workers to assist in alcohol production.

International transactions often involve issues related to employment and financing. Congress has addressed some of these issues, not eliminating the ethical compo- nents but clarifying some of the conflicts between the ethics of the United States and the ethics of other nations. For instance, the Civil Rights Act and the Foreign Cor- rupt Practices Act have clarified the U.S. ethical position on employment issues and bribery in foreign nations. (Other nations, including Mexico, have also enacted laws that prohibit bribery.)

5–5a Monitoring the Employment Practices of Foreign Suppliers

Many businesses contract with companies in developing nations to produce goods, such as shoes and clothing, because the wage rates in those nations are significantly lower than those in the United States. But what if one of those contractors hires women and children at

4. 15 U.S.C. Sections 7201 et seq.

below-minimum-wage rates or requires its employees to work long hours in a workplace full of health hazards? What if the company’s supervisors routinely engage in workplace conduct that is offensive to women? What if plants located abroad routinely violate labor and envi- ronmental standards?

■ EXAMPLE 5.12 Pegatron Corporation, a company based in China, manufactures and supplies parts to Apple, Inc., for iPads and other Apple products. After an explosion at a Pegatron factory in Shanghai, allegations surfaced that the conditions at the factory violated labor and environmental standards. Similar allegations were made about other Apple suppliers.

Apple started to evaluate practices at companies in its supply chain and to communicate its ethics policies to them. Its audits revealed numerous violations. Apple released a list of its suppliers for the first time and issued a lengthy “Supplier Responsibility Report” detailing supplier practices. Numerous facilities had withheld worker pay as a disciplinary measure. Some had falsified pay records and forced workers to use machines without safeguards. Oth- ers had engaged in unsafe environmental practices, such as dumping wastewater on neighboring farms. Apple termi- nated its relationship with one supplier and turned over its findings to the Fair Labor Association for further inquiry. ■

Given today’s global communications network, few companies can assume that their actions in other nations will go unnoticed by “corporate watch” groups that discover and publicize unethical corporate behavior. As a result, U.S. businesses today usually take steps to avoid such adverse publicity—either by refusing to deal with certain suppliers or by arranging to monitor their suppliers’ workplaces to make sure that the employees are not being mistreated.

5–5b The Foreign Corrupt Practices Act Another ethical problem in international business deal- ings has to do with the legitimacy of certain side pay- ments to government officials. In the United States, the majority of contracts are formed within the private sector. In many foreign countries, however, government officials make the decisions on most major construction and manufacturing contracts because of extensive gov- ernment regulation and control over trade and industry.

Side payments to government officials in exchange for favorable business contracts are not unusual in such countries, nor have they been considered unethical. In the past, U.S. corporations doing business in these nations largely followed the dictum “When in Rome, do as the Romans do.”

In the 1970s, however, the U.S. media uncovered a number of business scandals involving large side

C H A P T E R 5 Business Ethics 103

payments by U.S. corporations to foreign representatives for the purpose of securing advantageous international trade contracts. In response to this unethical behavior, Congress passed the Foreign Corrupt Practices Act5 (FCPA), which prohibits U.S. businesspersons from bribing foreign officials to secure beneficial contracts.

Prohibition against the Bribery of Foreign Officials The first part of the FCPA applies to all U.S. companies and their directors, officers, shareholders, employees, and agents. This part prohibits the bribery of most officials of foreign governments if the purpose of the payment is to motivate the official to act in his or her official capacity to provide business opportunities.

The FCPA does not prohibit payments made to minor officials whose duties are ministerial. A ministerial action is a routine activity, such as the processing of paperwork, with little or no discretion involved in the action. These payments are often referred to as “grease,” or facilitating payments. They are meant to accelerate the performance of administrative services that might otherwise be carried out at a slow pace. Thus, for instance, if a firm makes a payment to a minor official to speed up an import licens- ing process, the firm has not violated the FCPA.

Generally, the act, as amended, permits payments to foreign officials if such payments are lawful within the foreign country. Payments to private foreign companies or other third parties are permissible—unless the U.S. firm knows that the payments will be passed on to a foreign government in violation of the FCPA. The U.S. Department of Justice also uses the FCPA to prosecute foreign companies suspected of bribing officials outside the United States.

Accounting Requirements In the past, bribes were often concealed in corporate financial records. Thus, the second part of the FCPA is directed toward accountants.

5. 15 U.S.C. Sections 78dd-1 et seq.

All companies must keep detailed records that “accu- rately and fairly” reflect their financial activities. Their accounting systems must provide “reasonable assurance” that all transactions entered into by the companies are accounted for and legal. These requirements assist in detecting illegal bribes. The FCPA prohibits any person from making false statements to accountants or false entries in any record or account.

■ CASE IN POINT 5.13 Noble Corporation, an international provider of offshore drilling services and equipment, was operating some drilling rigs offshore in Nigeria. Mark Jackson and James Ruehlen were officers at Noble. The U.S. government accused Noble of bribing Nigerian government officials and charged Jackson and Ruehlen individually with violating the FCPA’s account- ing provisions. Jackson and Ruehlen allegedly assisted in the bribery because they repeatedly allowed allegedly ille- gal payments to be posted on Noble’s books as legitimate operating expenses.6 ■

Penalties for Violations The FCPA provides that business firms that violate the act may be fined up to $2 million. Individual officers or directors who violate the FCPA may be fined up to $100,000 (the fine cannot be paid by the company) and may be imprisoned for up to five years. These statutory amounts can be significantly increased under the Alternative Fines Act7 (up to twice the amount of any gain that the defendant obtained by making the corrupt payment).

Today, the U.S. government is actively seeking out violators and has around 150 FCPA investigations going on at any given time. In recent years, a high percentage of the total fines imposed by the Department of Justice have come from FCPA cases.

6. S.E.C. v. Jackson, 908 F.Supp.2d 834 (S.D.Tex—Houston Div. 2012). 7. 18 U.S.C. Section 3571.

Reviewing: Business Ethics

James Stilton is the chief executive officer (CEO) of RightLiving, Inc., a company that buys life insurance policies at a discount from terminally ill persons and sells the policies to investors. RightLiving pays the terminally ill patients a percentage of the future death benefit (usually 65 percent) and then sells the policies to investors for 85 percent of the value of the future benefit. The patients receive the cash to use for medical and other expenses. The investors are “guaranteed” a positive return on their investment, and RightLiving profits on the difference between the purchase and sale prices. Stilton is aware that some sick patients might obtain insurance policies through fraud (by not revealing the illness on the insurance application). Insurance companies that discover this will cancel the policy and refuse to pay.

104 U N I T O N E The Foundations

Debate This . . . Executives in large corporations are ultimately rewarded if their companies do well, particularly as evidenced by rising stock prices. Consequently, should we let those who run corporations decide what level of negative side effects of their goods or services is “acceptable”?

Stilton believes that most of the policies he has purchased are legitimate, but he knows that some probably are not. Using the information presented in this chapter, answer the following questions. 1. Would a person who adheres to the principle of rights consider it ethical for Stilton not to disclose the potential

risk of cancellation to investors? Why or why not? 2. Using Immanuel Kant’s categorical imperative, are the actions of RightLiving, Inc., ethical? Why or why not? 3. Under utilitarianism, are Stilton’s actions ethical? Why or why not? What difference does it make if most of the

policies are legitimate? 4. Using the Business Process Pragmatism/ steps discussed in this chapter, discuss the decision process Stilton should

use in deciding whether to disclose the risk of fraudulent policies to potential investors.

Terms and Concepts business ethics 89 categorical imperative 95 corporate social responsibility

(CSR) 96 cost-bene�t analysis 95

duty-based ethics 94 ethical reasoning 94 ethics 89 moral minimum 91 outcome-based ethics 94

principle of rights 94 stakeholders 96 triple bottom line 89 utilitarianism 95

Issue Spotters 1. Acme Corporation decides to respond to what it sees

as a moral obligation to correct for past discrimina- tion by adjusting pay differences among its employ- ees. Does this raise an ethical conflict between Acme and its employees? Between Acme and its sharehold- ers? Explain your answers. (See Making Ethical Business Decisions.)

2. Delta Tools, Inc., markets a product that under some cir- cumstances is capable of seriously injuring consumers. Does Delta have an ethical duty to remove this product from the market, even if the injuries result only from misuse? Why or why not? (See Making Ethical Business Decisions.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 5–1. Business Ethics. Jason Trevor owns a commercial bak- ery in Blakely, Georgia, that produces a variety of goods sold in grocery stores. Trevor is required by law to perform internal tests on food produced at his plant to check for contamina- tion. On three occasions, the tests of food products contain- ing peanut butter were positive for salmonella contamination. Trevor was not required to report the results to U.S. Food and Drug Administration officials, however, so he did not. Instead, Trevor instructed his employees to simply repeat the

tests until the results were negative. Meanwhile, the products that had originally tested positive for salmonella were eventu- ally shipped out to retailers.

Five people who ate Trevor’s baked goods that year became seriously ill, and one person died from a salmonella infection. Even though Trevor’s conduct was legal, was it unethical for him to sell goods that had once tested positive for salmonella? Why or why not? (See Business Ethics.)

C H A P T E R 5 Business Ethics 105

Business Case Problems 5–2. Spotlight on Pfizer, Inc.—Corporate Social Responsibility. Methamphetamine (meth) is an addictive

drug made chie�y in small toxic labs (STLs) in homes, tents, barns, or hotel rooms. �e manu- facturing process is dangerous and often results in explosions, burns, and toxic fumes. Government

entities spend time and resources to �nd and destroy STLs, imprison meth dealers and users, treat addicts, and provide services for a�ected families. Meth cannot be made without ingredients that are also used in cold and allergy medications. Arkansas has one of the highest numbers of STLs in the United States. To recoup the costs of �ghting the meth epi- demic, twenty counties in Arkansas �led a suit against P�zer, Inc., which makes cold and allergy medications. What is P�z- er’s ethical responsibility here, and to whom is it owed? Why? [Ashley County, Arkansas v. P�zer, Inc., [Ashley County, Arkansas v. P�zer, Inc., [ 552 F.3d. 659 (8th Cir. 2009)] (See Ethical Principles and Philosophies.) 5–3. Business Case Problem with Sample Answer— Online Privacy. Facebook, Inc., launched a program called

“Beacon” that automatically updated the pro�les of users on Facebook’s social networking site when those users had any activity on Beacon “partner” sites. For example, one partner site was Block-

buster.com. When a user rented or purchased a movie through Blockbuster.com, the user’s Facebook pro�le would be updated to share the purchase. �e Beacon program was set up as a default setting, so users never consented to the pro- gram, but they could opt out. What are the ethical implica- tions of an opt-in program versus an opt-out program in social media? [Lane v. Facebook, Inc., 696 F.3d 811 (9th Cir. 2011)] (See Business Ethics and Social Media.) • For a sample answer to Problem 5–3, go to Appendix E at

the end of this text.

5–4. Business Ethics on a Global Scale. After the fall of the Soviet Union, the new government of Azerbaijan began converting certain state-controlled industries to private own- ership. Ownership in these companies could be purchased through a voucher program. Frederic Bourke, Jr., and Vik- tor Kozeny wanted to purchase the Azerbaijani oil company, SOCAR, but it was unclear whether the Azerbaijani president would allow SOCAR to be put up for sale. Kozeny met with one of the vice presidents of SOCAR (who was also the son of the president of Azerbaijan) and other Azerbaijani leaders to discuss the sale of SOCAR. To obtain their cooperation, Kozeny set up a series of parent and subsidiary companies through which the Azerbaijani leaders would eventually receive two-thirds of the SOCAR pro�ts without ever invest- ing any of their own funds. In return, the Azerbaijani leaders would attempt to use their in�uence to convince the president to put SOCAR up for sale. Assume that Bourke and Kozeny are operating out of a U.S. company. Discuss the ethics of this scheme, both in terms of the Foreign Corrupt Practices Act

(FCPA) and as a general ethical issue. What duties did Kozeny have under the FCPA? [United States v. Kozeny, 667 F.3d 122 (2d Cir. 2011)] (See Making Ethical Business Decisions.) 5–5. Business Ethics. Mark Ramun worked as a manager for Allied Erecting and Dismantling Co., where he had a tense relationship with his father, who was Allied’s president. After more than ten years, Mark left Allied, taking 15,000 pages of Allied’s documents on DVDs and CDs, which constituted trade secrets. Later, he joined Genesis Equipment & Manufac- turing, Inc., a competitor. Genesis soon developed a piece of equipment that incorporated elements of Allied equipment. How might business ethics have been violated in these cir- cumstances? Discuss. [Allied Erecting and Dismantling Co. v. cumstances? Discuss. [Allied Erecting and Dismantling Co. v. cumstances? Discuss. [ Genesis Equipment & Manufacturing, Inc., 511 Fed.Appx. 398 (6th Cir. 2013)] (See Business Ethics.) 5–6. Business Ethics. Stephen Glass made himself infa- mous as a dishonest journalist by fabricating material for more than forty articles for �e New Republic magazine and �e New Republic magazine and �e New Republic other publications. He also fabricated supporting materials to delude �e New Republic’s fact checkers. At the time, he was a law student at Georgetown University. Once suspicions were aroused, Glass tried to avoid detection. Later, Glass applied for admission to the California bar. �e California Supreme Court denied his application, citing “numerous instances of dishon- esty and disingenuousness” during his “rehabilitation” follow- ing the exposure of his misdeeds. How do these circumstances underscore the importance of ethics? Discuss. [In re Glass, 58 Cal.4th 500, 316 P.3d 1199 (2014)] (See Business Ethics.) 5–7. Business Ethics. Operating out of an apartment in Secane, Pennsylvania, Hratch Ilanjian convinced Vicken Setra- kian, the president of Kenset Corp., that he was an international businessman who could help Kenset turn around its business in the Middle East. At Ilanjian’s insistence, Setrakian provided con�dential business documents. Claiming that they had an agreement, Ilanjian demanded full, immediate payment and threatened to disclose the con�dential information to a Kenset supplier if payment was not forthcoming. Kenset denied that they had a contract and �led a suit in a federal district court against Ilanjian, seeking return of the documents. During dis- covery, Ilanjian was uncooperative. Who behaved unethically in these circumstances? Explain. [Kenset Corp. v. Ilanjian, 600 Fed.Appx. 827 (3rd Cir. 2015)] (See Business Ethics.) 5–8. Business Ethics. Priscilla Dickman worked as a medical technologist at the University of Connecticut Health Center. Dickman’s supervisor received complaints that she was getting nonbusiness-related phone calls and was absent from her work area when she should have been working. Based on e-mails and other documents found on Dickman’s work computer, the state investigated her for violations of state law. She was convicted of conducting “personal busi- ness for �nancial gain on state time utilizing state resources.” Separate criminal investigations resulted in convictions for

106 U N I T O N E The Foundations

forgery and �ling an unrelated fraudulent insurance claim. She “retired” from her job and �led a claim with the state of Connecticut against the health center, alleging that her for- mer employer had initiated the investigations to harass her and force her to quit. For lack of “credible evidence or legal support,” the claim was dismissed. Which of these acts, if any, were unethical? Why? [Dickman v. University of Connecticut Health Center, 162 Conn.App. 441, __ A.3d __ (2016)] (See Business Ethics.) 5–9. A Question of Ethics—Consumer Rights. Best Buy,

a national electronics retailer, o�ered a credit card that allowed users to earn “reward points” that could be redeemed for discounts on Best Buy goods. After reading a newspaper advertisement for the card,

Gary Davis applied for, and was given, a credit card. As part of the application process, he visited a Web page containing Fre- quently Asked Questions as well as terms and conditions for the card. He clicked on a button a�rming that he understood the terms and conditions. When Davis received his card, it came with seven brochures about the card and the reward point program. As he read the brochures, he discovered that a $59 annual fee would be charged for the card. Davis went back to the Web pages he had

visited and found a statement that the card “may” have an annual fee. Davis sued, claiming that the company did not adequately disclose the fee. [Davis v. HSBC Bank Nevada, N.A., disclose the fee. [Davis v. HSBC Bank Nevada, N.A., disclose the fee. [ 691 F.3d 1152 (9th Cir. 2012)] (See Business Ethics.) (a) Online applications frequently have click-on buttons or

check boxes for consumers to acknowledge that they have read and understand the terms and conditions of applica- tions or purchases. Often, the terms and conditions are so long that they cannot all be seen on one screen and users must scroll to view the entire document. Is it unethical for companies to put terms and conditions, especially terms that may cost the consumer, in an electronic document that is too long to read on one screen? Why or why not? Does this differ from having a consumer sign a hard-copy document with terms and conditions printed on it? Why or why not?

(b) The Truth-in-Lending Act requires that credit terms be clearly and conspicuously disclosed in application materi- als. Assuming that the Best Buy credit-card materials had sufficient legal disclosures, discuss the ethical aspects of businesses strictly following the language of the law as opposed to following the intent of the law.

Legal Reasoning Group Activity 5–10. Global Business Ethics. P�zer, Inc., developed a new antibiotic called Trovan (trova�oxacinmesylate). Tests showed that in animals Trovan had life-threatening side e�ects, including joint disease, abnormal cartilage growth, liver dam- age, and a degenerative bone condition. Several years later, an epidemic of bacterial meningitis swept across Nigeria. P�zer sent three U.S. physicians to test Trovan on children who were patients in Nigeria’s Infectious Disease Hospital. P�zer did not obtain the patients’ consent, alert them to the risks, or tell them that Médecins Sans Frontières (Doctors without Borders) was providing an e�ective conventional treatment at the same site. Eleven children died in the experiment, and others were left blind, deaf, paralyzed, or brain damaged. Rabi

Abdullahi and other Nigerian children �led a suit in a U.S. federal court against P�zer, alleging a violation of a custom- ary international law norm prohibiting involuntary medical experimentation on humans. (See Global Business Ethics.) (a) One group should use the principles of ethical reasoning

discussed in this chapter to develop three arguments that Pfizer’s conduct was a violation of ethical standards.

(b) A second group should take a pro-Pfizer position and argue that the company did not violate any ethical stan- dards (and counter the first group).

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It is nearly impossible to apply for credit, obtain phone or Internet service, or buy goods online without agreeing to submit any claim arising from the deal to arbitration. This is also true with respect to employment—job applicants are generally informed by a potential employer that “any controversy or claim arising out of or relating to this employment application shall be settled by arbitration.”1

By including arbitration clauses in consumer and employment contracts, businesses can prevent customers and employees from getting their day in court. Claims removed from con- sideration by the courts in favor of arbitration have involved theft, fraud, sexual harassment, employment discrimination, and other serious issues.

Class Action A class action is a suit in which a large number of plaintiffs file a complaint as a group. A class action can increase the efficiency of the legal process and lower the costs to the parties. It can be an important method by which plaintiffs with similar claims seek relief. More importantly, a class action may be the best means by which the costs of wrongdoing can be imposed on a wrongdoer.

Best Means to Stop a Bad Practice In some circumstances, a class-action suit may be the only practical method for a group of individuals to stop an allegedly harmful business practice. For example, suppose a business pads all of its customers’ bills with an unexpected fee—adding up to millions in profit for the business. An individual customer may find it too costly to bring suit against the business or even to engage in arbitration to contest the charge. But a number of customers together could afford to fight the charge.

Groundless Claims and High Fees “Arbitration, No Class Actions,” states the terms of use for Budget Rent a Car System, Inc.2 Everyone who rents a car from Budget must agree to these terms. Businesses, such as Budget, assert that class-action suits are fomented by lawyers, who make millions of dollars in fees. Businesses claim that they have no choice but to settle such claims, even those that are groundless. Arbitration, they argue, can prevent these consequences.

Arbitration Arbitration is a method of alternative dispute resolution in which a dispute is submitted to a third party (an arbitrator), who listens to the parties, reviews the evidence, and renders a deci- sion. Arbitration clauses can be mandatory or voluntary. A dispute that is subject to mandatory

1. American Arbitration Association, Drafting Dispute Resolution Clauses: A Practical Guide, https://www.adr.org/aaa/ ShowPDF?doc=ADRSTG_002540 (Nov. 6, 2015).

2. Budget Rent a Car System, Inc., Terms of Use, http://www.budget.com /budgetWeb/html/en/customer/termsofuse.html (Nov. 6, 2015).

“Arbitration, No Class Actions”

U N I T O N E Application and Ethics

Continues

arbitration must be resolved through arbitration. The parties give up their right to sue in court, participate in a class action, or appeal the arbitration decision.

Professional and Unbiased Businesses argue that class-action suits are unnecessary because individuals can more easily resolve their complaints through arbitration. With arbitration, dis- putes can be resolved quickly without complicated procedures, the limits of judicial rules, or the time constraints of a crowded court’s schedule.

Proponents of arbitration also contend that arbitrators can act professionally and without bias. The American Arbitration Association and JAMS, the two largest arbitration firms, claim to ensure a professional and unbiased process. These organizations require an arbitrator to dis- close any conflict of interest before taking a case, for instance.

Biased and Unprofessional Opponents of arbitration emphasize that a party’s right to appeal an arbitrator’s handling of a case and its outcome is limited. Questions about a witness’s testi- mony, a party’s handling of the evidence, an arbitrator’s potential conflict of interest, and many other issues are not grounds for appeal to a court.

Arbitrators often depend for their business on a company against whom a customer or employee may have a grievance. An arbitrator may handle many cases involving the same com- pany and may therefore consider the company his or her client. For this reason, critics argue that an arbitrator is more likely to rule in favor of the business, regardless of the merits of a claim against it.

What Do the Courts Say? Most plaintiffs who are blocked from pursuing their claim as a group drop their case. Fur- thermore, in four out of five class actions filed between 2014 and 2016, judges remanded the disputes to arbitration. During the same period, only about five hundred consumers went to arbitration over a dispute of $2,500 or less. Among those contesting a credit card or loan fee, two-thirds received no award of money in arbitration.

In other words, individual consumers whose only recourse against a company is arbitration do not normally prevail in their claims. Despite this history, recent decisions by the United States Supreme Court upheld the use of arbitration clauses in consumer and merchant contracts to prohibit class-action suits.

Class Actions Interfere with Arbitration Vincent and Liza Concepcion, along with other consumers, filed a class action in a California state court against AT&T Mobility LLC, alleging that the company had promised them a free phone if they agreed to service but actually charged them $30.22 for the phone. AT&T responded that a class-action ban in an arbitration clause in the customers’ contracts barred the suit. The court ruled that the ban was unconscionable.

AT&T appealed to the United States Supreme Court, which reasoned that “requiring the availability of class-wide arbitration interferes with fundamental attributes of arbitration.” The main purpose of the federal law that applied in this case—the Federal Arbitration Act—“is to ensure the enforcement of arbitration agreements according to their terms.” This conclusion relegated state law on this issue, including California’s ruling, to the sidelines.state law on this issue, including California’s ruling, to the sidelines.state 3

3. AT&AT&AT T Mobility LLC v. Concepcion, 563 U.S. 333, 131 S.Ct. 1740, 179 L.Ed.2d 742 (2011).

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Arbitration Clauses Trump Class Actions Meanwhile, Alan Carlson, the owner of the res- taurant Italian Colors, pursued a suit against American Express Company over the fee that the company assessed merchants to process American Express credit-card charges. Carlson argued that a class-action ban in an arbitration clause in the company’s merchant contract prevented merchants from exercising their federal right to fight a monopoly. None of the merchants could federal right to fight a monopoly. None of the merchants could federal afford to fight the charge individually.

On appeal, the Supreme Court ruled in favor of American Express. The Court stated that federal antitrust “laws do not guarantee an affordable procedural path to the vindication of every claim.”4 Under this decision, an arbitration clause can outlaw a class action even if it is the only realistic, practical way to bring a case.

More recently, the U.S. Court of Appeals for the Fifth Circuit concluded that employers who require prospective employees to sign mandatory arbitration agreements do not violate the National Labor Relations Act.5

Ethical Connection Some persons would contend that a business’s principal ethical obligation is to make a profit for its owners. Others might propose that a business take a number of stakeholders’ perspectives into account when deciding on a course of action. Still others might insist that a business has a responsibility to act chiefly in the best interests of society. And there may be some who would impose a different ethical standard—religious, philosophical, or political.

Whichever standard is applied, a business has an interest in staying in business. Sometimes, a class action may be based on a groundless claim and brought for the sole purpose of generating a fee for the lawyer who brings it. There is no ethical requirement for a business to exhaust its assets to litigate or settle such a case.

Other times, though, a class action may be the best means of curbing a bad business practice. In that circumstance, engaging in harmful conduct and then cutting off an important means of redress for those harmed by the conduct cannot be seen as ethical.

Ethics Question Is it unethical for a business to include an arbitration clause with a class-action ban in its contracts with customers, employees, and other businesses? Discuss.

Critical Thinking Many businesses include opt-out provisions in their arbitration clauses, but few consumers and employees take advantage of them. Why?

4. American Express Co. v. Italian Colors Restaurant, 570 U.S. 333, 133 S.Ct. 2304, 186 L.Ed.2d 417 (2013).American Express Co. v. Italian Colors Restaurant, 570 U.S. 333, 133 S.Ct. 2304, 186 L.Ed.2d 417 (2013).American Express Co. v. Italian Colors Restaurant 5. Murphy Oil USA, Inc. v. National Labor Relations Board, 808 F.3d 1013 (5th Cir. 2015).Murphy Oil USA, Inc. v. National Labor Relations Board, 808 F.3d 1013 (5th Cir. 2015).Murphy Oil USA, Inc. v. National Labor Relations Board

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Unit Two

�e Public and International Environment

6. Tort Law

7. Strict Liability and Product Liability

8. Intellectual Property Rights

9. Internet Law, Social Media, and Privacy

10. Criminal Law and Cyber Crime

11. International and Space Law

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C H A P T E R 6

Compensatory Damages A plaintiff is awarded compensatory damages to compensate or reimburse the plaintiff for actual losses. Thus, the goal is to make the plaintiff whole and put her or him in the same posi- tion that she or he would have been in had the tort not occurred. Compensatory damages awards are often bro- ken down into special damages and special damages and special damages general damages.

Special damages compensate the plaintiff for quanti- fiable monetary losses, such as medical expenses and lost wages and benefits (now and in the future). Special dam- ages might also be awarded to compensate for extra costs, the loss of irreplaceable items, and the costs of repairing or replacing damaged property.or replacing damaged property.or replacing damaged property.

■ CASE IN POINT 6.1 Seaway Marine Transport operates the Enterprise, a large cargo ship, which has twenty-two hatches for storing coal. When the Enterprise positioned itself to receive a load of coal on the shores of Lake Erie, in Ohio, it struck a land-based coal-loading machine operated by Bessemer & Lake Erie Railroad Company. A federal court found Seaway liable and awarded $522,000 in special damages to compensate Bessemer for the cost of repairing the damage to the load- ing boom.1 ■

General damages compensate individuals (not com- panies) for the nonmonetary aspects of the harm suf-panies) for the nonmonetary aspects of the harm suf-panies) for the nonmonetary aspects of the harm suf fered, such as pain and suffering. A court might award general damages for physical or emotional pain and suf-general damages for physical or emotional pain and suf-general damages for physical or emotional pain and suf fering, loss of companionship, loss of consortium (losing

1. Bessemer & Lake Erie Railroad Co. v. Seaway Marine Transport, 357 F.3d Lake Erie Railroad Co. v. Seaway Marine Transport, 357 F.3d Lake Erie Railroad Co. v. Seaway Marine Transport 596 (6th Cir. 2010).

6–1 The Basis of Tort Law Two notions serve as the basis of all torts: wrongs and compensation. Tort law is designed to compensate those who have suffered a loss or injury due to another person’s wrongful act. In a tort action, one person or group brings a lawsuit against another person or group to obtain com- pensation (monetary damages) or other relief for the harm suffered.

6–1a The Purpose of Tort Law Generally, the purpose of tort law is to provide remedies for the violation of various protected interests. Society rec- ognizes an interest in personal physical safety. Thus, tort law provides remedies for acts that cause physical injury or that interfere with physical security and freedom of movement. Society also recognizes an interest in protect- ing property, and tort law provides remedies for acts that cause destruction of or damage to property.

6–1b Damages Available in Tort Actions Because the purpose of tort law is to compensate the injured party for the damage suffered, you need to have an understanding of the types of damages that plaintiffs seek in tort actions. Note that legal usage distinguishes between the terms damage and damage and damage damages. Damage refers Damage refers Damage to harm or injury to persons or property, while damages refers to monetary compensation for such harm or injury.

P art of doing business today—and, indeed, part of everyday life—is the risk of being involved in a

lawsuit. The list of circumstances in which businesspersons can be sued is long and varied. A customer who is injured by a security guard at a business establishment, for instance,

may sue the business owner, claiming that the security guard’s conduct was intentionally wrongful. A person who slips and falls at a retail store may sue the company for negligence.

Any time that one party’s alleg- edly wrongful conduct causes injury to another, an action may arise under

the law of torts (the word tort is tort is tort French for “wrong”). Through tort law, society compensates those who have suffered injuries as a result of the wrongful conduct of others. Many of the lawsuits brought by or against business firms are based on various tort theories.

Tort Law

C H A P T E R 6 Tort Law 113

the emotional and physical benefits of a spousal relation- ship), disfigurement, loss of reputation, or loss or impair- ment of mental or physical capacity.

Punitive Damages Occasionally, the courts also award punitive damages in tort cases to punish the wrongdoer and deter others from similar wrongdoing. Punitive damages are appropriate only when the defen- dant’s conduct was particularly egregious (flagrant) or reprehensible (blameworthy).

Usually, this means that punitive damages are available in intentional tort actions and only rarely in negligence intentional tort actions and only rarely in negligence intentional lawsuits (negligence actions will be discussed later in this chapter). They may be awarded, however, in suits involv- ing gross negligence. Gross negligence can be defined as an intentional failure to perform a manifest duty in reckless disregard of the consequences of such a failure for the life or property of another.

Courts exercise great restraint in granting punitive damages to plaintiffs in tort actions because punitive damages are subject to limitations under the due pro- cess clause of the U.S. Constitution. The United States Supreme Court has held that to the extent that an award of punitive damages is grossly excessive, it furthers no legitimate purpose and violates due process require- ments.2 Consequently, an appellate court will sometimes reduce the amount of punitive damages awarded to a plaintiff on the ground that it is excessive and thereby violates the due process clause.

Legislative Caps on Damages State laws may limit the amount of damages—both punitive and gen- eral—that can be awarded to the plaintiff. More than half of the states have placed caps ranging from $250,000 to $750,000 on noneconomic general damages (such as for pain and suffering), especially in medical malpractice suits. More than thirty states have limited punitive dam- ages, with some imposing outright bans.

6–1c Classification of Torts There are two broad classifications of torts: intentional torts and torts and torts unintentional torts (torts involving negligence). unintentional torts (torts involving negligence). unintentional torts The classification of a particular tort depends largely on how the tort occurs (intentionally or negligently) and the surrounding circumstances. Intentional torts result from the intentional violation of person or property (fault plus intent). Negligence results from the breach of a duty to act reasonably (fault without intent).

2. State Farm Mutual Automobile Insurance Co. v. Campbell, 538 U.S. 408, State Farm Mutual Automobile Insurance Co. v. Campbell, 538 U.S. 408, State Farm Mutual Automobile Insurance Co. v. Campbell 123 S.Ct. 1513, 155 L.Ed.2d 585 (2003).

6–1d Defenses Even if a plaintiff proves all the elements of a tort, the defendant can raise a number of legally recognized defenses (reasons why the plaintiff should not obtain damages). A successful defense releases the defendant from partial or full liability for the tortious act.

The defenses available may vary depending on the specific tort involved. A common defense to intentional torts against persons, for instance, is consent. When a per- son consents to the act that damages her or him, there is generally no liability. The most widely used defense in negligence actions is comparative negligence.

In addition, most states have a statute of limitations that establishes the time limit (often two years from the date of discovering the harm) within which a particular type of lawsuit can be filed. After that time period has run, the plaintiff can no longer file a claim.

6–2 Intentional Torts against Persons

An intentional tort, as the term implies, requires intent. The tortfeasor (the one committing the tort) must tortfeasor (the one committing the tort) must tortfeasor intend to commit an act, the consequences of which interfere with another’s personal or business interests in a way not permitted by law. An evil or harmful motive is not required—in fact, the person committing the action may even have a beneficial motive for doing what turns out to be a tortious act.

In tort law, intent means only that the person intended intent means only that the person intended intent the consequences of his or her act or knew with substan- tial certainty that specific consequences would result from the act. The law generally assumes that individuals intend the normal consequences of their actions. Thus, normal consequences of their actions. Thus, normal forcefully pushing another—even if done in jest—is an intentional tort (if injury results), because the object of a strong push can ordinarily be expected to fall down.

In addition, intent can be transferred when a defen- dant intends to harm one individual, but unintention- ally harms a second person. This is called transferred intent. ■ EXAMPLE 6.2 Alex swings a bat intending to hit Blake but misses and hits Carson instead. Carson can sue Alex for the tort of battery (discussed shortly) because Alex’s intent to harm Blake can be transferred to Carson. ■

6–2a Assault An assault is any intentional and unexcused threat of assault is any intentional and unexcused threat of assault immediate harmful or offensive contact—words or acts

114 U N I T T W O The Public and International Environment

that create a reasonably believable threat. An assault can occur even if there is no actual contact with the plaintiff, provided that the defendant’s conduct creates a reason- able apprehension of imminent harm in the plaintiff. Tort law aims to protect individuals from having to expect harmful or offensive contact.

6–2b Battery If the act that created the apprehension is completed and completed and completed results in harm to the plaintiff, it is a battery—an unexbattery—an unexbattery - cused and harmful or offensive physical contact inten- tionally performed. tionally performed. tionally ■ EXAMPLE 6.3 Ivan threatens Jean with a gun and then shoots her. The pointing of the gun at Jean is an assault. The firing of the gun (if the bullet hits Jean) is a battery. ■

The contact can be harmful, or it can be merely offen- sive (such as an unwelcome kiss). Physical injury need not occur. The contact can involve any part of the body or anything attached to it—for instance, a hat, a purse, or a jacket. The contact can be made by the defendant or by some force set in motion by the defendant, such as a rock thrown by the defendant. Whether the contact is offen- sive is determined by the reasonable person standard.3

If the plaintiff shows that there was contact, and the jury (or judge, if there is no jury) agrees that the contact was offensive, then the plaintiff has a right to compensa- tion. A plaintiff may be compensated for the emotional harm or loss of reputation resulting from a battery, as well as for physical harm. A defendant may assert self- defense or defense of others in an attempt to justify his or her conduct.

6–2c False Imprisonment False imprisonment is the intentional confinement or False imprisonment is the intentional confinement or False imprisonment restraint of another person’s activities without justifica- tion. False imprisonment interferes with the freedom to move without restraint. The confinement can be accom- plished through the use of physical barriers, physical restraint, or threats of physical force. Moral pressure does not constitute false imprisonment. It is essential that the person being restrained does not wish to be restrained. (The plaintiff ’s consent to the restraint bars any liability.)

Businesspersons often face suits for false imprison- ment after they have attempted to confine a suspected shoplifter for questioning. Under the “privilege to detain” granted to merchants in most states, a merchant can use

3. The reasonable person standard is an “objective” test of how a reasonable reasonable person standard is an “objective” test of how a reasonable reasonable person standard person would have acted under the same circumstances. See “The Duty of Care and Its Breach” later in this chapter.

reasonable force to detain or delay persons suspected of reasonable force to detain or delay persons suspected of reasonable force shoplifting and hold them for the police. Although laws pertaining to this privilege vary from state to state, gen- erally any detention must be conducted in a reasonable manner and for only a reasonable length of time. Undue force or unreasonable detention can lead to liability for the business.

Cities and counties may also face lawsuits for false imprisonment if they detain individuals without rea- son. ■ CASE IN POINT 6.4 Police arrested Adetokunbo Police arrested Adetokunbo Shoyoye for riding the subway without a ticket and for a theft that had been committed by someone who had stolen his identity. A court ordered him to be released, but a county employee mistakenly confused Shoyoye’s paperwork with that of another person who was sched- uled to be sent to state prison. As a result, instead of being released, Shoyoye was held in county jail for more than two weeks. Shoyoye later sued the county for false imprisonment and won.4 ■

6–2d Intentional Infliction of Emotional Distress

The tort of intentional infliction of emotional distress involves an intentional act that amounts to extreme and outrageous conduct resulting in severe emotional distress to another. To be actionable (capable of serving as the ground for a lawsuit), the act must be extreme and outra- geous to the point that it exceeds the bounds of decency accepted by society.

Outrageous Conduct Courts in most jurisdictions are wary of emotional distress claims and confine them to situations involving truly outrageous behavior. Gener- ally, repeated annoyances (such as those experienced by a person who is being stalked), coupled with threats, are enough. Acts that cause indignity or annoyance alone usually are not sufficient.

■ EXAMPLE 6.5 A father attacks a man who has had consensual sexual relations with the father’s nineteen- year-old daughter. The father handcuffs the man to a steel pole and threatens to kill him unless he leaves town immediately. The father’s conduct may be sufficiently extreme and outrageous to be actionable as an inten- tional infliction of emotional distress. ■

Limited by the First Amendment When the out- rageous conduct consists of speech about a public figure,

4. Shoyoye v. County of Los Angeles, 203 Cal.App.4th 947, 137 Cal.Rptr.3d 839 (2012).

C H A P T E R 6 Tort Law 115

the First Amendment’s guarantee of freedom of speech also limits emotional distress claims.

■ CASE IN POINT 6.6 Hustler magazine once printed Hustler magazine once printed Hustler a false advertisement that showed a picture of the late Reverend Jerry Falwell and described him as having lost his virginity to his mother in an outhouse while he was drunk. Falwell sued the magazine for intentional inflic- tion of emotional distress and won, but the United States Supreme Court overturned the decision. The Court held that parodies of public figures are protected under the First Amendment from intentional infliction of emo- tional distress claims. (The Court uses the same stan- dards that apply to public figures in defamation lawsuits, discussed next.)5 ■

6–2e Defamation The freedom of speech guaranteed by the First Amend- ment is not absolute. The courts are required to balance the vital guarantee of free speech against other pervasive

5. Hustler Magazine, Inc. v. Falwell, 485 U.S. 46, 108 S.Ct. 876, 99 L.Ed.2d Hustler Magazine, Inc. v. Falwell, 485 U.S. 46, 108 S.Ct. 876, 99 L.Ed.2d Hustler Magazine, Inc. v. Falwell 41 (1988). For another example of how the courts protect parody, see Busch v. Viacom International, Inc., 477 F.Supp.2d 764 (N.D.Tex. 2007), involving a false endorsement of televangelist Pat Robertson’s diet shake.

and strong social interests, including society’s interest in preventing and redressing attacks on reputation.

Defamation of character involves wrongfully hurting a person’s good reputation. The law imposes a general duty on all persons to refrain from making false, defama- tory statements of fact about others. Breaching this duty statements of fact about others. Breaching this duty statements of fact in writing or other permanent form (such as a digital recording) involves the tort of libel. Breaching this duty orally involves the tort of slander. The tort of defamation also arises when a false statement of fact is made about a person’s product, business, or legal ownership rights to property.

Establishing defamation involves proving the follow- ing elements: 1. The defendant made a false statement of fact. 2. The statement was understood as being about the

plaintiff and tended to harm the plaintiff ’s reputation. 3. The statement was published to at least one person

other than the plaintiff. 4. If the plaintiff is a public figure, she or he must also

prove actual malice, discussed later in the chapter. The following case involved the application of free

speech guarantees to online reviews of professional services.

In the Language of the Court CIKLIN, C.J. [Chief Judge]CIKLIN, C.J. [Chief Judge]CIKLIN

* * * * [Ann-Marie] Giustibelli represented

Copia Blake in a dissolution of mar- riage proceeding brought against Peter Birzon. After a breakdown in the attor- ney-client relationship between Giusti- belli and her client[,] Blake, and oddly, Birzon as well, took to the Internet to post defamatory reviews of Giustibelli. In response, Giustibelli brought suit [in a Florida state court against Blake and Birzon], pleading a count for libel.

Blake’s and Birzon’s posted Inter- net reviews contained the following statements:

This lawyer represented me in my divorce. She was combative and

explosive and took my divorce to a level of anger which caused major suffering of my minor children. She insisted I was an emotionally abused wife who couldn’t make rational decisions which caused my case to drag on in the system for a year and a half so her FEES would continue to multiply!! She misrepresented her fees with regards to the contract I initially signed. The contract she submitted to the courts for her fees were 4 times her original quote and pages of the original had been exchanged to support her claims, only the signature page was the same. Shame on me that I did not have an original copy, but like an idiot * * * I trusted my lawyer. Don’t mistake sincerity for honesty because I assure you, that in this attorney’s case, they are NOT the same thing. She absolutely perpetuates

the horrible image of attorneys who are only out for the money and themselves. Although I know this isn’t the case and there are some very good honest lawyers out there, Mrs. Giustibelli is simply not one of the “good ones.” Horrible horrible experience. Use anyone else, it would have to be a better result.

* * * *

No integrity. Will say one thing and do another. Her fees outweigh the truth. Altered her charges to 4 times the original quote with no explana- tion. Do not use her. Don’t mistake sincerity for honesty. In her case, they’re not at all the same. Will liter- ally lie to your face if it means more money for her. Get someone else.

Case Analysis 6.1 Blake v. Giustibelli District Court of Appeal of Florida, Fourth District, 182 So.3d 881, 41 Fla.L.Weekly D122 (2016).

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* * * Anyone else would do a superior effort for you.

* * * *

I accepted an initial VERY fair offer from my ex. Mrs. Giustibelli convinced me to “crush” him and that I could have permanent etc. Spent over a year (and 4 times her original estimate) to arrive at the same place we started at. Caused unnecessary chaos and fear with my kids, convinced me that my ex cheated (which he didn’t), that he was hiding money (which he wasn’t), and was mad at ME when I realized her fee circus had gone on long enough and finally said “stop.” Altered her fee structures, actu- ally replaced original documents with others to support her charges and gen- erally gave the kind of poor service you only hear about. I’m not a disgruntled

ex-wife. I’m just the foolish person who believes that a person’s word should be backed by integrity. Not even remotely true in this case. I’ve had 2 prior attor- neys and never ever have I seen ego and monies be so blatantly out of control.

Both Blake and Birzon admitted to posting the reviews on various Internet sites. The evidence showed that Blake had agreed to pay her attorney the amount reflected on the written retainer agreement—$300 an hour. Blake and Birzon both admitted at trial that Giusti- belli had not charged Blake four times more than what was quoted in the agree- ment. The court entered judgment in favor of Giustibelli and awarded punitive damages of $350,000.

On appeal, Blake and Birzon argue that their Internet reviews constituted

statements of opinion and thus were pro- tected by the First Amendment and not actionable as defamation. We disagree. An action for libel will lie for a false and unprivileged publication by letter, or oth- erwise, which exposes a person to distrust, hatred, contempt, ridicule or obloquy [cen- sure or disgrace] or which causes such person to be avoided, or which has a tendency to injure such person in their office, occupation, business or employment. [Emphasis added.]

Here, all the reviews contained alle- gations that Giustibelli lied to Blake regarding the attorney’s fee. Two of the reviews contained the allegation that Giustibelli falsified a contract. These are factual allegations, and the evidence showed they were false.

* * * * Affirmed.

Legal Reasoning Questions

1. What is the standard for the protection of free speech guaranteed by the First Amendment? 2. How did this standard apply to the statements posted online by Blake and Birzon? 3. The First Amendment normally protects statements of opinion, and this can be an effective defense against a charge of defama-

tion. Does it seem reasonable to disregard this defense, however, if any assertion of fact within a statement of opinion is false? any assertion of fact within a statement of opinion is false? any Explain.

Case 6.1 Continued

Statement-of-Fact Requirement Often at issue in defamation lawsuits (including online defamation) is whether the defendant made a statement of fact or a statement of opinion. Statements of opinion normally are not actionable, because they are protected under the First Amendment.

In other words, making a negative statement about another person is not defamation unless the statement is false and represents something as a fact rather than a is false and represents something as a fact rather than a is false and represents something as a fact rather than a personal opinion. ■ EXAMPLE 6.7 The statement “Lane cheats on his taxes,” if false, can lead to liability for defa- mation. The statement “Lane is a jerk” cannot constitute defamation because it is clearly an opinion. ■

The Publication Requirement The basis of the tort of defamation is the publication of a statement or state- ments that hold an individual up to contempt, ridicule, or

hatred. Publication here means that the defamatory state- ments are communicated (either intentionally or acciden- tally) to persons other than the defamed party.

The courts have generally held that even dictating a letter to a secretary constitutes publication, although the publication may be privileged (a concept that will be explained shortly). Moreover, if a third party merely overhears defamatory statements by chance, the courts usually hold that this also constitutes publication. Defamatory statements made via the Internet are action- able as well. Note also that any individual who repeats or republishes defamatory statements normally is liable even if that person reveals the source of the statements.

■ CASE IN POINT 6.8 Eddy Ramirez, a meat cut Eddy Ramirez, a meat cut- ter at Costco Wholesale Corporation, was involved in a workplace incident with a coworker, and Costco gave him a notice of suspension. After an investigation

C H A P T E R 6 Tort Law 117

in which coworkers were interviewed, Costco fired Ramirez. Ramirez sued, claiming that the suspension notice was defamatory. The court ruled in Costco’s favor. Ramirez could not establish defamation, because he had not shown that the suspension notice was published to any third parties. Costco did nothing beyond what was necessary to investigate the events that led to Ramirez’s termination.6 ■

Damages for Libel Once a defendant’s liability for libel is established, general damages are presumed as a matter of law. General damages are designed to compen- sate the plaintiff for nonspecific harms such as disgrace or dishonor in the eyes of the community, humiliation, injured reputation, and emotional distress—harms that are difficult to measure. In other words, to recover dam- ages, the plaintiff need not prove that he or she was actu- ally harmed in any specific way as a result of the libelous statement.

Damages for Slander In contrast to cases alleging libel, in a case alleging slander, the plaintiff must prove special damages to establish the defendant’s liability. The special damages to establish the defendant’s liability. The special damages plaintiff must show that the slanderous statement caused her or him to suffer actual economic or monetary losses.

Unless this initial hurdle of proving special damages is overcome, a plaintiff alleging slander normally can- not go forward with the suit and recover any damages. This requirement is imposed in slander cases because oral statements have a temporary quality. In contrast, a libel- ous (written) statement has the quality of permanence and can be circulated widely, especially through tweets and blogs. Also, libel usually results from some degree of deliberation by the author.

Slander Per Se Exceptions to the burden of prov- ing special damages in cases alleging slander are made for certain types of slanderous statements. If a false statement constitutes “slander per se,” it is actionable with no proof of special damages required. In most states, the following four types of declarations are considered to be slander per se: 1. A statement that another has a “loathsome” disease

(such as a sexually transmitted disease). 2. A statement that another has committed impropri-

eties while engaging in a profession or trade. 3. A statement that another has committed or has been

imprisoned for a serious crime.

6. Ramirez v. Costco Wholesale Corp., 2014 WL 2696737 (Ct.Sup.Ct. 2014).

4. A statement that a person is unchaste or has engaged in serious sexual misconduct. (This usually applies only to unmarried persons and sometimes only to women.)

Defenses to Defamation Truth is normally an absolute defense against a defamation charge. In other words, if a defendant in a defamation case can prove that the allegedly defamatory statements of fact were true, nor- mally no tort has been committed.

■ CASE IN POINT 6.9 David McKee, a neurologist, went to examine a patient who had been transferred from the intensive care unit (ICU) to a private room. In the room were family members of the patient, including his son. The patient’s son later made the following post on a “rate your doctor” Web site: “[Dr. McKee] seemed upset that my father had been moved [into a private room]. Never having met my father or his family, Dr. McKee said ‘When you weren’t in ICU, I had to spend time find- ing out if you transferred or died.’ When we gaped at him, he said ‘Well, 44 percent of hemorrhagic strokes die within 30 days. I guess this is the better option.’”

McKee filed suit for defamation but lost. The court found that all the statements made by the son were essen- tially true, and truth is a complete defense to a defama- tion action.7 ■ In other words, true statements are not actionable no matter how disparaging. Even the presence of minor inaccuracies of expression or detail does not render basically true statements false.

Other defenses to defamation may exist if the speech is privileged or if it concerns a public figure. We discuss these defenses next. Note that the majority of defama- tion actions are filed in state courts, and state laws differ somewhat in the defenses they allow.

Privileged Communications. In some circumstances, a person will not be liable for defamatory statements because she or he enjoys a privilege, or immunity. Privileged com- munications are of two types: absolute and quali�ed.8 Only in judicial proceedings and certain government pro- ceedings is an absolute privilege granted. �us, statements made by attorneys and judges in the courtroom during a trial are absolutely privileged, as are statements made by government o�cials during legislative debate.

7. McKee v. Laurion, 825 N.W.2d 725 (Minn.Sup. 2013). 8. Note that the term privileged communication in this context is not the

same as privileged communication between a professional, such as an attorney, and his or her client.

118 U N I T T W O The Public and International Environment

In other situations, a person will not be liable for defamatory statements because he or she has a qualified, or conditional, privilege. An employer’s statements in writ- ten evaluations of employees, for instance, are protected by a qualified privilege. Generally, if the statements are made in good faith and the publication is limited to those who have a legitimate interest in the communication, the statements fall within the area of qualified privilege.statements fall within the area of qualified privilege.statements fall within the area of qualified privilege.

■ EXAMPLE 6.10 Jorge has worked at Google for five years and is being considered for a management position. His supervisor, Lydia, writes a memo about Jorge’s per- formance to those evaluating him for the position. The memo contains certain negative statements, which Lydia honestly believes are true. If Lydia limits the disclosure of the memo to company representatives, her statements will likely be protected by a qualified privilege. ■

Public Figures. Politicians, entertainers, professional ath- letes, and others in the public eye are considered public �gures. Public �gures are regarded as “fair game.” False and defamatory statements about public �gures that are pub- lished in the media will not constitute defamation unless the statements are made with actual malice.9 To be made with actual malice, a statement must be made with either knowledge of its falsity or a reckless disregard of the truth.

Statements made about public figures, especially when they are communicated via a public medium, usu- ally relate to matters of general interest. They are made about people who substantially affect all of us. Further- more, public figures generally have some access to a public medium for answering belittling falsehoods about them- selves. For these reasons, public figures have a greater burden of proof in defamation cases—to show actual malice—than do private individuals.

■ CASE IN POINT 6.11 In Touch magazine published In Touch magazine published In Touch a story about a former call girl who claimed to have slept with legendary soccer player David Beckham more than once. Beckham sued In Touch magazine for libel, seeking $25 million in damages. He said that he had never met the woman, had not cheated on his wife with her, and had not paid her for sex. After months of litigation, a federal district court dismissed the case because Beckham could not show that the magazine had acted with actual malice. Whether or not the statements in the article were accurate, there was no evidence that the defendants had made the statements with knowledge of their falsity or reckless disregard for the truth.10 ■

9. New York Times Co. v. Sullivan, 376 U.S. 254, 84 S.Ct. 710, 11 L.Ed.2d 686 (1964).

10. Beckham v. Bauer Pub. Co., L.P., 2011 WL 977570 (2011).

6–2f Invasion of Privacy A person has a right to solitude and freedom from prying public eyes—in other words, to privacy. The courts have held that certain amendments to the U.S. Constitution imply a right to privacy. Some state constitutions explic- itly provide for privacy rights, as do a number of federal and state statutes.

Tort law also safeguards these rights through the tort of invasion of privacy. Generally, to sue successfully for an inva- sion of privacy, a person must have a reasonable expectation of privacy, and the invasion must be highly offensive. (See this chapter’s Digital Update feature for a discussion of how invasion of privacy claims can arise when someone posts pictures or videos taken with digital devices.)

Invasion of Privacy under the Common Law The following four acts qualify as an invasion of privacy under the common law: 1. Intrusion into an individual’s affairs or seclusion.

Invading someone’s home or searching some- one’s briefcase or laptop without authorization is an invasion of privacy. This tort has been held to extend to eavesdropping by wiretap, unauthorized scanning of a bank account, compulsory blood scanning of a bank account, compulsory blood scanning of a bank account, compulsory blood testing, and window peeping. ■ EXAMPLE 6.12 A female sports reporter for ESPN is digitally videoed while naked through the peephole in the door of her hotel room. She will probably win a lawsuit against the man who took the video and posted it on the Internet. ■

2. False light. Publication of information that places a person in a false light is also an invasion of privacy. For instance, writing a story that attributes to a per- son ideas and opinions not held by that person is an invasion of privacy. (Publishing such a story could invasion of privacy. (Publishing such a story could invasion of privacy. (Publishing such a story could involve the tort of defamation as well.) ■ EXAMPLE 6.13 An Iowa newspaper prints an article saying that An Iowa newspaper prints an article saying that nineteen-year-old Yassine Alam is part of the terror- ist organization Islamic State of Iraq (ISIL). Next to the article is a photo of Yassine’s brother, Salaheddin. Salaheddin can sue the paper for putting him in a false light by using his photo. If the report is not true, and Yassine is not involved with ISIL, Yassine can sue the paper for defamation. ■

3. Public disclosure of private facts. This type of invasion of privacy occurs when a person publicly discloses private facts about an individual that an ordinary person would find objectionable or embarrassing. A newspaper account of a private citizen’s sex life or financial affairs could be an actionable invasion of

C H A P T E R 6 Tort Law 119

Revenge Porn and Invasion of Privacy

Nearly every digital device today takes photos and videos at virtually no cost. Software allows the recording of conversations via Skype. Many couples immortalize their “private moments” using such digital devices. One partner may take a racy selfie and send it as an attachment to a text message to the other partner, for example.

Occasionally, after a couple breaks off their relation- ship, one of them seeks a type of digital revenge. The result, called revenge porn, has been defined in the Cyber Civil Rights Initiative as “the online distribution of sexually explicit images of a non-consenting indi- vidual with the intent to humiliate that person.”

Until relatively recently, few states had criminal stat- utes that covered revenge porn. Therefore, victims have sued on the basis of (1) invasion of privacy, (2) public disclosure of private facts, and (3) intentional infliction of emotional distress.

It Is More Than Just Pictures and Videos

Perhaps the worst form of revenge porn occurs when the perpetrator provides detailed information about the victim. Such information may include the victim’s name, Facebook page, address, and phone number, as well as the victim’s workplace and children’s names. This information, along with the sexually explicit pho- tos and videos, are posted on hosting Web sites. Many such Web sites have been shut down, as was the case with IsAnybodyDown? and Texxxan.com. But others are still active, usually with offshore servers and foreign domain name owners.

The Injurious Results of Revenge Porn

Of course, victims of revenge porn suffer extreme embarrassment. They may also have their reputations ruined. Some have lost their jobs. Others have been unable to obtain jobs because employers have seen their pictures online. A number of victims have been stalked in the physical world and harassed online and

offline. When attempts to have offending pho- tos removed from Web sites have failed, vic- tims have changed their phone numbers and sometimes their names.

A Class-Action Lawsuit

Hollie Toups, along with twenty-two other female plaintiffs, sued the domain name reg-

istrar and Web hosting company GoDaddy in a Texas court. Although GoDaddy did not create the defama- tory and offensive material at issue, GoDaddy knew of the content and did not remove it. The plaintiffs asserted causes of action “for intentional infliction of emotional distress,” among other claims.

Additionally, the plaintiffs argued that “by its know- ing participation in these unlawful activities, GoDaddy has also committed the intentional Texas tort of inva- sion of privacy . . . as well as intrusion on Plaintiffs’ right to seclusion, the public disclosure of their private facts, [and] the wrongful appropriation of their names and likenesses. . . .” GoDaddy sought to dismiss the case, and an appeals court eventually granted the motion to dismiss.a

Another Texas woman had better luck. The woman’s ex-boyfriend had uploaded videos of her to YouTube and other sites. At the time she made the complaint, revenge porn was not a crime in Texas. Nevertheless, in a jury trial in 2014, she won a $500,000 award. Since then, a handful of states have made revenge porn a crime. In 2015, a California man, Kevin Bollaert, was convicted for creating a revenge porn Web site and sentenced to serve eighteen years in prison.

Critical Thinking Should domain name hosting compa- nies be liable for revenge porn?

DIGITAL UPDATE

a. GoDaddy.com, LLC. v. Toups, 429 S.W.3d 752 (Tex.App.—Beaumont 2014).

privacy. This is so even if the information revealed is true, because it should not be a matter of public concern.

4. Appropriation of identity. Using a person’s name, pic- ture, likeness, or other identifiable characteristic for commercial purposes without permission is also an

invasion of privacy. An individual’s right to privacy normally includes the right to the exclusive use of normally includes the right to the exclusive use of normally includes the right to the exclusive use of her or his identity. ■ EXAMPLE 6.14 An advertising agency asks a singer with a distinctive voice and stage presence to take part in a marketing campaign for a new automobile. The singer rejects the offer. If the

120 U N I T T W O The Public and International Environment

agency then uses someone who imitates the singer’s voice and dance moves in the ad, it will be actionable as an appropriation of identity. ■

Appropriation Statutes Most states today have codified the common law tort of appropriation of identity in statutes that establish the distinct tort of appropriation, or right of publicity. States differ as to the degree of like- ness that is required to impose liability for appropriation, however.

Some courts have held that even when an animated character in a video or a video game is made to look like an actual person, there are not enough similarities to an actual person, there are not enough similarities to an actual person, there are not enough similarities to constitute appropriation. ■ CASE IN POINT 6.15 Rob Rob- ert Burck is a street entertainer in New York City who has become famous as “The Naked Cowboy.” Burck per- forms wearing only a white cowboy hat, white cowboy boots, and white underwear. He carries a guitar strate- gically placed to give the illusion of nudity. Burck sued Mars, Inc., the maker of M&Ms candy, over a video it showed on billboards in Times Square that depicted a blue M&M dressed exactly like The Naked Cowboy. The court, however, held that the use of Burck’s signature cos- tume did not amount to appropriation.11 ■

11. Burck v. Mars, Inc., 571 F.Supp.2d 446 (S.D.N.Y. 2008).

6–2g Fraudulent Misrepresentation A misrepresentation leads another to believe in a con- dition that is different from the condition that actually exists. Although persons sometimes make misrepre- sentations accidentally because they are unaware of the existing facts, the tort of fraudulent misrepresentation (fraud), involves intentional deceit for personal gain. The intentional deceit for personal gain. The intentional tort includes several elements: 1. A misrepresentation of material facts or conditions

with knowledge that they are false or with reckless disregard for the truth.

2. An intent to induce another party to rely on the misrepresentation.

3. A justifiable reliance on the misrepresentation by the deceived party.

4. Damages suffered as a result of that reliance. 5. A causal connection between the misrepresentation

and the injury suffered. For fraud to occur, more than mere puffery, or seller’s

talk, must be involved. Fraud exists only when a person represents as a fact something he or she knows is untrue. For instance, it is fraud to claim that the roof of a build- ing does not leak when one knows that it does. Facts are objectively ascertainable, whereas seller’s talk (such as “I am the best accountant in town”) is not, because the use of the word best is subjective. best is subjective. best

In the following case, the court considered each of the elements of fraud.

Background and Facts Joseph Guido bought a parcel of land in Stillwater, New York, that con- tained nine rental houses. The houses shared a waste disposal system that was defective. Guido had a new septic system installed. When town officials discovered sewage on the property, Guido had the system partially replaced. Prospective buyers, including Danny Revell, were given a property infor- mation sheet that stated, “Septic system totally new—each field totally replaced.” In response to a questionnaire from the buyers’ bank, Guido denied any knowledge of environmental problems.

A month after the buyers bought the houses, the septic system failed and required substantial repairs. The lender foreclosed on the property. The buyers filed a suit in a New York state court against Guido and his firm, Real Property Solutions, LLC, alleging fraud. A jury found fraud and awarded dam- ages. The court issued a judgment in the plaintiffs’ favor. The defendants appealed.

In the Language of the Court EGAN, Jr., J: [Judge:]

* * * * To prevail upon their cause of action for fraud, plaintiffs were required to establish that defendants, with

the intent to deceive, misrepresented or omitted a material fact that they knew to be false and that plaintiffs,

Revell v. Guido New York Supreme Court, Appellate Division, Third Department, 124 A.D.3d 1006, 2 N.Y.S.3d 252 (2015).

Case 6.2

C H A P T E R 6 Tort Law 121

in turn, justifiably relied upon such misrepresentation or omission, thereby incurring damages. As to the mis- representation element, plaintiffs point to the statement made on the property information sheet * * * , as well as Guido’s responses to certain of the inquiries contained on the environmental questionnaire. In this regard, the record reflects that the [replacement] septic system * * * was not “totally new,” as it retained the original pump house structure and, more to the point, utilized the holding tanks that origi- nally were part of the system * * * . There also is no question that Guido provided false answers to vari- ous inquiries posed on the environmental questionnaire. For example, Guido disavowed any knowledge of “governmental notification relating to past or recurrent violations of environmental laws with respect to the property * * * ”—despite having been advised by the Town of Stillwater * * * that partially treated sewage was discovered on the property. [Emphasis added.]

As to the intent element, * * * given the arguably cavalier [offhand] manner in which Guido com- pleted the environmental questionnaire, as well as his extensive knowledge regarding the * * * problems with the original septic system * * * , the jury could properly find that Guido made the cited misrepre- sentations with the intent to deceive plaintiffs.

With respect to the issue of justifiable reliance, Revell * * * conducted a visual inspection of the prop- erty prior to making an offer and did not observe any conditions indicative of a problem with the septic system. * * * If a septic system was represented to be “totally new” and a visual inspection of the property did not reveal any red flags, [that is,] boggy areas, odors or liquids bubbling up to the surface, one would assume that the system was working properly. * * * The jury [could] find that plaintiffs’ reliance upon the representation contained in the property information sheet was reasonable.

* * * * Nor are we persuaded that plaintiffs failed to tender sufficient admissible proof to substantiate the

damages awarded by the jury. During the trial, the parties stipulated to the admission into evidence of a binder containing, among other things, an abundance of receipts, invoices, billing statements and canceled checks detailing plaintiffs’ expenditures related to the subject property—and plaintiffs’ forensic accountant, in turn, utilized such documents to arrive at a damages figure. * * * We are satisfied that plaintiffs tendered sufficient admissible proof to sustain the damages awarded by the jury.

Decision and Remedy The state intermediate appellate court affirmed the lower court’s judgment in the plaintiffs’ favor. The facts of the case and the plaintiffs’ proof met all of the requirements for establish- ing fraud.

Critical Thinking • Legal Environment Financing for the purchase of the property was conditioned on the bank’s review of

Guido’s answers to the environmental questionnaire. How could the court conclude that the plaintiffs justi- fiably relied on misrepresentations made to the bank? Explain.

• What If the Facts Were Different? If a visual inspection of the property had revealed “boggy areas, odors or liquids bubbling up to the surface” indicating that the septic system was not working properly, would the outcome of this case have been different?

Case 6.2 Continued

Statement of Fact versus Opinion Normally, the tort of fraudulent misrepresentation occurs only when there is reliance on a statement of fact. Sometimes, however, reliance on a statement of opinion may involve the tort of fraudulent statement of opinion may involve the tort of fraudulent statement of opinion misrepresentation if the individual making the statement of opinion has superior knowledge of the subject matter. For instance, when a lawyer makes a statement of opinion about the law in a state in which the lawyer is licensed to practice, a court might treat it as a statement of fact.

Negligent Misrepresentation Sometimes, a tort action can arise from misrepresentations that are made negligently rather than intentionally. The key difference between intentional and negligent misrepresentation is whether the person making the misrepresentation had actual knowledge of its falsity. Negligent misrepresenta- tion requires only that the person making the statement or omission did not have a reasonable basis for believing its truthfulness.

122 U N I T T W O The Public and International Environment

Liability for negligent misrepresentation usually arises when the defendant who made the misrepresentation owed a duty of care to the plaintiff to supply correct information. (We discuss the duty of care in more detail later in the chapter.) Statements or omissions made by attorneys and accountants to their clients, for instance, can lead to liability for negligent misrepresentation.

6–2h Abusive or Frivolous Litigation Tort law recognizes that people have a right not to be sued without a legally just and proper reason, and there- fore it protects individuals from the misuse of litigation. Torts related to abusive litigation include malicious pros- ecution and abuse of process. If a party initiates a lawsuit

out of malice and without a legitimate legal reason, and ends up losing the suit, that party can be sued for mali- cious prosecution. Abuse of process can apply to any person cious prosecution. Abuse of process can apply to any person cious prosecution. Abuse of process using a legal process against another in an improper man- ner or to accomplish a purpose for which the process was not designed.

The key difference between the torts of abuse of process and malicious prosecution is the level of proof. Unlike malicious prosecution, abuse of process is not limited to prior litigation and does not require the plain- tiff to prove malice. It can be based on the wrongful use of subpoenas, court orders to attach or seize real property, or other types of formal legal process.

Concept Summary 6.1 reviews intentional torts against persons.

Intentional Torts against Persons

Concept Summary 6.1

Any unexcused and intentional act that causes another person to be apprehensive of immediate harm is an assault. An assault resulting in physical contact is a battery.

Assault and Battery

An intentional confinement or restraint of another person’s movement without justification.

False Imprisonment

An intentional act that amounts to extreme and outrageous conduct resulting in severe emotional distress to another.

Intentional Infliction of Emotional Distress

The filing of a lawsuit without legitimate grounds and with malice. Alternatively, the use of a legal process in an improper manner.

Abusive or Frivolous Litigation

A false statement of fact, not made under privilege, that is communicated to a third person and that causes damage to a person’s reputation. For public figures, the plaintiff must also prove that the statement was made with actual malice.

Defamation (Libel or Slander)

Publishing or otherwise making known or using information relating to a person’s private life and affairs, with which the public has no legitimate concern, without that person’s permission or approval.

Invasion of Privacy

A false representation made by one party, through misstatement of facts or through conduct, with the intention of deceiving another and on which the other reasonably relies to his or her detriment.

Fraudulent MisreprMisreprMisr esentation (Fraud)

C H A P T E R 6 Tort Law 123

6-2i Wrongful Interference The torts known as business torts generally involve wrongbusiness torts generally involve wrongbusiness torts - ful interference with another’s business rights. Public pol- icy favors free competition, and these torts protect against tortious interference with legitimate business. Business torts involving wrongful interference generally fall into two categories: interference with a contractual relation- ship and interference with a business relationship.

Wrongful Interference with a Contractual Relationship Three elements are necessary for wrong- ful interference with a contractual relationship to occur: 1. A valid, enforceable contract must exist between two

parties. 2. A third party must know that this contract exists. 3. This third party must intentionally induce a party to intentionally induce a party to intentionally induce

the contract to breach the contract. ■ CASE IN POINT 6.16 A landmark case in this area

involved an opera singer, Joanna Wagner, who was under contract to sing for a man named Lumley for a specified period of years. A man named Gye, who knew of this contract, nonetheless “enticed” Wagner to refuse to carry out the agreement, and Wagner began to sing for Gye. Gye’s action constituted a tort because it interfered with the contractual relationship between Wagner and Lumley. (Wagner’s refusal to carry out the agreement also entitled Lumley to sue Wagner for breach of contract.)12 ■

The body of tort law relating to wrongful interference with a contractual relationship has increased greatly in recent years. In principle, any lawful contract can be the basis for an action of this type. The contract could be between a firm and its employees or a firm and its cus- tomers. Sometimes, a competitor of a firm lures away one of the firm’s key employees. In this situation, the origi- nal employer can recover damages from the competitor only if it can be shown that the competitor knew of the contract’s existence and intentionally induced the breach.

Wrongful Interference with a Business Rela- tionship Businesspersons devise countless schemes to attract customers. They are prohibited, however, from unreasonably interfering with another’s business in their attempts to gain a greater share of the market.

There is a difference between competitive practices and competitive practices and competitive practices predatory behavior—actions undertaken with the intenpredatory behavior—actions undertaken with the intenpredatory behavior - tion of unlawfully driving competitors completely out of the market. Attempting to attract customers in gen- eral is a legitimate business practice, whereas specifically

12. Lumley v. Gye, 118 Eng.Rep. 749 (1853).

targeting the customers of a competitor is more likely to be predatory. A plaintiff claiming predatory behavior must show that the defendant used predatory methods to intentionally harm an established business relationship or gain a prospective economic advantage.or gain a prospective economic advantage.or gain a prospective economic advantage.

■ EXAMPLE 6.17 A shopping mall contains two ath- letic shoe stores: Joe’s and Ultimate Sport. Joe’s cannot station an employee at the entrance of Ultimate Sport’s to divert customers to Joe’s by telling them that Joe’s will beat Ultimate Sport’s prices. This type of activity con- stitutes the tort of wrongful interference with a business relationship, which is commonly considered to be an unfair trade practice. If this activity were permitted, Joe’s would reap the benefits of Ultimate Sport’s advertising. ■

Defenses to Wrongful Interference A person will not be liable for the tort of wrongful interference with a contractual or business relationship if it can be shown that the interference was justified or permissible. Bona fide competitive behavior—such as marketing and adver- tising strategies—is a permissible interference even if it results in the breaking of a contract.results in the breaking of a contract.results in the breaking of a contract.

■ EXAMPLE 6.18 Taylor Meats advertises so effectively Taylor Meats advertises so effectively that it induces Sam’s Restaurant to break its contract with Burke’s Meat Company. In that situation, Burke’s Meat Company will be unable to recover against Taylor Meats on a wrongful interference theory. The public policy that favors free competition through advertising outweighs any possible instability that such competitive activity might cause in contractual relations. ■

6–3 Intentional Torts against Property

Intentional torts against property include trespass to land, trespass to personal property, conversion, and dis- paragement of property. These torts are wrongful actions that interfere with individuals’ legally recognized rights with regard to their land or personal property.

The law distinguishes real property from personal property. Real property is land and things permanently Real property is land and things permanently Real property attached to the land, such as a house. Personal property consists of all other items, including cash and securities (such as stocks and bonds).

6–3a Trespass to Land A trespass to land occurs when a person, without pertrespass to land occurs when a person, without pertrespass to land - mission, does any of the following:

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1. Enters onto, above, or below the surface of land that is owned by another.

2. Causes anything to enter onto land owned by another. 3. Remains on land owned by another or permits any-

thing to remain on it. Actual harm to the land is not an essential element of this tort, because the tort is designed to protect the right of an owner to exclusive possession.

Common types of trespass to land include walking or driving on another’s land, shooting a gun over another’s land, and throwing rocks at a building that belongs to someone else. Another common form of trespass involves constructing a building so that part of it extends onto an adjoining landowner’s property.

Establishing Trespass Before a person can be a trespasser, the real property owner (or another person in actual and exclusive possession of the property, such as a renter) must establish that person as a trespasser. For instance, “posted” trespass signs expressly establish as a trespasser a person who ignores these signs and enters onto the property. A guest in your home is not a tres- passer, unless he or she has been asked to leave and refuses. Any person who enters onto another’s property to com- mit an illegal act (such as a thief entering a lumberyard at night to steal lumber) is impliedly a trespasser, with or without posted signs.

Liability for Harm At common law, a trespasser is liable for any damage caused to the property and gen- erally cannot hold the owner liable for injuries that the trespasser sustains on the premises. This common law rule is being modified in many jurisdictions, however, in favor of a reasonable duty of care rule that varies depending on reasonable duty of care rule that varies depending on reasonable duty of care the status of the parties.

For instance, a landowner may have a duty to post a notice that guard dogs patrol the property. Also, if young children are attracted to the property by some object, such a swimming pool or a sand pile, and are injured, the landowner may be held liable (under the attractive nuisance doctrine). Still, an owner can normally use rea- sonable force to remove a trespasser from the premises or detain the trespasser for a reasonable time without liabil- ity for damages.

Defenses against Trespass to Land One defense to a claim of trespass is to show that the trespass was war- ranted, such as when a trespasser enters a building to assist someone in danger. Another defense exists when the tres- passer can show that she or he had a license to come onto license to come onto license the land.

A licensee is one who is invited (or allowed to enter) onto the property of another for the licensee’s benefit. A person who enters another’s property to read an elec- tric meter, for example, is a licensee. When you purchase a ticket to attend a movie or sporting event, you are licensed to go onto the property of another to view that movie or event.

Note that licenses to enter onto another’s property are revocable by the property owner. If a property owner asks revocable by the property owner. If a property owner asks revocable an electric meter reader to leave and she or he refuses to do so, the meter reader at that point becomes a trespasser.

6–3b Trespass to Personal Property Whenever any individual wrongfully takes or harms the personal property of another or otherwise interferes with the lawful owner’s possession and enjoyment of personal property, trespass to personal property occurs. This trespass to personal property occurs. This trespass to personal property tort may also be called trespass to chattels or trespass to chattels or trespass to chattels trespass to per- sonalty.13 In this context, harm means not only destruc- tion of the property, but also anything that diminishes its value, condition, or quality.

Trespass to personal property involves intentional meddling with a possessory interest (one arising from possession), including barring an owner’s access to perpossession), including barring an owner’s access to perpossession), including barring an owner’s access to per- sonal property. ■ EXAMPLE 6.19 Kelly takes Ryan’s busi- ness law book as a practical joke and hides it so that Ryan is unable to find it for several days before the final exami- nation. Here, Kelly has engaged in a trespass to personal property (and also conversion, the tort discussed next). ■

If it can be shown that trespass to personal property was warranted, then a complete defense exists. Most states, for instance, allow automobile repair shops to hold a customer’s car (under what is called an artisan’s lien) when the customer refuses to pay for repairs already completed.

6–3c Conversion Any act that deprives an owner of personal property or of the use of that property without the owner’s permis- sion and without just cause can constitute conversion. Even the taking of electronic records and data may form the basis of a conversion claim. Often, when conver- sion occurs, a trespass to personal property also occurs. The original taking of the personal property from the owner was a trespass. Wrongfully retaining the property is conversion.

13. Pronounced per-sun-ul-tee.

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Failure to Return Goods Conversion is the civil side of crimes related to theft, but it is not limited to theft. Even when the rightful owner consented to the initial taking of the property, so no theft or trespass occurred, a failure to return the property may still be conver- sion. ■ EXAMPLE 6.20 Chen borrows Mark’s iPad mini to use while traveling home from school for the holidays. When Chen returns to school, Mark asks for his iPad back, but Chen says that he gave it to his little brother for Christmas. In this situation, Mark can sue Chen for conversion, and Chen will have to either return the iPad or pay damages equal to its replacement value. ■

Intention Conversion can occur even when a person mistakenly believed that she or he was entitled to the goods. In other words, good intentions are not a defense against conversion. Someone who buys stolen goods, for instance, may be sued for conversion even if he or she did not know the goods were stolen. If the true owner of the goods sues the buyer, the buyer must either return the property to the owner or pay the owner the full value of the property.

Conversion can also occur from an employee’s unauConversion can also occur from an employee’s unauConversion can also occur from an employee’s unau- thorized use of a credit card. ■ CASE IN POINT 6.21 Nich- olas Mora worked for Welco Electronics, Inc., but had also established his own company, AQM Supplies. Mora used Welco’s credit card without permission and deposited more than $375,000 into AQM’s account, which he then transferred to his personal account. Welco sued. A Cali- fornia court held that Mora was liable for conversion. The court reasoned that when Mora misappropriated Welco’s credit card and used it, he took part of Welco’s credit balance with the credit-card company.14 ■

6–3d Disparagement of Property Disparagement of property occurs when economically Disparagement of property occurs when economically Disparagement of property injurious falsehoods are made about another’s product or property rather than about another’s reputation (as in the tort of defamation). Disparagement of property is a general Disparagement of property is a general Disparagement of property term for torts that can be more specifically referred to as slander of quality or slander of quality or slander of quality slander of title.

Slander of Quality The publication of false informa- tion about another’s product, alleging that it is not what its seller claims, constitutes the tort of slander of qual- ity, or trade libel. or trade libel. or To establish trade libel, the plaintiff must prove that the improper publication caused a third

14. Welco Electronics, Inc. v. Mora, 223 Cal.App.4th 202, 166 Cal.Rptr.3d 877 (2014).

person to refrain from dealing with the plaintiff and that the plaintiff sustained economic damages (such as lost profits) as a result.

An improper publication may be both a slander of quality and a defamation of character. For instance, a statement that disparages the quality of a product may also, by implication, disparage the character of a person who would sell such a product.

Slander of Title When a publication falsely denies or casts doubt on another’s legal ownership of property, resulting in financial loss to the property’s owner, the tort of slander of title occurs. Usually, this is an intentional occurs. Usually, this is an intentional tort in which someone knowingly publishes an untrue statement about another’s ownership of certain property with the intent of discouraging a third person from deal- ing with the person slandered. For instance, it would be difficult for a car dealer to attract customers after compet- itors published a notice that the dealer’s stock consisted of stolen automobiles.

See Concept Summary 6.2 for a review of intentional torts against property.

6–4 Unintentional Torts—Negligence

The tort of negligence occurs when someone suf- occurs when someone suf- occurs when someone suf fers injury because of another’s failure to live up to a required duty of care. In contrast to intentional torts, in torts involving negligence, the tortfeasor neither wishes to bring about the consequences of the act nor believes that they will occur. The person’s conduct merely creates a risk of such consequences. If no risk is created, there is no negligence.

Moreover, the risk must be foreseeable. In other words, it must be such that a reasonable person engaging in the same activity would anticipate the risk and guard against it. In determining what is reasonable conduct, courts consider the nature of the possible harm.

Many of the actions giving rise to the intentional torts discussed earlier in the chapter constitute negli- gence if the element of intent is missing (or cannot be gence if the element of intent is missing (or cannot be gence if the element of intent is missing (or cannot be proved). ■ EXAMPLE 6.22 Juan walks up to Maya and intentionally shoves her. Maya falls and breaks her arm as a result. In this situation, Juan is liable for the intentional tort of battery. If Juan carelessly bumps into Maya, how- ever, and she falls and breaks her arm as a result, Juan’s action constitutes negligence. In either situation, Juan has committed a tort. ■

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To succeed in a negligence action, the plaintiff must prove each of the following: 1. Duty. The defendant owed a duty of care to the

plaintiff. 2. Breach. The defendant breached that duty. 3. Causation. The defendant’s breach caused the plain-

tiff ’s injury. 4. Damages. The plaintiff suffered a legally recognizable

injury.

6–4a The Duty of Care and Its Breach Central to the tort of negligence is the concept of a duty of care. The basic principle underlying the duty of care is that people are free to act as they please so long as their actions do not infringe on the interests of others. When someone fails to comply with the duty to exercise reasonable care, a potentially tortious act may have been committed.

Failure to live up to a standard of care may be an act (accidentally setting fire to a building) or an omission (neglecting to put out a campfire). It may be a careless act or a carefully performed but nevertheless dangerous act that results in injury. In determining whether the duty of care has been breached, courts consider several factors:

1. The nature of the act (whether it is outrageous or commonplace).

2. The manner in which the act was performed (cau- tiously versus heedlessly).

3. The nature of the injury (whether it is serious or slight).

Creating even a very slight risk of a dangerous explosion might be unreasonable, whereas creating a distinct pos- sibility of someone’s burning his or her fingers on a stove might be reasonable.

The Reasonable Person Standard Tort law mea- sures duty by the reasonable person standard. In deter- mining whether a duty of care has been breached, the courts ask how a reasonable person would have acted in the same circumstances. The reasonable person standard is said to be objective. It is not necessarily how a particu- lar person would act. It is society’s judgment of how an would act. It is society’s judgment of how an would ordinarily prudent person should act. If the so-called reashould act. If the so-called reashould - sonable person existed, he or she would be careful, consci- entious, even tempered, and honest.

The degree of care to be exercised varies, depending on the defendant’s occupation or profession, her or his relationship with the plaintiff, and other factors. Gener- ally, whether an action constitutes a breach of the duty of

Intentional Torts against Property

Concept Summary 6.2

The intentional interference with an owner’s right to use, possess, or enjoy his or her personal property without the owner’s consent.

Trespass to Personal Property

The wrongful possession or use of another person’s personal property without just cause.

Conversion

The invasion of another’s real property without consent or privilege. Once a person is expressly or impliedly established as a trespasser, the property owner has specific rights, which may include the right to detain or remove the trespasser.

Trespass to Land

Any economically injurious falsehood that is made about another’s product or property; an inclusive term for the torts of slander of quality and slander of quality and slander of quality slander of title.

Disparagement of Property

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care is determined on a case-by-case basis. The outcome depends on how the judge (or jury) decides that a reason- able person in the position of the defendant would have acted in the particular circumstances of the case.

Note that the courts frequently use the reasonable person standard in other areas of law as well as in neg- ligence cases. Indeed, the principle that individuals are required to exercise a reasonable standard of care in their activities is a pervasive concept in business law.

The Duty of Landowners Landowners are expected to exercise reasonable care to protect individuals coming onto their property from harm. In some jurisdictions, landowners may even have a duty to protect trespassers against certain risks. Landowners who rent or lease prem- ises to tenants are expected to exercise reasonable care to ensure that the tenants and their guests are not harmed in common areas, such as stairways, entryways, and laundry rooms.

The Duty to Warn Business Invitees of Risks. Retailers and other business operators who explicitly or implicitly invite persons to come onto their premises have a duty to exercise reasonable care to protect these business invitees. �e duty normally requires storeowners to warn business invitees of foreseeable risks, such as construction zones or wet �oors, about which the owners knew or should have known.

■ EXAMPLE 6.23 Liz enters Kwan’s neighborhood Liz enters Kwan’s neighborhood market, slips on a wet floor, and sustains injuries as a result. If there was no sign or other warning that the floor was wet at the time Liz slipped, the owner, Kwan, would be liable for damages. A court would hold that Kwan was negligent because he failed to exercise a reasonable degree of care to protect customers against foreseeable risks about which he knew or should have known. That a patron might slip on the wet floor and be injured was a foreseeable risk, and Kwan should have taken care to avoid this risk or warn the customer of it. ■

A business owner also has a duty to discover and remove any hidden dangers that might injure a customer or other invitee. Hidden dangers might include uneven surfaces or defects in the pavement of a parking lot or a walkway, or merchandise that has fallen off shelves in a store.

Obvious Risks Provide an Exception. Some risks are so obvious that an owner need not warn of them. For instance, a business owner does not need to warn custom- ers to open a door before attempting to walk through it. Other risks, however, even though they may seem obvious

to a business owner, may not be so in the eyes of another, such as a child. In addition, even if a risk is obvious, a business owner is not necessarily excused from the duty to protect customers from foreseeable harm from that risk.

■ CASE IN POINT 6.24 Giorgio’s Grill is a restaurant in Florida that becomes a nightclub after hours. At those times, traditionally, as the manager of Giorgio’s knew, the staff and customers throw paper napkins into the air as the music plays. The napkins land on the floor, but no one picks them up. One night, Jane Izquierdo went to Giorgio’s. Although she had been to the club on prior occasions and knew about the napkin-throwing tradi- tion, she slipped and fell, breaking her leg. She sued Giorgio’s for negligence, but lost at trial because a jury found that the risk of slipping on the napkins was obvi- ous. A state appellate court reversed, however, holding that the obviousness of a risk does not discharge a busi- ness owner’s duty to its invitees to maintain the premises in a safe condition.15 ■

The Duty of Professionals Persons who possess superior knowledge, skill, or training are held to a higher standard of care than others. Professionals—including physicians, dentists, architects, engineers, accountants, and lawyers, among others—are required to have a stan- dard minimum level of special knowledge and ability. In determining what constitutes reasonable care in the case of professionals, the law takes their training and expertise into account. Thus, an accountant’s conduct is judged not by the reasonable person standard, but by the reasonable accountant standard.

If a professional violates his or her duty of care toward a client, the client may bring a suit against the profes- sional, alleging malpractice, which is essentially profes- sional negligence. For instance, a patient might sue a physician for medical malpractice. A client might sue an attorney for legal malpractice.

6–4b Causation Another element necessary to a negligence action is cau- sation. If a person breaches a duty of care and someone suffers injury, the person’s act must have caused the harm for it to constitute the tort of negligence.

Courts Ask Two Questions In deciding whether the requirement of causation is met, the court must address two questions:

15. Izquierdo v. Gyroscope, Inc., 946 So.2d 115 (Fla.App. 2007).

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1. Is there causation in fact? Did the injury occur because Is there causation in fact? Did the injury occur because Is there causation in fact? of the defendant’s act, or would it have occurred any- way? If the injury would not have occurred without the defendant’s act, then there is causation in fact.

Causation in fact usually can be determined by use of the but for test: “but for” the wrongful act, the but for test: “but for” the wrongful act, the but for injury would not have occurred. This test seeks to determine whether there was a cause-and-effect rela- tionship between the act and the injury suffered. In theory, causation in fact is limitless. One could claim, for example, that “but for” the creation of the world, a particular injury would not have occurred. Thus, as a practical matter, the law has to establish limits, and it does so through the concept of proximate cause.

2. Was the act the proximate, or legal, cause of the injury? Proximate cause, or legal cause, exists when the con- nection between an act and an injury is strong enough to justify imposing liability. Proximate cause asks whether the injuries sustained were foreseeable or were too remotely connected to the incident to trigger lia- bility. Judges use proximate cause to limit the scope of the defendant’s liability to a subset of the total number of potential plaintiffs that might have been harmed by the defendant’s actions.

■ EXAMPLE 6.25 Ackerman carelessly leaves a Ackerman carelessly leaves a campfire burning. The fire not only burns down the forest but also sets off an explosion in a nearby chem- ical plant that spills chemicals into a river, killing all the fish for twenty miles downstream and ruining the economy of a tourist resort. Should Ackerman be liable to the resort owners? To the tourists whose vacations were ruined? These are questions of proxi- mate cause that a court must decide. ■

Both of these causation questions must be answered in the affirmative for liability in tort to arise. If there is causation in fact but a court decides that the defendant’s action is not the proximate cause of the plaintiff ’s injury, the causation requirement has not been met. Therefore, the defendant normally will not be liable to the plaintiff.

Foreseeability Questions of proximate cause are linked to the concept of foreseeability because it would be unfair to impose liability on a defendant unless the defen- dant’s actions created a foreseeable risk of injury. Gener- ally, if the victim or the consequences of a harm done were unforeseeable, there is no proximate cause.

Probably the most cited case on the concept of foresee- ability and proximate cause is the Palsgraf case, which estabPalsgraf case, which estabPalsgraf - lished foreseeability as the test for proximate cause. ■ CASE IN POINT 6.26 Helen Palsgraf was waiting for a train on a station platform. A man carrying a package was rushing to catch a train that was moving away from a platform across

the tracks from Palsgraf. As the man attempted to jump aboard the moving train, he seemed unsteady and about to fall. A railroad guard on the car reached forward to grab him, and another guard on the platform pushed him from behind to help him board the train.

In the process, the man’s package, which (unknown to the railroad guards) contained fireworks, fell on the railroad tracks and exploded. There was nothing about the package to indicate its contents. The repercussions of the explosion caused weighing scales at the other end of the train platform to fall on Palsgraf, causing injuries for which she sued the railroad company. At the trial, the jury found that the railroad guards had been negligent in their conduct. The railroad company appealed. New York’s highest state court held that the railroad company was not liable to Palsgraf. The railroad had not been negligent toward her, because injury to her was not foreseeable.16 ■

6–4c The Injury Requirement and Damages For tort liability to arise, the plaintiff must have suf-For tort liability to arise, the plaintiff must have suf-For tort liability to arise, the plaintiff must have suf fered a legally recognizable injury. To recover damages, the legally recognizable injury. To recover damages, the legally recognizable plaintiff must have suffered some loss, harm, wrong, or invasion of a protected interest. Essentially, the purpose of tort law is to compensate for legally recognized harms and injuries resulting from wrongful acts. If no harm or injury results from a given negligent action, there is noth- ing to compensate, and no tort exists.

For instance, if you carelessly bump into a passerby, who stumbles and falls as a result, you may be liable in tort if the passerby is injured in the fall. If the person is unharmed, however, there normally can be no lawsuit for damages, because no injury was suffered.

Compensatory damages are the norm in negligence cases. A court will award punitive damages only if the defendant’s conduct was grossly negligent, reflecting an intentional failure to perform a duty with reckless disre- gard of the consequences to others.

6–4d Good Samaritan Statutes Most states now have what are called Good Samaritan statutes.17 Under these statutes, someone who is aided voluntarily by another cannot turn around and sue the “Good Samaritan” for negligence. These laws were passed largely to protect physicians and medical personnel who

16. Palsgraf v. Long Island Railroad Co., 248 N.Y. 339, 162 N.E. 99 (1928). 17. These laws derive their name from the Good Samaritan story in the

Bible. In the story, a traveler who had been robbed and beaten lay along the roadside, ignored by those passing by. Eventually, a man from the region of Samaria (the “Good Samaritan”) stopped to render assistance to the injured person.

C H A P T E R 6 Tort Law 129

volunteer their services in emergency situations to those in need, such as individuals hurt in car accidents.

6–4e Dram Shop Acts Many states have also passed dram shop acts,18 under which a bar’s owner or bartender may be held liable for injuries caused by a person who became intoxicated while drinking at the bar. The owner or bartender may also be held responsible for continuing to serve a person who was already intoxicated.

Some states’ statutes also impose liability on social hosts (persons hosting parties) for injuries caused by guests who became intoxicated at the hosts’ homes. Under these stat- utes, it is unnecessary to prove that the bar owner, bar- tender, or social host was negligent. ■ EXAMPLE 6.27 Jane hosts a Super Bowl party at which Brett, a minor, sneaks alcoholic drinks. Jane is potentially liable for damages resulting from Brett’s drunk driving after the party. ■

6–5 Defenses to Negligence Defendants often defend against negligence claims by asserting that the plaintiffs have failed to prove

18. Historically, a dram was a small unit of liquid, and distilled spirits (strong alcoholic liquor) were sold in drams. Thus, a dram shop was a place where liquor was sold in drams.

the existence of one or more of the required elements for negligence. Additionally, there are three basic affirmative defenses in negligence cases (defenses that a defendant can use to avoid liability even if the facts are as the plaintiff states): assumption of risk, superseding cause, and contributory and comparative negligence.

6–5a Assumption of Risk A plaintiff who voluntarily enters into a risky situation, knowing the risk involved, will not be allowed to recover. This is the defense of assumption of risk, which requires two elements: 1. Knowledge of the risk. 2. Voluntary assumption of the risk. The defense of assumption of risk is frequently asserted when the plaintiff was injured during a recreational activ- ity that involves known risk, such as skiing or skydiving. (Courts do not apply the assumption of risk doctrine in emergency situations.)

Assumption of risk can apply not only to participants in sporting events, but also to spectators and bystanders who are injured while attending those events. In the fol- lowing Spotlight Case, the issue was whether a spectator at a baseball game voluntarily assumed the risk of being hit by an errant ball thrown while the players were warming up before the game.

Background and Facts Delinda Taylor went to a Seattle Mariners baseball game at Safeco Field with her boyfriend and her two minor sons. Their seats were four rows up from the field along the right field foul line. They arrived more than an hour before the game so that they could see the play- ers warm up and get their autographs. When she walked in, Taylor saw that a Mariners pitcher, Freddy Garcia, was throwing a ball back and forth with José Mesa right in front of their seats.

As Taylor stood in front of her seat, she looked away from the field, and a ball thrown by Mesa got past Garcia and struck her in the face, causing serious injuries. Taylor sued the Mariners for the alleg- edly negligent warm-up throw. The Mariners filed a motion for summary judgment in which they argued that Taylor, a longtime Mariners fan, was familiar with baseball and the inherent risk of balls entering the stands. Thus, the motion asserted, Taylor had assumed the risk of her injury. The trial court granted the motion and dismissed Taylor’s case. Taylor appealed.

In the Language of the Court DWYER, J. [Judge]

* * * * * * * For many decades, courts have required baseball stadiums to screen some seats—generally those

behind home plate—to provide protection to spectators who choose it.

Spotlight on the Seattle Mariners

Case 6.3 Taylor v. Baseball Club of Case 6.3 Taylor v. Baseball Club of Seattle, Leattle, LP Court of Appeals of Washington, 132 Wash.App. 32, 130 P.3d 835 (2006).Court of Appeals of Washington, 132 Wash.App. 32, 130 P.3d 835 (2006).

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A sport spectator’s assumption of risk and a defendant sports team’s duty of care are accordingly dis- cerned under the doctrine of primary assumption of risk. * * * “Implied primary assumption of risk arises primary assumption of risk arises primary where a plaintiff has impliedly consented (often in advance of any negligence by defendant) to relieve defendant of a duty to plaintiff regarding specific known and appreciated risks.”

* * * * Under this implied primary assumption of risk, defendant must show that plaintiff had full subjective

understanding of the specific risk, both its nature and presence, and that he or she voluntarily chose to encounter the risk.

* * * It is undisputed that the warm-up is part of the sport, that spectators such as Taylor purposely attend that portion of the event, and that the Mariners permit ticket-holders to view the warm-up.

* * * We find the fact that Taylor was injured during warm-up is not legally significant because that portion of the event is necessarily incident to the game.

* * * * Here, there is no evidence that the circumstances leading to Taylor’s injury constituted an unusual

danger. It is undisputed that it is the normal, every-day practice at all levels of baseball for pitchers to warm up in the manner that led to this incident. The risk of injuries such as Taylor’s are within the normal comprehension of a spectator who is familiar with the game. Indeed, the possibility of an errant ball enter- ing the stands is part of the game’s attraction for many spectators. [Emphasis added.]

* * * The record contains substantial evidence regarding Taylor’s familiarity with the game. She attended many of her sons’ baseball games, she witnessed balls entering the stands, she had watched Mariners’ games both at the Kingdome and on television, and she knew that there was no screen protect- ing her seats, which were close to the field. In fact, as she walked to her seat she saw the players warming up and was excited about being in an unscreened area where her party might get autographs from the players and catch balls.

Decision and Remedy The state intermediate appellate court affirmed the lower court’s judgment. As a spectator who chose to sit in an unprotected area of seats, Taylor voluntarily undertook the risk associated with being hit by an errant baseball thrown during the warm-up before the game.

Critical Thinking • What If the Facts Were Different? Would the result in this case have been different if it had been

Taylor’s minor son, rather than Taylor herself, who had been struck by the ball? Should courts apply the doctrine of assumption of risk to children? Discuss.

• Legal Environment What is the basis underlying the defense of assumption of risk? How does that basis support the court’s decision in this case?

6–5b Superseding Cause An unforeseeable intervening event may break the causal connection between a wrongful act and an injury to another. If so, the intervening event acts as a supersed- ing cause—that is, it relieves the defendant of liability for injuries caused by the intervening event.for injuries caused by the intervening event.for injuries caused by the intervening event.

■ EXAMPLE 6.28 While riding his bicycle, Derrick negligently runs into Julie, who is walking on the side- walk. As a result of the impact, Julie falls and fractures her hip. While she is waiting for help to arrive, a small aircraft crashes nearby and explodes, and some of the fiery debris hits her, causing her to sustain severe burns. Derrick will be liable for the damages related to Julie’s fractured hip, because the risk of injuring her with his

bicycle was foreseeable. Normally, though, Derrick will not be liable for the burns caused by the plane crash, because he could not have foreseen the risk that a plane would crash nearby and injure Julie. ■

6–5c Contributory Negligence All individuals are expected to exercise a reasonable degree of care in looking out for themselves. In the past, under the common law doctrine of contributory negliunder the common law doctrine of contributory negliunder the common law doctrine of - gence, a plaintiff who was also negligent (who failed to exercise a reasonable degree of care) could not recover anything from the defendant. Under this rule, no matter how insignificant the plaintiff ’s negligence was relative

Case 6.3 Continued

C H A P T E R 6 Tort Law 131

to the defendant’s negligence, the plaintiff would be pre- cluded from recovering any damages. Today, only a few jurisdictions still follow this doctrine.

6–5d Comparative Negligence In most states, the doctrine of contributory negligence has been replaced by a comparative negligence stan- dard. Under this standard, both the plaintiff ’s and the defendant’s negligence are computed, and the liability for damages is distributed accordingly.

Some jurisdictions have adopted a “pure” form of com- parative negligence that allows the plaintiff to recover,

even if the extent of his or her fault is greater than that of the defendant. Under pure comparative negligence, if the plaintiff was 80 percent at fault and the defendant 20 percent at fault, the plaintiff can recover 20 percent of his or her damages.

Many states’ comparative negligence statutes, how- ever, contain a “50 percent” rule that prevents the plaintiff from recovering any damages if she or he was more than 50 percent at fault. Under this rule, a plaintiff who was 35 percent at fault can recover 65 percent of his or her damages, but a plaintiff who was 65 percent (more than 50 percent) at fault can recover nothing.

Debate This . . . Each time a state legislature enacts a law that applies the assumption of risk doctrine to a particular sport, participants in that sport suffer.

Reviewing: Tort Law

Elaine Sweeney went to Ragged Mountain Ski Resort in New Hampshire with a friend. Elaine went snow tubing down a run designed exclusively for snow tubers. There were no Ragged Mountain employees present in the snow-tube area to instruct Elaine on the proper use of a snow tube. On her fourth run down the trail, Elaine crossed over the center line between snow-tube lanes, collided with another snow tuber, and was injured. Elaine filed a negligence action against Ragged Mountain seeking compensation for the injuries that she sustained. Two years earlier, the New Hampshire state legislature had enacted a statute that prohibited a person who participates in the sport of skiing from suing a ski-area operator for injuries caused by the risks inherent in skiing. Using the information presented in the chapter, answer the following questions. 1. What defense will Ragged Mountain probably assert? 2. The central question in this case is whether the state statute establishing that skiers assume the risks inherent in the

sport bars Elaine’s suit. What would your decision be on this issue? Why? 3. Suppose that the court concludes that the statute applies only to skiing and not to snow tubing. Will Elaine’s law-

suit be successful? Explain. 4. Now suppose that the jury concludes that Elaine was partly at fault for the accident. Under what theory might her

damages be reduced in proportion to the degree to which her actions contributed to the accident and her resulting injuries?

Terms and Concepts actionable 114 actual malice 118 assault 113 assumption of risk 129 battery 114 business invitee 127 causation in fact 128 comparative negligence 131 compensatory damages 112

contributory negligence 130 conversion 124 damages 112 defamation 115 disparagement of property 125 dram shop act 129 duty of care 126 fraudulent misrepresentation

(fraud) 120

general damages 112 Good Samaritan statute 128 intentional tort 113 libel 115 licensee 124 malpractice 127 negligence 125 privilege 117 proximate cause 128

132 U N I T T W O The Public and International Environment

public �gure 118 pu�ery 120 punitive damages 113 reasonable person standard 126 slander 115

slander of quality 125 slander of title 125 special damages 112 superseding cause 130 tort 112

tortfeasor 113 trade libel 125 transferred intent 113 trespass to land 123 trespass to personal property 124

Issue Spotters 1. Jana leaves her truck’s motor running while she enters a

Kwik-Pik Store. The truck’s transmission engages, and the vehicle crashes into a gas pump, starting a fire that spreads to a warehouse on the next block. The warehouse collapses, causing its billboard to fall and injure Lou, a bystander. Can Lou recover from Jana? Why or why not? (See Unintentional Torts—Negligence.)

2. A water pipe bursts, flooding a Metal Fabrication Com- pany utility room and tripping the circuit breakers on a panel in the room. Metal Fabrication contacts Nouri, a

licensed electrician with five years’ experience, to check the damage and turn the breakers back on. Without test- ing for short circuits, which Nouri knows that he should do, he tries to switch on a breaker. He is electrocuted, and his wife sues Metal Fabrication for damages, alleg- ing negligence. What might the firm successfully claim in defense? (See Defenses to Negligence.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 6–1. Defamation. Richard is an employee of the Dun Construction Corp. While delivering materials to a construc- tion site, he carelessly backs Dun’s truck into a passenger vehicle driven by Green. This is Richard’s second accident in six months. When the company owner, Dun, learns of this latest accident, a heated discussion ensues, and Dun fires Richard. Dun is so angry that he immediately writes a let- ter to the union of which Richard is a member and to all other construction companies in the community, stating that Richard is the “worst driver in the city” and that “anyone who hires him is asking for legal liability.” Richard files a suit against Dun, alleging libel on the basis of the statements

made in the letters. Discuss the results. (See Intentional Torts against Persons.) 6–2. Liability to Business Invitees. Kim went to Ling’s Market to pick up a few items for dinner. It was a stormy day, and the wind had blown water through the market’s door each time it opened. As Kim entered through the door, she slipped and fell in the rainwater that had accumulated on the floor. The manager knew of the weather conditions but had not posted any sign to warn customers of the water hazard. Kim injured her back as a result of the fall and sued Ling’s for damages. Can Ling’s be held liable for negligence? Discuss. (See Unintentional Torts—Negligence.)

Business Case Problems 6–3. Spotlight on Intentional Torts—Defamation.

Sharon Yeagle was an assistant to the vice presi- dent of student a�airs at Virginia Polytechnic Institute and State University (Virginia Tech). As part of her duties, Yeagle helped students partici-

pate in the Governor’s Fellows Program. �e Collegiate Times, Virginia Tech’s student newspaper, published an article about the university’s success in placing students in the program. �e article’s text surrounded a block quotation attributed to Yeagle with the phrase “Director of Butt Licking” under her name. Yeagle sued the Collegiate Times for defamation. She argued that the phrase implied the commission of sodomy and was therefore actionable. What is Collegiate Times defense Collegiate Times defense Collegiate Times to this claim? [Yeagle v. Collegiate Times, 497 S.E.2d 136 (Va. 1998)] (See Intentional Torts against Persons.)

6–4. Intentional Infliction of Emotional Distress. While living in her home country of Tanzania, Sophia Kiwa- nuka signed an employment contract with Anne Margareth Bakilana, a Tanzanian living in Washington, D.C. Kiwanuka traveled to the United States to work as a babysitter and maid in Bakilana’s house. When Kiwanuka arrived, Bakilana con- �scated her passport, held her in isolation, and forced her to work long hours under threat of having her deported. Kiwa- nuka worked seven days a week without breaks and was sub- jected to regular verbal and psychological abuse by Bakilana. Kiwanuka �led a complaint against Bakilana for intentional in�iction of emotional distress, among other claims. Bakilana argued that Kiwanuka’s complaint should be dismissed because the allegations were insu�cient to show outrageous intentional conduct that resulted in severe emotional distress. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 6 Tort Law 133

If you were the judge, in whose favor would you rule? Why? [Kiwanuka v. Bakilana, 844 F.Supp.2d 107 (D.D.C. 2012)] (See Intentional Torts against Persons.) 6–5. Business Case Problem with Sample Answer— Negligence. At the Weatherford Hotel in Flagsta�, Arizona,

in Room 59, a balcony extends across thirty inches of the room’s only window, leaving a twelve-inch gap with a three-story drop to the concrete below. A sign prohibits smoking in the room but invites

guests to “step out onto the balcony” to smoke. Toni Lucario was a guest in Room 59 when she climbed out of the window and fell to her death. Patrick McMurtry, her estate’s personal representative, �led a suit against the Weatherford. Did the hotel breach a duty of care to Locario? What might the Weath- erford assert in its defense? Explain. [McMurtry v. Weatherford erford assert in its defense? Explain. [McMurtry v. Weatherford erford assert in its defense? Explain. [ Hotel, Inc., 231 Ariz. 244, 293 P.3d 520 (2013)] (See Uninten- tional Torts—Negligence.) • For a sample answer to Problem 6–5, go to Appendix E at

the end of this text.

6–6. Negligence. Ronald Rawls and Zabian Bailey were in an auto accident in Bridgeport, Connecticut. Bailey rear-ended Rawls at a stoplight. Evidence showed it was more likely than not that Bailey failed to apply his brakes in time to avoid the collision, failed to turn his vehicle to avoid the collision, failed to keep his vehicle under control, and was inattentive to his surroundings. Rawls �led a suit in a Connecticut state court against his insurance company, Progressive Northern Insur- ance Co., to obtain bene�ts under an underinsured motorist clause, alleging that Bailey had been negligent. Could Rawls collect? Discuss. [Rawls v. Progressive Northern Insurance Co., 310 Conn. 768, 83 A.3d 576 (2014)] (See Unintentional Torts—Torts—Torts Negligence.—Negligence.— ) 6–7. Negligence. Charles Robison, an employee of West Star Transportation, Inc., was ordered to cover an unevenly loaded �atbed trailer with a 150-pound tarpaulin (a water- proof cloth). �e load included uncrated equipment and pallet crates of di�erent heights, about thirteen feet o� the ground at its highest point. While standing on the load, manipulating the tarpaulin without safety equipment or assis- tance, Robison fell and sustained a traumatic head injury. He

�led a suit against West Star to recover for his injury. Was West Star “negligent in failing to provide a reasonably safe place to work,” as Robison claimed? Explain. [West Star Transportation, Inc. v. Robison, 457 S.W.3d 178 (Tex.App.—Amarillo 2015)] (See Unintentional Torts—Negligence.) 6–8. Negligence. DSC Industrial Supply and Road Rider Supply are located in North Kitsap Business Park in Seattle, Washington. Both �rms are owned by Paul and Suzanne Marshall. �e Marshalls had outstanding commercial loans from Frontier Bank. �e bank dispatched one of its employ- ees, Suzette Gould, to North Kitsap to “spread Christmas cheer” to the Marshalls as an expression of appreciation for their business. Approaching the entry to Road Rider, Gould tripped over a concrete “wheel stop” and fell, su�ering a bro- ken arm and a dislocated elbow. �e stop was not clearly vis- ible, it had not been painted a contrasting color, and it was not marked with a sign. Gould had not been aware of the stop before she tripped over it. Is North Kitsap liable to Gould for negligence? Explain. [Gould v. North Kitsap Business Park Management, LLC, 2016 WL 236455 (2016)] (See Uninten- tional Torts—tional Torts—tional Torts Negligence.) 6–9. A Question of Ethics—Wrongful Interference.

White Plains Coat & Apron Co. is a New York– based linen rental business. Cintas Corp. is a com- petitor. White Plains had �ve-year exclusive contracts with some of its customers. As a result of Cintas’s

soliciting of business, dozens of White Plains’ customers breached their contracts and entered into rental agreements with Cintas. White Plains �led a suit against Cintas, alleging wrongful inter- ference. [ White Plains Coat & Apron Co. v. Cintas Corp., 8 N.Y.3d 422, 867 N.E.2d 381 (2007)] (See N.Y.3d 422, 867 N.E.2d 381 (2007)] (See N.Y.3d 422, 867 N.E.2d 381 (2007)] Intentional Torts against Persons.) (a) What are the two important policy interests at odds in

wrongful interference cases? Which of these interests should be accorded priority?

(b) The U.S. Court of Appeals for the Second Circuit asked the New York Court of Appeals to answer a question: Is a general interest in soliciting business for profit a sufficient defense to a claim of wrongful interference with a contrac- tual relationship? What do you think? Why?

Legal Reasoning Group Activity

6–10. Negligence. Donald and Gloria Bowden hosted a cookout at their home in South Carolina, inviting mostly business acquaintances. Justin Parks, who was nineteen years old, attended the party. Alcoholic beverages were available to all of the guests, even those who, like Parks, were between the ages of eighteen and twenty-one. Parks consumed alcohol at the party and left with other guests. One of these guests detained Parks at the guest’s home to give Parks time to “sober up.” Parks then drove himself from this guest’s home and was killed in a one-car accident. At the time of death, he had a blood alcohol content of 0.291 percent, which exceeded the state’s limit for driving a motor vehicle. Linda Marcum, Parks’s

mother, �led a suit in a South Carolina state court against the Bowdens and others, alleging that they were negligent. (See Unintentional Torts—Negligence.) (a) The first group will present arguments in favor of holding

the social hosts liable in this situation. (b) The second group will formulate arguments against

holding the social hosts liable based on principles in this chapter.

(c) The third group will determine the reasons why some courts do not treat social hosts the same as parents who serve alcoholic beverages to their underage children.Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

134

C H A P T E R 7

British courts liberally applied the doctrine that emerged from the case. Initially, though, few U.S. courts accepted the doctrine, presumably because the courts were worried about its effect on the expansion of Ameri- can business. Today, however, the doctrine of strict liabil- ity is the norm rather than the exception.

7–1a Abnormally Dangerous Activities Strict liability for damages proximately caused by an abnormally dangerous, or ultrahazardous, activity is one application of strict liability. Courts apply the doctrine of strict liability in these situations because of the extreme risk of the activity. Abnormally dangerous activities are those that involve a high risk of serious harm to persons or property that cannot be completely guarded against by the exercise of reasonable care.

Activities such as blasting or storing explosives qualify as abnormally dangerous, for instance. Even if blasting with dynamite is performed with all reasonable care, there is still a risk of injury. Considering the potential for harm, it seems reasonable to ask the person engaged

7–1 Strict Liability The modern concept of strict liability traces its origins, The modern concept of strict liability traces its origins, The modern concept of strict liability traces its origins, in part, to an English case decided in 1868. in part, to an English case decided in 1868. ■ CASE CASE IN POINT 7.1 In the coal-mining area of Lancashire, In the coal-mining area of Lancashire, England, the Rylands, who were mill owners, had con- structed a reservoir on their land. Water from the reser- voir broke through a filled-in shaft of an abandoned coal mine nearby and flooded the connecting passageways in an active coal mine owned by Fletcher.

Fletcher sued the Rylands, and the court held that the defendants (the Rylands) were liable, even though the circumstances did not fit within existing tort liability theories. The court held that a “person who for his own purposes brings on his land and collects and keeps there anything likely to do mischief if it escapes . . . is prima facie 2 answerable for all the damage which is the natural consequence of its escape.”3 ■

2. Prima facie is Latin for “at first sight.” Legally, it refers to a fact that is Prima facie is Latin for “at first sight.” Legally, it refers to a fact that is Prima facie presumed to be true unless contradicted by evidence.

3. Rylands v. Fletcher, 3 L.R.–E & I App. [Law Reports, English & Irish Appeal Cases] (H.L. [House of Lords] 1868).

I n this chapter, we look at a category of tort called strict liability, or liabil-liabil-liabil ity without fault. Under the doctrine

of strict liability, a person who engages in certain activities can be held respon- sible for any harm that results to oth- ers, even if the person used the utmost care.

We then look at an area of tort law of particular importance to busi- nesspersons—product liability. The manufacturers and sellers of products may incur product liability when product defects cause injury or prop- erty damage to consumers, users, or bystanders.

Although multimillion-dollar prod- uct liability claims often involve big automakers, pharmaceutical com- panies, or tobacco companies, many businesses face potential liability. For instance, a number of product liability lawsuits have been filed claiming that energy drinks like Monster, Red Bull, and Rockstar have serious adverse effects—especially on young people. A man who swallowed a bone frag- ment while eating sued McDonald’s in 2015 for allegedly defective chicken McNuggets.

Product liability lawsuits also reach across international borders. Takata

Corporation, a global company that supplies seat belts, airbags, and other automobile safety systems, is being sued by hundreds of plaintiffs in the United States. Takata manufactured allegedly defective airbags, which violently exploded and ejected metal debris, resulting in injuries and deaths.1

Takata has already paid a $70 million penalty to the National Highway Safety Administration for failing to promptly disclose defects in its airbags, millions of which have now been recalled.

1. In re Takata Airbag Products Liability Litiga- tion, 84 F.Supp.3d 1371 (2015).

Strict Liability and Product Liability

C H A P T E R 7 Strict Liability and Product Liability 135

in the activity to pay for injuries caused by that activ- ity. Although there is no fault, there is still responsibility because of the dangerous nature of the undertaking.

Similarly, persons who keep wild animals are strictly liable for any harm inflicted by the animals. The basis for applying strict liability is that wild animals, should they escape from confinement, pose a serious risk of harm to people in the vicinity. Even an owner of domes- tic animals (such as dogs or horses) may be strictly liable for harm caused by those animals if the owner knew, or should have known, that the animals were dangerous or had a propensity to harm others.

7–1b Application of Strict Liability to Product Liability

A significant application of strict liability is in the area of product liability—liability of manufacturers and sellers for harmful or defective products. Liability here is a mat- ter of social policy and is based on two factors: 1. The manufacturer can better bear the cost of injury

because it can spread the cost throughout society by increasing the prices of its goods.

2. The manufacturer is making a profit from its activi- ties and therefore should bear the cost of injury as an operating expense.

We discuss product liability in detail next. Strict liability is also applied in certain types of bailments (a bailment bailments (a bailment bailments exists when goods are transferred temporarily into the care of another).

7–2 Product Liability Those who make, sell, or lease goods can be held liable for physical harm or property damage caused by those goods to a consumer, user, or bystander. This is called product liability. Product liability may be based on the theories of negligence, misrepresentation, strict liability, and war- ranties. Multiple theories of liability can be, and often are, asserted in the same case. We look here at product liability based on negligence and on misrepresentation.

7–2a Based on Negligence Negligence is the failure to exercise the degree of care that Negligence is the failure to exercise the degree of care that Negligence a reasonable, prudent person would have exercised under the circumstances. If a manufacturer fails to exercise “due care” to make a product safe, a person who is injured by the product may sue the manufacturer for negligence.

Due Care Must Be Exercised Manufacturers must use due care in all of the following areas: 1. Designing the product. 2. Selecting the materials. 3. Using the appropriate production process. 4. Assembling and testing the product. 5. Placing adequate warnings on the label to inform the

user of dangers of which an ordinary person might not be aware.

6. Inspecting and testing any purchased components used in the product.

Privity of Contract Not Required A product liabil- ity action based on negligence does not require privity of contract between the injured plaintiff and the defendant-contract between the injured plaintiff and the defendant-contract manufacturer. Privity of contract refers to the relationPrivity of contract refers to the relationPrivity of contract - ship that exists between the parties to a contract. Privity is the reason that normally only the parties to a contract can enforce that contract.

In the context of product liability law, though, privity is not required. A person who is injured by a defective product may bring a negligence suit even though he or she was not the one who actually purchased the prod- uct—and thus is not in privity. A manufacturer, seller, or lessor is liable for failure to exercise due care to any person who sustains an injury proximately caused by a negligently made (defective) product.

A 1916 landmark decision established this exception to the privity requirement. ■ CASE IN POINT 7.2 Don- ald MacPherson suffered injuries while riding in a Buick automobile that suddenly collapsed because one of the wheels was made of defective wood. The spokes crumbled into fragments, throwing MacPherson out of the vehicle and injuring him.

MacPherson had purchased the car from a Buick dealer, but he brought a lawsuit against the manufac- turer, Buick Motor Company, alleging negligence. Buick itself had not made the wheel but had bought it from another manufacturer. There was evidence, though, that the defects could have been discovered by a reasonable inspection by Buick and that no such inspection had taken place. The primary issue was whether Buick owed a duty of care to anyone except the immediate purchaser of the car—that is, the Buick dealer. Although Buick itself had not manufactured the wheel, New York’s high- est state court held that Buick had a duty to inspect the wheels and that Buick “was responsible for the finished product.” Therefore, Buick was liable to MacPherson for the injuries he sustained. 4 ■

4. MacPherson v. Buick Motor Co., 217 N.Y. 382, 111 N.E. 1050 (1916). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

136 U N I T T W O The Public and International Environment

“Cause in Fact” and Proximate Cause In a product liability suit based on negligence, as in any action alleging that the defendant was negligent, the plaintiff must show that the defendant’s conduct was the “cause in fact” of an injury. “Cause in fact” requires showing that “but for” the defendant’s action, the injury would not have occurred.

It must also be determined that the defendant’s act was the proximate cause of the injury. This determination proximate cause of the injury. This determination proximate cause focuses on the foreseeability of the consequences of the act and whether the defendant should be held legally respon- sible. For proximate cause to become a relevant issue, how- ever, a plaintiff first must establish cause in fact. The cause of a serious accident was at issue in the following case.

In the Language of the Court PER CURIAM. [By the Whole Court]

* * * * * * * Karen Schwarck * * * was oper-

ating an Arctic Cat [660 snowmobile] near Mackinac Island’s Grand Hotel [in Michigan] with her sister, Edith Bonno, as passenger. The sisters met their demise when the Arctic Cat went, in reverse, backward through a wooden fence and over the West Bluff of the Island.

[Donald Schwarck and Joshua Bonno] the spouses of decedents, as their personal representatives, filed this action [in a Michigan state court] against defendant Arctic Cat [the manufacturer of the 660]. Plaintiffs alleged that the Arctic Cat 660 was negligently designed * * * without a backup alarm that oper- ated throughout all the reverse travel positions and as a result proximately caused decedents’ injuries.

Defendant filed a motion for sum- mary [judgment]. Defendant denied the existence of a “silent reverse zone,” but argued that even if such a zone existed, it was not a cause of the accident because the alarm was intended as a warning to bystanders and not as an indicator of shift position for operators.

* * * * * * * The court issued its decision and

order in favor of defendant. [The plain- tiffs appealed.]

* * * * There is no dispute that on the day

of the accident decedent Schwarck was driving the Arctic Cat 660 * * * and that she attempted to execute a three-point

or K-turn * * * . To make the turn dece- dent Schwarck had to turn left to face north, stop, reverse south, stop, and then complete the turn to drive east. * * * Plaintiffs argue that after decedent Schwarck reversed, she stopped a second time and shifted forward, and not hear- ing the reverse alarm, believed she was in forward, and accelerated. As a result, the craft went in reverse through the fence and off the bluff.

The trial court determined that there were no material questions of fact on * * * the operability of the reverse alarm. * * * It was undisputed that an inspec- tion of the Arctic Cat post-accident showed the reverse alarm to be operable.

* * * * * * * [But] the court’s conclusion

that the reverse alarm was working at the time of the accident does not deter- mine whether its operational process constituted a product defect. Plaintiffs’ claim was that the reverse alarm was defective because it did not sound dur- ing the entire time the vehicle was in reverse. Plaintiffs’ causation theory was that the Arctic Cat’s reverse alarm caused decedent Schwarck to be confused about whether she was in forward or reverse gear and that the confusion led to the accident that caused decedents’ deaths.

[Plaintiffs’ expert John Frackelton, an accident reconstructionist and snow- mobile mechanic,] observed that the shift lever traveled from full reverse to full forward in a distance of four inches. Frackelton’s testing revealed that when the lever was shifted all the way down

and pressed against the reverse buffer switch, the switch sounded a chime and the snowmobile was in full reverse mode. Frackelton experimented with the lever, shifting it up toward forward gear, an inch at a time. For the next two inches of shift travel forward, the reverse alarm did not sound, but the snowmobile was still in reverse. Frackelton observed that it was only in the last or fourth inch of shift travel that the snowmobile was in full forward.

* * * Frackelton observed that the transition from full reverse to full for- ward was smooth and accomplished with little pressure. He opined that an opera- tor could “become accustomed to the highly repeatable return performance.” On two occasions, however, Frackelton pushed the gearshift forward and the Arctic Cat did not return to forward gear as expected.

* * * Frackleton’s opinion * * * cre- ates a material question of fact as to whether the alarm failed to sound at all times when the gear was in reverse. Defendant argues that the alarm served its intended purpose which is to notify bystanders and not operators that the snowmobile is in reverse and that it was unreasonable for decedent Schwarck to rely on the alarm to determine the gear of the snowmobile. The fact that the manufacturer’s intended purpose for the alarm was to warn third-parties is not dispositive of the issue of whether decedent Schwarck relied on the alarm to

Case Analysis 7.1 Schwarck v. Arctic Cat, Inc. Court of Appeals of Michigan, 2016 WL 191992 (2016).

C H A P T E R 7 Strict Liability and Product Liability 137

determine her gear or whether that reli- ance was reasonable or a foreseeable misuse of the alarm and snowmobile. Decedent Schwarck is assumed to have acted with due care for her own safety. Her widower averred that, based upon his observations, decedent Schwarck had a practice and routine of relying upon the sounding of the alarm as a signal that she was in reverse. Evidence from Frackelton’s test runs also demonstrate that despite manual control of the shift lever, the lever could stop just short of the forward position and prevent the snowmobile from going into drive. [Emphasis added.]

Reasonable minds could differ as to whether a reverse alarm that does not sound throughout the reverse trajectory or only operates in a partial manner is defective.

* * * * Legal cause becomes a relevant issue

after cause in fact has been established. * * * To establish legal cause, the plaintiff

must show that it was foreseeable that the defendant’s conduct may create a risk of harm to the victim, and * * * that the result of that conduct and intervening causes were foreseeable. * * * It is foresee- able that an operator of the Arctic Cat may rely on the sound of the reverse alarm to indicate when the snowmobile is no longer in reverse and experience unexpected travel backward because the alarm does not sound during the entire reverse gear. It is further foreseeable that unanticipated reverse travel may cause a risk of harm to the operator. * * * Frack- elton’s tests regarding speed velocity without aggressive throttle demonstrate how the Arctic Cat can travel almost thirty feet in just 5.4 seconds. Not only can an operator of the Arctic Cat find him or herself unexpectedly travelling in reverse, but also doing so quickly. Plaintiffs’ other expert [Lila Laux, a psychologist and engineer] testified * * * that time is * * * required for the opera- tor to determine how to respond to the

unexpected stimuli, to engage the brake, and for the brake to activate. [Emphasis added.]

A jury could infer that traveling backward when one thought he or she would go forward is an unexpected stimulus. It is also a reasonable inference, from the opinions of both plaintiffs’ experts, that it was foreseeable that the operator would be surprised by the rear- ward motion. Given the evidence, rea- sonable minds may differ as to whether decedent Schwarck did not or could not correct the snowmobile’s rearward direc- tion in the time allotted.

Based on the whole record, there is evidence that warrants submission of this case to a jury to determine whether the reverse alarm was defective and whether that defect caused decedent Schwarck and Bonno’s deaths.

* * * * [The trial court’s judgment is]

vacated and remanded for proceedings consistent with this opinion.

Case 7.1 Continued

Legal Reasoning Questions

1. According to the plaintiffs, what was the product defect at the center of this case? According to the defendant, why was this not a defect?

2. How did the plaintiffs use evidence to support their claim? 3. Why did the court conclude that this case should be submitted to a jury? Explain.

7–2b Misrepresentation When a user or consumer is injured as a result of a man- ufacturer’s or seller’s fraudulent misrepresentation, the basis of liability may be the tort of fraud. In this situation, the misrepresentation must have been made knowingly or with reckless disregard for the facts. The intentional mislabeling of packaged cosmetics, for instance, or the intentional concealment of a product’s defects would constitute fraudulent misrepresentation.

In addition, the misrepresentation must be of a mate- rial fact, and the seller must have intended to induce the buyer’s reliance on the misrepresentation. Misrepresenta- tion on a label or advertisement is enough to show an intent to induce the reliance of anyone who may use the

product. In addition, the buyer must have relied on the misrepresentation.

7–3 Strict Product Liability As mentioned earlier, under the doctrine of strict liability, people may be liable for the results of their acts regardless of their intentions or their exercise of reasonable care. In addition, liability does not depend on privity of con- tract. Thus, the injured party does not have to be the buyer, as required under contract warranty theories. In the 1960s, courts applied the doctrine of strict liability in several landmark cases involving manufactured goods,

138 U N I T T W O The Public and International Environment

and it has since become a common method of holding manufacturers liable.

7–3a Strict Product Liability and Public Policy

The law imposes strict product liability as a matter of public policy. This public policy rests on a threefold assumption: 1. Consumers should be protected against unsafe

products. 2. Manufacturers and distributors should not escape

liability for faulty products simply because they are not in privity of contract with the ultimate user of those products.

3. Manufacturers and distributors can better bear the costs associated with injuries caused by their prod- ucts, because they can ultimately pass the costs on to all consumers in the form of higher prices.

Development of the Doctrine California was the first state to impose strict product liability in tort on manufacturers. ■ CASE IN POINT 7.3 William Greenman

was injured when his Shopsmith combination power tool threw off a piece of wood that struck him in the head. He sued the manufacturer, claiming that he had followed the product’s instructions and the product must be defective. In a landmark decision, Greenman v. Yuba Power Products, Inc.,5 the California Supreme Court set out the reason for applying tort law rather than contract law (including laws governing warranties) in cases involving consumers who were injured by defective products.

According to the Greenman court, the “purpose of such liability is to [e]nsure that the costs of injuries resulting from defective products are borne by the manu- facturers . . . rather than by the injured persons who are powerless to protect themselves.” ■ Today, the majority of states recognize strict product liability, although some state courts limit its application to situations involving personal injuries (rather than property damage).

Stated Public Policy Public policy may be expressed in a statute or in the common law. Sometimes, public pol- icy may be revealed in a court’s interpretation of a statute, as in the following case.

5. 59 Cal.2d 57, 377 P.2d 897, 27 Cal.Rptr. 697 (1962).

Company Profile Wyeth, LLC—a subsidiary of Pfizer, Inc.—is an international pharmaceutical and health-care company with its corporate headquarters in Madison, New Jersey. Wyeth develops, makes, and markets medical therapies, clinical programs, nutritional supplements, prescription drugs, and other health- care products, including over-the-counter medications. Wyeth was incorporated in 1926. In 1994, the company bought Lederle Laboratories. Since 1948, Lederle had been making the diphtheria, tetanus, and pertussis (DTP) vaccine for children.

Background and Facts When Hannah Bruesewitz was six months old, her pediatrician adminis- tered a dose of the DTP vaccine according to the Centers for Disease Control’s recommended child- hood immunization schedule. Within twenty-four hours, Hannah began to experience seizures. She suffered more than one hundred seizures during the next month. Her doctors diagnosed her with “residual seizure disorder” and “developmental delay.”

Hannah’s parents, Russell and Robalee Bruesewitz, filed a claim for relief in the U.S. Court of Fed- eral Claims under the National Childhood Vaccine Injury Act (NCVIA). The NCVIA had set up a no- fault compensation program for persons injured by vaccines. The claim was denied. The Bruesewitzes then filed a suit in a state court against Wyeth, LLC, the maker of the vaccine, alleging strict product liability. The suit was moved to a federal district court. The court held that the claim was preempted by the NCVIA, which includes provisions protecting manufacturers from liability for “a vaccine’s unavoidable, adverse side effects.” The U.S. Court of Appeals for the Third Circuit affirmed the district court’s judgment. The Bruesewitzes appealed to the United States Supreme Court.

Spotlight on Injuries from Vaccines

Case 7.2 Bruesewitz v. Case 7.2 Bruesewitz v. Wyeth, LLC Supreme Court of the United States, 562 U.S. 223, 131 S.Ct. 1068, 179 L.Ed.2d 1 (2011).Supreme Court of the United States, 562 U.S. 223, 131 S.Ct. 1068, 179 L.Ed.2d 1 (2011).Supreme Court of the United States, 562 U.S. 223, 131 S.Ct. 1068, 179 L.Ed.2d 1 (2011).

C H A P T E R 7 Strict Liability and Product Liability 139

In the Language of the Court Justice SCALIA delivered the opinion of the Court.

* * * * In the 1970’s and 1980’s vaccines became, one might say, victims of their own success. They had

been so effective in preventing infectious diseases that the public became much less alarmed at the threat of those diseases, and much more concerned with the risk of injury from the vaccines themselves.

Much of the concern centered around vaccines against * * * DTP, which were blamed for children’s disabilities * * * . This led to a massive increase in vaccine-related tort litigation. * * * This destabilized the DTP vaccine market, causing two of the three domestic manufacturers to withdraw.

* * * * To stabilize the vaccine market and facilitate compensation, Congress enacted the NCVIA in 1986.

The Act establishes a no-fault compensation program designed to work faster and with greater ease than the civil tort system. A person injured by a vaccine, or his legal guardian, may file a petition for compen- sation in the United States Court of Federal Claims.

* * * * Successful claimants receive compensation for medical, rehabilitation, counseling, special education,

and vocational training expenses; diminished earning capacity; pain and suffering; and $250,000 for vaccine-related deaths. Attorney’s fees are provided * * * . These awards are paid out of a fund created by a * * * tax on each vaccine dose.

The quid pro quo [something done in exchange] for this, designed to stabilize the vaccine market, was the provision of significant tort-liability protections for vaccine manufacturers. * * * Manufacturers are generally immunized from liability * * * if they have complied with all regulatory requirements * * * . * * * And most relevant to the present case, the Act expressly eliminates liability for a vaccine’s unavoidable, adverse side effects. [Emphasis added.]

* * * * The Act’s structural quid pro quo leads to the * * * conclusion: The vaccine manufacturers fund from

their sales an informal, efficient compensation program for vaccine injuries; in exchange they avoid costly tort litigation.

Decision and Remedy The United States Supreme Court affirmed the lower court’s judgment. The NCVIA preempted the Bruesewitzes’ claim against Wyeth for compensation for the injury to their daughter caused by the DTP vaccine’s side effects. The Court found that the NCVIA’s compensation program strikes a balance between paying victims harmed by vaccines and protecting the vaccine industry from collapsing under the costs of tort liability.

Critical Thinking • Economic What is the public policy expressed by the provisions of the NCVIA? • Political If the public wants to change the policy outlined in this case, which branch of the

government—and at what level—should be lobbied to make the change? Explain.

Case 7.2 Continued

7–3b The Requirements for Strict Product Liability

After the Restatement (Second) of Torts was issued in Restatement (Second) of Torts was issued in Restatement (Second) of Torts 1964, Section 402A became a widely accepted statement of how the doctrine of strict liability should be applied to sellers of goods (including manufacturers, processors, assemblers, packagers, bottlers, wholesalers, distributors, retailers, and lessors). The bases for an action in strict liability that are set forth in Section 402A can be sum- marized as a set of six requirements.

1. The product must be in a defective condition when the defendant sells it.

2. The defendant must normally be engaged in the business of selling (or otherwise distributing) that business of selling (or otherwise distributing) that business of selling product.

3. The product must be unreasonably dangerous to the unreasonably dangerous to the unreasonably dangerous user or consumer because of its defective condition (in most states).

4. The plaintiff must incur physical harm to self or prop- erty by use or consumption of the product.Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

140 U N I T T W O The Public and International Environment

5. The defective condition must be the proximate cause of the injury or damage.

6. The goods must not have been substantially changed from the time the product was sold to the time the injury was sustained.

Depending on the jurisdiction, if these requirements are met, a manufacturer’s liability to an injured party can be almost unlimited.

Proving a Defective Condition Under these require- ments, in any action against a manufacturer, seller, or les- sor, the plaintiff need not show why or in what manner the product became defective. The plaintiff does, however, have to prove that the product was defective at the time it left the hands of the seller or lessor. The plaintiff must also show that this defective condition made the product “unreasonably dangerous” to the user or consumer.

Unless evidence can be presented to support the con- clusion that the product was defective when it was sold or leased, the plaintiff will not succeed. If the product was delivered in a safe condition and subsequent mishandling made it harmful to the user, the seller or lessor normally is not strictly liable.

Unreasonably Dangerous Products The Restate- ment recognizes that many products cannot be made ment recognizes that many products cannot be made ment entirely safe for all uses. Thus, sellers or lessors are lia- ble only for products that are unreasonably dangerous. A unreasonably dangerous. A unreasonably court could consider a product so defective as to be an unreasonably dangerous product in either of the followunreasonably dangerous product in either of the followunreasonably dangerous product - ing situations: 1. The product was dangerous beyond the expectation

of the ordinary consumer. 2. A less dangerous alternative was economically feasible economically feasible economically

for the manufacturer, but the manufacturer failed to produce it.

As will be discussed next, a product may be unreasonably dangerous due to the manufacturing process, the design, or the warning.

7–3c Product Defects The Restatement (Third) of Torts: Products Liability defines Restatement (Third) of Torts: Products Liability defines Restatement (Third) of Torts: Products Liability the three types of product defects that have traditionally been recognized in product liability law—manufacturing defects, design defects, and inadequate warnings.

Manufacturing Defects According to Section 2(a) of the Restatement (Third) of Torts, a product “contains a manufacturing defect when the product departs from

its intended design even though all possible care was exercised in the preparation and marketing of the prod- uct.” Basically, a manufacturing defect is a departure from a product unit’s design specifications that results in products that are physically flawed, damaged, or incor- rectly assembled. A glass bottle that is made too thin and explodes in a consumer’s face is an example of a product with a manufacturing defect.

Quality Control. Usually, manufacturing defects occur when a manufacturer fails to assemble, test, or check the quality of a product adequately. Liability is imposed on the manufacturer (and on the wholesaler and retailer) regardless of whether the manufacturer’s quality con- trol e�orts were “reasonable.” �e idea behind holding defendants strictly liable for manufacturing defects is to encourage greater investment in product safety and strin- gent quality control standards.

Expert Testimony. Cases involving allegations of a man- ufacturing defect are often decided based on the opinions ufacturing defect are often decided based on the opinions ufacturing defect are often decided based on the opinions and testimony of experts. ■ CASE IN POINT 7.4 Kevin Kevin Schmude purchased an eight-foot stepladder and used it to install radio-frequency shielding in a hospital room. While Schmude was standing on the ladder, it collapsed, and he was seriously injured. He �led a lawsuit against the ladder’s maker, Tricam Industries, Inc., based on a manu- facturing defect.

Experts testified that the preexisting holes in the lad- der’s top cap did not properly line up with the holes in the rear right rail and backing plate. As a result of the misalignment, the rear legs of the ladder were not securely fastened in place, causing the ladder to fail. A jury concluded that this manufacturing defect made the ladder unreasonably dangerous and awarded Schmude more than $677,000 in damages.6 ■

Design Defects Unlike a product with a manufac- turing defect, a product with a design defect is made in conformity with the manufacturer’s design specifications. Nevertheless, the product results in injury to the user because the design itself was faulty. A product “is defec- tive in design when the foreseeable risks of harm posed by the product could have been reduced or avoided by the adoption of a reasonable alternative design by the seller or other distributor, or a predecessor in the commercial chain of distribution, and the omission of the alternative design renders the product not reasonably safe.”7

6. Schmude v. Tricam Industries, Inc., 550 F.Supp.2d 846 (E.D.Wis. 2008). 7. Restatement (Third) of Torts: Products Liability, Section 2(b).

C H A P T E R 7 Strict Liability and Product Liability 141

Test for Design Defects. To successfully assert a design defect, a plainti� has to show that: 1. A reasonable alternative design was available. 2. As a result of the defendant’s failure to adopt the

alternative design, the product was not reasonably safe.

In other words, a manufacturer or other defendant is liable only when the harm was reasonably preventable.

Factors to Be Considered. According to the Restatement, a court can consider a broad range of factors in decid- ing claims of design defects. �ese include the magnitude and probability of the foreseeable risks, as well as the rela- tive advantages and disadvantages of the product as it was designed and as it could have been designed.

Risk-Utility Analysis. Most courts engage in a risk- utility analysis to determine whether the risk of harm from the product as designed outweighs its utility to the from the product as designed outweighs its utility to the from the product as designed outweighs its utility to the user and to the public. ■ CASE IN POINT 7.5 Benjamin Riley, the county sheri�, was driving his Ford F-150 pickup truck near Ehrhardt, South Carolina, when it collided with another vehicle. �e impact caused Riley’s truck to leave the road and roll over. �e driver’s door of the truck opened in the collision, and Riley was ejected and killed.

Riley’s widow, Laura, as the representative of his estate, filed a product liability suit against Ford Motor Company. She alleged that the design of the door-latch system of the truck allowed the door to open in the colli- sion. A state court awarded the estate $900,000 in dam- ages “because of the stature of Riley and what he’s done in life, what he’s contributed to his family.”

Ford appealed, but the court found that a reasonable alternative design was available for the door-latch system. Evidence showed that Ford was aware of the safety prob- lems presented by the current system (a rod-linkage sys- tem). After conducting a risk-utility analysis of a different system (a cable-linkage system), Ford had concluded that the alternative system was feasible and perhaps superior. The state’s highest court affirmed the damages award.8 ■

Consumer-Expectation Test. Other courts apply the consumer-expectation test to determine whether a prod- uct’s design was defective. Under this test, a product is unreasonably dangerous when it fails to perform in the manner that would reasonably be expected by an ordinary consumer.

8. Riley v. Ford Motor Co., 414 S.C. 185, 777 S.E.2d 824 (2015).

■ CASE IN POINT 7.6 A representative from Wil- son Sporting Goods Company gave Edwin Hickox an umpire’s mask that was designed to be safer than other such masks. The mask had a newly designed throat guard that angled forward instead of extending straight down. Hickox was wearing the mask while working as an umpire at a game when he was struck by a ball and injured. He suffered a concussion and damage to his inner ear, which caused permanent hearing loss.

Hickox and his wife sued Wilson for product liability based on a defective design and won. Wilson appealed. The reviewing court affirmed the jury’s verdict. The design was defective because “an ordinary consumer would have expected the mask to perform more safely than it did.” The evidence presented to the jury had shown that Wilson’s mask was more dangerous than comparable masks sold at the time.9 ■

Inadequate Warnings A product may also be deemed defective because of inadequate instructions or warnings. A product will be considered defective “when the foreseeable risks of harm posed by the product could have been reduced or avoided by the provision of reasonable instructions or warnings by the seller or other distributor . . . and the omission of the instruc- tions or warnings renders the product not reasonably safe.”10 Generally, a seller must also warn consumers of the harm that can result from the foreseeable misuse of misuse of misuse its product.

Content of Warnings. Important factors for a court to consider include the risks of a product, the “content and comprehensibility” and “intensity of expression” of warnings and instructions, and the “characteristics of expected user groups.”11 Courts apply a “reasonable- ness” test to determine if the warnings adequately alert consumers to the product’s risks. For instance, children will likely respond readily to bright, bold, simple warning labels, whereas educated adults might need more detailed information. For more on tips on making sure a product’s warnings are adequate, see this chapter’s Managerial Strat-Managerial Strat-Managerial Strat egy feature.egy feature.egy

■ CASE IN POINT 7.7 Jeffrey Johnson went to an Jeffrey Johnson went to an emergency room for an episode of atrial fibrillation, a heart rhythm disorder. Dr. David Hahn used a defibrilla- tor manufactured by Medtronic, Inc., to deliver electric shocks to Johnson’s heart. The defibrillator had synchro- nous and asynchronous modes, and it reverted to the

9. Wilson Sporting Goods Co. v. Hickox, 59 A.3d 1267 (D.C.App. 2013). 10. Restatement (Third) of Torts: Products Liability, Section 2(c). 11. Restatement (Third) of Torts: Products Liability, Section 2, Comment h.

142 U N I T T W O The Public and International Environment

When Is a Warning Legally Bulletproof?

A company can sell a perfectly manufactured and designed product, yet still face product liability lawsuits for failure to provide appropri- ate warnings. According to the Restatement (Third) of Torts, a product may be deemed defective because of inadequate instructions or warnings when the foreseeable risks of harm posed by the product could have been reduced by reasonable warnings offered by the seller or other distributor.

Manufacturers and distributors have a duty to warn users of any hidden dangers of their products. Additionally, they have a duty to instruct users in how to use the product to avoid any dangers. Warnings generally must be clear and specific. They must also be conspicuous.

When No Warning Is Required

Not all products have to provide warnings. People are expected to know that knives can cut fingers, for exam- ple, so a seller need not place a bright orange label on each knife sold reminding consumers of this danger. Most household products are generally safe when used as intended.

In a New Jersey case, an appeals court reviewed a product liability case against the manufacturer of a Razor A–type kick scooter. A ten-year-old boy was injured when he fell and struck his face on the scooter’s handlebars. The padded end caps on the handlebars had deteriorated, and the boy’s mother had thrown them away, exposing the metal ends.

The boy and his mother sued, claiming that the manufacturer was required to provide a warning to prevent injuries of this type. The appellate court noted, however, that the plaintiffs were not able to claim that the Razor A was defective. “Lacking evidence that Razor A’s end-cap design was defective, plaintiffs cannot show that Razor A had a duty to warn of such a defect, and

therefore cannot make out their failure to warn claim.”a

Warnings on Medications

In a case involving a prescription medication, a woman suffered neurological disorders after taking a generic drug to treat her gastroesoph- ageal reflux disease. Part of her complaint

asserted strict liability for failure to warn. The plaintiff claimed that the manufacturer had not updated its label to indicate that usage should not exceed twelve weeks. The reviewing court reasoned that “The ade- quacy of the instructions . . . made no difference to the outcome . . . because [the plaintiff alleges that her pre- scribing physician] did not read those materials.” b

In contrast, in a 2014 Pennsylvania case, a family was awarded over $10 million in a lawsuit against John- son & Johnson for defective warnings on bottles of chil- dren’s Motrin. A three-year-old girl suffered burns over 84 percent of her skin, experienced brain damage, and went blind after suffering a reaction to the drug. The drug did have a specific warning label that instructed consumers to stop taking the medication and contact a physician in the event of an allergic reaction. Nonethe- less, Johnson & Johnson was found liable for failing to warn about the known risk of severe side effects.c

Business Questions 1. To protect themselves, manufacturers have been forced

to include lengthy safety warnings for their products. What might be the downside of such warnings?

2. Does a manufacturer have to create safety warnings for every product? Why or why not?

MANAGERIAL STRATEGY

a. Vann v. Toys R Us, 2014 WL3537937 (N.J.Sup. A.D. 2014). b. Brinkley v. Pfizer, Inc., 772 F.3d 1133 (8th Cir. 2014). c. Maya v. Johnson and Johnson, 97 A.3d 1203, 2014 PA Super. 152

(2014).

asynchronous mode after each use. Hahn intended to deliver synchronized shocks, which would have required him to select the synchronous mode for each shock. But Hahn did not read the device’s instructions, which Medtronic had provided both in a manual and on the device itself. As a result, the physician delivered one synchronized shock, followed by twelve asynchronous shocks that endangered Johnson’s life.

Johnson and his wife filed a product liability suit against Medtronic, asserting that Medtronic had provided

inadequate warnings about the defibrillator and that the device had a design defect. A Missouri appellate court held that the Johnsons could not pursue a claim based on the inadequacy of Medtronic’s warnings, but they could pursue a claim alleging a design defect. The court rea- soned that, in some cases, “a manufacturer may be held liable where it chooses to warn of the danger . . . rather than preclude the danger by design.”12 ■

C H A P T E R 7 Strict Liability and Product Liability 143

Obvious Risks. �ere is no duty to warn about risks that are obvious or commonly known. Warnings about such risks do not add to the safety of a product and could even detract from it by making other warnings seem less signi�cant. As will be discussed later in the chapter, the obviousness of a risk and a user’s decision to proceed in the face of that risk may be a defense in a product liability suit based on an inadequate warning.suit based on an inadequate warning.suit based on an inadequate warning.

■ EXAMPLE 7.8 Sixteen-year-old Lana White attempts Sixteen-year-old Lana White attempts to do a back flip on a trampoline and fails. She is paralyzed as a result. There are nine warning labels affixed to the trampoline, an instruction manual with safety warnings, and a placard at the entrance advising users not to do flips. If White sues the manufacturer for inadequate warnings in this situation, she is likely to lose. The warning labels are probably sufficient to make the risks obvious and insulate the manufacturer from liability for her injuries. ■

Risks that may seem obvious to some users, though, will not be obvious to all users, especially when the users are likely to be children. A young child may not be able to read or understand warning labels or comprehend the risk of certain activities. To avoid liability, the manufacturer would have to prove that the warnings it provided were adequate to make the risk of injury obvious to a young child.13

State Laws and Constitutionality. An action alleging that a product is defective due to an inadequate label can be based on state law, but that law must not violate the U.S. Constitution. ■ CASE IN POINT 7.9 California once California once enacted a law imposing restrictions and a labeling require- ment on the sale or rental of “violent video games” to minors. Although the video game industry had adopted a voluntary rating system for games, the legislators deemed those labels inadequate.

The Video Software Dealers Association and the Entertainment Software Association immediately filed a suit in federal court to invalidate the law, and the law was struck down. The state appealed to the United States Supreme Court. The Court found that the definition of a violent video game in California’s law was unconstitu- tionally vague and violated the First Amendment’s guar- antee of freedom of speech.14 ■

7–3d Market-Share Liability Ordinarily, in all product liability claims, a plaintiff must prove that the defective product that caused his or her

13. See, for example, Bunch v. Hoffinger Industries, Inc.,123 Cal.App.4th 1278, 20 Cal.Rptr.3d 780 (2004).

14. Video Software Dealers Association v. Schwarzenegger, 556 F.3d 950 (9th Cir. 2009); Brown v. Entertainment Merchants Association, ___ U.S. ___, 131 S.Ct. 2729, 180 L.Ed.2d 708 (2011).

injury was the product of a specific defendant. In a few situations, however, courts have dropped this require- ment when plaintiffs could not prove which of many distributors of a harmful product supplied the particu- lar product that caused the injuries. Under a theory of market-share liability, a court can hold each manufac- turer responsible for a percentage of the plaintiff ’s dam- ages that is equal to the percentage of its market share.ages that is equal to the percentage of its market share.ages that is equal to the percentage of its market share.

■ CASE IN POINT 7.10 Suffolk County Water Author- ity (SCWA) is a municipal water supplier in New York. SCWA discovered the presence of a toxic chemical—per- chlolorethylene (PCE), which is used by dry cleaners and others—in its local water. SCWA filed a product liability lawsuit against Dow Chemical Corporation and other companies that manufactured and distributed PCE. Dow filed a motion to dismiss the case for failure to state a claim, since SCWA could not identify each defen- dant whose allegedly defective product caused the water contamination.

A state trial court refused to dismiss the action, hold- ing that SCWA’s allegations were sufficient to invoke market-share liability. Under market-share liability, the burden of identification shifts to defendants if the plain- tiff establishes a prima facie case on every element of the claim except identification of the specific defendant. (A prima facie case is one in which the plaintiff has presented sufficient evidence for the claim to go forward.)15 ■

Many jurisdictions do not recognize the market-share theory of liability because they believe that it deviates too significantly from traditional legal principles. Juris- dictions that do recognize market-share liability apply it only when it is difficult to determine which company made a particular product.

7–3e Other Applications of Strict Product Liability

Almost all courts extend the strict liability of manufac- turers and other sellers to injured bystanders. Thus, if a defective forklift that will not go into reverse injures a passerby, that individual can sue the manufacturer for product liability (and possibly also sue the forklift opera- tor for negligence).

Strict product liability also applies to suppliers of com- ponent parts. ■ EXAMPLE 7.11 Toyota buys brake pads from a subcontractor and puts them in Corollas without changing their composition. If those pads are defective, both the supplier of the brake pads and Toyota will be held strictly liable for the injuries caused by the defects. ■

15. Suffolk County Water Authority v. Dow Chemical Co., 44 Misc.3d 569, 987 N.Y.S.2d 819 (N.Y.Sup. 2014).

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7–4 Defenses to Product Liability Defendants in product liability suits can raise a number of defenses. One defense, of course, is to show that there is no basis for the plaintiff ’s claim. Thus, for instance, in an action based on negligence, If a defendant can show that the plaintiff has not met the requirements for such not met the requirements for such not an action (such as causation), then generally the defen- dant will not be liable.

Similarly, in a case involving strict product liability, a defendant can claim that the plaintiff failed to meet one of the requirements. For instance, if the defendant shows that the goods were altered after they were sold, normally the defendant will not be held liable.

In the following case, a product’s safety switch had been disabled before the plaintiff used the product.

Background and Facts Drew VeRost was employed at a manufacturing facility in Buffalo, New York, owned by Nuttall Gear, LLC. While operating a forklift at Nuttall’s facility, VeRost climbed out of the seat and attempted to engage a lever on the vehicle. As he stood on the front of the forklift and reached for the lever with his hand, he inadvertently stepped on the vehicle’s gearshift. The activated gears caused part of the forklift to move backward, injuring him. He filed a suit in a New York state court against the forklift’s maker, Mitsubishi Caterpillar Forklift America, Inc., and others, asserting claims in product liability.

The defendants established that the vehicle had been manufactured with a safety switch that would have prevented the accident had it not been disabled after delivery to Nuttall. The court issued a summary judgment in the defendants’ favor. VeRost appealed.

In the Language of the Court MEMORANDUM:

* * * * The forklift in question was manufactured by defendant Mitsubishi Caterpillar Forklift America, Inc.

(MCFA), and sold new to Nuttall Gear by defendants Buffalo Lift Trucks, Inc. (Buffalo Lift) and Mullen Industrial Handling Corp. (Mullen). The forklift as manufactured was equipped with a seat safety switch that would render the forklift inoperable if the operator was not in the driver’s seat. At the time of the accident, however, someone had intentionally disabled the safety switch by installing a “jumper wire” under the seat of the forklift. As a result, the forklift still had power when the operator was not in the driver’s seat. Of the 10 forklifts owned by Nuttall Gear, seven had “jumper wires” installed that disabled the safety switches.

The complaint asserts causes of action against MCFA, Buffalo Lift and Mullen sounding in strict products liability, alleging, inter alia [“among other things”], that the forklift was defectively designed and that those defendants failed to provide adequate “warnings for the safe operation, maintenance repair and servicing of the forklift.” * * * Following discovery, the * * * defendants * * * each moved for summary judgment dismissing the complaint against them, contending that the forklift was safe when it was manufactured and delivered to Nuttall Gear, and that it was thereafter rendered unsafe by a third party who deactivated the safety switch. * * * [The] Supreme Court [of New York] granted the motions and dismissed the complaint in its entirety, and this appeal ensued.

We conclude that the court properly granted the motions of the * * * defendants. * * * A manufac- turer, who has designed and produced a safe product, will not be liable for injuries resulting from substantial alterations or modifications of the product by a third party which render the product defective or otherwise unsafe. Here, the * * * defendants established as a matter of law that the forklift was not defectively designed by establishing that, when it was manufactured and delivered to Nuttall Gear, it had a safety switch that would have prevented plaintiff ’s accident, and a third party thereafter made a substantial modification to the forklift by disabling the safety switch. [Emphasis added.]

VeRost v. Mitsubishi Caterpillar Forklift America, Inc. New York Supreme Court, Appellate Division, Fourth Department, 124 A.D.3d 1219, 1 N.Y.S.3d 589 (2015).

Case 7.3

C H A P T E R 7 Strict Liability and Product Liability 145

Decision and Remedy The state intermediate appellate court affirmed the lower court’s judgment in Mitsubishi’s favor. To succeed in an action based on product liability, the goods at issue must not have been substantially changed from the time the product was sold to the time the injury was sustained. VeRost could not meet this requirement.

Critical Thinking • Legal Environment Could VeRost succeed in an action against Nuttall, alleging that the company’s

failure to maintain the forklift in a safe condition constituted negligence? Discuss.

Case 7.3 Continued

7–4a Preemption A defense that has been successfully raised by defendants in recent years is preemption—that government regula- tions preempt claims for product liability (see Spotlight Case 7.2). An injured party may not be able to sue the Case 7.2). An injured party may not be able to sue the Case manufacturer of defective products that are subject to comprehensive federal regulatory schemes.comprehensive federal regulatory schemes.comprehensive federal regulatory schemes.

■ CASE IN POINT 7.12 Medical devices are subject to extensive government regulation and undergo a rig- orous premarket approval process. The United States Supreme Court decided in Riegel v. Medtronic, Inc., that a man who was injured by an approved medical device (a balloon catheter) could not sue its maker for product liability. The Court reasoned that Congress had created a comprehensive scheme of federal safety oversight for medical devices. The U.S. Food and Drug Administra- tion is required to review the design, labeling, and manu- facturing of medical devices before they are marketed to make sure that they are safe and effective. Because pre- market approval is a “rigorous process,” it preempts all common law claims challenging the safety or effective- ness of a medical device that has been approved.16 ■

Since the Medtronic decision, some courts have Medtronic decision, some courts have Medtronic extended the preemption defense to other product liabil- ity actions. Other courts have been unwilling to deny an injured party relief simply because the federal govern- ment was supposed to ensure a product’s safety.17 Even the United States Supreme Court refused to extend the preemption defense to preclude a drug maker’s liability in one subsequent case.18

16. Riegel v. Medtronic, Inc., 552 U.S. 312, 128 S.Ct. 999, 169 L.Ed.2d 892 (2008).

17. See, for example, McGuan v. Endovascular Technologies, Inc., 182 Cal. App.4th 974, 106 Cal.Rptr.3d 277 (2010), and Paduano v. American Honda Motor Co., 169 Cal.App.4th 1453, 88 Cal.Rptr.3d 90 (2009).

18. Wyeth v. Levine, 555 U.S. 555, 129 S.Ct. 1187, 173 L.Ed.2d 51 (2009).

7–4b Assumption of Risk Assumption of risk can sometimes be used as a defense in a product liability action. To establish assumption of risk, the defendant must show the following: 1. The plaintiff knew and appreciated the risk created

by the product defect. 2. The plaintiff voluntarily assumed the risk—by

express agreement or by words or conduct—even though it was unreasonable to do so.

Some states do not allow the defense of assumption of risk in strict product liability claims, however. ■ CASE IN POINT 7.13 When Savannah Boles became a customer of Executive Tans, she signed a contract. One part of the contract stated that signers used the company’s tanning booths at their own risk. It also released the manufacturer and others from liability for any injuries.

Later, Boles’s fingers were partially amputated when they came into contact with a tanning booth’s fan. Boles sued the manufacturer for strict product liability. The Colorado Supreme Court held that assumption of risk was not applicable because strict product liability is driven by public-policy considerations. The theory focuses on the nature of the product rather than the con- duct of either the manufacturer or the person injured.19 ■

7–4c Product Misuse Similar to the defense of voluntary assumption of risk is that of product misuse, which occurs when a product is used for a purpose for which it was not intended. The courts have severely limited this defense, however, and it is now recognized as a defense only when the particular use was not foreseeable. If the misuse is reasonably foreseeable, the seller must take measures to guard against it.

146 U N I T T W O The Public and International Environment

■ CASE IN POINT 7.14 David Stults developed bron- chiolitis obliterans (“popcorn lung”) from consuming multiple bags of microwave popcorn daily for several years. When Stults filed a lawsuit against the popcorn manufacturers, they asked the court for a summary judg- ment in their favor. The court denied the defendants’ motion and found that a manufacturer has a duty to warn of dangers associated with reasonably foreseeable misuses of a product. If it is foreseeable that a person might consume several bags of microwave popcorn a day, then the manufacturer might have to warn users about the potential health risks associated with doing so.20 ■

7–4d Comparative Negligence (Fault) Comparative negligence, or fault, can also affect strict liability claims. Today, courts in many jurisdictions con- sider the negligent or intentional actions of both the plaintiff and the defendant when apportioning liability and damages. A defendant may be able to limit some of its liability if it can show that the plaintiff ’s misuse of the product contributed to his or her injuries.

When proved, comparative negligence differs from other defenses in that it does not completely absolve the defendant of liability. It can, however, reduce the total amount of damages that will be awarded to the plaintiff. Note that some jurisdictions allow only intentional con- duct to affect a plaintiff ’s recovery, whereas other states allow ordinary negligence to be used as a defense to prod- uct liability.

7–4e Commonly Known Dangers The dangers associated with certain products (such as matches and sharp knives) are so commonly known that, as mentioned, manufacturers need not warn users of those dangers. If a defendant succeeds in convincing the court that a plaintiff ’s injury resulted from a commonly known danger,known danger,known danger, the defendant will not be liable.

■ CASE IN POINT 7.15 In a classic example from 1957, Marguerite Jamieson was injured when an elastic exercise rope slipped off her foot and struck her in the eye, caus- ing a detachment of the retina. Jamieson claimed that the manufacturer should be liable because it had failed to warn users that the exerciser might slip off a foot in such a manner.

The court stated that to hold the manufacturer liable in these circumstances “would go beyond the reasonable dictates of justice in fixing the liabilities of manufactur- ers.” After all, stated the court, “almost every physical

20. Stults v. International Flavors and Fragrances, Inc., 31 F.Supp.3d 1015 (N.D. Iowa 2014).

object can be inherently dangerous or potentially danger- ous in a sense. . . . A manufacturer cannot manufacture a knife that will not cut or a hammer that will not mash a thumb or a stove that will not burn a finger. The law does not require [manufacturers] to warn of such com- mon dangers.”21 ■

7–4f Knowledgeable User A related defense is the knowledgeable user defense. If a knowledgeable user defense. If a knowledgeable user particular danger (such as electrical shock) is or should be commonly known by particular users of a product (such as electricians), the manufacturer need not warn these users of the danger.users of the danger.users of the danger.

■ CASE IN POINT 7.16 The parents of teenagers who had become overweight and developed health problems filed a product liability suit against McDonald’s. The plaintiffs claimed that the fast-food chain had failed to warn customers of the adverse health effects of eating its food. The court rejected this claim, however, based on the knowledgeable user defense.

The court found that it is well known that the food at McDonald’s contains high levels of cholesterol, fat, salt, and sugar and is therefore unhealthful. The court stated: “If consumers know (or reasonably should know) the potential ill health effects of eating at McDonald’s, they cannot blame McDonald’s if they, nonetheless, choose to satiate their appetite with a surfeit [excess] of supersized McDonald’s products.”22 ■

7–4g Statutes of Limitations and Repose Statutes of limitations restrict the time within which an action may be brought. The statute of limitations for product liability cases varies according to state law. Usually, the injured party must bring a product liability claim within two to four years. Often, the running of the prescribed period is tolled (that is, suspended) until the tolled (that is, suspended) until the tolled party suffering an injury has discovered it or should have discovered it.

To ensure that sellers and manufacturers will not be left vulnerable to lawsuits indefinitely, many states have passed statutes of repose, which place outer time limits on prodouter time limits on prodouter - uct liability actions. For instance, a statute of repose may require that claims be brought within twelve years from the date of sale or manufacture of the defective product. If the plaintiff does not bring an action before the prescribed period expires, the seller cannot be held liable.

Concept Summary 7.1 reviews the possible defenses in product liability actions.

21. Jamieson v. Woodward & Lothrop, 247 F.2d 23 (D.C.Cir. 1957). 22. Pelman v. McDonald’s Corp., 237 F.Supp.2d 512 (S.D.N.Y. 2003).Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 7 Strict Liability and Product Liability 147

Defenses to Product Liability

Concept Summary 7.1

If the product is subject to comprehensive federal safety regulationsPreemption

When the user or consumer knew the risk and voluntarily assumed itAssumption of Risk

If the consumer misused the product in an unforeseeable wayProduct Misuse

Apportions liability if the defendant was also negligentComparative Negligence

If the particular danger is commonly known by particular users of the productKnowledgeable User

If the statute of limitations or statute of repose period has expiredStatutory Time Periods

If the product was commonly known to be dangerous Commonly Known Dangers

Debate This . . . All liability suits against tobacco companies for lung cancer should be thrown out of court now and forever.

Reviewing: Strict Liability and Product Liability

Shalene Kolchek bought a Great Lakes Spa from Val Porter, a dealer who was selling spas at the state fair. Kolchek signed an installment contract. Porter then handed her the manufacturer’s paperwork and arranged for the spa to be delivered and installed for her. Three months later, Kolchek left her six-year-old daughter, Litisha, alone in the spa. While exploring the spa’s hydromassage jets, Litisha stuck her index finger into one of the jet holes and was unable to remove her finger from the jet.

Litisha yanked hard, injuring her finger, then panicked and screamed for help. Kolchek was unable to remove Litisha’s finger, and the local police and rescue team were called to assist. After a three-hour operation that included draining the spa, sawing out a section of the spa’s plastic molding, and slicing the jet casing, Litisha’s finger was freed. Following this procedure, the spa was no longer functional. Litisha was taken to the local emergency room, where she was told that a bone in her finger was broken in two places. Using the information presented in the chapter, answer the following questions. 1. Under which theories of product liability can Kolchek sue Porter to recover for Litisha’s injuries? 2. Would privity of contract be required for Kolchek to succeed in a product liability action against Great Lakes?

Explain. 3. For an action in strict product liability against Great Lakes, what six requirements must Kolchek meet? 4. What defenses to product liability might Porter or Great Lakes be able to assert?

148 U N I T T W O The Public and International Environment

Terms and Concepts market-share liability 143 privity of contract 135 product liability 134

product misuse 145 statute of repose 146 strict liability 134

tolling 146 unreasonably dangerous

product 140

Issue Spotters 1. Rim Corporation makes tire rims that it sells to Supe-

rior Vehicles, Inc., which installs them on cars. One set of rims is defective, which an inspection would reveal. Supe- rior does not inspect the rims. The car with the defective rims is sold to Town Auto Sales, which sells the car to Uri. Soon, the car is in an accident caused by the defec- tive rims, and Uri is injured. Is Superior Vehicles liable? Explain your answer. (See Strict Product Liability.)

2. Bensing Company manufactures generic drugs for the treatment of heart disease. A federal law requires generic

drug makers to use labels that are identical to the labels on brand-name versions of the drugs. Hunter Rothfus purchased Bensing’s generic drugs in Ohio and wants to sue Bensing for defective labeling based on its failure to comply with Ohio state common law (rather than the fed- eral labeling requirements). What defense might Bensing assert to avoid liability under state law? (See Defenses to Product Liability.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 7–1. Strict Liability. Danny and Marion Klein were injured when part of a fireworks display went astray and exploded near them. They sued Pyrodyne Corp., the pyrotechnic com- pany that was hired to set up and discharge the fireworks. The Kleins alleged, among other things, that the company should be strictly liable for damages caused by the fireworks display. Will the court agree with the Kleins? What factors will the court con- sider in making its decision? Discuss fully. (See Strict Liability.) 7–2. Product Liability. Jason Clark, an experienced hunter, bought a paintball gun. Clark practiced with the gun and knew how to screw in the carbon dioxide cartridge, pump the gun, and use its safety and trigger. Although Clark was aware that he could purchase protective eyewear, he chose not to buy it.

Clark had taken gun safety courses and understood that it was “common sense” not to shoot anyone in the face. Clark’s friend, Chris Wright, also owned a paintball gun and was simi- larly familiar with the gun’s use and its risks.

Clark, Wright, and their friends played a game that involved shooting paintballs at cars whose occupants also had the guns. One night, while Clark and Wright were cruising with their guns, Wright shot at Clark’s car, but hit Clark in the eye. Clark filed a product liability lawsuit against the manufacturer of Wright’s paintball gun to recover for the injury. Clark claimed that the gun was defectively designed. During the trial, Wright testified that his gun “never malfunctioned.” In whose favor should the court rule? Why? (See Product Liability.)

Business Case Problems 7–3. Design Defects. Yun Tung Chow tried to unclog a �oor drain in the kitchen of the restaurant where he worked. He used a drain cleaner called Lewis Red Devil Lye that con- tained crystalline sodium hydroxide. �e product label said to wear eye protection, to put one tablespoon of lye directly into the drain, and to keep one’s face away from the drain because there could be dangerous backsplash.

Without eye protection, Chow mixed three tablespoons of lye in a can and poured that mixture down the drain while bending over it. Liquid splashed back into his face, causing injury. He brought a product liability suit based on inadequate warnings and design defect. The trial court granted summary judgment to the manufacturer, and Chow appealed. An expert for Chow stated that the product was defective because it had a tendency to backsplash. Is that a convincing argument? Why or why not? [Yun Tung Chow v. Reckitt & Coleman, Inc., 69 A.D.3d 413, 891 N.Y.S.2d 402 (N.Y.A.D. 1 Dept. 2010)] (See Strict Product Liability.)

7–4. Strict Product Liability. David Dobrovolny bought a new Ford F-350 pickup truck. A year later, the truck spon- taneously caught �re in Dobrovolny’s driveway. �e truck was destroyed, but no other property was damaged, and no one was injured. Dobrovolny �led a suit in a Nebraska state court against Ford Motor Co. on a theory of strict product liability to recover the cost of the truck. Nebraska limits the applica- tion of strict product liability to situations involving personal injuries. Is Dobrovolny’s claim likely to succeed? Why or why not? Is there another basis for liability on which he might recover? Explain. [Dobrovolny v. Ford Motor Co., 281 Neb. 86, 793 N.W.2d 445 (2011)] (See Strict Product Liability.)

7–5. Product Misuse. Five-year-old Cheyenne Stark was riding in the backseat of her parents’ Ford Taurus. Chey- enne was not sitting in a booster seat. Instead, she was using a seatbelt designed by Ford, but was wearing the shoulder belt behind her back. �e car was involved in a collision. As

C H A P T E R 7 Strict Liability and Product Liability 149

a result, Cheyenne su�ered a spinal cord injury and was para- lyzed from the waist down. �e family �led a suit against Ford Motor Co., alleging that the seatbelt was defectively designed. Could Ford successfully claim that Cheyenne had misused the seatbelt? Why or why not? [Stark v. Ford Motor Co., 365 N.C. 468, 723 S.E.2d 753 (2012)] (See Defenses to Product Liability.) 7–6. Business Case Problem with Sample Answer— Product Liability. While driving on Interstate 40 in North

Carolina, Carroll Jett became distracted by a texting system in the cab of his tractor-trailer truck. He smashed into several vehicles that were slowed or stopped in front of him, injuring Barbara and

Michael Durkee and others. �e injured motorists �led a suit in a federal district court against Geologic Solutions, Inc., the maker of the texting system, alleging product liability. Was the accident caused by Jett’s inattention or the texting device? Should a manufacturer be required to design a product that is incapable of distracting a driver? Discuss. [Durkee v. Geologic Solutions, Inc., 2013 WL 14717 (4th Cir. 2013)] (See Product Liability.) • For a sample answer to Problem 7–6, go to Appendix E at

the end of this text.

7–7. Strict Product Liability. Medicis Pharmaceutical Corp. makes Solodyn, a prescription oral antibiotic. Medi- cis warns physicians that “autoimmune syndromes, includ- ing drug-induced lupus-like syndrome,” may be associated with use of the drug. Amanda Watts had chronic acne. Her physician prescribed Solodyn. Information included with the drug did not mention the risk of autoimmune disorders, and Watts was not otherwise advised of it. She was prescribed the drug twice, each time for twenty weeks. Later, she experienced debilitating joint pain and, after being hospitalized, was diag- nosed with lupus. On what basis could Watts recover from Medicis in an action grounded in product liability? Explain. [Watts v. Medicis Pharmaceutical Corp., 236 Ariz. 511, 342 P.3d 847 (2015)] (See Strict Product Liability.) 7–8. Strict Product Liability. Duval Ford, LLC, sold a new Ford F-250 pick-up truck to David Sweat. Before taking delivery, Sweat ordered a lift kit to be installed on the truck by a Duval subcontractor. Sweat also replaced the tires and modi�ed the suspension system to increase the towing capac- ity. Later, through Burkins Chevrolet, Sweat sold the truck to

Shaun Lesnick. Sweat had had no problems with the truck’s steering or suspension, but Lesnick did. He had the steer- ing repaired and made additional changes, including install- ing a steering stabilizer and replacing the tires. Two months later, Lesnick was driving the truck when the steering and suspension suddenly failed, and the truck �ipped over, caus- ing Lesnick severe injuries. Could Lesnick successfully claim that Duval and Burkins had failed to warn him of the risk of a lifted truck? Explain. [Lesnick v. Duval Ford, LLC, 41 Fla.L.Weekly D281, __ So.3d __ (1 Dist. 2016)] (See Strict Product Liability.) 7–9. A Question of Ethics—Dangerous Products. Susan

Calles lived with her four daughters—Amanda, age eleven; Victoria, age �ve; and Jenna and Jillian, age three. In March 1998, Calles bought an Aim N Flame utility lighter, which she stored on the top shelf of her

kitchen cabinet. A trigger can ignite the Aim N Flame after an “ON/OFF” switch is slid to the “on” position. On the night of March 31, Calles and Victoria left to get videos. Jenna and Jillian were in bed, and Amanda was watching television. Calles returned to �nd �re trucks and emergency vehicles around her home. Robert Finn, a �re investigator, determined that Jenna had started a �re using the lighter. Jillian su�ered smoke inhalation, was hospitalized, and died on April 21. Calles �led a suit in an Illinois state court against Scripto-Tokai Corp., which distributed the Aim N Flame, and oth- ers. In her suit, which was grounded, in part, in strict liability claims, Calles alleged that the lighter was an “unreasonably danger-claims, Calles alleged that the lighter was an “unreasonably danger-claims, Calles alleged that the lighter was an “unreasonably danger ous product.” Scripto �led a motion for summary judgment. [Calles [Calles [ v. Scripto-Tokai Corp., 224 Ill.2d 247, 864 N.E.2d 249, 309 Ill. Dec. 383 (2007)] (See Strict Product Liability.) (a) A product is “unreasonably dangerous” when it is dan-

gerous beyond the expectation of the ordinary consumer. Whose expectation—Calles’s or Jenna’s—applies? Does the lighter pass this test? Explain.

(b) Calles presented evidence as to the likelihood and seri- ousness of injury from lighters that do not have child- safety devices. Scripto argued that the Aim N Flame is an alternative source of fire and is safer than a match. Calles admitted that she knew the dangers presented by light- ers in the hands of children. Scripto admitted that it had been a defendant in several suits for injuries under similar circumstances. How should the court rule? Why?

Legal Reasoning Group Activity 7–10. Product Liability. Bret D’Auguste was an expe- rienced skier when he rented equipment to ski at Hunter Mountain Ski Bowl in New York. When D’Auguste entered an extremely di�cult trail, he noticed immediately that the surface consisted of ice with almost no snow. He tried to exit the steeply declining trail by making a sharp right turn, but in the attempt, his left ski snapped o�. D’Auguste lost his bal- ance, fell, and slid down the mountain, striking his face and head against a fence along the trail. According to a report by a rental shop employee, one of the bindings on D’Auguste’s skis had a “cracked heel housing.” D’Auguste �led a lawsuit

against the bindings’ manufacturer on a theory of strict prod- uct liability. �e manufacturer �led a motion for summary judgment. (See Product Liability.)

(a) The first group will take the position of the manufacturer and develop an argument for why the court should grant the summary judgment motion and dismiss the strict product liability claim.

(b) The second group will take the position of D’Auguste and formulate a basis for why the court should deny the deny the deny motion and allow the strict product liability claim.

150

C H A P T E R 8

identify a business or product was protected in the use of that trademark. Clearly, by using another’s trademark, a business could lead consumers to believe that its goods were made by the other business. The law seeks to avoid this kind of confusion.

In the following classic case, the defendants argued that the Coca-Cola trademark was entitled to no protec- tion under the law because the term did not accurately represent the product.

8–1 Trademarks and Related Property

A trademark is a distinctive mark, motto, device, or trademark is a distinctive mark, motto, device, or trademark implement that a manufacturer stamps, prints, or other- wise affixes to the goods it produces so that they can be identified on the market and their origins made known. In other words, a trademark is a source indicator. At common law, the person who used a symbol or mark to

I ntellectual property is any prop- erty that results from intellectual, creative processes—the products of

an individual’s mind. Although it is an abstract term for an abstract concept, intellectual property is nonetheless familiar to almost everyone. The apps for your iPhone, iPad, or Samsung Galaxy, the movies you see, and the music you listen to are all forms of intellectual property.

More than two hundred years ago, the framers of the U.S. Constitution

recognized the importance of pro- tecting creative works in Article I, Sec- tion 8. Statutory protection of these rights began in the 1940s and con- tinues to evolve to meet the needs of modern society. In today’s global economy, however, protecting intel- lectual property in one country is no longer sufficient. The United States is participating in various international agreements to secure ownership rights in intellectual property in other countries.

Whether locally or globally, busi- nesspersons have a vital need to protect their rights in intellectual property, which may be more valu- able than their physical property, such as machines and buildings. Consider, for instance, the importance of intel- lectual property rights to technology companies, such as Apple, Inc., and Samsung. These two companies have been involved in patent litigation over the designs of their smartphones for several years.

Intellectual Property Rights

Company Profile John Pemberton, an Atlanta pharmacist, invented a caramel-colored, carbonated soft drink in 1886. His bookkeeper, Frank Robinson, named the beverage Coca-Cola after two of the ingredients, coca leaves and kola nuts. Asa Candler bought the Coca-Cola Company in 1891, and within seven years, he had made the soft drink available throughout the United States, as well as in parts of Canada and Mexico. Candler continued to sell Coke aggressively and to open up new markets, reaching Europe before 1910. In doing so, however, he attracted numerous competitors, some of which tried to capitalize directly on the Coke name.

Classic Case 8.1 The Coca-Cola Co. v. The Koke Co. of America Supreme Court of the United States, 254 U.S. 143, 41 S.Ct. 113, 65 L.Ed.189 (1920).

C H A P T E R 8 Intellectual Property Rights 151

Background and Facts The Coca-Cola Company sought to enjoin (prevent) the Koke Company of America and other beverage companies from, among other things, using the word Koke for their Koke for their Koke products. The Koke Company of America and other beverage companies contended that the Coca- Cola trademark was a fraudulent representation and that Coca-Cola was therefore not entitled to any help from the courts. The Koke Company and the other defendants alleged that the Coca-Cola Com- pany, by its use of the Coca-Cola name, represented that the beverage contained cocaine (from coca leaves), which it no longer did. The trial court granted the injunction against the Koke Company, but the appellate court reversed the lower court’s ruling. Coca-Cola then appealed to the United States Supreme Court.

In the Language of the Court Mr. Justice HOLMES delivered the opinion of the Court.HOLMES delivered the opinion of the Court.HOLMES

* * * * * * * Before 1900 the beginning of [Coca-Cola’s] good will was more or less helped by the pres-

ence of cocaine, a drug that, like alcohol or caffeine or opium, may be described as a deadly poison or as a valuable [pharmaceutical item, depending on the speaker’s purposes]. The amount seems to have been very small,a but it may have been enough to begin a bad habit and after the Food and Drug Act a but it may have been enough to begin a bad habit and after the Food and Drug Act a of June 30, 1906, if not earlier, long before this suit was brought, it was eliminated from the plaintiff ’s compound.

* * * Since 1900 the sales have increased at a very great rate corresponding to a like increase in adver- tising. The name now characterizes a beverage to be had at almost any soda fountain. It means a single thing coming from a single source, and well known to the community. It hardly would be too much to say that the drink characterizes the name as much as the name the drink. In other words Coca-Cola prob- ably means to most persons the plaintiff ’s familiar product to be had everywhere rather than a compound of particular substances. * * * Before this suit was brought the plaintiff had advertised to the public that it must not expect and would not find cocaine, and had eliminated everything tending to suggest cocaine effects except the name and the picture of [coca] leaves and nuts, which probably conveyed little or nothing to most who saw it. It appears to us that it would be going too far to deny the plaintiff relief against a palpable [readily evident] fraud because possibly here and there an ignorant person might call for the drink with the hope for incipient cocaine intoxication. The plaintiff ’s position must be judged by the facts as they were when the suit was begun, not by the facts of a different condition and an earlier time. [Emphasis added.]

Decision and Remedy The district court’s injunction was allowed to stand. The competing beverage companies were enjoined from calling their products Koke.

Impact of This Case on Today’s Law In this early case, the United States Supreme Court made it clear that trademarks and trade names (and nicknames for those marks and names, such as the nickname “Coke” for “Coca-Cola”) that are in common use receive protection under the common law. This holding is significant historically because it is the predecessor to the federal statute later passed to protect trademark rights—the Lanham Act of 1946. In many ways, this act represented a codification of common law prin- ciples governing trademarks.

Critical Thinking • What If the Facts Were Different? Suppose that Coca-Cola had been trying to make the public

believe that its product contained cocaine. Would the result in this case likely have been different? Why or why not?

Case 8.1 Continued

a. In reality, until 1903 the amount of active cocaine in each bottle of Coke was equivalent to one “line” of cocaine.

152 U N I T T W O The Public and International Environment

8–1a Statutory Protection of Trademarks Statutory protection of trademarks and related property is provided at the federal level by the Lanham Act of 1946.1 The Lanham Act was enacted, in part, to protect manufacturers from losing business to rival companies that used confusingly similar trademarks. The act incor- porates the common law of trademarks and provides remedies for owners of trademarks who wish to enforce their claims in federal court. Many states also have trade- mark statutes.

Trademark Dilution In 1995, Congress amended the Lanham Act by passing the Federal Trademark Dilution Act,2 which allowed trademark owners to bring suits in federal court for trademark dilution. In 2006, Congress further amended the law on trademark dilution by pass- ing the Trademark Dilution Revision Act (TDRA).3

Under the TDRA, to state a claim for trademark dilu- tion, a plaintiff must prove the following: 1. The plaintiff owns a famous mark that is distinctive. 2. The defendant has begun using a mark in commerce

that allegedly is diluting the famous mark. 3. The similarity between the defendant’s mark and the

famous mark gives rise to an association between the marks.

4. The association is likely to impair the distinctiveness of the famous mark or harm its reputation.

Trademark dilution laws protect “distinctive” or “famous” trademarks (such as Rolls Royce, McDonald’s, Starbucks, and Apple) from certain unauthorized uses. Such a mark is protected even when the use is on non- competing goods or is unlikely to cause confusion. More than half of the states have also enacted trademark dilu- tion laws.

Marks Need Not Be Identical Note that a famous mark may be diluted by the use of an identical mark or by identical mark or by identical the use of a similar mark.similar mark.similar 4 A similar mark is more likely to lessen the value of a famous mark when the companies using the marks provide related goods or compete against each other in the same market.

■ CASE IN POINT 8.1 Samantha Lundberg opened a business called “Sambuck’s Coffeehouse,” in Astoria, Oregon, even though she knew that “Starbucks” was one of the largest coffee chains in the nation. Starbucks

1. 15 U.S.C. Sections 1051–1128. 2. 15 U.S.C. Section 1125. 3. Pub. L. No. 103-312, 120 Stat. 1730 (2006). 4. See Louis Vuitton Malletier S.A. v. Haute Diggity Dog, LLC, 507 F.3d 252 Louis Vuitton Malletier S.A. v. Haute Diggity Dog, LLC, 507 F.3d 252 Louis Vuitton Malletier S.A. v. Haute Diggity Dog, LLC

(4th Cir. 2007); and Moseley v. V Secret Catalogue, Inc., 537 U.S. 418, 123 S.Ct. 1115, 155 L.Ed.2d 1 (2003).

Corporation filed a dilution lawsuit, and a federal court ruled that use of the “Sambuck’s” mark constituted trademark dilution because it created confusion for consumers. Not only was there a “high degree” of simi- larity between the marks, but also both companies pro- vided coffee-related services and marketed their services through “stand-alone” retail stores. Therefore, the use of the similar mark (Sambuck’s) reduced the value of the famous mark (Starbucks).5 ■

8–1b Trademark Registration Trademarks may be registered with the state or with the federal government. To register for protection under fed- eral trademark law, a person must file an application with the U.S. Patent and Trademark Office in Washington, D.C. Under current law, a mark can be registered (1) if it is currently in commerce or (2) if the applicant intends to put it into commerce within six months.

In special circumstances, the six-month period can be extended by thirty months. Thus, the applicant would have a total of three years from the date of notice of trademark approval to make use of the mark and file the required use statement. Registration is postponed until the mark is actually used. During this waiting period, any applicant can legally protect his or her trademark against a third party who previously has neither used the mark nor filed an application for it.

Registration is renewable between the fifth and sixth years after the initial registration and every ten years thereafter (every twenty years for those trademarks reg- istered before 1990).

8–1c Trademark Infringement Registration of a trademark with the U.S. Patent and Trademark Office gives notice on a nationwide basis that the trademark belongs exclusively to the registrant. The registrant is also allowed to use the symbol - to indi- cate that the mark has been registered. Whenever that trademark is copied to a substantial degree or used in its entirety by another, intentionally or unintention- ally, the trademark has been infringed (used without infringed (used without infringed authorization).

When a trademark has been infringed, the owner of the mark has a cause of action against the infringer. To succeed in a trademark infringement action, the owner must show that the defendant’s use of the mark created a likelihood of confusion about the origin of the defen- dant’s goods or services. The owner need not prove that

5. Starbucks Corp. v. Lundberg, 2005 WL 3183858 (D.Or. 2005).Starbucks Corp. v. Lundberg, 2005 WL 3183858 (D.Or. 2005).Starbucks Corp. v. Lundberg Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 8 Intellectual Property Rights 153

the infringer acted intentionally or that the trademark was registered (although registration does provide proof of the date of inception of the trademark’s use).

The most commonly granted remedy for trademark infringement is an injunction to prevent further infringe- ment. Under the Lanham Act, a trademark owner that successfully proves infringement can recover actual damages, plus the profits that the infringer wrongfully

received from the unauthorized use of the mark. A court can also order the destruction of any goods bearing the unauthorized trademark. In some situations, the trade- mark owner may also be able to recover attorneys’ fees.

At the center of the following case was an injunction granted in an earlier dispute between two brothers pro- hibiting one of them from using trademarks owned by the other, including a mark featuring their shared last name.

Background and Facts Brothers Jimmy and Larry Flynt owned “The Hustler Club,” a bar and night- club in Cincinnati, Ohio. Larry opened Hustler clubs in other Ohio cities. Within a few years, he also began publishing Hustler, a sexually explicit magazine. Larry formed LFP IP, Inc., and other corpora- tions to conduct his enterprises. Many of them used the trademarks “HUSTLER” and “LARRY FLYNT,” which LFP owned. Jimmy opened his own store, Hustler Cincinnati, and paid LFP licensing fees to use the “HUSTLER” mark.

When the store stopped paying the fees, LFP filed a suit in a federal district court against the store’s corporate owner, alleging trademark infringement. The court issued an injunction prohibiting Jimmy from using the “HUSTLER” mark. Later, he opened a store called “FLYNT Sexy Gifts.” LFP claimed that this name was likely to cause confusion with the “LARRY FLYNT” mark. The court modified the injunc- tion to limit Jimmy’s use of the “Flynt” name without “Jimmy.” Jimmy appealed.

In the Language of the Court SUTTON, Circuit Judge.

* * * * Courts * * * may exercise their sound judicial discretion to modify an injunction if the circumstances,

whether of law or fact, obtaining at the time of its issuance have changed, or new ones have since arisen. * * * The [district] court * * * applied the traditional test for trademark infringement under federal

law, asking whether (1) Larry and his companies owned the LARRY FLYNT trademark, (2) Jimmy used the mark in commerce, and (3) the use was likely to cause confusion. The court found all three ele- ments satisfied * * * . Because the original injunction was tailored to prevent trademark infringement by [Jimmy] and because Jimmy had committed new violations, the district court acted appropriately when it modified its initial grant of relief to cover Jimmy’s conduct at the [new] outlet.

The district court’s modified injunction was also suitably tailored to the changed circumstances. Balancing the competing interests of Larry and Jimmy, the court permitted Jimmy to use his full name while protecting Larry’s interest in the LARRY FLYNT trademark.

* * * * Jimmy * * * takes issue with some of the factual findings that the district court used to justify the

modified injunction. But none of the district court’s factual findings is clearly erroneous. * * * Larry * * * presented evi-

dence that he used the mark in connection with a wide range of adult entertainment products, including the kinds of products sold at Jimmy’s store. Because product use * * * marks the salient [most noticeable] indicator of ownership in trademark-infringement actions, the district court reasonably found that Larry * * * owned the LARRY FLYNT trademark with respect to retail goods. The court also reasonably found that Larry began using the mark on adult entertainment products before Jimmy did. * * * And * * * Larry’s company * * * continued to use that mark in commerce. [Emphasis added.]

In claiming an absence of evidence of consumer confusion, Jimmy missteps. Some of the evidence comes from Jimmy himself. When asked about instances where a consumer has been confused, in terms of whether or not Jimmy was the owner of the store, Jimmy responded, “I have experienced the

LFP IP, LLC v. P, LLC v. P Hustler Cincinnati, Inc. United States Court of Appeals, Sixth Circuit, 810 F.3d 424 (2016).

Case 8.2

154 U N I T T W O The Public and International Environment

confusion in the names, you know. Jimmy and Larry Flynt, in this market area, is somewhat synony- mous with Hustler or with Flynt. You’re not going to get around that.”

Decision and Remedy The U.S. Court of Appeals for the Sixth Circuit affirmed the lower court’s modifi- cation of the injunction. The injunction was initially tailored to prevent Jimmy’s infringement of his brother’s marks. When Jimmy committed a new violation by opening “FLYNT Sexy Gifts,” the district court acted appropriately in modifying the injunction to cover this conduct.

Critical Thinking • E-Commerce Could Jimmy use his last name—the name that he shares with his brother—as a domain

name? Why or why not? • What If the Facts Were Different? Suppose that Jimmy had used the marks at the center of this case

on an entirely different line of goods, not adult entertainment products. Would the result have been the same? Explain.

Case 8.2 Continued

8–1d Distinctiveness of the Mark A trademark must be sufficiently distinctive to enable consumers to identify the manufacturer of the goods eas- ily and to distinguish between those goods and compet- ing products.

Strong Marks Fanciful, arbitrary, or suggestive trade- marks are generally considered to be the most distinctive (strongest) trademarks. These marks receive automatic protection because they serve to identify a particular prod- uct’s source, as opposed to describing the product itself.

Fanciful and Arbitrary Trademarks. Fanciful trade- marks use invented words, such as “Xerox” for one manufacturer’s copiers and “Google” for a search engine. Arbitrary trademarks use common words in an uncom- mon way that is not descriptive of the product, such as “Dutch Boy” as a name for paint.

Even a single letter used in a particular style can be an Even a single letter used in a particular style can be an Even a single letter used in a particular style can be an arbitrary trademark. ■ CASE IN POINT 8.2 Sports enter Sports enter- tainment company ESPN sued Quiksilver, Inc., a maker of youth-oriented clothing, alleging trademark infringe- ment. ESPN claimed that Quiksilver’s clothing used the stylized “X” mark that ESPN uses in connection with the “X Games” (“extreme” sports competitions).

Quiksilver filed counterclaims for trademark infringe- ment and dilution, arguing that it had a long history of using the stylized X on its products. ESPN had created the X Games in the mid-1990s, and Quiksilver had been using the X mark since 1994. ESPN asked the court to dismiss Quiksilver’s counterclaims, but the court refused, holding that the X on Quiksilver’s clothing is clearly an arbitrary mark. The court found that the two Xs are

“similar enough that a consumer might well confuse them.” Therefore, Quicksilver could continue its claim for trademark infringement.6 ■

Suggestive Trademarks. Suggestive trademarks indicate something about a product’s nature, quality, or charac- teristics, without describing the product directly. �ese marks require imagination on the part of the consumer to identify the characteristic.

“Dairy Queen,” for instance, suggests an association between its products and milk, but it does not directly describe ice cream. “Blu-ray” is a suggestive mark that is associated with the high-quality, high-definition video contained on a particular type of optical data storage disc. Although blue-violet lasers are used to read blu-ray discs, the term blu-ray does not directly describe the disc.blu-ray does not directly describe the disc.blu-ray

Secondary Meaning Descriptive terms, geographic terms, and personal names are not inherently distinctive and do not receive protection under the law until they acquire a secondary meaning. A secondary meaning may arise when customers begin to associate a specific term or phrase (such as London Fog) with specific trademarked London Fog) with specific trademarked London Fog items (coats with “London Fog” labels) made by a par- ticular company.

Whether a secondary meaning becomes attached to a name usually depends on how extensively the product is advertised, the market for the product, the number of sales, and other factors. ■ CASE IN POINT 8.3 Unity Unity Health Plans Insurance Corporation has been a health maintenance organization (HMO) insurer in Wisconsin since 1955. In 2013, another health-care provider, Iowa

6. ESPN, Inc. v. Quiksilver, Inc., 586 F.Supp.2d 219 (S.D.N.Y. 2008). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 8 Intellectual Property Rights 155

Health System, began rebranding itself (changing its name and marketing) as UnityPoint Health. When the company expanded into Wisconsin, where Unity Health already had an established presence, Unity Health filed a trademark infringement suit in federal court.

The court found that Unity Health was a descriptive mark, and thus not inherently distinctive. But the court also held that the Unity Health mark had acquired a sec- ondary meaning, largely because it had been used for so long and so exclusively by one health insurer in Wiscon- sin. It made no difference to the court that only one part of the mark (Unity) was common to both trademarks. To allow Iowa Health Systems to use the mark UnityPoint Health in Wisconsin would likely create confusion for consumers. Therefore, the court issued an injunction and blocked Iowa Health from using the trademark Unity- Point Health.7 ■

Once a secondary meaning is attached to a term or name, a trademark is considered distinctive and is pro- tected. Even a color can qualify for trademark protection, as did the color schemes used by some state university sports teams, including Ohio State University and Loui- siana State University.8

■ CASE IN POINT 8.4 Federal Express Corporation Federal Express Corporation (FedEx) provides transportation and delivery services worldwide using the logo FedEx in a specific color com- bination. FedEx sued a competitor, JetEx Management Services, Inc., for using the same color combination and a similar name and logo. JetEx also mimicked FedEx’s trademarked slogan (“The World on Time” for FedEx, and “Keeping the World on Time” for JetEx). FedEx alleged trademark infringement and dilution, among other claims. A federal district court in New York granted a permanent injunction to block JetEx from using the infringing mark in FedEx colors.9 ■

Generic Terms Generic terms that refer to an entire class of products, such as bicycle and bicycle and bicycle computer, receive no protection, even if they acquire secondary meanings. A particularly thorny problem arises when a trademark acquires generic use. For instance, aspirin and thermos were originally the names of trademarked products, but today the words are used generically. Other trademarks that have acquired generic use are escalator, trampoline, raisin bran, dry ice, lanolin, linoleum, nylon, and cornflakes.

7. Unity Health Plans Insurance Co. v. Iowa Health System, 995 F.Supp.2d 874 (W.D.Wis. 2014).

8. Board of Supervisors of Louisiana State University v. Smack Apparel Co., 438 F.Supp.2d 653 (E.D.La. 2006). See also Abraham v. Alpha Chi Omega, 781 F.Supp.2d 396 (N.D.Tex. 2011).

9. Federal Express Corp. v. JetEx Management Services, Inc., 2014 WL 4628983 (E.D.N.Y. 2014).

A trademark does not become generic simply because A trademark does not become generic simply because A trademark does not become generic simply because it is commonly used, however. ■ CASE IN POINT 8.5 In 2014, David Elliot and Chris Gillespie sought to register numerous domain names, including “googledisney.com” and “googlenewstvs.com.” (A domain name is part of domain name is part of domain name an Internet address, such as “cengage.com.”) They were unable to register the names because all of them used the word google, a trademark of Google, Inc.

Elliot and Gillespie brought an action in federal court to have the Google trademark cancelled because it had become a generic term. They argued that because most people now use google as a verb (“to google”) when refergoogle as a verb (“to google”) when refergoogle - ring to searching the Internet with any search engine (not just Google), the term should no longer be protected. The court held that even if people do use the word google as a verb, it is still a protected trademark if consumers associate the noun with one company. The court con- cluded that “the primary significance of the word google to a majority of the public who utilize Internet search engines is a designation of the Google search engine.”10 ■

8–1e Service, Certification, and Collective Marks

A service mark is essentially a trademark that is used to service mark is essentially a trademark that is used to service mark distinguish the services (rather than the products) of one services (rather than the products) of one services person or company from those of another. For instance, each airline has a particular mark or symbol associated with its name. Titles and character names used in radio and television are frequently registered as service marks.

Other marks protected by law include certification marks and collective marks. A certification mark is certification mark is certification mark used by one or more persons, other than the owner, to certify the region, materials, mode of manufacture, qual- ity, or other characteristic of specific goods or services. Certification marks include “Good Housekeeping Seal of Approval” and “UL Tested.”

When used by members of a cooperative, association, or other organization, a certification mark is referred to or other organization, a certification mark is referred to or other organization, a certification mark is referred to as a collective mark. ■ EXAMPLE 8.6 Collective marks appear at the ends of motion picture credits to indicate the various associations and organizations that partici- pated in the making of the films. The union marks found on the tags of certain products are also collective marks. ■

8–1f Trade Dress The term trade dress refers to the image and overall appearance of a product. Trade dress is a broad concept

156 U N I T T W O The Public and International Environment

and can include either all or part of the total image or overall impression created by a product or its packaging.overall impression created by a product or its packaging.overall impression created by a product or its packaging.

■ EXAMPLE 8.7 The distinctive decor, menu, lay The distinctive decor, menu, lay- out, and style of service of a particular restaurant may be regarded as trade dress. Trade dress can also include the layout and appearance of a catalogue, the use of a light- house as part of the design of a golf hole, the fish shape of a cracker, or the G-shaped design of a Gucci watch. ■

Basically, trade dress is subject to the same protection as trademarks. In cases involving trade dress infringe- ment, as in trademark infringement cases, a major con- sideration is whether consumers are likely to be confused by the allegedly infringing use.

8–1g Counterfeit Goods Counterfeit goods copy or otherwise imitate trade- marked goods, but they are not the genuine trademarked goods. The importation of goods that bear counterfeit (fake) trademarks poses a growing problem for U.S. businesses, consumers, and law enforcement. In addi- tion to the negative financial effects on legitimate busi- nesses, certain counterfeit goods, such as pharmaceuticals and nutritional supplements, can present serious public health risks.

The Stop Counterfeiting in Manufactured Goods Act The Stop Counterfeiting in Manufactured Goods Act11 (SCMGA) was enacted to combat counter- feit goods. The act makes it a crime to traffic intentionally in or attempt to traffic in counterfeit goods or services, or to knowingly use a counterfeit mark on or in connection with goods or services.

Before this act, the law did not prohibit the creation or shipment of counterfeit labels that were not attached to any product. Therefore, counterfeiters would make labels and packaging bearing another’s trademark, ship the labels to another location, and then affix them to an inferior product to deceive buyers. The SCMGA closed this loophole by making it a crime to knowingly traf-this loophole by making it a crime to knowingly traf-this loophole by making it a crime to knowingly traf fic in counterfeit labels, stickers, packaging, and the like, regardless of whether the items are attached to any goods.

Penalties for Counterfeiting Persons found guilty of violating the SCMGA may be fined up to $2 million or imprisoned for up to ten years (or more if they are repeat offenders). If a court finds that the statute was violated, it must order the defendant to forfeit the counterfeit prod- ucts (which are then destroyed), as well as any property

11. Pub. L. No. 109-181 (2006), which amended 18 U.S.C. Sections 2318–2320.

used in the commission of the crime. The defendant must also pay restitution to the trademark holder or victim in an amount equal to the victim’s actual loss.

■ CASE IN POINT 8.8 Charles Anthony Jones pleaded guilty to trafficking of counterfeit prescription erectile dysfunction drugs. The court sentenced Jones to thirty- seven months in prison and ordered him to pay $633,019 in restitution. Jones appealed, arguing that the amount awarded was more than the pharmaceutical companies’ actual losses. The court agreed. The pharmaceutical com- panies were entitled only to their lost net profits rather than the retail price of the genuine drugs.12 ■

Combating Foreign Counterfeiters Although Congress has enacted statutes against counterfeit goods, the United States cannot prosecute foreign counterfeit- ers because our national laws do not apply to them. One effective tool that U.S. officials have used to combat online sales of counterfeit goods is to obtain a court order to close down the domain names of Web sites that sell such goods. For instance, U.S. agents have shut down hundreds of domain names on the Monday after Thanks- giving (“Cyber Monday”). Shutting down the Web sites, particularly on key shopping days, prevents some coun- terfeit goods from entering the United States. Europol, an international organization, has also used this tactic.

8–1h Trade Names Trademarks apply to products. A trade name indicates part or all of a business’s name, whether the business is a sole proprietorship, a partnership, or a corporation. Gen- erally, a trade name is directly related to a business and its goodwill.

A trade name may be protected as a trademark if the trade name is also the name of the company’s trade- marked product—for example, Coca-Cola. Unless it is also used as a trademark or service mark, a trade name cannot be registered with the federal government. Trade names are protected under the common law, but only if they are unusual or fancifully used. The word Safeway, for example, was sufficiently fanciful to obtain protection as a trade name for a grocery chain.

8–1i Licensing One way to avoid litigation and still make use of anoth- er’s trademark or other form of intellectual property is to obtain a license to do so. A license in this context is an agreement, or contract, permitting the use of a

C H A P T E R 8 Intellectual Property Rights 157

trademark, copyright, patent, or trade secret for certain purposes. The party that owns the intellectual property rights and issues the license is the licensor, and the party obtaining the license is the licensee. The licensee generally pays fees, or royalties, for the privilege of using the intel- lectual property.

A license grants only the rights expressly described in the license agreement. A licensor might, for example, allow the licensee to use the trademark as part of its com- pany or domain name, but not otherwise use the mark on any products or services. Disputes frequently arise over licensing agreements, particularly when the license involves Internet uses.

■ CASE IN POINT 8.9 George V Restauration S.A. George V Restauration S.A. and others owned and operated the Buddha Bar Paris, a restaurant with an Asian theme in Paris, France. One of the owners allowed Little Rest Twelve, Inc., to use the Buddha Bar trademark and its associated concept in New York City under the name Buddha Bar NYC. Little Rest paid royalties for its use of the Buddha Bar mark and advertised Buddha Bar NYC’s affiliation with Buddha Bar Paris. This connection was also noted on its Web site and in the media.

When a dispute arose, the owners of Buddha Bar Paris withdrew their permission for Buddha Bar NYC’s use of their mark, but Little Rest continued to use it. The own- ers of the mark filed a suit in a New York state court against Little Rest. The court granted an injunction to prevent Little Rest from using the mark.13 ■

8–2 Patents A patent is a grant from the government that gives an patent is a grant from the government that gives an patent inventor the exclusive right to make, use, or sell his or her invention for a period of twenty years. Patents for designs, as opposed to those for inventions, are given for a fourteen-year period. The applicant must demonstrate to the satisfaction of the U.S. Patent and Trademark Office that the invention, discovery, process, or design is novel, useful, and not obvious in light of current technology.

Until recently, U.S. patent law differed from the laws of many other countries because the first person to invent a product obtained the patent rights rather than the first person to file for a patent. It was often difficult to prove who invented an item first, however, which prompted Congress to change the system in 2011 by passing the

13. George V Restauration S.A. v. Little Rest Twelve, Inc., 58 A.D.3d 428, 871 N.Y.S.2d 65 (2009).

America Invents Act.14 Now the first person to file an application for a patent on a product or process will receive patent protection. In addition, the new law estab- lished a nine-month limit for challenging a patent on any ground.

The period of patent protection begins on the date the patent application is filed, rather than when the pat- ent is issued, which may sometimes be years later. After the patent period ends (either fourteen or twenty years later), the product or process enters the public domain, and anyone can make, sell, or use the invention without paying the patent holder.

8–2a Searchable Patent Databases A significant development relating to patents is the avail- ability online of the world’s patent databases. The Web site of the U.S. Patent and Trademark Office (www. uspto.gov) provides searchable databases covering U.S. patents granted since 1976. The Web site of the Euro- pean Patent Office (www.epo.org) provides online access to 50 million patent documents in more than seventy nations through a searchable network of databases.

Businesses use these searchable databases in many ways. Companies may conduct patent searches to list or inventory their patents, which are valuable assets. Patent searches may also be conducted to study trends and pat- terns in a specific technology or to gather information about competitors in the industry.

8–2b What Is Patentable? Under federal law, “[w]hoever invents or discovers any new and useful process, machine, manufacture, or com- position of matter, or any new and useful improvement thereof, may obtain a patent therefor, subject to the conditions and requirements of this title.”15 Thus, to be patentable, the applicant must prove that the invention, discovery, process, or design is novel, useful, and not obvi- ous in light of current technology.ous in light of current technology.ous

In sum, almost anything is patentable, except the laws of nature, natural phenomena, and abstract ideas (including algorithms16). Even artistic methods and works of art, certain business processes, and the struc-

14. The full title of this law is the Leahy-Smith America Invents Act, Pub. L. No. 112-29 (2011), which amended 35 U.S.C. Sections 1, 41, and 321.

15. 35 U.S.C. Section 101. 16. An algorithm is a step-by-step procedure, formula, or set of instructions

for accomplishing a specific task. An example is the set of rules used by a search engine to rank the listings contained within its index in response to a query.

158 U N I T T W O The Public and International Environment

tures of storylines are patentable, provided that they are novel and not obvious.17

Plants that are reproduced asexually (by means other than from seed), such as hybrid or genetically engi- neered plants, are patentable in the United States, as are genetically engineered (or cloned) microorganisms and genetically engineered (or cloned) microorganisms and genetically engineered (or cloned) microorganisms and animals. ■ CASE IN POINT 8.10 Monsanto, Inc., sells its patented genetically modified (GM) seeds to farm- ers to help them achieve higher yields from crops using fewer pesticides. It requires farmers who buy GM seeds to sign licensing agreements promising to plant the seeds for only one crop and to pay a technology fee for each acre planted. To ensure compliance, Monsanto has many full-time employees whose job is to investigate and prosecute farmers who use the GM seeds illegally. Mon- santo has filed nearly 150 lawsuits against farmers in the United States and has been awarded more than $15 mil- lion in damages (not including out-of-court settlement amounts).18 ■

8–2c Patent Infringement If a firm makes, uses, or sells another’s patented design, product, or process without the patent owner’s permis- sion, that firm commits the tort of patent infringement. Patent infringement may occur even though the patent owner has not put the patented product into commerce. Patent infringement may also occur even though not all features or parts of a product are copied. (To infringe the patent on a process, however, all steps or their equiva- lent must be copied.) To read about an important issue in patent infringement today, see this chapter’s Digital Update feature.

Patent Infringement Lawsuits and High-Tech Companies Obviously, companies that specialize in developing new technology stand to lose significant prof-developing new technology stand to lose significant prof-developing new technology stand to lose significant prof its if someone “makes, uses, or sells” devices that incorpo- rate their patented inventions. Because these firms are the holders of numerous patents, they are frequently involved in patent infringement lawsuits (as well as other types of intellectual property disputes).

■ CASE IN POINT 8.11 Apple sued Samsung in federal Apple sued Samsung in federal court alleging that Samsung’s Galaxy smartphones and tablets that use Google’s HTC Android operating system infringe on Apple’s patents. Apple has design patents that

17. For a United States Supreme Court case discussing the obviousness requirement, see KSR International Co. v. Teleflex, Inc., 550 U.S. 398, 127 S.Ct. 1727, 167 L.Ed.2d 705 (2007).

18. See, for example, Monsanto Co. v. Bowman, 657 F.3d 1341 (Fed.Cir. 2011); and Monsanto Co. v. Scruggs, 2009 WL 1228318 (Fed.Cir. 2009).

cover its devices’ graphical user interface (the display of icons on the home screen), shell, and screen and button design. Apple has also patented the way information is displayed on iPhones and other devices, the way win- dows pop open, and the way information is scaled and rotated.

A jury found that Samsung had willfully infringed five of Apple’s patents and awarded damages. The parties appealed. A judge later reduced the amount of damages awarded on the patent claims, but litigation between the two companies has continued. In 2015, a federal appel- late court held that elements of the physical design of these two manufacturers’ mobile devices and their on- screen icons were functional and thus not protected under the Lanham Act. A product feature is functional and not protected as trade dress if it is essential to the article’s use or purpose or affects the cost or quality of the article. 19 ■

Patent Infringement and Foreign Sales Many companies that make and sell electronics and computer software and hardware are based in foreign nations (for instance, Samsung Electronics Company is a Korean firm). Foreign firms can apply for and obtain U.S. pat- ent protection on items that they sell within the United States. Similarly, U.S. firms can obtain protection in for- eign nations where they sell goods.

In the United States, the Supreme Court has narrowly construed patent infringement as it applies to exported software, however. As a general rule, under U.S. law, no patent infringement occurs when a patented product is patent infringement occurs when a patented product is patent infringement occurs when a patented product is made and sold in another country. ■ CASE IN POINT 8.12 AT&T Corporation holds a patent on a device used to digitally encode, compress, and process recorded speech. AT&T brought an infringement case against Microsoft Corporation, which admitted that its Win- dows operating system incorporated software code that infringed on AT&T’s patent.

The United States Supreme Court held that Micro- soft was liable only for infringement in the United States and not for the Windows-based computers produced in foreign locations. The Court reasoned that Microsoft had not “supplied” the software for the computers but had only electronically transmitted a master copy, which the foreign manufacturers copied and loaded onto the computers.20 ■

19. Apple, Inc. v. Samsung Electronics Co., 926 F.Supp.2d 1110 (N.D.Cal. 2013); 786 F.3d 983 (Fed. Cir. 2015).

20. Microsoft Corp. v. AT&Microsoft Corp. v. AT&Microsoft Corp. v. AT T Corp., 550 U.S. 437, 127 S.Ct. 1746, 167 L.Ed.2d 737 (2007).

C H A P T E R 8 Intellectual Property Rights 159

The Problem of Patent Trolls

In recent years, a huge number of patent infringement lawsuits have been filed against software and technology firms. Many patent cases involve companies defending real inno- vations, but some lawsuits are “shakedowns” by patent trolls.

Patent trolls—more formally called nonprac-Patent trolls—more formally called nonprac-Patent trolls ticing entities (NPEs) or patent assertion enti- ties (PAEs)—are firms that do not make or sell products or services but are in the business of patent litigation. These firms buy patents and then try to enforce them against companies that do sell products or services, do sell products or services, do demanding licensing fees and threatening infringement lawsuits. Patent trolls usually target online businesses.

“I’m Going to Sue You Unless You Pay Me to Go Away”

Patent trolls literally bank on the fact that when threat- ened with infringement suits, most companies would rather pay to settle than engage in costly litigation, even if they believe they could win.

Consider an example. Soverain Software, LLC, sued dozens of online retailers, including Amazon, Avon, Home Depot, Macy’s, Nordstrom, Kohl’s, RadioShack, The Gap, and Victoria’s Secret. Soverain claimed that it owned patents that covered nearly any use of online shopping-cart technology and that all these retailers had infringed on its patents. Amazon paid millions to settle with Soverain, as did most of the other defendants.

Interestingly, one online retailer, Newegg, Inc., refused to pay Soverain and ultimately won in court. In 2013, a federal appellate court held that the

shopping-cart patent claim was invalid on the ground of obviousness because the technol- ogy for it had already existed before Soverain obtained its patent.a

The Role of Software Patents

The patent troll problem is concentrated in software patents, which often include

descriptions of what the software does rather than the computer code involved. Many software patents are vaguely worded and overly broad. In the United States, both the patent system and the courts have had diffi- culty evaluating and protecting such patents.

As a result, nearly any business that uses basic tech- nology can be a target of patent trolls. In fact, more than 60 percent of all new patent cases are filed by pat-new patent cases are filed by pat-new patent cases ent trolls. The firms most commonly targeted by patent trolls are large technology companies, including AT&T, Google, Apple, Samsung, Amazon, and Verizon. In one recent year, “AT&T was sued for patent infringement by patent trolls 54 times—more than once a week.”b

Critical Thinking Some argue that the best way to stop patent trolls from taking advantage of the system would be to eliminate software patents completely and pass a law that makes software unpatentable. Would this be fair to software and technology companies? Why or why not?

DIGITAL UPDATE

a. Soverain Software, LLC v. Newegg, Inc., 728 F.3d 1332 (Fed. Cir. 2013), cert. denied, 134 S.Ct. 910 (2014).

b. Roger Parloff, “Taking on the Patent Trolls,” “Taking on the Patent Trolls,” “ Fortune, February 27, 2014.

8–2d Remedies for Patent Infringement If a patent is infringed, the patent holder may sue for relief in federal court. The patent holder can seek an injunction against the infringer and can also request damages for royalties and lost profits. In some cases, the court may grant the winning party reimbursement for attorneys’ fees and costs. If the court determines that the infringement was willful, the court can triple the amount of damages awarded (treble damages).

In the past, permanent injunctions were routinely granted to prevent future infringement. Today, however, according to the United States Supreme Court, a patent holder must prove that it has suffered irreparable injury and that the public interest would not be disserved by disserved by disserved

a permanent injunction.21 Thus, courts have discretion to decide what is equitable in the circumstances and to consider what is in the public interest rather than just the interests of the parties.

■ CASE IN POINT 8.13 Cordance Corporation devel- oped some of the technology and software that automates Internet communications. Cordance sued Amazon.com, Inc., for patent infringement, claiming that Amazon’s one-click purchasing interface infringed on one of Cor- dance’s patents. After a jury found Amazon guilty of infringement, Cordance requested the court to issue a permanent injunction against Amazon’s infringement or,

21. eBay, Inc. v. MercExchange, LLC, 547 U.S. 388, 126 S.Ct. 1837, 164 eBay, Inc. v. MercExchange, LLC, 547 U.S. 388, 126 S.Ct. 1837, 164 eBay, Inc. v. MercExchange, LLC L.Ed.2d 641 (2006).

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alternatively, to order Amazon to pay Cordance an ongo- ing royalty.

The court refused to issue a permanent injunction because Cordance had not proved that it would otherwise suffer irreparable harm. Cordance and Amazon were not direct competitors in the relevant market. Cordance had never sold or licensed the technology infringed by Ama- zon’s one-click purchasing interface and had presented no market data or evidence to show how the infringement negatively affected Cordance. The court also refused to impose an ongoing royalty on Amazon.22 ■

8–3 Copyrights A copyright is an intangible property right granted by copyright is an intangible property right granted by copyright federal statute to the author or originator of a literary or artistic production of a specified type. The Copyright Act of 1976,23 as amended, governs copyrights. Works cre- ated after January 1, 1978, are automatically given statu- tory copyright protection for the life of the author plus 70 years. For copyrights owned by publishing houses, the copyright expires 95 years from the date of publication or 120 years from the date of creation, whichever comes first. For works by more than one author, the copyright expires 70 years after the death of the last surviving author.24

When copyright protection ends, works enter into the public domain. Intellectual property, such as songs and other published works, that have entered into the pub- lic domain belong to everyone and are not protected by copyright or patent laws.copyright or patent laws.copyright or patent laws.

■ CASE IN POINT 8.14 The popular character Sher- lock Holmes originated in stories written by Arthur Conan Doyle and published from 1887 through 1927. Over the years, elements of the characters and stories cre- ated by Doyle have appeared in books, movies, and tele- vision series, including Elementary on CBS and Sherlock on BBC.

Before 2013, those who wished to use the copyrighted Sherlock material had to pay a licensing fee to Doyle’s estate. Then, in 2013, the editors of a book of Holmes- related stories filed a lawsuit in federal court claiming that the basic Sherlock Holmes story elements intro- duced before 1923 should no longer be protected. The

22. Cordance Corp. v. Amazon.com, Inc., 730 F.Supp.2d 333 (D.Del. 2010). 23. 17 U.S.C. Sections 101 et seq. 24. These time periods reflect the extensions of the length of copyright

protection enacted by Congress in the Copyright Term Extension Act of 1998, 17 U.S.C. Section 302. The United States Supreme Court upheld the constitutionality of the act in 2003. See Eldred v. Ashcroft, 537 U.S. Eldred v. Ashcroft, 537 U.S. Eldred v. Ashcroft 186, 123 S.Ct. 769, 154 L.Ed.2d 683 (2003).

court agreed and ruled that these elements have entered the public domain—that is, the copyright has expired, and they can be used without permission.25 ■

8–3a Registration Copyrights can be registered with the U.S. Copyright Office (www.copyright.gov) in Washington, D.C. Reg- istration is not required, however. A copyright owner no longer needs to place the symbol . or the term Copr. or Copyright on the work to have the work protected against Copyright on the work to have the work protected against Copyright infringement. Chances are that if somebody created it, somebody owns it.

Generally, copyright owners are protected against the following: 1. Reproduction of the work. 2. Development of derivative works. 3. Distribution of the work. 4. Public display of the work.

8–3b What Is Protected Expression? Works that are copyrightable include books, records, films, artworks, architectural plans, menus, music vid- eos, product packaging, and computer software. To be protected, a work must be “fixed in a durable medium” from which it can be perceived, reproduced, or commu- nicated. As noted, protection is automatic, and registra- tion is not required.

Section 102 of the Copyright Act explicitly states that it protects original works that fall into one of the follow- ing categories: 1. Literary works (including newspaper and magazine

articles, computer and training manuals, catalogues, brochures, and print advertisements).

2. Musical works and accompanying words (including advertising jingles).

3. Dramatic works and accompanying music. 4. Pantomimes and choreographic works (including

ballets and other forms of dance). 5. Pictorial, graphic, and sculptural works (including

cartoons, maps, posters, statues, and even stuffed animals).

6. Motion pictures and other audiovisual works (includ- ing multimedia works).

7. Sound recordings. 8. Architectural works.

25. Klinger v. Conan Doyle Estate, Ltd., 988 F.Supp.2d 879 (N.D.III. 2013). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 8 Intellectual Property Rights 161

Section 102 Exclusions Generally, anything that is not an original expression will not qualify for copy- right protection. Facts widely known to the public are not copyrightable. Page numbers are not copyrightable because they follow a sequence known to everyone. Math- ematical calculations are not copyrightable.

Furthermore, it is not possible to copyright an idea. Section 102 of the Copyright Act specifically excludes copyright protection for any “idea, procedure, process, sys- tem, method of operation, concept, principle, or discovery, regardless of the form in which it is described, explained, illustrated, or embodied.” Thus, anyone can freely use the underlying ideas or principles embodied in a work.

What is copyrightable is the particular way in which an idea is expressed. Whenever an idea and an expression are inseparable, the expression cannot be copyrighted. An idea and its expression, then, must be separable to be copyrightable. Thus, for the design of a useful item to be copyrightable, the way it looks must be separate from its utilitarian (functional) purpose.utilitarian (functional) purpose.utilitarian (functional) purpose.

■ CASE IN POINT 8.15 Inhale, Inc., registered a copy Inhale, Inc., registered a copy- right on a hookah—a device for smoking tobacco by fil- tering the smoke through water held in a container at the base. Starbuzz Tobacco, Inc., sold hookahs with water containers shaped exactly like the Inhale containers.

Inhale filed a suit in a federal district court against Star- buzz for copyright infringement. The court determined that the shape of the water container on Inhale’s hookahs was not copyrightable. The U.S. Court of Appeals for the Ninth Circuit affirmed the judgment. “The shape of a container is not independent of the container’s utilitar- ian function—to hold the contents within its shape— because the shape accomplishes the function.”26 ■

26. Inhale, Inc. v. Starbuzz Tobacco, Inc., 755 F.3d 1038 (2014).

Compilations of Facts Unlike ideas, compilations of compilations of compilations facts are copyrightable. Under Section 103 of the Copyright Act, a compilation is “a work formed by the collection and assembling of preexisting materials or data that are selected, coordinated, or arranged in such a way that the resulting work as a whole constitutes an original work of authorship.”

The key requirement in the copyrightability of a compilation is originality. If the facts are selected, coor- dinated, or arranged in an original way, they can qualify for copyright protection. Therefore, the White Pages of a telephone directory do not qualify for copyright protec- tion, because they simply list alphabetically names and telephone numbers. The Yellow Pages of a directory can be copyrightable, provided the information is selected, coordinated, or arranged in an original way. Similarly, a compilation of information about yachts listed for sale has qualified for copyright protection.27

8–3c Copyright Infringement Whenever the form or expression of an idea is copied, an infringement of copyright has occurred. The reproduc- tion does not have to be exactly the same as the original, nor does it have to reproduce the original in its entirety. If a substantial part of the original is reproduced, the copyright has been infringed.

In the following case, rapper Curtis Jackson—better known as “50 Cent”—was the defendant in a suit that claimed his album Before I Self-Destruct, and the film of the same name, infringed the copyright of Shadrach Winstead’s book The Preacher’s Son—But the Streets Turned Me into a Gangster.

27. BUC International Corp. v. International Yacht Council, Ltd., 489 F.3d BUC International Corp. v. International Yacht Council, Ltd., 489 F.3d BUC International Corp. v. International Yacht Council, Ltd 1129 (11th Cir. 2007).

In the Language of the Court PER CURIAM. [By the Whole Court]

* * * * * * * Winstead filed his * * * com-

plaint in the United States District Court for the District of New Jersey, claiming that Jackson’s album/CD and film derived their contents from, and infringed the copyright of, his book.

* * * *

* * * The District Court dismissed Winstead’s * * * complaint * * * , concluding that Jackson * * * did not improperly copy protected aspects of Winstead’s book.

* * * * Winstead appeals. * * * * Here, it is not disputed that Win-

stead is the owner of the copyrighted

property * * * . How- ever, not all copying is copyright infringe- ment, so even if actual copying is proven, the court must decide, by comparing the allegedly infringing work with the original work, whether the copying was unlawful. Copying may be proved inferentially by showing that the allegedly infringing work is substantially similar to the copyrighted

Case Analysis 8.3 Winstead v. Jackson United States Court of Appeals, Third Circuit, 509 Fed.Appx. 139 (2013).

162 U N I T T W O The Public and International Environment

work. A court compares the allegedly infringing work with the original work, and considers whether a “lay-observer” would believe that the copying was of protectable aspects of the copyrighted work. The inquiry involves distinguish- ing between the author’s expression and the idea or theme that he or she seeks to convey or explore, because the former is protected and the latter is not. The court must determine whether the alleg- edly infringing work is similar because it appropriates the unique expressions of the original work, or merely because it contains elements that would be expected when two works express the same idea or explore the same theme. [Emphasis added.]

* * * A lay observer would not believe that Jackson’s album/CD and film cop- ied protectable aspects of Winstead’s book. Jackson’s album/CD is comprised of 16 individual songs, which explore drug-dealing, guns and money, ven- geance, and other similar clichés of hip hop gangsterism. Jackson’s fictional film is the story of a young man who turns to violence when his mother is killed in a drive-by shooting. The young man takes revenge by killing the man who killed his mother, and then gets rich by becoming an “enforcer” for a powerful criminal. He takes up with a woman who eventu- ally betrays him, and is shot to death by her boyfriend, who has just been released from prison. The movie ends with his younger brother vowing to seek vengeance. Winstead’s book purports to be autobiographical and tells the story of a young man whose beloved father was a Bishop in the church. The pro- tagonist was angry as a child because his stepmother abused him, but he found acceptance and self-esteem on the streets of Newark because he was physically

powerful. He earned money robbing and beating people, went to jail, returned to crime upon his release, and then made even more money. The protagonist dis- cusses his time at Rahway State Prison in great and compelling detail. The story ends when the protagonist learns that his father has passed away; he conveys his belief that this tragedy has led to his redemption, and he hopes that others might learn from his mistakes.

* * * Although Winstead’s book and Jackson’s works share similar themes and setting, the story of an angry and wronged protagonist who turns to a life of violence and crime has long been a part of the public domain [and is there- fore not protected by copyright law]. Winstead argues * * * that a protagonist asking for God’s help when his father dies, cutting drugs with mixing agents to maximize profits, and complaining about relatives who are addicts and steal the product, are protectable, but these things are not unique. To the extent that Jackson’s works contain these elements, they are to be expected when two works express the same idea about “the streets” or explore the same theme. Winstead argues that not every protagonist whose story concerns guns, drugs, and violence in an urban setting winds up in prison or loses a parent, but this argument only serves to illustrate an important differ- ence between his book and Jackson’s film. Jackson’s protagonist never spends any time in prison, whereas Winstead’s protagonist devotes a considerable part of his story to his incarcerations.

In addition, Winstead’s book and Jackson’s works are different with respect to character, plot, mood, and sequence of events. Winstead’s protagonist embarks on a life of crime at a very young age, but is redeemed by the death of his beloved

father. Jackson’s protagonist turns to crime when he is much older and only after his mother is murdered. He winds up dead at a young age, unredeemed. Winstead’s book is hopeful; Jackson’s film is characterized * * * by moral apathy. It is true that both works involve the loss of a parent and the protagonist’s recognition of the parent’s importance in his life, but nowhere does Jackson appropriate any- thing unique about Winstead’s expression of this generic topic.

Winstead contends that direct phrases from his book appear in Jackson’s film. * * * He emphasizes these phrases: “Yo, where is my money at,” “I would never have done no shit like that to you,” “my father, my strength was gone,” “he was everything to me,” and “I did not know what to do,” but, like the phrases “putting the work in,” “get the dope, cut the dope,” “let’s keep it popping,” and “the strong take from the weak but the smart take from everybody,” they are either common in general or common with respect to hip hop culture, and do not enjoy copyright protection. The average person reading or listening to these phrases in the context of an overall story or song would not regard them as unique and protectable. Moreover, words and short phrases do not enjoy copyright protection. The similarity between Winstead’s book and the lyr- ics to Jackson’s songs on the album/CD is even more tenuous. “Stretching the dope” and “bloodshot red eyes” are com- mon phrases that do not enjoy copyright protection. A side-by-side comparison of Winstead’s book and the lyrics from Jackson’s album/CD do not support a claim of copyright infringement.

For the foregoing reasons, we will affirm the order of the District Court dismissing [Winstead’s] complaint.

Legal Reasoning Questions

1. Which expressions of an original work are protected by copyright law? 2. Is all copying copyright infringement? If not, what is the test for determining whether a creative work has been unlawfully

copied? 3. How did the court in this case determine whether the defendant’s work infringed on the plaintiff ’s copyright?

Case 8.3 Continued

C H A P T E R 8 Intellectual Property Rights 163

Remedies for Copyright Infringement Those who infringe copyrights may be liable for damages or criminal penalties. These range from actual damages or statutory damages, imposed at the court’s discretion, to criminal proceedings for willful violations.

Actual damages are based on the harm caused to the copyright holder by the infringement, while statutory damages, not to exceed $150,000, are provided for under the Copyright Act. Criminal proceedings may result in fines and/or imprisonment. A court can also issue a perma- nent injunction against a defendant when the court deems it necessary to prevent future copyright infringement.it necessary to prevent future copyright infringement.it necessary to prevent future copyright infringement.

■ CASE IN POINT 8.16 Rusty Carroll operated an online term paper business, R2C2, Inc., that offered up to 300,000 research papers for sale at nine Web sites. Individuals whose work was posted on these Web sites without their permis- sion filed a lawsuit against Carroll for copyright infringe- ment. Because Carroll had repeatedly failed to comply with court orders regarding discovery, the court found that the copyright infringement was likely to continue unless an injunction was issued. The court therefore issued a perma- nent injunction prohibiting Carroll and R2C2 from selling any term paper without sworn documentary evidence that the paper’s author had given permission.28 ■

The “Fair Use” Exception An exception to liability for copyright infringement is made under the “fair use” doctrine. In certain circumstances, a person or organization can reproduce copyrighted material without paying royal- ties. Section 107 of the Copyright Act provides as follows:

[T]he fair use of a copyrighted work, including such use by reproduction in copies or phonorecords or by any other means specified by [Section 106 of the Copyright Act], for purposes such as criti- cism, comment, news reporting, teaching (includ- ing multiple copies for classroom use), scholarship, or research, is not an infringement of copyright. In determining whether the use made of a work in any particular case is a fair use the factors to be consid- ered shall include—

(1) the purpose and character of the use, includ- ing whether such use is of a commercial nature or is for nonprofit educational purposes;

(2) the nature of the copyrighted work; (3) the amount and substantiality of the portion

used in relation to the copyrighted work as a whole; and

(4) the effect of the use upon the potential market for or value of the copyrighted work.

28. Weidner v. Carroll, 2010 WL 310310 (S.D.Ill. 2010).

What Is Fair Use? Because these guidelines are very broad, the courts determine whether a particular use is fair on a case-by-case basis. Thus, anyone who reproduces copyrighted material may be committing a violation. In determining whether a use is fair, courts have often con- sidered the fourth factor to be the most important.

■ CASE IN POINT 8.17 A number of research univer- sities, in partnership with Google, Inc., agreed to digi- tize books from their libraries and create a repository for them. Eighty member institutions (including many col- leges and universities) contributed more than ten million works into the HathiTrust Digital Library. Some authors complained that this book scanning violated their rights and sued the HathiTrust and several associated entities for copyright infringement.

The court, however, sided with the defendants and held that making digital copies for the purposes of online search was a fair use. The library’s searchable database enabled researchers to find terms of interest in the digital vol- umes—but not to read the volumes online. Therefore, the court concluded that the digitization did not provide a sub- stitute that damaged the market for the original works.29 ■

The First Sale Doctrine Section 109(a) of the Copy- right Act provides that the owner of a particular item that is copyrighted can, without the authority of the copyright owner, sell or otherwise dispose of it. This rule is known as the first sale doctrine.

Under this doctrine, once a copyright owner sells or gives away a particular copy of a work, the copyright owner no longer has the right to control the distribu- tion of that copy. Thus, for instance, a person who buys a copyrighted book can sell it to someone else. The first sale doctrine also applies to a person who receives promo- tional CDs, such as a music critic or radio programmer.tional CDs, such as a music critic or radio programmer.tional CDs, such as a music critic or radio programmer. 30

■ CASE IN POINT 8.18 Supap Kirtsaeng, a citizen of Thailand, was a graduate student at the University of Southern California. He enlisted friends and family in Thailand to buy copies of textbooks there and ship them to him in the United States. Kirtsaeng resold the textbooks on eBay, where he eventually made about $100,000.

John Wiley & Sons, Inc., had printed eight of those textbooks in Asia. Wiley sued Kirtsaeng in federal dis- trict court for copyright infringement. Kirtsaeng argued that Section 109(a) of the Copyright Act allows the first purchaser-owner of a book to sell it without the copyright owner’s permission. The trial court held in favor of Wiley, and that decision was affirmed on appeal. Kirtsaeng then appealed to the United States Supreme Court, which ruled

29. Authors Guild, Inc., v. HathiTrust, 755 F.3d 87 (2d Cir. 2014). 30. See, for example, UMG Recordings, Inc. v. Augusto, 628 F.3d 1175 (9th

164 U N I T T W O The Public and International Environment

in Kirtsaeng’s favor. The first sale doctrine applies even to goods purchased abroad and resold in the United States.31 ■

8–3d Copyright Protection for Software The Computer Software Copyright Act amended the Copyright Act to include computer programs in the list of creative works protected by federal copyright law.32 Generally, copyright protection extends to those parts of a computer program that can be read by humans, such as the “high-level” language of a source code. Protection also extends to the binary-language object code, which is readable only by the computer, and to such elements as the overall structure, sequence, and organization of a program.

Not all aspects of software are protected, however. Courts typically have not extended copyright protection to the “look and feel”—the general appearance, com- mand structure, video images, menus, windows, and other screen displays—of computer programs. (Note that copying the “look and feel” of another’s product may be a violation of trade dress or trademark laws, however.) Sometimes it can be difficult for courts to decide which particular aspects of software are protected.

■ CASE IN POINT 8.19 Oracle America, Inc., is a soft- ware company that owns numerous application program- ming interfaces, or API packages. Oracle grants licenses to others to use these API packages to write applications in the Java programming language. Java is open and free for anyone to use, but using it requires an interface. When Google began using some of Oracle’s API packages to run Java on its Android mobile devices, Oracle sued for copy- right infringement. Google argued that the software pack- ages were command structure and, as such, not protected under copyright law. Ultimately, a federal appellate court concluded that the API packages were source code and were entitled to copyright protection.33 ■

8–4 Trade Secrets The law of trade secrets protects some business processes and information that are not, or cannot be, patented, copy-and information that are not, or cannot be, patented, copy-and information that are not, or cannot be, patented, copy righted, or trademarked. A trade secret is basically informatrade secret is basically informatrade secret - tion of commercial value, such as customer lists, plans, and research and development. Trade secrets may also include pricing information, marketing methods, production tech- niques, and generally anything that makes an individual company unique and that would have value to a competitor.

31. Kirtsaeng v. John Wiley & Sons, Inc., ___ U.S. ___, 133 S.Ct. 1351, 185 L.Ed.2d 392 (2013).

32. Pub. L. No. 96-517 (1980), amending 17 U.S.C. Sections 101, 117. 33. Oracle America, Inc. v. Google Inc., 750 F.3d 1339 (Fed.Cir. 2014).

Unlike copyright and trademark protection, pro- tection of trade secrets extends to both ideas and their expression. For this reason, and because there are no registration or filing requirements for trade secrets, trade secret protection may be well suited for software.

Of course, a company’s trade secrets must be dis- closed to some persons, particularly to key employees. Businesses generally attempt to protect their trade secrets by having all employees who use a protected process or information agree in their contracts, or in confidentiality agreements, never to divulge it.

8–4a State and Federal Law on Trade Secrets

Under Section 757 of the Restatement of Torts, those who disclose or use another’s trade secret, without authoriza- tion, are liable to that other party if either of the follow- ing is true: 1. They discovered the secret by improper means. 2. Their disclosure or use constitutes a breach of a duty

owed to the other party. Stealing confidential business data by industrial espio- nage, such as by tapping into a competitor’s computer, is a theft of trade secrets without any contractual violation and is actionable in itself.

Trade secrets have long been protected under the common law. Today, nearly every state has enacted trade secret laws based on the Uniform Trade Secrets Act.34 Additionally, the Economic Espionage Act35 makes the theft of trade secrets a federal crime.

8–4b Trade Secrets in Cyberspace Computer technology is undercutting many business firms’ ability to protect their confidential informa- tion, including trade secrets. For example, a dishonest employee could e-mail trade secrets in a company’s com- puter to a competitor or a future employer. If e-mail is not an option, the employee might walk out with the information on a flash drive.

Misusing a company’s social media account is yet another way in which employees may appropriate trade secrets. ■ CASE IN POINT 8.20 Noah Kravitz worked for Noah Kravitz worked for a company called PhoneDog for four years as a prod- uct reviewer and video blogger. PhoneDog provided him with the Twitter account “,PhoneDog_Noah.” Kravitz’s popularity grew, and he had approximately 17,000

34. The Uniform Trade Secrets Act, as drafted by the National Conference of Commissioners on Uniform State Laws (NCCUSL), can be found at uniformlaws.org.

C H A P T E R 8 Intellectual Property Rights 165

followers by the time he quit. PhoneDog requested that Kravitz stop using the Twitter account. Although Kravitz changed his handle to “,noahkravitz,” he continued to use the account. PhoneDog subsequently sued Kravitz for misappropriation of trade secrets, among other things. Kravitz moved for a dismissal, but the court found that the complaint adequately stated a cause of action for

misappropriation of trade secrets and allowed the suit to continue.36 ■

Exhibit 8–1 outlines trade secrets and other forms of intellectual property discussed in this chapter.

36. PhoneDog v. Kravitz, 2011 WL 5415612 (N.D.Cal. 2011). See also Mintel Learning Technology, Inc. v. Ambrow Education Holding Ltd., Mintel Learning Technology, Inc. v. Ambrow Education Holding Ltd., Mintel Learning Technology, Inc. v. Ambrow Education Holding Ltd 2012 WL 762126 (N.D.Cal. 2012).

Definition

How Acquired

Duration

Remedy for Infringement

A grant from the government that gives an inventor exclusive rights to an invention.

By filing a patent application with the U.S. Patent and Trademark Office and receiving its approval.

Twenty years from the date of the application; for design patents, fourteen years.

Monetary damages, Including royalties and lost profits, plus attorneys’ fees. Damages may be tripled for intentional infringements.

PATENTS

The right of an author or originator of a literary or artistic work, or other production that falls within a specified category, to have the exclusive use of that work for a given period of time.

Automatic (once the work or creation is put in tangible form). Only the expression of an idea (and not the idea itself) can be protected by copyright.

For authors: the life of the author, plus 70 years. For publishers: 95 years after the date of publication or 120 years after creation.

Actual damages plus profits received by the party who infringed or statutory damages under the Copyright Act, plus costs and attorneys’ fees in either situation.

COPYRIGHTS TRADEMARKS

Any distinctive word, name, symbol, or device (image or appearance), or combination thereof,or combination thereof,or combination thereof that an entity uses to distinguish its goods or services from those of others. The owner has the exclusive right to use that mark or trade dress.

1. At common law, t common law, t common law ownership created

by use of the mark. 2. Registration with the

appropriate federal or state office gives notice and is permitted if the mark is currently in use or will be within the

next six months.

Unlimited, as long as it is in use. To continueTo continueT notice by registration, the owner must renew by filing between the fifth and sixth years, and thereafter, every ten years.

1. Injunction prohibiting the future use of the mark.

2. Actual damages plus profits received by the party who infringed (can be increased

under the Lanham Act). 3. Destruction of articles

that infringed. 4. Plus costs and

attorneys’ fees.

TRADE SECRETS

Any information that a business possesses and that gives the business an advantage over competitors (including formulas, lists, patterns, plans, processes, and programs).

Through the originality and development of the information and processes that constitute the business secret and are unknown to others.

Monetary damages for misappropriation (the Uniform Trade Secrets Act also permits punitive damages if willful), plus costs and attorneys’ fees.

Unlimited, so long as not revealed to others. Once revealed to others, it is no longer a trade secret.

E X H I B I T 8 – 1 Forms of Intellectual Property

166 U N I T T W O The Public and International Environment

8–5 International Protection for Intellectual Property

For many years, the United States has been a party to various international agreements relating to intellectual property rights. For instance, the Paris Convention of 1883, to which almost 180 countries are signatory, allows parties in one country to file for patent and trademark protection in any of the other member countries. Other international agreements in this area include the Berne Convention, the Trade-Related Aspects of Intellectual Property Rights (known as the TRIPS agreement), the Madrid Protocol, and the Anti-Counterfeiting Trade Agreement.

8–5a The Berne Convention Under the Berne Convention, if a U.S. citizen writes a book, every country that has signed the convention must recognize the U.S. author’s copyright in the book. Also, if a citizen of a country that has not signed the conven- tion first publishes a book in one of the 169 countries that have signed, all other countries that have signed the convention must recognize that author’s copyright. Copyright notice is not needed to gain protection under the Berne Convention for works published after March 1, 1989.

In 2011, the European Union altered its copyright rules under the Berne Convention to extend the period of royalty protection for musicians from fifty years to sev- enty years. This decision aids major record labels as well as performers and musicians who previously faced losing royalties from sales of their older recordings. The profits of musicians and record companies have been shrinking for years because of the sharp decline in sales of compact discs and the rise in illegal downloads.

8–5b The TRIPS Agreement The Berne Convention and other international agree- ments have given some protection to intellectual prop- erty on a worldwide level. None of them, however, has been as significant and far reaching in scope as the TRIPS agreement. Representatives from more than one hundred nations signed the TRIPS agreement in 1994.

Establishes Standards and Procedures The TRIPS agreement established, for the first time, standards for the international protection of intellectual property

rights, including patents, trademarks, and copyrights for movies, computer programs, books, and music. Each member country of the World Trade Organization must include in its domestic laws broad intellectual property rights and effective remedies (including civil and crimi- nal penalties) for violations of those rights.

Each member nation must also ensure that legal pro- cedures are available for parties who wish to bring actions for infringement of intellectual property rights. Addi- tionally, a related document established a mechanism for settling disputes among member nations.

Prohibits Discrimination Generally, the TRIPS agreement forbids member nations from discriminating against foreign owners of intellectual property rights in the administration, regulation, or adjudication of those rights. In other words, a member nation cannot give its own nationals (citizens) favorable treatment without offering the same treatment to nationals of all other memoffering the same treatment to nationals of all other memoffering the same treatment to nationals of all other mem- ber countries. ■ EXAMPLE 8.21 A U.S. software manu- facturer brings a suit for the infringement of intellectual property rights under Germany’s national laws. Because Germany is a member of the TRIPS agreement, the U.S. manufacturer is entitled to receive the same treatment as a German manufacturer. ■

8–5c The Madrid Protocol In the past, one of the difficulties in protecting U.S. trademarks internationally was the time and expense required to apply for trademark registration in foreign nations. The filing fees and procedures for trademark registration vary significantly among individual coun- tries. The Madrid Protocol, which was signed into law in 2003, may help to resolve these problems.

The Madrid Protocol is an international treaty that has been signed by about a hundred countries. Under its provisions, a U.S. company wishing to register its trademark abroad can submit a single application and designate other member countries in which the company would like to register its mark. The treaty was designed to reduce the costs of international trademark protection by more than 60 percent.

Although the Madrid Protocol may simplify and reduce the cost of trademark registration in foreign countries, it remains to be seen whether it will provide significant benefits to trademark owners. Even with an easier registration process, there are still questions as to whether all member countries will enforce the law and protect the mark.

C H A P T E R 8 Intellectual Property Rights 167

8–5d The Anti-Counterfeiting Trade Agreement

In 2011, Australia, Canada, Japan, Korea, Morocco, New Zealand, Singapore, and the United States signed the Anti-Counterfeiting Trade Agreement (ACTA), an international treaty to combat global counterfeiting and piracy. Other nations have since signed the agreement.

Goals and Provisions The goals of the treaty are to increase international cooperation, facilitate the best law enforcement practices, and provide a legal framework to combat counterfeiting. ACTA applies not only to counterfeit physical goods, such as medications, but also to pirated copyrighted works being distributed via the Internet. The idea is to create a new standard of enforce- ment for intellectual property rights that goes beyond the TRIPS agreement and encourages international

cooperation and information sharing among signatory countries.

Border Searches Under ACTA, member nations are required to establish border measures that allow officials, on their own initiative, to search commercial shipments of imports and exports for counterfeit goods. The treaty neither requires nor prohibits random border searches of electronic devices, such as laptops, tablet devices, and smartphones, for infringing content.

If border authorities reasonably believe that any goods in transit are counterfeit, the treaty allows them to keep the suspect goods unless the owner proves that the items are authentic and noninfringing. The treaty allows mem- ber nations, in accordance with their own laws, to order online service providers to furnish information about suspected trademark and copyright infringers, including their identities.

Debate This . . . Congress has amended copyright law several times so that copyright holders now have protection for many decades. Was Congress right in extending these copyright time periods?

Reviewing: Intellectual Property Rights

Two computer science majors, Trent and Xavier, have an idea for a new video game, which they propose to call Hal- lowed. They form a business and begin developing their idea. Several months later, Trent and Xavier run into a problem with their design and consult a friend, Brad, who is an expert in designing computer source codes. After the software is completed but before Hallowed is marketed, a video game called Halo 2 is released for both the Xbox and the Play- station systems. Halo 2 uses source codes similar to those of Hallowed and imitates Hallowed’s overall look and feel, although not all the features are alike. Using the information presented in the chapter, answer the following questions. 1. Would the name Hallowed receive protection as a trademark or as trade dress? Explain.Hallowed receive protection as a trademark or as trade dress? Explain.Hallowed 2. If Trent and Xavier had obtained a patent on Hallowed, would the release of Halo 2 have infringed on their patent?

Why or why not? 3. Based only on the facts described above, could Trent and Xavier sue the makers of Halo 2 for copyright infringe-

ment? Why or why not? 4. Suppose that Trent and Xavier discover that Brad took the idea of Hallowed and sold it to the company that pro-

duced Halo 2. Which type of intellectual property issue does this raise?

Terms and Concepts certi�cation mark 155 collective mark 155 copyright 160 dilution 152

intellectual property 150 license 156 patent 157 service mark 155

trade dress 155 trade name 156 trade secret 164 trademark 150

168 U N I T T W O The Public and International Environment

Issue Spotters 1. Roslyn, a food buyer for Organic Cornucopia Food Com-

pany, decides to go into business for herself as Roslyn’s Kitchen. She contacts Organic’s suppliers, offering to buy their entire harvest for the next year. She also contacts Organic’s customers, offering to sell her products at prices lower than Organic’s prices. Has Roslyn violated any of the intellectual property rights discussed in this chapter? Explain. (See Trade Secrets.)

2. Global Products develops, patents, and markets software. World Copies, Inc., sells Global’s software without the maker’s permission. Is this patent infringement? If so, how might Global save the cost of suing World for infringe- ment and at the same time profit from World’s sales? (See Patents.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 8–1. Fair Use. Professor Wise is teaching a summer semi- nar in business torts at State University. Several times during the course, he makes copies of relevant sections from business law texts and distributes them to his students. Wise does not realize that the daughter of one of the textbook authors is a member of his seminar. She tells her father about Wise’s copy- ing activities, which have taken place without her father’s or his publisher’s permission. Her father sues Wise for copyright infringement. Wise claims protection under the fair use doc- trine. Who will prevail? Explain. (See Copyrights.)

8–2. Patent Infringement. John and Andrew Doney invented a hard-bearing device for balancing rotors. Although they obtained a patent for their invention from the U.S. Pat- ent and Trademark Office, it was never used as an automobile wheel balancer. Some time later, Exetron Corp. produced an automobile wheel balancer that used a hard-bearing device with a support plate similar to that of the Doneys’ device. Given that the Doneys had not used their device for auto- mobile wheel balancing, does Exetron’s use of a similar device infringe on the Doneys’ patent? Why or why not? (See Patents.)

Business Case Problems 8–3. Spotlight on Macy’s—Copyright Infringement.

United Fabrics International, Inc., bought a fabric design from an Italian designer and registered a copyright to it with the U.S. Copyright O�ce. When Macy’s, Inc., began selling garments with a

similar design, United �led a copyright infringement suit against Macy’s. Macy’s argued that United did not own a valid copyright to the design and so could not claim infringement. Does United have to prove that the copyright is valid to estab- lish infringement? Explain. [United Fabrics International, Inc. v. C&v. C&v. C J Wear, Inc.,&J Wear, Inc.,& 630 F.3d 1255 (9th Cir. 2011)] (See Copyrights.)

8–4. Theft of Trade Secrets. Hanjuan Jin, a citizen of China, worked as a software engineer for Motorola for many years in a division that created proprietary standards for cellu- lar communications. Contrary to Motorola’s policies, Jin also secretly began working as a consultant for Lemko Corp., as well as with Sun Kaisens, a Chinese software company, and with the Chinese military. She started corresponding with Sun Kaisens’s management about a possible full-time job in China. Jin took several medical leaves of absence from Motorola to return to Beijing and work with Sun Kaisens and the military.

After one of these medical leaves, Jin returned to Motorola. Over a period of several days, Jin accessed and downloaded thousands of documents on her personal laptop and on pen drives. When, later, she attempted to board a flight to China from Chicago, she was randomly searched by U.S. Customs

and Border Protection officials at the airport. U.S. officials dis- covered the downloaded Motorola documents. Are there any circumstances under which Jin could avoid being prosecuted for theft of trade secrets? If so, what are these circumstances? Discuss fully. [United States v. Hanjuan Jin, 833 F.Supp.2d 977 (N.D.Ill. 2012)] (See Trade Secrets.) 8–5. Copyright Infringement. SilverEdge Systems Soft- ware hired Catherine Conrad to perform a singing telegram. SilverEdge arranged for James Bendewald to record Conrad’s performance of her copyrighted song to post on its Web site. Conrad agreed to wear a microphone to assist in the record- ing, told Bendewald what to �lm, and asked for an additional fee only if SilverEdge used the video for a commercial pur- pose. Later, the company chose to post a video of a di�erent performer’s singing telegram instead. Conrad �led a suit in a federal district court against SilverEdge and Bendewald for copyright infringement. Are the defendants liable? Explain. [Conrad v. Bendewald, 500 Fed.Appx. 526 (7th Cir. 2013)] (See Copyrights.) 8–6. Business Case Problem with Sample Answer— Patents. �e U.S. Patent and Trademark O�ce (PTO)

denied Raymond Gianelli’s application for a pat- ent for a “Rowing Machine”—an exercise machine on which a user pulls on handles to per- form a rowing motion against a selected resis-

tance. �e PTO considered the device obvious in light of a previously patented “Chest Press Apparatus for Exercising

C H A P T E R 8 Intellectual Property Rights 169

Regions of the Upper Body”—an exercise machine on which a user pushes on handles to overcome a selected resistance. On what ground might this result be reversed on appeal? Discuss. [In re Gianelli, 739 F.3d 1375 (Fed. Cir. 2014)] (See Patents.) • For a sample answer to Problem 8–6, go to Appendix E at

the end of this text.

8–7. Patents. Rodney Klassen was employed by the U.S. Department of Agriculture (USDA). Without the USDA’s authorization, Klassen gave Jim Ludy, a grape grower, plant material for two unreleased varieties of grapes. For almost two years, most of Ludy’s plantings bore no usable fruit, none of the grapes were sold, and no plant material was given to any other person. �e plantings were visible from publicly acces- sible roads, but none of the vines were labeled, and the variety could not be identi�ed by simply viewing the vines. Under patent law, an applicant may not obtain a patent for an inven- tion that is in public use for more than one year before the date of the application. Could the USDA successfully apply for patents on the two varieties given to Ludy? Explain. [Del-Del-Del ano Farms Co. v. California Table Grape Commission, 778 F.3d 1243 (Fed. Cir. 2015)] (See Patents.) 8–8. Copyright. Savant Homes, Inc., is a custom home designer and builder. Using what it called the “Anders Plan,” Savant built a model house in Windsor, Colorado. �is was a ranch house with two bedrooms on one side and a master suite on the other, separated by a combined family room, din- ing room, and kitchen. Ron and Tammie Wagner toured the Savant house. �e same month, the Wagners hired builder Douglas Collins and his �rm, Douglas Consulting, LLC, to build a house for them in Windsor. After it was built, Savant �led a suit in a federal district court against Collins for copy- right infringement, alleging that the builder had copied the Anders Plan in the design and construction of the Wagner house. Collins showed that the Anders Plan consisted of standard elements and standard arrangements of elements. In these circumstances, has infringement occurred? Explain.

[Savant Homes, Inc. v. Collins, 809 F.3d 1133 (10th Cir. 2016)] (See Copyrights.) 8–9. A Question of Ethics—Copyright Infringement.

Custom Copies, Inc., prepares and sells coursepacks, which contain compilations of readings for college courses. A teacher selects the readings and delivers a syllabus to the copy shop, which obtains the materials

from a library, copies them, and binds the copies. Blackwell Pub- lishing, Inc., which owns the copyright to some of the materials, �led a suit, alleging copyright infringement. Custom Copies �led a motion to dismiss for failure to state a claim. [ Blackwell Pub- lishing, Inc. v. Custom Copies, Inc., 2006 WL 1529503 (N.D.Fla. 2006)] (See (N.D.Fla. 2006)] (See (N.D.Fla. 2006)] Copyrights.) (a) Custom Copies argued, in part, that creating and selling

did not “distribute” the coursepacks. Does a copy shop violate copyright law if it only copies materials for course- packs? Does the copying fall under the “fair use” excep- tion? Should the court grant the defendant’s motion? Why or why not?

(b) What is the potential impact of copying and selling a book or journal without the permission of, and the payment of royalties or a fee to, the copyright owner? Explain.

8–10. Special Case Analysis—Copyright Infringement. Go to Case Analysis 8.3, Winstead v. Jackson. Read the excerpt, and answer the following questions. (See Copyrights.) (a) Issue: This case focused on an allegation of copyright

infringement involving what parties and which creative works?

(b) Rule of Law: What is the test for determining whether a creative work infringes the copyright of another work?

(c) Applying the Rule of Law: How did the court deter- mine whether the claim of copyright infringement was supported in this case?

(d) Conclusion: Was the defendant liable for copyright infringement? Why or why not?

Legal Reasoning Group Activity 8–11. Patents. After years of research, your company develops a product that might revolutionize the green (envi- ronmentally conscious) building industry. �e product is made from relatively inexpensive and widely available materials combined in a unique way that can substantially lower the heating and cooling costs of residential and com- mercial buildings. �e company has registered the trade- mark it intends to use on the product and has �led a patent application with the U.S. Patent and Trademark O�ce. (See Patents.)

(a) One group should provide three reasons why this product does or does not qualify for patent protection.

(b) Another group should develop a four-step procedure for how your company can best protect its intellectual prop- erty rights (trademark, trade secret, and patent) and pre- vent domestic and foreign competitors from producing counterfeit goods or cheap knockoffs.

170

C H A P T E R 9

same sources. For instance, in some states, an unsolicited e-mail must include a toll-free phone number or return e-mail address that the recipient can use to ask the sender to send no more unsolicited e-mails.

The Federal CAN-SPAM Act In 2003, Congress enacted the Controlling the Assault of Non-Solicited Por- nography and Marketing (CAN-SPAM) Act.2 The legisla- tion applies to any “commercial electronic mail messages” that are sent to promote a commercial product or service. Significantly, the statute preempts state antispam laws except for those provisions in state laws that prohibit false and deceptive e-mailing practices.

Generally, the act permits the sending of unsolicited commercial e-mail but prohibits certain types of spam- ming activities. Prohibited activities include the use of a false return address and the use of false, misleading, or deceptive information when sending e-mail. The statute also prohibits the use of “dictionary attacks”—sending messages to randomly generated e-mail addresses—and the “harvesting” of e-mail addresses from Web sites through the use of specialized software.through the use of specialized software.through the use of specialized software.

■ EXAMPLE 9.1 Sanford Wallace, known as the “Spam Sanford Wallace, known as the “Spam King,” is considered to be one of the world’s most prolific

2. 15 U.S.C. Sections 7701 et seq.

9–1 Internet Law A number of laws specifically address issues that arise only on the Internet. Three such issues are unsolicited e-mail, domain names, and cybersquatting, as we discuss here. We also discuss how the law is dealing with prob- lems of trademark infringement and dilution online.

9–1a Spam Businesses and individuals alike are targets of spam.1 Spam is the unsolicited “junk e-mail” that floods virtual mailboxes with advertisements, solicitations, and other messages. Considered relatively harmless in the early days of the Internet, by 2017 spam accounted for roughly 75 percent of all e-mails.

State Regulation of Spam In an attempt to combat spam, thirty-seven states have enacted laws that prohibit or regulate its use. Many state laws that regulate spam require the senders of e-mail ads to instruct the recipients on how they can “opt out” of further e-mail ads from the

1. The term spam is said to come from the lyrics of a Monty Python song that repeats the word spam over and over.

T he Internet has changed our lives and our laws. Technology has put the world at our finger-

tips and now allows even the smallest business to reach customers around the globe. At the same time, the Inter- net presents a variety of challenges for the law.

Courts are often in uncharted waters when deciding disputes that involve the Internet, social media, and online privacy. Judges may have no common law precedents to rely on

when resolving a case. Long-standing principles of justice may be inapplica- ble. New rules are evolving, but often not as quickly as technology.

For instance, Facebook is confront- ing lawsuits over its facial recogni- tion software, which scans the faces in uploaded photos and identifies them in other photos across the site. As a result of this technology, Face- book has collected and stored a huge amount of facial recognition data— data that some users claim violates

their privacy. The situation has been complicated by DeepFace, a sophisti- cated new technology developed by Facebook that can recognize faces almost as well as humans. In fact, Facebook has already agreed not to use the facial recognition software in Europe due to privacy complaints. In the United States, however, privacy rights generally hinge on whether the person has a reasonable expectation of privacy, which might be lacking in photos posted online.

Internet Law, Social Media, and Privacy

C H A P T E R 9 Internet Law, Social Media, and Privacy 171

spammers. He has operated several businesses over the years that used botnets (automated spamming networks) botnets (automated spamming networks) botnets to send out hundreds of millions of unwanted e-mails. Wallace also infected computers with spyware and then sold consumers the software to fix it. He infiltrated Face- book accounts to spam 27 million of its users. He has been sued by the Federal Trade Commission, Facebook, and MySpace, and ordered to pay millions of dollars in fines. The Federal Bureau of Investigation ultimately arrested Wallace and brought criminal charges. In 2015, he pleaded guilty to fraud, spam, and violating a court order not to access Facebook. ■

Arresting prolific spammers, however, has done little to curb spam, which continues to flow at a rate of 70 bil- lion messages per day. In effect, this means that the fed- eral CAN-SPAM act has done little or nothing to reduce the amount of spam.

The U.S. Safe Web Act After the CAN-SPAM Act prohibited false and deceptive e-mails originating in the United States, spamming from servers located in other nations increased. These cross-border spammers generally were able to escape detection and legal sanctions because the Federal Trade Commission (FTC) lacked the author- ity to investigate foreign spamming.

Congress sought to rectify the situation by enacting the U.S. Safe Web Act (also known as the Undertaking Spam, Spyware, and Fraud Enforcement with Enforcers Beyond Borders Act).3 The act allows the FTC to cooper- ate and share information with foreign agencies in inves- tigating and prosecuting those involved in spamming, spyware, and various Internet frauds and deceptions.

The Safe Web Act also provides a “safe harbor” for Internet service providers (ISPs)—that is, organiza- tions that provide access to the Internet. The safe harbor gives ISPs immunity from liability for supplying infor- mation to the FTC concerning possible unfair or decep- tive conduct in foreign jurisdictions.

9–1b Domain Names As e-commerce expanded worldwide, one issue that emerged involved the rights of a trademark owner to use the mark as part of a domain name. A domain name is part of an Internet address, such as “cengage.com.”

Structure of Domain Names Every domain name ends with a top-level domain (TLD), which is the part of the name to the right of the period. The TLD often

3. Pub. L. No. 109-455, 120 Stat. 3372 (2006), codified in various sections of 15 U.S.C. and 12 U.S.C. Section 3412.

indicates the type of entity that operates the site. For instance, com is an abbreviation for commercial, and edu is short for education.

The second-level domain (SLD)—the part of the name to the left of the period—is chosen by the busi- ness entity or individual registering the domain name. Competition for SLDs among firms with similar names and products has led to numerous disputes. By using an identical or similar domain name, parties have attempted to profit from a competitor’s goodwill (the nontangible value of a business).

Distribution System The Internet Corporation for Assigned Names and Numbers (ICANN), a nonprofit corporation, oversees the distribution of domain names and operates an online arbitration system. Due to numer- ous complaints, ICANN recently overhauled the domain name distribution system.

In 2012, ICANN started selling new generic top-level domain names (gTLDs) for an initial price of $185,000 plus an annual fee of $25,000. Whereas TLDs were lim- ited to only a few terms (such as com, net, and org), gTLDs org), gTLDs org can take any form. By 2017, many companies and corpo- rations had acquired gTLDs based on their brands, such as aol, bmw, canon, target, and walmart. Some companies have numerous gTLDs. Google’s gTLDs, for instance, include android, bing, chrome, gmail, goog, and YouTube.

Because gTLDs have greatly increased the potential number of domain names, domain name registrars have proliferated. Registrar companies charge a fee to busi- nesses and individuals to register new names and to renew annual registrations (often through automated software). Many of these companies also buy and sell expired domain names.

9–1c Cybersquatting One of the goals of the new gTLD system was to address the problem of cybersquatting. Cybersquatting occurs Cybersquatting occurs Cybersquatting when a person registers a domain name that is the same as, or confusingly similar to, the trademark of another and then offers to sell the domain name back to the trademark owner.

■ CASE IN POINT 9.2 Apple, Inc., has repeatedly sued cybersquatters that registered domain names similar to its products, such as iphone4s.com and ipods.com. Apple won a judgment in litigation at the World Intellectual Property Organization against a company that was squat- ting on the domain name iPhone6s.com.4 ■

172 U N I T T W O The Public and International Environment

Anticybersquatting Legislation Because cyber- squatting has led to so much litigation, Congress enacted the Anticybersquatting Consumer Protection Act (ACPA),5 which amended the Lanham Act—the federal law protecting trademarks. The ACPA makes cybersquat- ting illegal when both of the following are true: 1. The domain name is identical or confusingly similar

to the trademark of another. 2. The one registering, trafficking in, or using the

domain name has a “bad faith intent” to profit from that trademark.

Despite the ACPA, cybersquatting continues to present a problem for businesses.

Frequent Changes in Domain Name Owner- ship Facilitates Cybersquatting All domain name registrars are supposed to relay information about their transactions to ICANN and other companies that keep a master list of domain names, but this does not always occur. The speed at which domain names change hands and the difficulty in tracking mass automated registra- tions have created an environment in which cybersquat- ting can flourish.ting can flourish.ting can flourish.

■ CASE IN POINT 9.3 OnNet USA, Inc., owns the English-language rights to 9Dragons, a game with a mar- tial arts theme, and operates a Web site for its promotion. When a party known as “Warv0x” began to operate a pirated version of the game at Play9D.com, OnNet filed an action under the ACPA in a federal court. OnNet was unable to obtain contact information for the owner of Play9D.com through its Australian domain name reg- istrar, however, and thus could not complete service of process. Therefore, the federal court allowed OnNet to serve the defendant by publishing a notice of the suit in a newspaper in Gold Coast, Australia.6 ■

Typosquatting Typosquatting is registering a name Typosquatting is registering a name Typosquatting that is a misspelling of a popular brand, such as googl. com or appple.com. Because many Internet users are not perfect typists, Web pages using these misspelled names receive a lot of traffic. More traffic generally means increased profit (advertisers often pay Web sites based on the number of unique visits, or hits).

Typosquatting may sometimes fall beyond the reach of the ACPA. If the misspelling is significant, the trade- mark owner may have difficulty proving that the name is identical or confusingly similar to the trademark of another, as the ACPA requires.

5. 15 U.S.C. Section 1129. 6. OnNet USA, Inc. v. Play9D.com, 2013 WL 120319 (N.D.Cal. 2013).

Typosquatting adds costs for businesses seeking to protect their domain name rights. Companies must attempt to register not only legitimate variations of their domain names but also potential misspellings. Large corporations may have to register thousands of domain names across the globe just to protect their basic brands and trademarks.

Applicability and Sanctions of the ACPA The ACPA applies to all domain name registrations of trade- marks. Successful plaintiffs in suits brought under the act can collect actual damages and profits, or they can elect to receive statutory damages ranging from $1,000 to $100,000.

Although some companies have been successful suing under the ACPA, there are roadblocks to pursuing such lawsuits. Some domain name registrars offer privacy ser- vices that hide the true owners of Web sites, making it difficult for trademark owners to identify cybersquatters. Thus, before bringing a suit, a trademark owner has to ask the court for a subpoena to discover the identity of the owner of the infringing Web site. Because of the high costs of court proceedings, discovery, and even arbitra- tion, many disputes over cybersquatting are settled out of court.

To facilitate dispute resolution, ICANN now offers the Uniform Rapid Suspension (URS) system. URS allows trademark holders with clear-cut infringeallows trademark holders with clear-cut infringeallows trademark holders with clear-cut infringe- ment claims to obtain rapid relief. ■ EXAMPLE 9.4 In In the first dispute filed involving gTLDs, IBM filed a complaint with URS against an individual who reg- istered the domain names IBM.guru and IBM.ven- tures in February 2014. A week later, the URS panel decided in IBM’s favor and suspended the two domain names. ■

9–1d Meta Tags Meta tags are key words that give Internet browsers Meta tags are key words that give Internet browsers Meta tags specific information about a Web page. Meta tags can be used to increase the likelihood that a site will be included in search engine results, even if the site has nothing to do with the key words. In effect, one site can appropriate the key words of other sites with more frequent hits so that the appropriating site will appear in the same search engine results as the more popular sites.

Using another’s trademark in a meta tag without the owner’s permission normally constitutes trademark infringement. Some uses of another’s trademark as a meta tag may be permissible, however, if the use is reasonably

C H A P T E R 9 Internet Law, Social Media, and Privacy 173

necessary and does not suggest that the owner authorized or sponsored the use.

■ CASE IN POINT 9.5 Farzad and Lisa Tabari are auto brokers—the personal shoppers of the automotive world. They contact authorized dealers, solicit bids, and arrange for customers to buy from the dealer offering the best combination of location, availability, and price. The Tabaris offered this service at the Web sites buy-a-lexus. com and buyorleaselexus.com.

Toyota Motor Sales U.S.A., Inc., the exclusive dis- tributor of Lexus vehicles and the owner of the Lexus mark, objected to the Tabaris’ practices. The Tabaris removed Toyota’s photographs and logo from their site and added a disclaimer in large type at the top, but they refused to give up their domain names. Toyota sued for infringement. The court forced the Tabaris to stop using any “domain name, service mark, trademark, trade name,

meta tag or other commercial indication of origin that includes the mark LEXUS.”7 ■

9–1e Trademark Dilution in the Online World

Trademark dilution occurs when a trademark is used, without authorization, in a way that diminishes the dis- tinctive quality of the mark. Unlike trademark infringe- ment, a claim of dilution does not require proof that consumers are likely to be confused by a connection between the unauthorized use and the mark. For this reason, the products involved need not be similar, as the following Spotlight Case illustrates.Spotlight Case illustrates.Spotlight Case

7. Toyota Motor Sales, U.S.A., Inc. v. Tabari, 610 F.3d 171 (9th Cir. 2011).

Background and Facts In 1949, Hasbro, Inc.—then known as the Milton Bradley Company—pub- lished its first version of Candy Land, a children’s board game. Hasbro is the owner of the trademark “Candy Land,” which has been registered with the U.S. Patent and Trademark Office since 1951. Over the years, Hasbro has produced several versions of the game, including Candy Land puzzles, a travel version, a computer game, and a handheld electronic version. In the mid-1990s, Brian Cartmell and his employer, the Internet Entertainment Group, Ltd., used the term candyland.com as a domain name for a sexually explicit Internet site. Anyone who performed an online search using the word candyland was directed to this adult Web site. Hasbro filed a trademark dilution claim in a federal court, seeking a permanent injunction to prevent the defendants from using the Candy Land trademark.

In the Language of the Court DWYER, U.S. District Judge

* * * * 2. Hasbro has demonstrated a probability of proving that defendants Internet Entertainment Group,

Ltd., Brian Cartmell and Internet Entertainment Group, Inc. (collectively referred to as “defendants”) have been diluting the value of Hasbro’s CANDY LAND mark by using the name CANDYLAND to identify a sexually explicit Internet site, and by using the name string “candyland.com” as an Internet domain name which, when typed into an Internet-connected computer, provides Internet users with access to that site.

* * * * 4. Hasbro has shown that defendants’ use of the CANDY LAND name and the domain name candy-

land.com in connection with their Internet site is causing irreparable injury to Hasbro. 5. The probable harm to Hasbro from defendants’ conduct outweighs any inconvenience that defendants

will experience if they are required to stop using the CANDYLAND name. [Emphasis added.] * * * * THEREFORE, IT IS HEREBY ORDERED that Hasbro’s motion for preliminary injunction is

granted.

Spotlight on Internet Porn

Case 9.1 Hasbro, Inc. v. Internet asbro, Inc. v. Internet Entertainment Group, ntertainment Group, LLtd. United States District Court, Western District of Washington, 1996 WL 84853 (1996).United States District Court, Western District of Washington, 1996 WL 84853 (1996).

174 U N I T T W O The Public and International Environment

Decision and Remedy The federal district court granted Hasbro an injunction against the defendants, agreeing that the domain name candyland was “causing irreparable injury to Hasbro.” The judge ordered the defendants to immediately remove all content from the candyland.com Web site and to stop using the Candy Land mark.

Critical Thinking • Economic How can companies protect themselves from others who create Web sites that have similar

domain names, and what limits each company’s ability to be fully protected? • What If the Facts Were Different? Suppose that the site using candyland.com had not been sexually

explicit but had sold candy. Would the result have been the same? Explain.

Case 9.1 Continued

9–1f Licensing A company may permit another party to use a trademark (or other intellectual property) under a license. A licensor might grant a license allowing its trademark to be used as part of a domain name, for instance.

Another type of license involves the use of a product such as software. This sort of licensing is ubiquitous in the online world. When you download an application on your smartphone, tablet, or other mobile device, for instance, you are typically entering into a license agreement. You are obtaining only a license to use that license to use that license app and not ownership rights in it. Apps published on Google Play, for instance, may use its licensing service to prompt users to agree to a license at the time of instal- lation and use.

Licensing agreements frequently include restrictions that prohibit licensees from sharing the file and using it to create similar software applications. The license may also limit the use of the application to a specific device or give permission to the user for a certain time period.

9–2 Copyrights in Digital Information

Copyright law is probably the most important form of intellectual property protection on the Internet. This is because much of the material on the Internet (includ- ing software and database information) is copyrighted, and in order to transfer that material online, it must be “copied.” Generally, whenever a party downloads soft- ware or music into a computer’s random access memory, or RAM, without authorization, a copyright is infringed.

Initially, criminal penalties for copyright violations could be imposed only if unauthorized copies were

exchanged for financial gain. Then, Congress amended the law and extended criminal liability for the piracy of copyrighted materials to persons who exchange unau- thorized copies of copyrighted works without realizing a profit.

9–2a Digital Millennium Copyright Act In 1998, Congress enacted the Digital Millennium Copyright Act (DMCA).8 The DMCA gave significant protection to owners of copyrights in digital information. Among other things, the act established civil and criminal penalties for anyone who circumvents (bypasses) encryp- tion software or other technological antipiracy protec- tion. Also prohibited are the manufacture, import, sale, and distribution of devices or services for circumvention.

Allows Fair Use The DMCA provides for excep- tions to fit the needs of libraries, scientists, universities, and others. In general, the law does not restrict the “fair use” of circumvention methods for educational and other noncommercial purposes. For instance, circumvention is allowed to test computer security, to conduct encryption research, to protect personal privacy, and to enable par- ents to monitor their children’s use of the Internet. The exceptions are to be reconsidered every three years.

One federal appellate court extended the situations in which the fair use doctrine applies. ■ CASE IN POINT 9.6 Stephanie Lenz posted a short video on YouTube of her toddler son dancing with the Prince song “Let’s Go Crazy” playing in the background. Universal Music Group (UMG) sent YouTube a take-down notice that stated that the video violated copyright law under the DMCA. YouTube removed the “dancing baby” video and

8. 17 U.S.C. Sections 512, 1201–1205, 1301–1332; and 28 U.S.C. Section 4001.

C H A P T E R 9 Internet Law, Social Media, and Privacy 175

notified Lenz of the allegations of copyright infringe- ment, warning her that repeated incidents of infringe- ment could lead it to delete her account.

Lenz filed a lawsuit against UMG claiming that accusing her of infringement constituted a material mis- representation (fraud) because UMG knew that Lenz’s video was a fair use of the song. The district court held that UMG should have considered the fair use doctrine before sending the take-down notice. UMG appealed, and the U.S. Court of Appeals for the Ninth Circuit affirmed. Lenz was allowed to pursue nominal damages from UMG for sending the notice without considering whether her use was fair.9 ■

Limits Liability of Internet Service Providers The DMCA also limits the liability of Internet service providers (ISPs). Under the act, an ISP is not liable for copyright infringement by its customer unless the ISP is unless the ISP is unless aware of the subscriber’s violation. An ISP may be held liable only if it fails to take action to shut down the sub- scriber after learning of the violation. A copyright holder must act promptly, however, by pursuing a claim in court, or the subscriber has the right to be restored to online access.

9–2b File-Sharing Technology Soon after the Internet became popular, a few enterpris- ing programmers created software to compress large data files, particularly those associated with music. The best- known compression and decompression system is MP3, which enables music fans to download songs or entire CDs onto their computers or onto portable listening devices, such as smartphones and tablets. The MP3 sys- tem also made it possible for music fans to access other fans’ files by engaging in file-sharing via the Internet.

Methods of File-Sharing File-sharing is accom- plished through peer-to-peer (P2P) networking. The concept is simple. Rather than going through a central Web server, P2P networking uses numerous personal computers (PCs) that are connected to the Internet. Indi- viduals on the same network can access files stored on one another’s PCs through a distributed network. Parts of the network may be distributed all over the country or the world, which offers an unlimited number of uses. Per- sons scattered throughout the country or the world can work together on the same project by using file-sharing programs.

9. Lenz v. Universal Music Group, 801 F.3d 1126 (9th Cir. 2015).

A newer method of sharing files via the Internet is cloud computing, which is essentially a subscription- based or pay-per-use service that extends a computer’s software or storage capabilities. Cloud computing can deliver a single application through a browser to multiple users. Alternatively, cloud computing might be a utility program to pool resources and provide data storage and virtual servers that can be accessed on demand. Ama- zon, Facebook, Google, IBM, and Sun Microsystems are using and developing more cloud computing services.

Sharing Stored Music and Movies When file- sharing is used to download others’ stored music files, copyright issues arise. Recording artists and their labels stand to lose large amounts of royalties and revenues if relatively few digital downloads or CDs are purchased and then made available on distributed networks. Anyone can get the music for free on these networks, which has prompted recording companies to pursue individuals for file-sharing copyrighted works.file-sharing copyrighted works.file-sharing copyrighted works.

■ CASE IN POINT 9.7 Maverick Recording Company and other recording companies sued Whitney Harper in federal court for copyright infringement. Harper had used a file-sharing program to download a number of copyrighted songs from the Internet and had then shared the audio files with others via a P2P network. The plain- tiffs sought $750 per infringed work—the minimum amount of statutory damages available under the Copy- right Act.

Harper claimed that she was an “innocent” infringer because she was unaware that her actions consti- tuted copyright infringement. Under the act, innocent infringement can result in a reduced penalty. The court, however, noted that a copyright notice appeared on all the songs that Harper had downloaded. She therefore could not assert the innocent infringer defense, and the court ordered her to pay damages of $750 per infringed work.10 ■

Pirated Movies and Television File-sharing also creates problems for the motion picture and television industries, which lose significant amounts of revenue annually as a result of piracy. Numerous Web sites offer software that facilitates the illegal copying of movies and television programs. BitTorrent, for instance, is a P2P protocol that enables users to download and transfer high-quality files from the Internet. Popcorn Time is a BitTorent site that offers streaming services that enable users to watch pirated movies and television shows with- out downloading them.

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9–3 Social Media Social media provide a means by which people can create, Social media provide a means by which people can create, Social media share, and exchange ideas and comments via the Inter- net. Social networking sites, such as Facebook, Google+, LinkedIn, Pinterest, and Tumblr, have become ubiqui- tous. Studies show that Internet users spend more time on social networks than at any other sites. The amount of time people spend accessing social networks on their smartphones and other mobile devices has been increas- ing every year (by nearly 30 percent in 2016 alone).ing every year (by nearly 30 percent in 2016 alone).ing every year (by nearly 30 percent in 2016 alone).

■ EXAMPLE 9.8 Facebook has more than 1.6 billion active monthly users. Individuals use Facebook to main- tain social contacts, update friends on events, and dis- tribute images to others. Facebook members often share common interests based on their school, location, or rec- reational affiliation, such as a sports team. ■

9–3a Legal Issues The emergence of Facebook and other social network- ing sites has created a number of legal and ethical issues for businesses. For instance, a firm’s rights in valuable intellectual property may be infringed if users post trade- marked images or copyrighted materials on these sites without permission. Various aspects of the legal process may involve the content of social media, as discussed next. Employers’ social media policies may also be at issue.

Impact on Litigation Social media posts now are routinely included in discovery in litigation because they can provide damaging information that establishes a per- son’s intent or what she or he knew at a particular time. Like e-mail, posts on social networks can be the smoking gun that leads to liability.

Tweets and other social media posts can also be used to reduce damages awards. ■ EXAMPLE 9.9 Jill Daniels sued for injuries she sustained in a car accident, claiming that her injuries made it impossible for her to continue working as a hairstylist. The jury initially determined that her damages were $237,000, but when the jurors saw tweets and photographs of Daniels partying in New Orleans and vacationing on the beach, they reduced the final award to $142,000. ■

Impact on Settlement Agreements Social media posts have been used to invalidate settlement agreements posts have been used to invalidate settlement agreements posts have been used to invalidate settlement agreements that contain confidentiality clauses. ■ CASE IN POINT NT 9.10 Patrick Snay was the headmaster of Gulliver Prepa Patrick Snay was the headmaster of Gulliver Prepa- ratory School in Florida. When Gulliver did not renew

Snay’s employment contract, Snay sued the school for age discrimination. During mediation, Snay agreed to settle the case for $80,000 and signed a confidentiality clause that required him and his wife not to disclose the “terms and existence” of the agreement. Nevertheless, Snay and his wife told their daughter, Dana, that the dispute had been settled and that they were happy with the results.

Dana, a college student, had recently graduated from Gulliver and, according to Snay, had suffered retalia- tion at the school. Dana posted a Facebook comment that said “Mama and Papa Snay won the case against Gulliver. Gulliver is now officially paying for my vaca- tion to Europe this summer. SUCK IT.” The comment went out to 1,200 of Dana’s Facebook friends, many of whom were Gulliver students, and school officials soon learned of it. The school immediately notified Snay that he had breached the confidentiality clause and refused to pay the settlement amount. Ultimately, a state inter- mediate appellate court held that Snay had breached the confidentiality clause and therefore could not enforce the settlement agreement.11 ■

Criminal Investigations Law enforcement uses social media to detect and prosecute criminals. A surpris- ing number of criminals boast about their illegal activities ing number of criminals boast about their illegal activities ing number of criminals boast about their illegal activities on social media. ■ EXAMPLE 9.11 A nineteen-year-old A nineteen-year-old posts a message on Facebook bragging about how drunk he was on New Year’s Eve and apologizing to the owner of the parked car that he hit. The next day, police officers arrest him for drunk driving and leaving the scene of an accident. ■

Some police departments now authorize officers to go Some police departments now authorize officers to go Some police departments now authorize officers to go undercover on social media sites. ■ EXAMPLE 9.12 As As part of Operation Crew Cut, New York Police Depart- ment (NYPD) officers routinely pretend to be young women in order to “friend” suspects on Facebook. Using these fake identities, officers are able to avoid the social media site’s privacy settings and gain valuable informa- tion about illegal activities. ■

Administrative Agency Investigations Federal regulators also use social media posts in their investigaregulators also use social media posts in their investigaregulators also use social media posts in their investiga- tions into illegal activities. ■ EXAMPLE 9.13 Reed Hast Reed Hast- ings, the top executive of Netflix, stated on Facebook that Netflix subscribers had watched a billion hours of video the previous month. As a result, Netflix’s stock price rose, which prompted a federal agency investigation. Under securities laws, such a statement is considered to be mate- rial information to investors. Thus, it must be disclosed to

11. Gulliver Schools, Inc. v. Snay, 137 So.3d 1045 (Fla.App. 2014).

C H A P T E R 9 Internet Law, Social Media, and Privacy 177

all investors, not just a select group, such as those who had access to Hastings’s Facebook post.

The agency ultimately concluded that it could not hold Hastings responsible for any wrongdoing because the agency’s policy on social media use was not clear. The agency then issued new guidelines that allow companies to disclose material information through social media if investors have been notified in advance. ■

In addition, an administrative law judge can base her or his decision on the content of social media posts. ■ CASE IN POINT 9.14 Jennifer O’Brien was a ten- ured teacher at a public school in New Jersey when she posted two messages on her Facebook page. “I’m not a teacher—I’m a warden for future criminals!” and “They had a scared straight program in school—why couldn’t I bring first graders?” Not surprisingly, outraged parents protested. The deputy superintendent of schools filed a complaint against O’Brien with the state’s commissioner of education, charging her with conduct unbecoming a teacher.

After a hearing, an administrative law judge (ALJ) ordered that O’Brien be removed from her teaching posi- tion. O’Brien appealed to a state court, claiming that her Facebook postings were protected by the First Amend- ment and could not be used by the school district to dis- cipline or discharge her. The court found that O’Brien had failed to establish that her Facebook postings were protected speech and that the seriousness of O’Brien’s conduct warranted removal from her position.12 ■

Employers’ Social Media Policies Many large corporations have established specific guidelines on using social media in the workplace. Employees who use social media in a way that violates their employer’s stated poli- cies may be disciplined or fired from their jobs. Courts and administrative agencies usually uphold an employer’s right to terminate a person based on his or her violation of a social media policy.

■ CASE IN POINT 9.15 Virginia Rodriquez worked for Wal-Mart Stores, Inc., for almost twenty years and had been promoted to management. Then she was disci- plined for violating the company’s policies by having a fel- low employee use Rodriquez’s password to alter the price of an item that she purchased. Under Wal-Mart’s rules, another violation within a year would mean termination.

Nine months later, on Facebook, Rodriquez publicly chastised employees under her supervision for calling in sick to go to a party. The posting violated Wal-Mart’s “Social Media Policy,” which was “to avoid public comment that adversely affects employees.” Wal-Mart

12. In re O’Brien, 2013 WL 132508 (N.J. Sup. 2013).

terminated Rodriquez. She filed a lawsuit, alleging dis- crimination, but the court issued a summary judgment in Wal-Mart’s favor.13 ■

9–3b The Electronic Communications Privacy Act

The Electronic Communications Privacy Act (ECPA)14 amended federal wiretapping law to cover electronic forms of communications. Although Congress enacted the ECPA many years before social media networks existed, it nev- ertheless applies to communications through social media.

The ECPA prohibits the intentional interception of any wire, oral, or electronic communication. It also pro- hibits the intentional disclosure or use of the information obtained by the interception.

Exclusions Excluded from the ECPA’s coverage are any electronic communications through devices that an employer provides for its employee to use “in the ordi- nary course of its business.” Consequently, if a company provides the electronic device (cell phone, laptop, tablet) to the employee for ordinary business use, the company is not prohibited from intercepting business communi- cations made on it. This “business-extension exception” permits employers to monitor employees’ electronic com- munications made in the ordinary course of business. It does not, however, permit employers to monitor employ- ees’ personal communications.

Another exception to the ECPA allows an employer to avoid liability under the act if the employees consent to having their electronic communications monitored by the employer.

Stored Communications Part of the ECPA is known as the Stored Communications Act (SCA).15 The SCA prohibits intentional and unauthorized access to stored electronic communications and sets forth criminal stored electronic communications and sets forth criminal stored and civil sanctions for violators. A person can violate the SCA by intentionally accessing a stored electronic com- munication. The SCA also prevents “providers” of com- munication services (such as cell phone companies and social media networks) from divulging private commu- nications to certain entities and individuals.

■ CASE IN POINT 9.16 Two restaurant employees, Two restaurant employees, Brian Pietrylo and Doreen Marino, were fired after their manager uncovered their password-protected MySpace group. The group’s communications, stored on MySpace’s

13. Rodriquez v. Wal-Mart Stores, Inc., 2013 WL 102674 (N.D.Tex. 2013). 14. 18 U.S.C. Sections 2510–2521. 15. 18 U.S.C. Sections 2701–2711.

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Web site, contained sexual remarks about customers and management, as well as comments about illegal drug use and violent behavior. One employee said the group’s pur- pose was to “vent about any BS we deal with out of work without any outside eyes spying on us.”

The restaurant learned about the private MySpace group when a hostess showed it to a manager who requested access. The hostess was not explicitly threat- ened with termination but feared she would lose her job if she did not comply.

After they were fired, Pietrylo and Marino filed a law- suit against the restaurant. They claimed that their for- mer employer had gained unauthorized access to their MySpace group communications in violation of the SCA. The court allowed the employees’ SCA claim, and the jury awarded them $17,003 in compensatory and punitive damages.16 ■

9–3c Protection of Social Media Passwords In recent years, employees and applicants for jobs or col- leges have sometimes been asked to divulge their social media passwords. An employer or school may look at an individual’s Facebook or other account to see if it includes controversial postings such as racially discrimi- natory remarks or photos of drug parties. Such postings can have a negative effect on a person’s prospects even if they were made years earlier or are taken out of context.

By 2017, about half of the states had enacted legislation to protect individuals from having to disclose their social media passwords. Each state’s law is slightly different. Some states, such as Michigan, prohibit employers from taking adverse action against an employee or job applicant based on what the person has posted online. Michigan’s law also applies to e-mail and cloud storage accounts.

Legislation will not completely prevent employers and others from taking actions against a person based on his or her social network postings, though. Management and human resources personnel are unlikely to admit that they looked at someone’s Facebook page and that it influ- enced their decision. They may not even have to admit to looking at the Facebook page if they use private brows- ing, which enables people to keep their Web browsing activities confidential. How, then, would a rejected job applicant be able to prove that she or he was rejected because the employer accessed social media postings? See this chapter’s Digital Update feature for a discussion of Digital Update feature for a discussion of Digital Update employer monitoring of social media.

16. Pietrylo v. Hillstone Restaurant Group, 2009 WL 3128420 (D.N.J. 2009).

9–3d Company-wide Social Media Networks

Many companies, including Dell, Inc., and Nikon Instruments, form their own internal social media net- works. Software companies offer a variety of systems, including Salesforce.com’s Chatter, Microsoft’s Yammer, and Cisco Systems’ WebEx Social. Posts on these internal networks, or intranets, are quite different from the typi- cal posts on Facebook, LinkedIn, and Twitter. Employees use these intranets to exchange messages about topics related to their work, such as deals that are closing, new products, production flaws, how a team is solving a prob- lem, and the details of customer orders. Thus, the tone is businesslike.

Protection of Trade Secrets An important advan- tage to using an internal system for employee communi- cations is that the company can better protect its trade secrets. The company usually decides which employees can see particular intranet files and which employees will belong to each specific “social” group within the com- pany. Companies providing internal social media net- works often keep the resulting data on their own servers in secure “clouds.”

Other Advantages Internal social media systems also offer additional benefits. They provide real-time information about important issues, such as production glitches. Additionally, posts can include tips on how to best sell new products or deal with difficult customers, as well as information about competitors’ products and services. Another major benefit is a significant reduc- tion in e-mail. Rather than wasting fellow employees’ time reading mass e-mailings, workers can post messages or collaborate on presentations via the company’s social network.

9–4 Online Defamation Cyber torts are torts that arise from online conduct. One of the most prevalent cyber torts is online defamation. Defamation is wrongfully hurting a person’s reputation by communicating false statements about that person to others. Because the Internet enables individuals to com- municate with large numbers of people simultaneously (via a blog or tweet, for instance), online defamation has become a problem in today’s legal environment.become a problem in today’s legal environment.become a problem in today’s legal environment.

■ EXAMPLE 9.17 Singer-songwriter Courtney Love was sued for defamation based on remarks she posted

C H A P T E R 9 Internet Law, Social Media, and Privacy 179

Monitoring Employees’ Social Media—Right or Wrong?

Just about everyone seems to be using some form of social media. That, of course, includes employees. Increasingly, employees’ social media use is being monitored by their employ- ers. Sometimes, employees are even being fired over their social media posts.

Monitoring of Employees’ Social Media Use

Employers have monitored their employees’ Internet use for years. According to Gartner, Inc., an informa- tion technology advisory company, employers are now using the same technology to examine workers’ social media use.

Companies have a number of concerns about how their employees use social media. For one thing, they may worry about security problems, such as employ- ees’ posting unauthorized videos of company activities. In addition, they do not wish to have their clients dis- cussed on employees’ social media posts. Finally, some companies are concerned that certain posts may violate the law. For instance, if hospital employees discuss patients, they not only are disregarding hospital regula- tions, but also are violating the federal Health Insurance Portability and Accountability Act (HIPAA).a

Restrictions on Access to Employees’ Social Media Records

In disputes over discrimination, hostile work environ- ment, and other employment situations, employers typically seek access to certain employees’ complete social media records. The courts have not uniformly

accepted such access.b The general rule is that during any dispute, courts require employers to demonstrate a “reasonable” need for social media evidence. So-called fishing expeditions are rarely allowed.

But what about regular monitoring of employee online behavior? As long as an employee has no expectation of privacy on

the social media site and is not part of a protected class, courts will side with employers. After all, social media posts are public, even when privacy settings are enabled. Note, though, that whenever employer moni- toring involves obtaining information about religious affiliation, sexual orientation, or pregnancies, litigation may ensue.

The rule of thumb is that the more personal the information about any employee, the more problem- atic social media monitoring becomes. As one expert in the field stated, “Recent cases teach that when a com- pany decides to monitor employee behavior online, uncertainty takes over.”c

Critical Thinking Some companies use internal social media networks for work-related employee communica- tions. Would the same legal rules that apply to monitor- ing public social media platforms, such as Twitter and Facebook, also apply to company-provided social media platforms?

DIGITAL UPDATE

a. Pub. L. No. 104-191 (1996); 29 U.S.C. Sections 1181 et seq.

b. Ogden v. All-State Career School, 299 F.R.D. 446 (2014). See also Ogden v. All-State Career School, 299 F.R.D. 446 (2014). See also Ogden v. All-State Career School Appler v. Mead Johnson & Co., LLC, 2015 WL 5615038, and Co., LLC, 2015 WL 5615038, and Co., LLC In re Milo’s Kitchen Dog Treats Consol, 307 F.R.D. 177 (2015).Milo’s Kitchen Dog Treats Consol, 307 F.R.D. 177 (2015).Milo’s Kitchen Dog Treats Consol

c. Rodney Satterwhite, “‘Friend’ or Foe? Balancing the Litigation Risks of Monitoring Employees’ Social Media Profiles at Various Stages of Employment,” 2014 WL 5465794 (2014).

about fashion designer Dawn Simorangkir on Twitter. Love claimed that her statements were statements of opinion (rather than statements of fact, as required) and therefore were not actionable as defamation. Neverthe- less, Love ended up paying $430,000 to settle the case out of court. ■

9–4a Identifying the Author of Online Defamation

An initial issue raised by online defamation is simply discovering who is committing it. In the real world,

identifying the author of a defamatory remark generally is an easy matter. It is more difficult if a business firm dis- covers that defamatory statements about its policies and products are being posted in an online forum, because the postings are anonymous. Therefore, a threshold bar- rier to anyone who seeks to bring an action for online defamation is discovering the identity of the person who posted the defamatory message.

An Internet service provider (ISP) can disclose per- sonal information about its customers only when ordered to do so by a court. Consequently, businesses and indi- viduals are increasingly bringing lawsuits against “John Does” (John Doe, Jane Doe, and the like are fictitious

180 U N I T T W O The Public and International Environment

names used in lawsuits when the identity of a party is not known or when a party wishes to conceal his or her name for privacy reasons). Then, using the authority of the courts, the plaintiffs can obtain from the ISPs the identity of the persons responsible for the defamatory messages.messages.messages.

■ CASE IN POINT 9.18 Seven users of Yelp, Inc.— a social networking Web site for consumer reviews— posted negative reviews of Hadeed Carpet Cleaning, Inc., in Alexandria, Virginia. Hadeed brought a defamation suit against the “John Doe” reviewers in a Virginia state court, claiming that because these individuals were not actual customers, their comments were false and defama- tory. Yelp failed to comply with a court order to reveal the users’ identities and was held in contempt.

Yelp appealed, claiming that releasing the identities would violate the defendants’ First Amendment right to free speech. A state intermediate appellate court affirmed the lower court’s judgment, noting that Hadeed could not move forward with its defamation lawsuit unless it knew the identities of the defendants. Revealing the identities of Yelp reviewers was not a violation of their First Amendment rights.17 ■

9–4b Liability of Internet Service Providers Recall that under tort law those who repeat or otherwise republish a defamatory statement are normally subject to liability. Thus, newspapers, magazines, and television and radio stations are subject to liability for defamatory content that they publish or broadcast, even though the content was prepared or created by others. Applying this rule to cyberspace, however, raises an important issue: Should ISPs be regarded as publishers and therefore be held liable for defamatory messages that are posted by their users?

General Rule The Communications Decency Act (CDA) states that “[n]o provider or user of an interac- tive computer service shall be treated as the publisher or speaker of any information provided by another informa- tion content provider.”18 Thus, under the CDA, ISPs usu- ally are treated differently from publishers in print and other media and are not liable for publishing defamatory statements that come from a third party.

17. Yelp, Inc. v. Hadeed Carpet Cleaning, Inc., 62 Va.App. 678, 752 S.E.2d 554 (2014).

18. 47 U.S.C. Section 230.

Exceptions Although the courts generally have con- strued the CDA as providing a broad shield to protect ISPs from liability for third party content, some courts have started establishing limits to this immunity. have started establishing limits to this immunity. ■ CASE IN POINT 9.19 Roommate.com, LLC, operates an online roommate-matching Web site that helps individuals find roommates based on their descriptions of themselves and their roommate preferences. Users respond to a series of online questions, choosing from answers in drop-down and select-a-box menus.

Some of the questions asked users to disclose their sex, family status, and sexual orientation—which is not permitted under the federal Fair Housing Act. When a nonprofit housing organization sued Room- mate.com, the company claimed it was immune from liability under the CDA. A federal appellate court disagreed and ruled that Roommate.com was not immune from liability. By creating the Web site and the questionnaire and answer choices, Roommate.com prompted users to express discriminatory preferences and matched users based on these preferences in viola- tion of federal law.19 ■

9–5 Other Actions Involving Online Posts

Online conduct can give rise to a wide variety of legal actions. E-mails, tweets, posts, and every sort of online communication can form the basis for almost any type of tort. For example, in addition to defamation, suits relating to online conduct may involve allegations of wrongful interference or infliction of emotional distress.

Besides actions grounded in the common law, online conduct may give rise to a cause of action directed expressly at online communications by a statute. In the following case, the court was asked to issue an injunc- tion to prohibit speech that was alleged to constitute cyberstalking. The applicable statute defined this term to cyberstalking. The applicable statute defined this term to cyberstalking require, in part, “substantial emotional distress.”

19. Fair Housing Council of San Fernando Valley v. Roommate.com, LLC, 666 Fair Housing Council of San Fernando Valley v. Roommate.com, LLC, 666 Fair Housing Council of San Fernando Valley v. Roommate.com, LLC F.3d 1216 (9th Cir. 2012).

C H A P T E R 9 Internet Law, Social Media, and Privacy 181

In the Language of the Court WARNER, J. [Judge].

* * * * [Alkiviades] David and [John] Tex-

tor both have companies which produce holograms used in the music industry. * * * Shortly before the Billboard Music Awards show, it was announced that Textor’s company, Pulse Entertainment, would show a Michael Jackson hologram performance. Immediately thereafter, David’s company, Hologram USA, Inc., * * * filed suit for patent infringement against Pulse in the U.S. District Court in Nevada * * * . Pulse countered by fil- ing a business tort suit against David in California.

[One month later,] Textor filed a petition [in a Florida state court against David under Florida Statutes] Sections 784.046 and 784.0485, which concern cyberstalking.

The alleged acts of cyberstalking were (1) a * * * text from David to Textor, demanding that Textor give credit to David’s company at the Bill- board Awards show for the hologram, for which David would drop his pat- ent infringement suit; otherwise, he threatened to increase damages in that suit and stated, “You will be ruined I promise you”; (2) an e-mail from David to business associates (other than Textor) that he had more information about Textor that would be released soon, but not specifying what that information was; (3) an online article from July 2014 on Entrepreneur.com, in which David was quoted as saying that he “would have killed [Textor] if he could”; and (4) articles about Textor that David posted and reposted in vari- ous online outlets.

* * * * The trial court [issued an injunction]

prohibiting David from communicating with Textor or posting any information about him online, and ordering that

he remove any materials he already had posted.

David * * * moved to dissolve the * * * injunction. * * * The court denied the motion to dissolve and amended its order to prohibit David from com- municating with Textor either through electronic means, in person, or through third parties. The amended order also provided:

Respondent David shall immediately cease and desist from sending any text messages, e-mails, posting any tweets (including the re-tweeting or forwarding), posting any images or other forms of communication directed at John Textor without a legitimate purpose. Threats or warn- ings of physical or emotional harm or attempts to extort Textor or any entity associated with Textor by Respondent David, personally or through his agents, directed to John Textor, directly or by other means, are prohibited.

From this order, David appeals. David claims that none of the allega-

tions in the petition constitute cyber- stalking, but are merely heated rhetoric over a business dispute. Further, he claims that the injunction constitutes a prior restraint on speech, which violates the First Amendment.

[Florida Statutes] Section 784.0485 allows an injunction against * * * cyber- stalking. * * * Section 784.048 defines * * * cyberstalking:

* * * “Cyberstalk” means to engage in a course of conduct to commu- nicate, or to cause to be communi- cated, words, images, or language by or through the use of electronic mail or electronic communication, directed at a specific person, causing substantial emotional distress to that person and serving no legitimate purpose.

Whether a com- munication causes substantial emotional distress * * * is governed by the reason- able person standard. * * * Whether a communication serves a legitimate purpose * * * will cover a wide variety of conduct. * * * Where comments are made on an electronic medium to be read by others, they cannot be said to be directed to a particular person. [Emphasis added.]

In this case, Textor alleged that two communications came directly from David to him, both of which were demands that Textor drop his lawsuit. In neither of them did David make any threat to Textor’s safety. From the full e-mail, David’s threats that Textor would be “sorry” if he didn’t settle must be taken in the context of the lawsuit and its potential cost to Textor. Because of the existence of the various lawsuits and the heated controversy over the hologram patents, these e-mails had a legitimate purpose in trying to get Textor to drop what David considered a spurious lawsuit. Moreover, noth- ing in the e-mails should have caused substantial emotional distress to Textor, himself a sophisticated businessman. Indeed, that they did not is reflected in Textor’s refusal to settle or adhere to their terms.

The postings online are also not communications which would cause substantial emotional distress. Most of them are simply re-tweets of articles or headlines involving Textor. That they may be embarrassing to Textor is not at all the same as causing him substantial emotional distress sufficient to obtain an injunction.

Even the alleged physical threat made by David in an online interview, that David would have killed Textor if he could have, would not cause a reasonable person substantial emotional distress.

Case Analysis 9.2 David v. Textor District Court of Appeal of Florida, Fourth District, 41 Fla.L.Weekly D131, __ So.3d __ (2016).

182 U N I T T W O The Public and International Environment

In the online article the author stated that “David joked” when stating that he would have killed Textor. Spoken to a journalist for publication, it hardly amounts to an actual and credible threat of violence to Textor.

In sum, none of the allegations in Textor’s petition show acts constituting cyberstalking, in that a reasonable person would not suffer substantial emotional distress over them. Those communica- tions made directly to Textor served a legitimate purpose.

An injunction in this case would also violate [the freedom of speech under the U.S. Constitution’s First Amend- ment. An] injunction directed to speech is a classic example of prior restraint on speech triggering First Amendment concerns. * * * Prior restraints on speech and publication are the most serious and the least tolerable infringement on First Amendment rights. [Florida Statutes] Sec- tion 784.048 itself recognizes the First Amendment rights of individuals by concluding that a “course of conduct” for

purposes of the statute does not include protected speech. [Emphasis added.]

Here, the online postings simply provide information, gleaned from other sources, regarding Textor and the many lawsuits against him. The injunc- tion prevents not only communications to Textor, but also communications about Textor. Such prohibition by prior about Textor. Such prohibition by prior about restraint violates the Constitution.

For the foregoing reasons, we reverse the * * * injunction and remand with directions to dismiss the petition.

Legal Reasoning Questions

1. How is cyberstalking defined by the statute in this case, and what conduct by the defendant allegedly fit this definition?cyberstalking defined by the statute in this case, and what conduct by the defendant allegedly fit this definition?cyberstalking 2. What standard determines whether certain conduct meets the requirements of the cyberstalking statute? What law or legal

principle limits an injunction that is directed at speech? 3. Why did the court in this case “reverse the . . . injunction and remand with directions to dismiss the petition”? Explain.

9–6 Privacy Online businesses have been accused of violating users’ privacy rights. The courts have held that the right to pri- vacy is guaranteed by the Bill of Rights and some state constitutions. To maintain a suit for the invasion of pri- vacy, though, a person must have a reasonable expecta- tion of privacy in the particular situation.

9–6a Reasonable Expectation of Privacy People clearly have a reasonable expectation of privacy when they enter their personal banking or credit-card information online. They also have a reasonable expecta- tion that online companies will follow their own privacy policies. But it is probably not reasonable to expect pri- vacy in statements made on Twitter—or photos posted on Twitter, Flickr, or Instagram, for that matter.

Case 9.2 Continued

Sometimes, to be sure, people mistakenly believe that they are making statements or posting photos in that they are making statements or posting photos in that they are making statements or posting photos in a private forum. ■ EXAMPLE 9.20 Randi Zuckerberg, the older sister of Mark Zuckerberg (the founder of Facebook), used a mobile app called “Poke” to post a “private” photo on Facebook of their family gathering during the holidays. Poke allows the sender to decide how long the photo can be seen by others. Facebook allows users to configure their privacy settings to limit access to photos, which Randi thought she had done. Nonetheless, the photo showed up in the Facebook feed of Callie Schweitzer, who then put it on Twitter, where it eventually “went viral.” Schweitzer apologized and removed the photo, but it had already gone public for the world to see. ■

In the following case, the court considered whether a Facebook user’s expectation of privacy in photos that she posted on the site was reasonable.

Background and Facts Maria Nucci filed a suit in a Florida state court against Target Corporation, alleging that she suffered an injury when she slipped and fell on a “foreign substance” on the floor of a Target store. Target filed a motion to compel an inspection of Nucci’s Facebook profile, which

Nucci v. Target Corp. District Court of Appeal of Florida, Fourth District, 162 So.3d 146 (2015).

Case 9.3

C H A P T E R 9 Internet Law, Social Media, and Privacy 183

included 1,249 photos. Target argued that it was entitled to view the profile because Nucci’s lawsuit put her physical and mental condition at issue.

Nucci responded that her Facebook page’s privacy setting prevented the general public from having access to it. She claimed that she had a reasonable expectation of privacy in the profile and that Target’s access would invade that privacy right. The court issued an order to compel discovery of certain photos, including some on Nucci’s Facebook page, that were relevant to her physical and mental condition before and following the alleged injury. Nucci petitioned a state intermediate appel- late court for relief from the order.

In the Language of the Court GROSS, J. [Judge]

* * * * In a personal injury case * * * , In a personal injury case * * * , In a personal injury case the fact-finder is required to examine the quality of the plaintiff ’s life

before and after the accident to determine the extent of the loss. From testimony alone, it is often difficult for the fact-finder to grasp what a plaintiff ’s life was like prior to an accident. It would take a great nov- elist, a Tolstoy, a Dickens, or a Hemingway, to use words to summarize the totality of a prior life. If a photograph is worth a thousand words, there is no better portrayal of what an individual’s life was like than those photographs the individual has chosen to share through social media before the occurrence of an accident causing injury. Such photographs are the equivalent of a “day in the life” slide show produced by the plaintiff before the existence of any motive to manipulate reality. [Emphasis added.]

* * * * The Florida Constitution expressly protects an individual’s right to privacy. * * * The right to privacy

in the Florida Constitution ensures that individuals are able to determine for themselves when, how and to what extent information about them is communicated to others.

Before the right to privacy attaches, there must exist a legitimate expectation of privacy. * * * * * * Social networking sites, such as Facebook, are free websites where an individual creates a “pro-

file” which functions as a personal Web page and may include, at the user’s discretion, numerous photos and a vast array of personal information including age, employment, education, religious and political views and various recreational interests. Once a user joins a social networking site, he or she can use the site to search for “friends” and create linkages to others based on similar interests.

* * * * * * * Generally, the photographs posted on a social networking site are neither privileged nor protected by any

right of privacy, regardless of any privacy settings that the user may have established. Such posted photographs are unlike medical records or communications with one’s attorney, where disclosure is confined to narrow, confidential relationships. Facebook itself does not guarantee privacy. By creating a Facebook account, a user acknowledges that her personal information would be shared with others. Indeed, that is the very nature and purpose of these social networking sites else they would cease to exist. [Emphasis added.]

* * * The expectation that such information is private, in the traditional sense of the word, is not a reasonable one.

Decision and Remedy The state intermediate appellate denied Nucci’s petition for relief from the order to compel discovery of her Facebook photos. The court concluded that “the photographs sought were reasonably calculated to lead to the discovery of admissible evidence, and Nucci’s privacy interest in them was minimal.”

Critical Thinking • What If the Facts Were Different? Suppose that Target had asked for a much broader range of

Facebook material that concerned not just Nucci’s physical and mental condition at the time of her alleged injury but also her personal relationships with her family, romantic partners, and significant others. Would the result have been the same? Discuss.

• Ethical Would a court also allow Target discovery of Facebook photos that were posted by Nucci’s friends and family? Why or why not?

Case 9.3 Continued

184 U N I T T W O The Public and International Environment

9–6b Data Collection and Cookies Whenever a consumer purchases items online from a retailer, such as Amazon.com or Best Buy, the retailer col- lects information about the consumer. Cookies are invis- ible files that computers, smartphones, and other mobile devices create to track a user’s Web browsing activities. Cookies provide detailed information to marketers about an individual’s behavior and preferences, which is then used to personalize online services.

Over time, a retailer can amass considerable data about a person’s shopping habits. Does collecting this informa- tion violate a consumer’s right to privacy? Should retailers be able to pass on the data they have collected to their affil- iates? Should they be able to use the information to predict what a consumer might want and then create online “cou- pons” customized to fit the person’s buying history?pons” customized to fit the person’s buying history?pons” customized to fit the person’s buying history?

■ EXAMPLE 9.21 Facebook, Inc., once used a tar Facebook, Inc., once used a tar- geted advertising technique called “Sponsored Stories.” An ad would display a Facebook friend’s name and pro- file picture, along with a statement that the friend “likes” the company sponsoring the advertisement. A group of plaintiffs filed suit, claiming that Facebook had used their pictures for advertising without their permission. When a federal court refused to dismiss the case, Face- book agreed to settle. ■

9–6c Internet Companies’ Privacy Policies The Federal Trade Commission (FTC) investigates con- sumer complaints of privacy violations. The FTC has forced many companies, including Google, Facebook, Twitter, and MySpace, to enter a consent decree that gives the FTC broad power to review their privacy and data practices. It can then sue companies that violate the terms of the decree.

■ EXAMPLE 9.22 In 2012, Google settled a suit brought by the FTC alleging that it had misused data from Apple’s Safari users. Google allegedly had used cookies to trick the Safari browser on iPhones and iPads so that Google could monitor users who had blocked such tracking. This violated the company’s consent decree with the FTC. Google agreed to pay $22.5 mil- lion to settle the suit without admitting liability. ■

Facebook has faced a number of complaints about its privacy policy and has changed its policy several times to satisfy its critics and ward off potential government investigations. Other companies, including mobile app developers, have also changed their privacy policies to provide more information to consumers. Consequently, it is frequently the companies, rather than courts or legis- latures, that are defining the privacy rights of their online users.

Debate This . . . Internet service providers should be subject to the same defamation laws as newspapers, magazines, and television and radio stations.

Reviewing: Internet Law, Social Media, and Privacy

While he was in high school, Joel Gibb downloaded numerous songs to his smartphone from an unlicensed file-sharing service. He used portions of the copyrighted songs when he recorded his own band and posted videos on YouTube and Facebook. Gibb also used BitTorrent to download several movies from the Internet. Now he has applied to Boston University. The admissions office has requested access to his Facebook password, and he has complied. Using the infor- mation presented in the chapter, answer the following questions. 1. What laws, if any, did Gibb violate by downloading the music and videos from the Internet? 2. Was Gibb’s use of portions of copyrighted songs in his own music illegal? Explain. 3. Can individuals legally post copyrighted content on their Facebook pages? Why or why not? 4. Did Boston University violate any laws when it asked Joel to provide his Facebook password? Explain.

Terms and Concepts cloud computing 175 cookie 184 cybersquatting 171 cyber tort 178

distributed network 175 domain name 171 goodwill 171 Internet service provider (ISP) 171

peer-to-peer (P2P) networking 175 social media 176 spam 170 typosquatting 172

C H A P T E R 9 Internet Law, Social Media, and Privacy 185

Issue Spotters 1. Karl self-publishes a cookbook titled Hole Foods, in which

he sets out recipes for donuts, Bundt cakes, tortellini, and other foods with holes. To publicize the book, Karl designs the Web site holefoods.com. Karl appropriates the key words of other cooking and cookbook sites with more frequent hits so that holefoods.com will appear in the same search engine results as the more popular sites. Has Karl done anything wrong? Explain. (See Internet Law.)

2. Eagle Corporation began marketing software in 2007 under the mark “Eagle.” In 2017, Eagle.com, Inc., a dif-under the mark “Eagle.” In 2017, Eagle.com, Inc., a dif-under the mark “Eagle.” In 2017, Eagle.com, Inc., a dif ferent company selling different products, begins to use eagle as part of its URL and registers it as a domain name. eagle as part of its URL and registers it as a domain name. eagle Can Eagle Corporation stop this use of eagle? If so, what must the company show? (See Internet Law.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 9–1. Internet Service Providers. CyberConnect, Inc., is an Internet service provider (ISP). Pepper is a CyberCon- nect subscriber. Market Reach, Inc., is an online advertis- ing company. Using sophisticated software, Market Reach directs its ads to those users most likely to be interested in a particular product. When Pepper receives one of the ads, she objects to the content. Further, she claims that CyberConnect should pay damages for “publishing” the ad. Is the ISP regarded as a publisher and therefore liable for the content of Market Reach’s ad? Why or why not? (See Online Defamation.)

9–2. Privacy. SeeYou, Inc., is an online social network. SeeYou’s members develop personalized profiles to inter- act and share information—photos, videos, stories, activity updates, and other items—with other members. Members post the information that they want to share and decide with whom they want to share it. SeeYou launched a program to allow members to share with others what they do elsewhere online. For example, if a member rents a movie through Netf-online. For example, if a member rents a movie through Netf-online. For example, if a member rents a movie through Netf lix, SeeYou will broadcast that information to everyone in the member’s online network. How can SeeYou avoid complaints that this program violates its members’ privacy? (See Privacy.)

Business Case Problems 9–3. Business Case Problem with Sample Answer— Privacy. Using special software, South Dakota law

enforcement o�cers found a person who appeared to possess child pornography at a spe- ci�c Internet address. �e o�cers subpoenaed Midcontinent Communications, the service

that assigned the address, for the personal information of its subscriber. With this information, the o�cers obtained a search warrant for the residence of John Rolfe, where they found a laptop that contained child pornography. Rolfe argued that the subpoenas violated his “expectation of pri- vacy.” Did Rolfe have a privacy interest in the information obtained by the subpoenas issued to Midcontinent? Dis- cuss. [State of South Dakota v. Rolfe, 825 N.W.2d 901 (S.Dak. 2013)] (See Privacy.) • For a sample answer to Problem 9–3, go to Appendix E at

the end of this text.

9–4. File-Sharing. Dartmouth College professor M. Eric Johnson, in collaboration with Tiversa, Inc., a company that monitors peer-to-peer networks to provide security services, wrote an article titled “Data Hemorrhages in the Health-Care Sector.” In preparing the article, Johnson and Tiversa searched the networks for data that could be used to commit medical or �nancial identity theft. �ey found a document that con- tained the Social Security numbers, insurance information, and treatment codes for patients of LabMD, Inc. Tiversa noti- �ed LabMD of the �nd in order to solicit its business. Instead

of hiring Tiversa, however, LabMD �led a suit in a federal district court against the company, alleging trespass, conver- sion, and violations of federal statutes. What do these facts indicate about the security of private information? Explain. How should the court rule? [LabMD, Inc. v. Tiversa, Inc., 2013 WL 425983 (11th Cir. 2013)] (See Copyrights in Digital Information.) 9–5. Social Media. Mohammad Omar Aly Hassan and nine others were indicted in a federal district court on charges of conspiring to advance violent jihad (holy war against ene- mies of Islam) and other o�enses related to terrorism. �e evi- dence at Hassan’s trial included postings he made on Facebook concerning his adherence to violent jihadist ideology. Con- victed, Hassan appealed, contending that the Facebook items had not been properly authenticated (established as his own comments). How might the government show the connection between postings on Facebook and those who post them? Dis- cuss. [United States v. Hassan, 742 F.3d 104 (4th Cir. 2014)] (See Social Media.) 9–6. Social Media. Kenneth Wheeler was angry at cer- tain police o�cers in Grand Junction, Colorado, because of a driving-under-the-in�uence arrest that he viewed as unjust. While in Italy, Wheeler posted a statement to his Facebook page urging his “religious followers” to “kill cops, drown them in the blood of their children, hunt them down and kill their entire bloodlines” and provided names. Later, Wheeler added a post to “commit a massacre in the

186 U N I T T W O The Public and International Environment

Stepping Stones preschool and day care, just walk in and kill everybody.” Could a reasonable person conclude that Wheeler’s posts were true threats? How might law enforce- ment o�cers use Wheeler’s posts? Explain. [United States v. Wheeler, 776 F.3d 736 (10th Cir. 2015)] (See Social Media.)

9–7. Social Media. Irvin Smith was charged in a Geor- gia state court with burglary and theft. Before the trial, during the selection of the jury, the state prosecutor asked the prospective jurors whether they knew Smith. No one responded a�rmatively. Jurors were chosen and sworn in, without objection. After the trial, during deliberations, the jurors indicated to the court that they were deadlocked. �e court charged them to try again. Meanwhile, the prosecutor learned that “Juror 4” appeared as a friend on the defen- dant’s Facebook page and �led a motion to dismiss her. �e court replaced Juror 4 with an alternate. Was this an appro- priate action, or was it an “abuse of discretion”? Should the court have admitted evidence that Facebook friends do not always actually know each other? Discuss. [Smith v. State of Georgia, 335 Ga.App. 497, 782 S.E.2d 305 (2016)] (See Social Media.)

9–8. A Question of Ethics—Criminal Investigations. After the unauthorized release and posting of classi- �ed U.S. government documents to WikiLeaks.org, allegedly involving Bradley Manning, a U.S. Army private �rst class, the U.S. government began a crim-

inal investigation. �e government obtained a court order to require Twitter, Inc., to turn over subscriber information and com- munications to and from the e-mail addresses of Birgitta Jonsdottir and others. �e court sealed the order and the other documents in the case, reasoning that “there exists no right to public notice of all the types of documents �led in a . . . case.” Jonsdottir and the others appealed this decision. [In re Application of the United States of [In re Application of the United States of [ America for an Order Pursuant to 18 U.S.C. Section 2703(d), 707 F.3d 283 (4th Cir. 2013)] (See 707 F.3d 283 (4th Cir. 2013)] (See 707 F.3d 283 (4th Cir. 2013)] Social Media.) (a) Why would the government want to “seal” the docu-

ments of an investigation? Why would the individu- als under investigation want those documents to be “unsealed”? What factors should be considered in strik- ing a balance between these competing interests?

(b) How does law enforcement use social media to detect and prosecute criminals? Is this use of social media an unethical invasion of individuals’ privacy? Discuss.

Legal Reasoning Group Activity 9–9. File-Sharing. James, Chang, and Sixta are roommates. �ey are music fans and frequently listen to the same artists and songs. �ey regularly exchange MP3 music �les that con- tain songs from their favorite artists. (See Copyrights in Digital Information.)

(a) One group of students will decide whether the fact that the roommates are transferring files among themselves for

no monetary benefit precludes them from being subject to copyright law.

(b) The second group will consider an additional fact. Each roommate regularly buys CDs and rips (copies) them to his or her hard drive. Then the roommate gives the CDs to the other roommates to do the same.

187

C H A P T E R 10

10–1 Civil Law and Criminal Law Civil law pertains to the duties that exist between perCivil law pertains to the duties that exist between perCivil law - sons or between persons and their governments. Crimi- nal law, in contrast, has to do with crime. A crime can be defined as a wrong against society set forth in a statute and punishable by a fine and/or imprisonment—or, in some cases, death.

Because crimes are offenses against society as a whole, they are prosecuted by a public official, such as a district attorney (D.A.) or an attorney general (A.G.), not by the victims. Once a crime has been reported, the D.A.’s office decides whether to file criminal charges and to what extent to pursue the prosecution or carry out addi- tional investigation.

10–1a Key Differences between Civil Law and Criminal Law

Because the state has extensive resources at its disposal when prosecuting criminal cases, there are numerous procedural safeguards to protect the rights of defen- dants. We look here at one of these safeguards—the higher burden of proof that applies in a criminal case—as well as the harsher sanctions for criminal acts compared with those for civil wrongs. Exhibit 10–1

summarizes these and other key differences between civil law and criminal law.

Burden of Proof In a civil case, the plaintiff usually must prove his or her case by a preponderance of the evi- dence. Under this standard, the plaintiff must convince the court that based on the evidence presented by both parties, it is more likely than not that the plaintiff ’s allega- tion is true.

In a criminal case, in contrast, the government must prove its case beyond a reasonable doubt. If the jury views the evidence in the case as reasonably permitting either a guilty or a not guilty verdict, then the jury’s ver- dict must be not guilty. In other words, the government (prosecutor) must prove beyond a reasonable doubt that the defendant has committed every essential element of the offense with which she or he is charged.

Note also that in a criminal case, the jury’s verdict normally must be unanimous—agreed to by all members of the jury—to convict the defendant.1 (In a civil trial by jury, in contrast, typically only three-fourths of the jurors need to agree.)

1. A few states allow jury verdicts that are not unanimous. Arizona, for example, allows six of eight jurors to reach a verdict in criminal cases. Louisiana and Oregon have also relaxed the requirement of unanimous jury verdicts.

C riminal law is an important part of the legal environment of business. Society imposes a

variety of sanctions to protect busi- nesses from harm so that they can compete and flourish. These sanc- tions include damages for various types of tortious conduct, damages for breach of contract, and various equitable remedies. Additional sanc- tions are imposed under criminal law.

Many statutes regulating business provide for criminal as well as civil penalties.

In this chapter, after explain- ing some essential differences between criminal law and civil law, we look at how crimes are classi- fied and at the elements that must be present for criminal liability to exist. We then examine the various categories of crimes, the defenses

that can be raised to avoid criminal liability, and the rules of criminal procedure.

We conclude the chapter with a discussion of crimes that occur in cyberspace, which are often called cyber crimes. Cyber attacks are becoming all too common—even e-mail and data of government agen- cies and of former U.S. presidents have been hacked.

Criminal Law and Cyber Crime

188 U N I T T W O The Public and International Environment

Criminal Sanctions The sanctions imposed on crimi- nal wrongdoers are normally harsher than those applied in civil cases. Remember that the purpose of tort law is to enable a person harmed by a wrongful act to obtain com- pensation from the wrongdoer, rather than to punish the wrongdoer. In contrast, criminal sanctions are designed to punish those who commit crimes and to deter others from committing similar acts in the future.

Criminal sanctions include fines as well as the much stiffer penalty of the loss of one’s liberty by incarceration in a jail or prison. Most criminal sanctions also involve probation and sometimes require performance of com- munity service, completion of an educational or treat- ment program, or payment of restitution. The harshest criminal sanction is, of course, the death penalty.

10–1b Civil Liability for Criminal Acts Some torts, such as assault and battery, provide a basis for a criminal prosecution as well as a civil action in tort. ■ EXAMPLE 10.1 Jonas is walking down the street, minding his own business, when a person attacks him. In the ensuing struggle, the attacker stabs Jonas several times, seriously injuring him. A police officer restrains and arrests the assailant. In this situation, the attacker may be subject both to criminal prosecution by the state and to a tort lawsuit brought by Jonas to obtain compen- sation for his injuries. ■

Exhibit 10–2 illustrates how the same wrongful act can result in both a civil (tort) action and a criminal action against the wrongdoer.

10–1c Classification of Crimes Depending on their degree of seriousness, crimes are classified as felonies or misdemeanors. Felonies are serious crimes punishable by death or by imprisonment for more than one year.2 Many states also define differ- ent degrees of felony offenses and vary the punishment according to the degree.3 For instance, most jurisdic- tions punish a burglary that involves forced entry into a home at night more harshly than a burglary that involves breaking into a nonresidential building during the day.

Misdemeanors are less serious crimes, punishable by a fine or by confinement for up to a year. Petty offenses are minor violations, such as jaywalking or violations of building codes, considered to be a subset of misdemean- ors. Even for petty offenses, however, a guilty party can be put in jail for a few days, fined, or both, depending on state or local law. Whether a crime is a felony or a misdemeanor can determine in which court the case is tried and, in some states, whether the defendant has a right to a jury trial.

2. Federal law and most state laws use this definition, but there is some variation among states as to the length of imprisonment associated with a felony conviction.

3. Note that the Model Penal Code is not a uniform code and each state has developed its own set of laws governing criminal acts. Thus, types of crimes and prescribed punishments may differ from one jurisdiction to another.

Remedy is compensation (damages) or equitable decree

A wrongful act causes harm to a person or property

The person who suffered the harm sues

Typically three-fourths majority of jury necessary for a verdict

Burden of Proof— Preponderance of the evidence

Remedy is punishment (imprisonment, fine, or death)

A person or entity violates a statute

The government files the complaint

Verdict nearly always requires unanimous jury

Burden of Proof— Beyond a reasonable doubt

CRIMINAL LAW

CIVIL LAW

E X H I B I T 1 0 – 1 Key Differences between Civil Law and Criminal Law

C H A P T E R 1 0 Criminal Law and Cyber Crime 189

10–2 Criminal Liability The following two elements normally must exist simulta- neously for a person to be convicted of a crime:neously for a person to be convicted of a crime:neously

1. The performance of a prohibited act (actus reus). 2. A specified state of mind, or intent, on the part of the

actor (mens rea).

10–2a The Criminal Act Every criminal statute prohibits certain behavior. Most crimes require an act of commission—that is, a person must do something in order to be accused of a crime. In criminal law, a prohibited act is referred to as the actus reus,4 or guilty act. In some instances, an act of omission can be a crime, but only when a person has a legal duty to perform the omitted act, such as filing a tax return.

4. Pronounced ak-tuhs ray-uhs.

The guilty act requirement is based on one of the premises of criminal law—that a person should be pun- ished for harm done to society. For a crime to exist, the guilty act must thus cause some harm to a person or to property. Thinking about killing someone or about steal- ing a car may be morally wrong, but the thoughts do no harm until they are translated into action.

Of course, a person can be punished for attempting murder or robbery, but normally only if he or she has taken substantial steps toward the criminal objective. Additionally, the person must have specifically intended to commit the crime to be convicted of an attempt.

10–2b State of Mind Mens rea,5 or wrongful mental state, also is typically required to establish criminal liability. The required men- tal state, or intent, is indicated in the applicable statute or law. Murder, for instance, involves the guilty act of

5. Pronounced mehns ray-uh.

E X H I B I T 1 0 – 2 Civil (Tort) Lawsuit and Criminal Prosecution for the Same Act

The assailant commits an assault (an intentional, unexcused act

that creates in Jonas the reasonable fear of immediate harmful contact) and a battery

(intentional harmful or offensive contact).

PHYSICAL ATTACK AS A TORTTORTT

Jonas files a civil suit against the assailant.

A court orders the assailant to pay Jonas for his injuries.

The state prosecutes the assailant.

A court orders the assailant to be fined or imprisoned.

PHYSICAL ATTACK AS A CRIME

The assailant violates a statute that defines and prohibits the crime of assault (attempt to commit a violent injury on

another) and battery (commission of an intentional act resulting in

injury to another).

A person suddenly attacks Jonas as he is walking down the street.

190 U N I T T W O The Public and International Environment

killing another human being, and the guilty mental state is the desire, or intent, to take another’s life. For theft, the guilty act is the taking of another person’s property. The mental state involves both the awareness that the property belongs to another and the desire to deprive the owner of it.

Recklessness A court can also find that the required mental state is present when a defendant’s acts are reckless or criminally negligent. A defendant is criminally reckless if he or she consciously disregards a substantial and unjus- tifiable risk.

■ EXAMPLE 10.2 A fourteen-year-old New Jersey A fourteen-year-old New Jersey girl posts a Facebook message saying that she is going to launch a terrorist attack on her high school and ask- ing if anyone wants to help. The police arrest the girl for the crime of making a terrorist threat. The statute requires the intent to commit an act of violence with “the intent to terrorize” or “in reckless disregard of the risk of causing” terror or inconvenience. Although the girl argues that she had no intent to cause harm, the police can prosecute her under the “reckless disregard” part of the statute. ■

Criminal Negligence Criminal negligence involves Criminal negligence involves Criminal negligence the mental state in which the defendant takes an unjusti- fied, substantial, and foreseeable risk that results in harm. A defendant can be negligent even if she or he was not actually aware of the risk but should have been aware of it.hould have been aware of it.hould have been aware 6

A homicide is classified as involuntary manslaughter when it results from an act of criminal negligence and when it results from an act of criminal negligence and when it results from an act of criminal negligence and there is no intent to kill. ■ EXAMPLE 10.3 Dr. Con Dr. Con- rad Murray, the personal physician of pop star Michael Jackson, was convicted of involuntary manslaughter for prescribing the drug that led to Jackson’s sudden death. Murray had given Jackson propofol, a powerful anes- thetic normally used in surgery, as a sleep aid on the night of his death, even though he knew that Jackson had already taken other sedatives. ■

Strict Liability and Overcriminalization An increasing number of laws and regulations impose crimi- nal sanctions for strict liability crimes. Strict liability crimes are offenses that do not require a wrongful mental state to establish criminal liability.

Proponents of strict liability criminal laws argue that they are necessary to protect the public and the environ- ment. Critics say laws that criminalize conduct without requiring intent have led to overcriminalization. They argue that when the requirement of intent is removed,

6. Model Penal Code Section 2.02(2)(d).

people are more likely to commit crimes unknowingly— and perhaps even innocently. When an honest mistake can lead to a criminal conviction, the idea that crimes are a wrong against society is undermined.

Federal Crimes. �e federal criminal code lists more than four thousand criminal o�enses, many of which do not require a speci�c mental state. In addition, many of these rules do not require intent. See this chapter’s Mana- gerial Strategy feature for a discussion of how these laws and rules a�ect American businesspersons.

■ EXAMPLE 10.4 Eddie Leroy Anderson, a retired Eddie Leroy Anderson, a retired logger and former science teacher, went digging for arrowheads with his son near a campground in Idaho. They did not realize that they were on federal land and that it is a felony to remove artifacts from federal land without a permit. Although the crime carries a penalty of as much as two years in prison, the father and son pleaded guilty, and each received a sentence of probation and a $1,500 fine. ■

Strict liability crimes are particularly common in environmental laws, laws aimed at combatting illegal drugs, and other laws affecting public health, safety, and welfare. Under federal law, for instance, tenants can be evicted from public housing if one of their relatives or a guest used illegal drugs—regardless of whether the tenant knew about the drug activity.

State Crimes. Many states have also enacted laws that punish behavior as criminal without the need to show criminal intent. ■ EXAMPLE 10.5 In Arizona, a hunter In Arizona, a hunter who shoots an elk outside the area speci�ed by the hunt- ing permit has committed a crime. �e hunter can be convicted of the crime regardless of her or his intent or knowledge of the law. ■

10–2c Corporate Criminal Liability A corporation is a legal entity created under the laws of a state. At one time, it was thought that a corpora- tion could not incur criminal liability because, although a corporation is a legal person, it can act only through its agents (corporate directors, officers, and employees). Therefore, the corporate entity itself could not “intend” to commit a crime. Over time, this view has changed. Obviously, corporations cannot be imprisoned, but they can be fined or denied certain legal privileges (such as necessary licenses).

Liability of the Corporate Entity Today, corpo- rations normally are liable for the crimes committed by their agents and employees within the course and scope of

C H A P T E R 1 0 Criminal Law and Cyber Crime 191

The Criminalization of American Business

What do Bank of America, Citigroup, JPMorgan Chase, and Goldman Sachs have in common? All paid hefty fines for purportedly misleading investors about mortgage-backed securities. In fact, these companies paid the government a total of $50 billion in fines. The payments were made in lieu of criminal prosecutions.

Today, several hundred thousand federal rules that apply to businesses carry some form of criminal penalty. That is in addition to more than four thousand federal laws, many of which carry criminal sanctions for their violation. From 2000 to the beginning of 2017, about 2,200 corporations either were convicted or pleaded guilty to violating federal statutes or rules.

Criminal Convictions

The first successful criminal conviction in a federal court against a company—the New York Central and Hudson River Railroad—was upheld by the Supreme Court in 1909 (the violation: cutting prices).a Many other suc- cessful convictions followed.

One landmark case developed the aggregation test, now called the Doctrine of Collective Knowledge.b This test aggregates the omissions and acts of two or more persons in a corporation, thereby constructing an actus reus and a reus and a reus mens rea out of the conduct and knowledge mens rea out of the conduct and knowledge mens rea of several individuals.

Not all government attempts at applying criminal law to corporations survive. In 2013, for example, Sentinel Offender Services, LLC, prevailed on appeal. There was no actual evidence to show that the com- pany had acted with specific intent to commit theft by deception.c

In 2014, FedEx Corporation was indicted for purportedly illegally shipping prescription drugs ordered through Web sites. FedEx has chosen to proceed to trial in the U.S. District Court for the Northern District of California in San Francisco.d Many companies, however, choose to reach settlement agreements with the gov- ernment rather than fight criminal indictments.

Many Pay Substantial Fines in Lieu of Prosecution

More than three hundred corporations reached so-called non-prosecution agreements with the government from 2000 to the beginning of 2017. These agreements typically involve multimillion- or multibillion-dollar fines. This number does not include fines paid to the Environmental Protection Agency or to the Fish and Wildlife Service.

According to law professors Margaret Lemos and Max Minzner, “Public enforcers often seek large mon- etary awards for self-interested reasons divorced from the public interest and deterrents. The incentives are strongest when enforcement agencies are permitted to retain all or some of the proceeds of enforcement.”e

Business Questions 1. Why might a corporation’s managers agree to pay a

large fine rather than to be indicted and proceed to trial?

2. How does a manager determine the optimal amount of legal research to undertake to prevent her or his company from violating the many thousands of federal regulations?

MANAGERIAL STRATEGY

a. New York Central and Hudson River Railroad v. United States, 212 U.S. 481, 29 S.Ct. 304, 53 L.Ed 613 (1909).

b. United States v. Bank of New England, 821 F.2d 844 (1st Cir. 1987). c. McGee v. Sentinel Offender Services, LLC, 719 F.3d 1236 (11th Cir.

2013).

d. United States v. FedEx Corp., Case No. CR14-380 Northern District, California, July 17, 2014.

e. Margaret Lemos and Max Minzner, “For-Profit Public Enforcement,” Harvard Law Review 127, January 17, 2014.

their employment.7 For liability to be imposed, the pros- ecutor generally must show that the corporation could have prevented the act or that a supervisor authorized or had knowledge of the act. In addition, corporations can be criminally liable for failing to perform specific duties

7. See Model Penal Code Section 2.07.

imposed by law (such as duties under environmental laws or securities laws).

■ CASE IN POINT 10.6 A prostitution ring, the Gold Club, was operating out of some motels in West Virginia. A motel manager, who was also a corporate officer, gave discounted rates to Gold Club prostitutes, and they paid him in cash. The corporation received a portion of the

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funds generated by the Gold Club’s illegal operations. A jury found that the corporation was criminally liable because a supervisor within the corporation—the motel manager—had knowledge of the prostitution activities and the corporation had allowed it to continue.8 ■

Liability of Corporate Officers and Direc- tors Corporate directors and officers are personally lia- ble for the crimes they commit, regardless of whether the crimes were committed for their private benefit or on the corporation’s behalf. Additionally, corporate directors and officers may be held liable for the actions of employees under their supervision. Under the responsible corporate officer doctrine, a court may impose criminal liability on a corporate officer who participated in, directed, or merely knew about a given criminal violation.knew about a given criminal violation.knew about a given criminal violation.

■ CASE IN POINT 10.7 Austin DeCoster owned and Austin DeCoster owned and controlled Quality Egg, LLC, an egg production and pro- cessing company with facilities across Iowa. His son Peter DeCoster was the chief operating officer. Due to unsani- tary conditions in some of its facilities, Quality shipped and sold eggs that contained salmonella bacteria, which sickened thousands of people across the United States.

The federal government prosecuted the DeCosters under the responsible corporate officer doctrine, in part, for Quality’s failure to comply with regulations on egg pro- duction facilities. The DeCosters ultimately pleaded guilty to violating three criminal statutes. But when they were ordered to serve three months in jail, the DeCosters chal- lenged the sentence as unconstitutional. The court held that the sentence of incarceration was appropriate because the evidence suggested that the defendants knew about the unsanitary conditions in their processing plants.9 ■

10–3 Types of Crimes Federal, state, and local laws provide for the classification and punishment of hundreds of thousands of different criminal acts. Generally, though, criminal acts fall into five broad categories: violent crime (crimes against per- sons), property crime, public order crime, white-collar crime, and organized crime. In addition, when crimes are committed in cyberspace rather the physical world, we often refer to them as cyber crimes.

8. As a result of the convictions, the motel manager was sentenced to fifteen months in prison, and the corporation was ordered to forfeit the motel property. United States v. Singh, 518 F.3d 236 (4th Cir. 2008).

9. United States v. Quality Egg, LLC, 99 F.Supp.3d 920 (N.D. Iowa 2015).

10–3a Violent Crime Certain crimes are called violent crimes, or crimes against persons, because they cause others to suffer harm or death. Murder is a violent crime. So is sex- ual assault, or rape. Robbery—defined as the taking Robbery—defined as the taking Robbery of money, personal property, or any other article of value from a person by means of force or fear—is also a violent crime. Typically, states have more severe penal- ties for aggravated robbery—robbery with the use of a aggravated robbery—robbery with the use of a aggravated robbery deadly weapon.

Assault and battery, which were discussed in the context of tort law, are also classified as violent crimes. ■ EXAMPLE 10.8 Former rap star Flavor Flav (whose real name is William Drayton) was arrested in Las Vegas on assault and battery charges. During an argu- ment with his fiancée, Drayton allegedly threw her to the ground and then grabbed two kitchen knives and chased her son. ■

Each violent crime is further classified by degree, depending on the circumstances surrounding the crim- inal act. These circumstances include the intent of the person committing the crime and whether a weapon was used. For crimes other than murder, the level of pain and suffering experienced by the victim is also a factor.

10–3b Property Crime The most common type of criminal activity is property crime, in which the goal of the offender is some form of economic gain or the damaging of property. Rob- bery is a form of property crime, as well as a violent crime, because the offender seeks to gain the property of another.

Burglary Traditionally, burglary was defined as burglary was defined as burglary breaking and entering the dwelling of another at night with the intent to commit a felony. This definition was aimed at protecting an individual’s home and its occupants.

Most state statutes have eliminated some of the requirements found in the common law definition. The time of day at which the breaking and entering occurs, for instance, is usually immaterial. State statutes fre- quently omit the element of breaking, and some states do not require that the building be a dwelling. When a deadly weapon is used in a burglary, the perpetrator can be charged with aggravated burglary and punished more aggravated burglary and punished more aggravated burglary severely.

The defendant in the following case challenged whether the evidence presented by the state was sufficient to support his conviction for burglary.

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Background and Facts Over a Labor Day weekend in Rochester, Minnesota, two homes and the Rochester Tennis Center, a business, were burglarized. One day later, at the nearby Bell Tower Inn, cleaning personnel found a garbage bag in the room of Albert Smith. The bag contained a passport that belonged to the owner of one of the burglarized homes and documents that belonged to the business.

Police officers arrested Smith. They found a Sentry safe stolen in one of the burglaries in Smith’s room. A search of a bag in his possession revealed other stolen items, as well as burglary tools. Smith claimed that he had bought some of the items from a man named Mali and had bought other items on Craigslist. He said that he had found the documents from the tennis center in a dumpster. Con- victed of burglary in a Minnesota state court, Smith appealed.

In the Language of the Court CHUTICH, Judge.

* * * * * * * Both burglarized homes and the burglarized business were within a few blocks of the hotel

where Smith stayed over the Labor Day weekend, and each burglary occurred during the holiday week- end. In fact, two of the burglaries occurred in the morning and early evening of September 3. On the morning of September 4, only hours after two of the burglaries occurred, Smith possessed property sto- len in each of the three burglaries. Some of the items found in Smith’s possession were worthless to any- one but their owners, including a passport, a birth certificate, and property documents. In addition, the hotel manager saw Smith carrying the stolen Sentry safe into the hotel during the relevant time frame and identified the safe found in Smith’s room as the Sentry safe. When the police confronted Smith in the hotel, he was carrying a bag that contained numerous stolen electronics and burglary tools, including a flashlight and gloves.

* * * Smith possessed property reported as stolen from both homes and the business, and the nature of several of the items he possessed suggested that they came directly from the burglaries. * * * The assortment of items found in Smith’s possession, from the electronics to the financially worthless docu- ments, as well as gloves and a flashlight, illustrate Smith’s guilt of each of the burglaries. The mishmash of items found in defendant’s possession looks like the raw loot that a thief quickly grabbed and made off with. Moreover, the brief time that passed between the burglaries and the discovery of the stolen items in Smith’s possession, along with the close proximity of the hotel to the burglarized homes and tennis center, are consistent with the findings that Smith was the thief. [Emphasis added.]consistent with the findings that Smith was the thief. [Emphasis added.]consistent with the findings that Smith was the thief.

Smith contends that a reasonable inference can be drawn from his alternate explanation of the events that is inconsistent with finding him guilty of the burglaries, namely that he obtained the valuable stolen items from Mali or from Craigslist, while he found the tennis club’s records in a dumpster. The [trial] court, however, did not find Smith’s testimony credible, determining that Smith “demonstrated a flex- ible approach to the truth—a looseness with the facts, in which the incriminatory truth is conceded only when and to the extent it is inescapable.” Further, we consider it improbable, considering the timing and locations of the break-ins, that Smith came into possession of stolen items from a September 3 burglary by way of Mali, while finding additional stolen items from another September 3 burglary that same evening by fortuitously finding them in a dumpster. * * * The only rational hypothesis that can be drawn from the proved circumstances is that Smith committed the burglaries.

Decision and Remedy A state intermediate appellate court affirmed Smith’s conviction for burglary. The appellate court concluded that the circumstances “are consistent with guilt and inconsistent with any rational hypothesis except that of guilt.”

Critical Thinking • Social Who is in the best position to evaluate the credibility of the evidence and the witnesses in a case? Why?

State of Minnesota v. Smith Court of Appeals of Minnesota, 2015 WL 303643 (2015).

Case 10.1

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Larceny Under the common law, the crime of lar- ceny involved the unlawful taking and carrying away of ceny involved the unlawful taking and carrying away of ceny someone else’s personal property with the intent to per- manently deprive the owner of possession. Put simply, lar- ceny is stealing, or theft. Whereas robbery involves force or fear, larceny does not. Therefore, picking pockets is lar- ceny, not robbery. Similarly, an employee taking company products and supplies home for personal use without per- mission is committing larceny.

Most states have expanded the definition of property that is subject to larceny statutes. Stealing computer pro- grams may constitute larceny even though the “property” is not physical (see the discussion of computer crime later in this chapter). The theft of natural gas, Internet access, or television cable service can also constitute larceny.

Obtaining Goods by False Pretenses Obtain- ing goods by means of false pretenses is a form of theft that involves trickery or fraud, such as using someone else’s credit-card number without permission to purchase an iPad. Statutes dealing with such illegal activities vary widely from state to state. They often apply not only to property, but also to services and cash.

■ CASE IN POINT 10.9 While Matthew Steffes was incarcerated, he started a scheme to make free collect calls from prison. (A collect call is a telephone call in which the collect call is a telephone call in which the collect call calling party places a call at the called party’s expense.) Steffes had his friends and family members set up new phone number accounts by giving false information to AT&T. This information included fictitious business names, as well as personal identifying information stolen from a health-care clinic. Once a new phone number was working, Steffes made unlimited collect calls to it with- out paying the bill until AT&T eventually shut down the account. For nearly two years, Steffes used sixty fraudu- lently obtained phone numbers to make hundreds of col- lect calls. The loss to AT&T was more than $28,000.

Steffes was convicted in a state court of theft by fraud of property in excess of $10,000. He appealed, arguing that he had not made false representations to AT&T. The Wisconsin Supreme Court affirmed his conviction. The court held that Steffes had made false representa- tions to AT&T by providing fictitious business names and stolen personal identifying information to the phone company. He made these false representations so that he could make phone calls without paying for them, which deprived the company of its “property”—meaning its electricity.10 ■

10. State of Wisconsin v. Steffes, 347 Wis.2d 683, 832 N.W.2d 101 (2013).

Theft Sometimes, state statutes consolidate the crime of obtaining goods by false pretenses with other property offenses, such as larceny and embezzlement (discussed shortly), into a single crime called simply “theft.” Under such a statute, it is not necessary for a defendant to be charged specifically with larceny or obtaining goods by false pretenses. Petty theft is the theft of a small quantity of Petty theft is the theft of a small quantity of Petty theft cash or low-value goods. Grand theft is the theft of a larger Grand theft is the theft of a larger Grand theft amount of cash or higher-value property.

Receiving Stolen Goods It is a crime to receive goods that a person knows or should have known were stolen or illegally obtained. To be convicted, the recipi- ent of such goods need not know the true identity of the owner or the thief, and need not have paid for the goods. All that is necessary is that the recipient knows or should know that the goods are stolen, which implies an intent to deprive the true owner of those goods.

Arson The willful and malicious burning of a build- ing (or, in some states, a vehicle or other item of personal property) is the crime of arson. At common law, arson applied only to burning down another person’s house. The law was designed to protect human life. Today, arson statutes have been extended to cover the destruction of any building, regardless of ownership, by fire or explosion.

Every state has a special statute that covers the act of burning a building for the purpose of collecting insur- ance. (Of course, the insurer need not pay the claim when insurance fraud is proved.)

Forgery The fraudulent making or altering of any writing (including an electronic record) in a way that changes the legal rights and liabilities of another is changes the legal rights and liabilities of another is changes the legal rights and liabilities of another is forg-forg-forg ery. ■ EXAMPLE 10.10 Without authorization, Severson signs Bennett’s name to the back of a check made out to Bennett and attempts to cash it. Severson is committing forgery. ■ Forgery also includes changing trademarks, fal- sifying public records, counterfeiting, and altering a legal document.

10–3c Public Order Crime Historically, societies have always outlawed activities that are considered contrary to public values and mor- als. Today, the most common public order crimes include public drunkenness, prostitution, gambling, and illegal drug use. These crimes are sometimes referred to as victimless crimes because they normally harm only the victimless crimes because they normally harm only the victimless crimes offender. From a broader perspective, however, they are deemed detrimental to society as a whole because they

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may create an environment that gives rise to property and violent crimes.

■ EXAMPLE 10.11 A flight attendant observes a man and woman engaging in sex acts while on a flight to Las Vegas. A criminal complaint is filed, and the two defen- dants plead guilty in federal court to misdemeanor disor- derly conduct. ■

10–3d White-Collar Crime Crimes occurring in the business context are popularly referred to as white-collar crimes, although this is not an official legal term. Ordinarily, white-collar crime involves an illegal act or series of acts committed by an individual or business entity using some nonviolent means to obtain a personal or business advantage.

Usually, this kind of crime takes place in the course of a legitimate business occupation. Corporate crimes fall into this category. Certain property crimes, such as lar- ceny and forgery, may also be white-collar crimes if they occur within the business context. The crimes discussed next normally occur only in the business context.

Embezzlement When a person who is entrusted with another person’s property fraudulently appropri- ates it, embezzlement occurs. Embezzlement is not larembezzlement occurs. Embezzlement is not larembezzlement - ceny, because the wrongdoer does not physically take the physically take the physically property from another’s possession, and it is not robbery, because no force or fear is used.

Typically, embezzlement is carried out by an employee who steals funds a small amount at a time over a long period. Banks are particularly prone to this problem, but embezzlement can occur in any firm. In a number of businesses, corporate officers or accoun- tants have fraudulently converted funds for their own benefit and then “fixed” the books to cover up their crimes.

Embezzlement occurs whether the embezzler takes the funds directly from the victim or from a third person. If the financial officer of a large corporation pockets checks from third parties that were given to her to deposit into the corporate account, she is embezzling.

The intent to return embezzled property—or its actual return—is not a defense to the crime of embezzle- ment, as the following Spotlight Case illustrates.Spotlight Case illustrates.Spotlight Case

Background and Facts Lou Sisuphan was the director of finance at a Toyota dealership. His responsibilities included managing the financing contracts for vehicle sales and working with lenders to obtain payments. Sisuphan complained repeatedly to management about the performance and attitude of one of the finance managers, Ian McClelland. The general manager, Michael Christian, would not terminate McClelland “because he brought a lot of money into the dealership.”

One day, McClelland accepted $22,600 in cash and two checks totaling $7,275.51 from a cus- tomer in payment for a car. McClelland placed the cash, the checks, and a copy of the receipt in a large envelope. As he tried to drop the envelope into the safe through a mechanism at its top, the envelope became stuck. While McClelland went for assistance, Sisuphan wiggled the envelope free and kept it. On McClelland’s return, Sisuphan told him that the envelope had dropped into the safe. When the payment turned up missing, Christian told all the managers he would not bring criminal charges if the payment was returned within twenty-four hours.

After the twenty-four-hour period had lapsed, Sisuphan told Christian that he had taken the enve- lope, and he returned the cash and checks to Christian. Sisuphan claimed that he had no intention of stealing the payment but had taken it to get McClelland fired. Christian fired Sisuphan the next day, and the district attorney later charged Sisuphan with embezzlement.

After a jury trial, Sisuphan was found guilty. Sisuphan appealed, arguing that the trial court had erred by excluding evidence that he had returned the payment. The trial court had concluded that the evidence was not relevant because return of the property is not a defense to embezzlement.

Spotlight on White-Collar Crime

Case 10.2 Case 10.2 People v. Sisuphan Court of Appeal of California, First District, 181 Cal.App.4th 800, 104 Cal.Rptr.3d 654 (2010).Court of Appeal of California, First District, 181 Cal.App.4th 800, 104 Cal.Rptr.3d 654 (2010).Court of Appeal of California, First District, 181 Cal.App.4th 800, 104 Cal.Rptr.3d 654 (2010).

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In the Language of the Court JENKINS, J. [Judge]

* * * * Fraudulent intent is an essential element of embezzlement. Although restoration of the property is not a

defense, evidence of repayment may be relevant to the extent it shows that a defendant’s intent at the time of the taking was not fraudulent. Such evidence is admissible “only when [a] defendant shows a relevant and probative [confirming] link in his subsequent actions from which it might be inferred his original intent was innocent.” The question before us, therefore, is whether evidence that Sisuphan returned the money reasonably tends to prove he lacked the requisite intent at the time of the taking. [Emphasis added.]

Section 508 [of the California Penal Code], which sets out the offense of which Sisuphan was con- victed, provides: “Every clerk, agent, or servant of any person who fraudulently appropriates to his own use, or secretes with a fraudulent intent to appropriate to his own use, any property of another which has come into his control or care by virtue of his employment * * * is guilty of embezzlement.” Sisuphan denies he ever intended “to use the [money] to financially better himself, even temporarily” and con- tends the evidence he sought to introduce showed “he returned the [money] without having appropri- ated it to his own use in any way.” He argues that this evidence negates fraudulent intent because it supports his claim that he took the money to get McClelland fired and acted “to help his company by drawing attention to the inadequacy and incompetency of an employee.” We reject these contentions.

In determining whether Sisuphan’s intent was fraudulent at the time of the taking, the issue is not whether he intended to spend the money, but whether he intended to use it for a purpose other than that for which the dealership entrusted it to him. The offense of embezzlement contemplates a principal’s entrustment of property to an agent for certain purposes and the agent’s breach of that trust by acting outside his authority in his use of the property. * * * Sisuphan’s undisputed purpose—to get McClelland fired—was beyond the scope of his responsibility and therefore outside the trust afforded him by the dealership. Accordingly, even if the proffered [submitted] evidence shows he took the money for this purpose, it does not tend to prove he lacked fraudulent intent, and the trial court properly excluded this evidence. [Emphasis added.]

Decision and Remedy The California appellate court affirmed the trial court’s decision. The fact that Sisuphan had returned the payment was irrelevant. He was guilty of embezzlement.

Critical Thinking • Legal Environment Why was Sisuphan convicted of embezzlement instead of larceny? What is the dif-Why was Sisuphan convicted of embezzlement instead of larceny? What is the dif-Why was Sisuphan convicted of embezzlement instead of larceny? What is the dif

ference between these two crimes? • Ethical Given that Sisuphan returned the cash, was it fair of the dealership’s general manager to termi-

nate Sisuphan’s employment? Why or why not?

Case 10.2 Continued

Mail and Wire Fraud Among the most potent weap- ons against white-collar criminals are the federal laws that prohibit mail fraud11 and wire fraud.12 These laws make it a federal crime to devise any scheme that uses U.S. mail, commercial carriers (FedEx, UPS), or wire (telegraph, telephone, television, the Internet, e-mail) with the intent to defraud the public. These laws are often applied when persons send out advertisements or e-mails with the intent to fraudulently obtain cash or property by false pretenses.to fraudulently obtain cash or property by false pretenses.to fraudulently obtain cash or property by false pretenses.

■ CASE IN POINT 10.12 Cisco Systems, Inc., offers a Cisco Systems, Inc., offers a warranty program to authorized resellers of Cisco parts.

11. The Mail Fraud Act, 18 U.S.C. Sections 1341–1342. 12. 18 U.S.C. Section 1343.

Iheanyi Frank Chinasa and Robert Kendrick Chambliss devised a scheme to intentionally defraud Cisco with respect to this program and to obtain replacement parts to which they were not entitled. The two men planned and used specific language in numerous e-mails and Internet service requests that they sent to Cisco to con- vince Cisco to ship them new parts via commercial car- riers. Ultimately, Chinasa and Chambliss were convicted of mail and wire fraud and of conspiracy to commit mail and wire fraud.13 ■

13. United States v. Chinasa, 789 F.Supp.2d 691 (E.D.Va. 2011). See also United States v. Lyons, 569 F.3d 995 (9th Cir. 2009).

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The maximum penalty under these statutes is substan- tial. Persons convicted of mail, wire, and Internet fraud may be imprisoned for up to twenty years and/or fined. If the violation affects a financial institution or involves fraud in connection with emergency disaster-relief funds, the violator may be fined up to $1 million, imprisoned for up to thirty years, or both.

Bribery The crime of bribery involves offering to give something of value to a person in an attempt to influ- ence that person in a way that serves a private interest. Three types of bribery are considered crimes: bribery of public officials, commercial bribery, and bribery of for- eign officials.

The bribe itself can be anything the recipient consid- ers to be valuable, but the defendant must have intended it as a bribe. Realize that the crime of bribery occurs when the bribe is offered—it is not required that the bribe be the bribe is offered—it is not required that the bribe be the bribe is offered accepted. Accepting a bribe is a separate crime.Accepting a bribe is a separate crime.Accepting a bribe

Commercial bribery involves corrupt dealings between private persons or businesses. Typically, people make commercial bribes to obtain proprietary infor- mation, cover up an inferior product, or secure new business. Industrial espionage sometimes involves combusiness. Industrial espionage sometimes involves combusiness. Industrial espionage sometimes involves com- mercial bribes. ■ EXAMPLE 10.13 Kent Peterson works at the firm of Jacoby & Meyers. He offers to pay Laurel, an employee in a competing firm, to give him that firm’s trade secrets and pricing schedules. Peterson has commit- ted commercial bribery. ■ So-called kickbacks, or payoffs for special favors or services, are a form of commercial bribery in some situations.

Bankruptcy Fraud Federal bankruptcy law allows individuals and businesses to be relieved of oppressive debt through bankruptcy proceedings. Numerous white- collar crimes may be committed during the many phases of a bankruptcy action. A creditor may file a false claim against the debtor, which is a crime. Also, a debtor may fraudulently transfer assets to favored parties before or after the bankruptcy is filed. For instance, a company- owned automobile may be “sold” at a bargain price to a trusted friend or relative. Closely related to the crime of fraudulent transfer of property is the crime of fraudulent concealment of property, such as the hiding of gold coins.

Insider Trading An individual who obtains “inside information” about the plans of a publicly listed corpora- tion can often make stock-trading profits by purchasing or selling corporate securities based on this information. Insider trading is a violation of securities law. Basically, a Insider trading is a violation of securities law. Basically, a Insider trading person who possesses inside information and has a duty not to disclose it to outsiders may not trade on that

information. A person may not profit from the purchase or sale of securities based on inside information until the information is made available to the public.

Theft of Trade Secrets and Other Intellectual Property The Economic Espionage Act14 makes the theft of trade secrets a federal crime. The act also makes it a federal crime to buy or possess another person’s trade secrets, knowing that the trade secrets were stolen or oth- erwise acquired without the owner’s authorization.

Violations of the Economic Espionage Act can result in steep penalties: imprisonment for up to ten years and a fine of up to $500,000. A corporation or other organization can be fined up to $5 million. Addition- ally, any property acquired as a result of the violation, such as airplanes and automobiles, is subject to criminal forfeiture, or seizure by the government. Similarly, any property used in the commission of the violation is sub- ject to forfeiture.

10–3e Organized Crime White-collar crime takes place within the confines of the legitimate business world. Organized crime, in contrast, operates illegitimately by, among other things, providing illegitimately by, among other things, providing illegitimately illegal goods and services. Traditionally, organized crime has been involved in gambling, prostitution, illegal nar- cotics, counterfeiting, and loan sharking (lending funds at higher-than-legal interest rates), along with more recent ventures into credit-card scams and cyber crime.

Money Laundering The profits from organized crime and illegal activities amount to billions of dollars a year. These profits come from illegal drug transactions and, to a lesser extent, from racketeering, prostitution, and gambling. Under federal law, banks, savings and loan associations, and other financial institutions are required to report currency transactions involving more than $10,000. Consequently, those who engage in illegal activities face difficulties in depositing their cash profits from illegal transactions.

As an alternative to storing the cash from illegal trans- actions in a safe-deposit box, wrongdoers and racketeers often launder “dirty” money through legitimate busi- nesses to make it “clean.” Money laundering is engaging Money laundering is engaging Money laundering in financial transactions to conceal the identity, source, or destination of illegally gained funds.or destination of illegally gained funds.or destination of illegally gained funds.

■ EXAMPLE 10.14 Leo Harris, a successful drug Leo Harris, a successful drug dealer, becomes a partner with a restaurateur. Little by little, the restaurant shows increasing profits. As a partner

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in the restaurant, Harris is able to report the “profits” of the restaurant as legitimate income on which he pays federal and state taxes. He can then spend those funds without worrying that his lifestyle may exceed the level possible with his reported income. ■

Racketeering To curb the entry of organized crime into the legitimate business world, Congress enacted the Racketeer Influenced and Corrupt Organizations Act (RICO).15 The statute makes it a federal crime to: 1. Use income obtained from racketeering activity to

purchase any interest in an enterprise. 2. Acquire or maintain an interest in an enterprise

through racketeering activity. 3. Conduct or participate in the affairs of an enterprise

through racketeering activity. 4. Conspire to do any of the preceding activities.

Broad Application of RICO. �e broad language of RICO has allowed it to be applied in cases that have little or noth- ing to do with organized crime. RICO incorporates by ref-ing to do with organized crime. RICO incorporates by ref-ing to do with organized crime. RICO incorporates by ref erence twenty-six separate types of federal crimes and nine types of state felonies.16 If a person commits two of these o�enses, he or she is guilty of “racketeering activity.”

Under the criminal provisions of RICO, any indi- vidual found guilty is subject to a fine of up to $25,000 per violation, imprisonment for up to twenty years, or both. Additionally, any assets (property or cash) that were acquired as a result of the illegal activity or that were “involved in” or an “instrumentality of ” the activity are subject to government forfeiture.

Civil Liability. In the event of a RICO violation, the government can seek not only criminal penalties but also civil penalties. �e government can, for instance, seek the divestiture of a defendant’s interest in a business or the dissolution of the business. (Divestiture refers to the tak- ing of possession—or forfeiture—of the defendant’s inter- est and its subsequent sale.)

Moreover, in some cases, the statute allows private individuals to sue violators and potentially recover three times their actual losses (treble damages), plus attorneys’ fees, for business injuries caused by a RICO violation. This is perhaps the most controversial aspect of RICO and one that continues to cause debate in the nation’s fed- eral courts. The prospect of receiving treble damages in

15. 18 U.S.C. Sections 1961–1968. 16. See 18 U.S.C. Section 1961(1)(A). The crimes listed in this section

include murder, kidnapping, gambling, arson, robbery, bribery, extor- tion, money laundering, securities fraud, counterfeiting, dealing in obscene matter, dealing in controlled substances (illegal drugs), and a number of others.

civil RICO lawsuits has given plaintiffs a financial incen- tive to pursue businesses and employers for violations.

See Concept Summary 10.1 for a review of the differ- ent types of crimes.

10–4 Defenses to Criminal Liability Persons charged with crimes may be relieved of criminal liability if they can show that their criminal actions were justified under the circumstances. In certain situations, the law may also allow a person to be excused from crimi- nal liability because she or he lacks the required mental state. We look at several defenses to criminal liability here.

Note that procedural violations (such as obtaining evidence without a valid search warrant) may also oper- ate as defenses. Evidence obtained in violation of a defen- dant’s constitutional rights may not be admitted in court. If the evidence is suppressed, then there may be no basis for prosecuting the defendant.

10–4a Justifiable Use of Force Probably the best-known defense to criminal liability is self-defense. Other situations, however, also justify the use of force: the defense of one’s dwelling, the defense of other property, and the prevention of a crime. In all of these situations, it is important to distinguish between deadly and nondeadly force. Deadly force is likely to result Deadly force is likely to result Deadly force in death or serious bodily harm. Nondeadly force is force that reasonably appears necessary to prevent the immi- nent use of criminal force.

Generally speaking, people can use the amount of nondeadly force that seems necessary to protect them- selves, their dwellings, or other property, or to prevent the commission of a crime. Deadly force can be used in self-defense only when the defender reasonably believes that imminent death or grievous bodily harm will oth- erwise result. In addition, normally the attacker must be using unlawful force, and the defender must not have initiated or provoked the attack.

Many states are expanding the situations in which the use of deadly force can be justified. Florida, for instance, allows the use of deadly force to prevent the commission of a “forcible felony,” including robbery, carjacking, and sexual battery.

10–4b Necessity Sometimes, criminal defendants can be relieved of lia- bility by showing necessity—that a criminal act was necessity—that a criminal act was necessity

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necessary to prevent an even greater harm. necessary to prevent an even greater harm. ■ EXAMPLE 10.15 Jake Trevor is a convicted felon and, as such, is legally prohibited from possessing a firearm. While he and his wife are in a convenience store, a man draws a gun, points it at the cashier, and demands all the cash in the register. Afraid that the man will start shooting, Trevor grabs the gun and holds onto it until police arrive. In this situation, if Trevor is charged with possession of a firearm, he can assert the defense of necessity. ■

10–4c Insanity A person who suffers from a mental illness may be inca- pable of the state of mind required to commit a crime. Thus, insanity may be a defense to a criminal charge. Note that an insanity defense does not enable a person to avoid imprisonment. It simply means that if the defen- dant successfully proves insanity, she or he will be placed in a mental institution.

■ EXAMPLE 10.16 James Holmes opened fire with an automatic weapon in a crowded Colorado movie the- ater during a screening of The Dark Knight Rises, killing

twelve people and injuring seventy. Holmes had been a graduate student but had suffered from mental health problems and had left school. Before the incident, he had no criminal history. Holmes’s attorneys asserted the defense of insanity to try to avoid a possible death sen- tence. Although a jury ultimately rejected the defense and convicted Holmes of multiple counts of mur- der in 2015, he was sentenced to life in prison rather than death. If the insanity defense had been successful, Holmes would have been confined to a mental institu- tion, not a prison. ■

Model Penal Code The courts have had difficulty deciding what the test for legal insanity should be. Federal courts and some states use the substantial-capacity test set forth in the Model Penal Code:

A person is not responsible for criminal conduct if at the time of such conduct as a result of mental disease or defect he or she lacks substantial capacity either to appreciate the wrongfulness of his [or her] conduct or to conform his [or her] conduct to the requirements of the law.

Types of Crimes

Concept Summary 10.1

Crimes that cause others to suffer harm or death, such as murder, assault and battery, and robbery.

Violent Crime

Crimes that are contrary to public values and morals, such as public drunkenness and prostitution.

Public Order Crime

An illegal act or series of acts committed by an individual or business entity using some nonviolent means to obtain a personal or business advantage. These crimes are usually committed in the course of a legitimate occupation. Examples include embezzlement, bribery, and fraud.

White-Collar Crime

Crime conducted by groups operating illegitimately to provide illegal goods and services, such as narcotics. Organized crime may also include money laundering and racketeering.

Organized Crime

Crimes in which the goal of the offender is some form of economic gain or the damaging of property. Property crime includes theft-related offenses such as burglary, larceny, and forgery.

Property Crime

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M’Naghten and Other Tests Some states use the M’Naghten test.17 Under this test, a person is not respon- sible if, at the time of the offense, he or she did not know the nature and quality of the act or did not know that the act was wrong. Other states use the irresistible-impulse test. A person operating under an irresistible impulse may know an act is wrong but cannot refrain from doing it.

Under any of these tests, proving insanity is extremely difficult. For this reason, the insanity defense is rarely used and usually is not successful. Four states have abol- ished the insanity defense.

10–4d Mistake Everyone has heard the saying “Ignorance of the law is no excuse.” Ordinarily, ignorance of the law or a mistaken idea about what the law requires is not a valid defense. A mistake of fact, however, as opposed to a mistake of law, can normally excuse criminal responsibility if it negates the mental state necessary to commit a crime.

■ EXAMPLE 10.17 Oliver Wheaton mistakenly walks Oliver Wheaton mistakenly walks off with Julie Tyson’s briefcase. If Wheaton genuinely thought that the case was his, there is no theft. Theft requires knowledge that the property belongs to another. (If Wheaton’s act causes Tyson to incur damages, how- ever, she may sue him in a civil tort action for trespass to personal property or conversion.) ■

10–4e Duress Duress exists when the wrongful threat of one person wrongful threat of one person wrongful threat induces another person to perform an act that he or she would not otherwise have performed. In such a situa- tion, duress is said to negate the mental state necessary to commit a crime because the defendant was forced or compelled to commit the act.

Duress can be used as a defense to most crimes except murder. Both the definition of duress and the types of crimes that it can excuse vary among the states, however. Generally, to successfully assert duress as a defense, the defendant must reasonably have believed that he or she was in immediate danger, and the jury (or judge) must conclude that the defendant’s belief was reasonable.

10–4f Entrapment Entrapment is a defense designed to prevent police offiEntrapment is a defense designed to prevent police offiEntrapment - cers or other government agents from enticing persons

17. A rule derived from M’Naghten’s Case, 8 Eng.Rep. 718 (1843).M’Naghten’s Case, 8 Eng.Rep. 718 (1843).M’Naghten’s

to commit crimes in order to later prosecute them for those crimes. In the typical entrapment case, an under- cover agent suggests that a crime be committed and somesuggests that a crime be committed and somesuggests - how pressures or induces an individual to commit it. The agent then arrests the individual for the crime.

For entrapment to be considered a defense, both the suggestion and the inducement must take place. The defense is not intended to prevent law enforce- ment agents from setting a trap for an unwary crimi- nal. Rather, its purpose is to prevent them from pushing the individual into a criminal act. The crucial issue is whether the person who committed a crime was predis- posed to commit the illegal act or did so only because the agent induced it.

10–4g Statute of Limitations With some exceptions, such as the crime of murder, stat- utes of limitations apply to crimes just as they do to civil wrongs. In other words, the government must initiate criminal prosecution within a certain number of years. If a criminal action is brought after the statutory time period has expired, the accused person can raise the stat- ute of limitations as a defense.

The running of the time period in a statute of limi- tations may be tolled—that is, suspended or stopped tolled—that is, suspended or stopped tolled temporarily—if the defendant is a minor or is not in the jurisdiction. When the defendant reaches the age of majority or returns to the jurisdiction, the statutory time period begins to run again.

10–4h Immunity Accused persons are understandably reluctant to give information if it will be used to prosecute them, and they cannot be forced to do so. The privilege against self-incrimination is guaranteed by a clause in the Fifth Amendment to the U.S. Constitution. The clause reads “nor shall [any person] be compelled in any criminal case to be a witness against himself.”

When the state wishes to obtain information from a person accused of a crime, the state can grant immunity from prosecution. Alternatively, the state can agree to prosecute the accused for a less serious offense in exchange for the information. Once immunity is given, the person has an absolute privilege against self-incrimination and therefore can no longer refuse to testify on Fifth Amend- ment grounds.

Often, a grant of immunity from prosecution for a serious crime is part of the plea bargaining between plea bargaining between plea bargaining the defending and prosecuting attorneys. The defendant

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may be convicted of a lesser offense, while the state uses the defendant’s testimony to prosecute accomplices for serious crimes carrying heavy penalties.

10–5 Criminal Procedures Criminal law brings the force of the state, with all of its resources, to bear against the individual. Criminal proce- dures are designed to protect the constitutional rights of individuals and to prevent the arbitrary use of power on the part of the government.

The U.S. Constitution provides specific safeguards for those accused of crimes. The United States Supreme Court has ruled that most of these safeguards apply not only in federal court but also in state courts by virtue of the due process clause of the Fourteenth Amendment. These protections include the following: 1. The Fourth Amendment protection from unreason-

able searches and seizures. 2. The Fourth Amendment requirement that no war-

rant for a search or an arrest be issued without prob- able cause.

3. The Fifth Amendment requirement that no one be deprived of “life, liberty, or property without due process of law.”

4. The Fifth Amendment prohibition against double jeopardy (trying someone twice for the same crimijeopardy (trying someone twice for the same crimijeopardy - nal offense).18

5. The Fifth Amendment requirement that no person be required to be a witness against (incriminate) him- self or herself.

6. The Sixth Amendment guarantees of a speedy trial, a trial by jury, a public trial, the right to confront wit- nesses, and the right to a lawyer at various stages in some proceedings.

7. The Eighth Amendment prohibitions against exces- sive bail and fines and against cruel and unusual punishment.

10–5a Fourth Amendment Protections The Fourth Amendment protects the “right of the people to be secure in their persons, houses, papers, and effects.” Before searching or seizing private property, normally law enforcement officers must obtain a search warrant—an search warrant—an search warrant

18. The prohibition against double jeopardy does not preclude the crime victim from bringing a civil suit against that same person to recover civil suit against that same person to recover civil damages, however. Additionally, a state’s prosecution of a crime will not prevent a separate federal prosecution of the same crime, and vice versa.

order from a judge or other public official authorizing the search or seizure.

Advances in technology allow the authorities to track phone calls and vehicle movements with greater ease and precision. The use of such technology can consti- tute a search within the meaning of the Fourth Amendtute a search within the meaning of the Fourth Amendtute a search within the meaning of the Fourth Amend- ment. ■ CASE IN POINT 10.18 Antoine Jones owned and operated a nightclub in the District of Columbia. Gov- ernment agents suspected that he was also trafficking in narcotics. As part of their investigation, agents obtained a warrant to attach a global positioning system (GPS) device to Jones’s wife’s car, which Jones regularly used. The warrant authorized installation in the District of Columbia within ten days, but agents installed the device on the eleventh day in Maryland.

The agents then tracked the vehicle’s movement for about a month, eventually arresting Jones for posses- sion and intent to distribute cocaine. Jones was con- victed. He appealed, arguing that the government did not have a valid warrant for the GPS tracking. The United States Supreme Court held that the attachment of a GPS tracking device to a suspect’s vehicle does constitute a Fourth Amendment search. The Court did not rule on whether the search in this case was unrea- sonable, however, and allowed Jones’s conviction to stand.19 ■

Probable Cause To obtain a search warrant, law enforcement officers must convince a judge that they have reasonable grounds, or probable cause, to believe a search will reveal a specific illegality. Probable cause requires the officers to have trustworthy evidence that would convince a reasonable person that the proposed search or seizure is more likely justified than not.more likely justified than not.more likely justified than not.

■ CASE IN POINT 10.19 Based on a tip that Oscar Gutierrez was involved in drug trafficking, law enforce- ment officers went to his home with a drug-sniffing dog. The dog alerted officers to the scent of narcotics at the home’s front door. Officers knocked for fifteen min- utes, but no one answered. Eventually, they entered and secured the men inside the home. They then obtained a search warrant based on the dog’s positive alert. Officers found eleven pounds of methamphetamine in the search, and Gutierrez was convicted.

On appeal, a court held that the search was permis- sible because the evidence of the drug-sniffing dog’s posi- tive alert for the presence of drugs established probable cause for the warrant.20 The court noted that a recent

19. United States v. Jones, __ U.S. __, 132 S.Ct. 945, 181 L.Ed.2d 911 (2012).

20. United States v. Gutierrez, 760 F.3d 750 (7th Cir. 2014).

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United States Supreme Court decision would have pro- hibited the search. In that decision, the Court held that police officers cannot bring drug-sniffing dogs onto the front porch of a person’s home without a warrant.21 But the officers’ conduct in this case had occurred before the Supreme Court’s decision, so the officers could reason- ably rely on the sniff evidence. ■

Scope of Warrant The Fourth Amendment prohib- its general warrants. It requires a specific description of what is to be searched or seized. General searches through a person’s belongings are impermissible. The search can- not extend beyond what is described in the warrant. Nev- ertheless, if a warrant is issued for a person’s residence, items in that residence may be searched even if they do not belong to that individual.

Reasonable Expectation of Privacy The Fourth Amendment protects only against searches that violate a person’s reasonable expectation of privacy. A reasonable expectation of privacy exists if (1) the individual actually expects privacy and (2) the person’s expectation is one that society as a whole would consider legitimate.society as a whole would consider legitimate.society as a whole would consider legitimate.

■ CASE IN POINT 10.20 Angela Marcum was the drug court coordinator responsible for collecting money for the District Court of Pittsburg County, Oklahoma. She was romantically involved with James Miller, an assis- tant district attorney. The state charged Marcum with obstructing an investigation of suspected embezzlement and offered in evidence text messages sent and received by her and Miller. The state had obtained a search war- rant and collected the records of the messages from U.S. Cellular, Miller’s phone company.

Marcum filed a motion to suppress the messages, which the court granted. The state appealed. A state intermediate appellate court reversed the lower court’s judgment. Marcum had no reasonable expectation of privacy in U.S. Cellular’s records of her text messages in Miller’s account. “Once the messages were both trans- mitted and received, the expectation of privacy was lost.”22 ■

10–5b The Exclusionary Rule Under what is known as the exclusionary rule, any evi- dence obtained in violation of the constitutional rights spelled out in the Fourth, Fifth, and Sixth Amendments generally is not admissible at trial. All evidence derived

21. Florida v. Jardines, 569 U.S. 1, 133 S.Ct. 1409, 185 L.Ed.2d 495 (2013).

22. State of Oklahoma v. Marcum, 319 P.3d 681 (2014).

from the illegally obtained evidence is known as the “fruit of the poisonous tree,” and it normally must also be excluded from the trial proceedings. For instance, if a confession is obtained after an illegal arrest, the arrest is the “poisonous tree,” and the confession, if “tainted” by the arrest, is the “fruit.”

The purpose of the exclusionary rule is to deter police from conducting warrantless searches and engaging in other misconduct. The rule can sometimes lead to injustice, however. If evidence of a defendant’s guilt was obtained improperly (without a valid search warrant, for instance), it normally cannot be used against the defen- dant in court.

10–5c The Miranda Rule In Miranda v. Arizona,23 a landmark case decided in 1966, the United States Supreme Court established the rule that individuals who are arrested must be informed of certain constitutional rights. Suspects must be informed of their Fifth Amendment right to remain silent and their Sixth Amendment right to counsel. If the arresting offi- cers fail to inform a criminal suspect of these constitu- tional rights, any statements the suspect makes normally will not be admissible in court.

Although the Supreme Court’s decision in the Miranda case was controversial, it has survived several Miranda case was controversial, it has survived several Miranda attempts by Congress to overrule it. Over time, however, the Supreme Court has made a number of exceptions to the Miranda ruling.Miranda ruling.Miranda

For instance, the Court has recognized a “public safety” exception that allows certain statements to be admitted even if the defendant was not given Miranda warnings. Miranda warnings. Miranda A defendant’s statements that reveal the location of a weapon would be admissible under this exception.

Additionally, a suspect must unequivocally and assert- ively ask to exercise her or his right to counsel in order to stop police questioning. Saying “Maybe I should talk to a lawyer” during an interrogation after being taken into custody is not enough.

10–5d Criminal Process A criminal prosecution differs significantly from a civil case in several respects. These differences reflect the desire to safeguard the rights of the individual against the state. Exhibit 10–3 summarizes the major steps in processing a criminal case, several of which we discuss here.

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G R A N D J U R Y A grand jury determines if there is probable cause to believe that the defen- dant committed the crime. The federal government and about half of the states require grand jury indictments for at least some felonies.

A R R A I G N M E N T The defendant is brought before the court, informed of the charges, and asked to enter a plea. Usually, the prosecutor will attempt to get the defendant to enter into a plea plea. Usually, the prosecutor will attempt to get the defendant to enter into a plea plea. Usually bargain at this stage. Most defendants plead guilty to a lesser offense or receive a reduced sentence for their crime without ever proceeding to trial.

T R I A L The trial can be either a jury trial or a bench trial. (In a bench trial, there is no jury, andhe trial can be either a jury trial or a bench trial. (In a bench trial, there is no jury, andhe trial can be either a jury trial or a bench trial. (In a bench trial, there is no jury the judge decides questions of fact as well as questions of law.) If the verdict is “guilty,” .) If the verdict is “guilty,” .) If the verdict is “guilty the judge sets a date for the sentencing. Everyone convicted of a crime has the right to an appeal.

P R E L I M I N A R Y H E A R I N G In a court proceeding, a prosecutor presents evidence, and the judge determines if there is probable cause to hold the defendant over for trial.

I N D I C T M E N T An indictment is a written document issued by the grand jury to formally charge the defendant with a crime.

I N F O R M AT I O N An information is a formal criminal charge made by the prosecutor.

A R R E S T

B O O K I N G

I N I T I A L A P P E A R A N C E The defendant appears before the judge and is informed of the charges and of his or her rights. A lawyer may be appointed for the defendant. The judge sets bail (conditions under which a suspect can obtain release pending disposition of the case).

E X H I B I T 1 0 – 3 Major Procedural Steps in a Criminal Case

Arrest Before a warrant for arrest can be issued, there must be probable cause to believe that the individual in question has committed a crime. Note that probable cause involves a substantial likelihood that the person has committed a crime, not just a possibility. Arrests can be made without a warrant if there is no time to obtain one,

but the action of the arresting officer is still judged by the standard of probable cause.

Indictment or Information Individuals must be formally charged with having committed specific crimes before they can be brought to trial. If issued by a grand

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jury, such a charge is called an indictment.24 A grand jury does not determine the guilt or innocence of an jury does not determine the guilt or innocence of an jury accused party. Rather, its function is to hear the state’s evidence and to determine whether a reasonable basis (probable cause) exists for believing that a crime has been committed and that a trial ought to be held. For less seri- ous crimes, an individual may be formally charged with a crime by an information, or criminal complaint, issued by a government prosecutor.

Trial At a criminal trial, the accused person does not have to prove anything. The entire burden of proof is on the prosecutor (the state). The prosecution must show that, based on all the evidence, the defendant’s guilt is established beyond a reasonable doubt. If there is reason- able doubt as to whether a criminal defendant committed the crime with which she or he has been charged, then the verdict must be “not guilty.” Returning a verdict of “not guilty” is not the same as stating that the defendant is innocent. It merely means that not enough evidence was properly presented to the court to prove guilt beyond a reasonable doubt.

At the conclusion of the trial, a convicted defendant will be sentenced by the court. The U.S. Sentencing Commission performs the task of standardizing sentences for federal crimes. The commission’s guidelines establish a range of possible penalties, but judges are allowed to depart from the guidelines if circumstances warrant. Sen- tencing guidelines also provide for enhanced punishment for white-collar crimes, violations of the Sarbanes-Oxley Act, and violations of securities laws.25

10–6 Cyber Crime The U.S. Department of Justice broadly defines com- puter crime as any violation of criminal law that involves knowledge of computer technology for its perpetration, investigation, or prosecution. Many computer crimes fall under the broad label of cyber crime, which describes any criminal activity occurring via a computer in the vir- tual community of the Internet.

Most cyber crimes are simply existing crimes, such as fraud and theft, in which the Internet is the instru- ment of wrongdoing. Here, we look at several types of activities that constitute cyber crimes against persons or property.

24. Pronounced in-dyte-ment. 25. The sentencing guidelines were amended in 2003, as required under the

Sarbanes-Oxley Act of 2002, to impose stiffer penalties for corporate securities fraud.

10–6a Cyber Fraud Fraud is any misrepresentation knowingly made with the intention of deceiving another and on which a reason- able person would and does rely to her or his detriment. Cyber fraud is fraud committed over the Internet. Cyber Cyber fraud is fraud committed over the Internet. Cyber Cyber fraud scams have been estimated to affect over 1.5 million people worldwide every day.26 Scams that were once con- ducted solely by mail or phone can now be found online, and new technology has led to increasingly more creative ways to commit fraud.

Advance Fee and Online Auction Fraud Two widely reported forms of cyber crime are advance fee fraud and online auction fraud. In the simplest form of advance fee fraud, consumers order and pay for items, such as automobiles or antiques, that are never delivered. Online auction fraud is also fairly straightforward. A person lists an expensive item for auction, on either a legitimate or a fake auction site, and then refuses to send the product after receiving payment. Or, as a variation, the wrongdoer may send the purchaser an item that is worth less than the one offered in the auction.

■ CASE IN POINT 10.21 Jeremy Jaynes grossed more than $750,000 per week selling nonexistent or worthless products such as “penny stock pickers” and “Internet his- tory erasers.” By the time he was arrested, he had amassed an estimated $24 million from his various fraudulent schemes.27 ■

Consumer Protections The larger online auction sites, such as eBay, try to protect consumers against such schemes by providing warnings about deceptive sellers or offering various forms of insurance. It is nearly impos- sible to completely block fraudulent auction activity on the Internet, however. Because users can assume multiple identities, it is very difficult to pinpoint fraudulent sell- ers—they will simply change their screen names with each auction.

10–6b Cyber Theft In cyberspace, thieves are not subject to the physical limi- tations of the “real” world. A thief can steal data stored in a networked computer with Internet access from any- where on the globe. Only the speed of the connection and the thief ’s computer equipment limit the quantity of data that can be stolen.

26. 2013 Norton Report (Mountain View, Calif.: Symantec, 2014), pg. 8.2013 Norton Report (Mountain View, Calif.: Symantec, 2014), pg. 8.2013 Norton Report 27. Jaynes v. Commonwealth of Virginia, 276 Va. 443, 666 S.E.2d 303

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Identity Theft Not surprisingly, there has been a marked increase in identity theft in recent years. Identity theft occurs when the wrongdoer steals a form of identitheft occurs when the wrongdoer steals a form of identitheft - fication—such as a name, date of birth, or Social Security number—and uses the information to access the victim’s financial resources. According to the federal government, about 7 percent of Americans have been victims of iden- tity theft.

More than half of identity thefts involve the misap- propriation of an existing credit-card account. In most situations, the legitimate holders of credit cards are not held responsible for the costs of purchases made with a stolen number. The loss is born by the businesses and banks.

The Internet has provided relatively easy access to pri- vate data that includes credit-card numbers and more. Frequent Web surfers surrender a wealth of information

about themselves. Web sites use “cookies” to collect data on those who visit their sites and make purchases. Often, sites store information such as the consumer’s name, e-mail address, and credit-card number. Identity thieves may be able to steal this information by fooling a Web site into thinking that they are the true account holders.

In addition, people often enter important personal information, such as their birthdays, hometowns, or employers, on social media sites. Identity thieves can use such information to convince a third party to reveal someone’s Social Security or bank account number.

Identity theft can be committed in the course of pur- suing other criminal objectives. In the following case, for example, the defendant was charged with identity theft in connection with the filing of five thousand false income tax returns to obtain refunds. He challenged his conviction on these charges and sought a new trial.

In the Language of the Court PER CURIAM [By the Whole Court]:

* * * * A [federal district court] jury con-

victed Mauricio Warner on all 50 counts of an indictment that charged him with obtaining individuals’ identities and using such identities to file over 5,000 false income tax returns resulting in millions of dollars in refunds that were deposited in bank accounts Warner con- trolled. [The court sentenced Warner to prison for a total of 240 months.] He now appeals his convictions. He seeks the vacation of his convictions and a new trial on the grounds that the Dis- trict Court abused its discretion (1) in refusing to permit a polygraph examiner to testify to the results of a polygraph examination he administered to Warner; (2) admitting into evidence government Exhibits 500 and 500A, spreadsheets of fraudulently submitted tax returns, as business records; and (3) permitting each juror to have a copy of the indictment throughout trial.

* * * *

A district court’s decision to admit or exclude expert testimony under Federal Rule of Evidence 702 is reviewed for abuse of discretion, which is the stan- dard we apply in reviewing evidentiary rulings in general. A district court abuses its discretion when it applies the wrong law, follows the wrong procedure, bases its decision on clearly erroneous facts, or com- mits a clear error in judgment. [Emphasis added.]

Federal Rule of Evidence 702 pro- vides that an expert witness may testify in the form of an opinion if the expert’s specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact at issue.

The results of a polygraph examina- tion are not inadmissible per se. The trial judge in the exercise of discretion may admit the results of such examina- tion to impeach or corroborate witness testimony.

The District Court did not abuse its discretion in concluding that the polygraph examination was inadmis- sible under Rule 702. The question

posed by the exam- iner addressed an issue that was to be decided by the jury, that is, whether Warner knowingly filed tax returns without the individuals’ authority or knowing that they were not entitled to the refund requested. Since Warner took the stand and answered the same ques- tions, the jury was capable of determin- ing his credibility without the aid of an expert.

* * * * Federal Rule of Evidence 1006 autho-

rizes the admission into evidence of a summary of voluminous business records but only where the originals or duplicates of those originals are available for exami- nation or copying by the other party.

The business record exception to the hearsay rule under Federal Rule of Evi- dence 803(6) states, in relevant part, that a record will be admitted if:

(A) the record was made at or near the time by—or from information trans- mitted by—someone with knowledge;

Case Analysis 10.3 United States v. Warner United States Court of Appeals, Eleventh Circuit, 2016 WL 403166 (2016).

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(B) the record was kept in the course of a regularly conducted activity of a business, organization, occupation, or calling, whether or not for profit;

(D) all these conditions are shown by the testimony of the custodian or another qualified witness * * *;

(E) the opponent does not show that the source of information or the method of circumstances of prepara- tion indicate a lack of trustworthiness.

Rule 803(6) requires that both the underlying records and the report sum- marizing those records be prepared and maintained for business purposes in the ordinary course of business and not for purposes of litigation. * * * The touch- stone of admissibility under Rule 803(6) is reliability, and a trial judge has broad discretion to determine the admissibility of such evidence. [Emphasis added.]

Computer-generated business records are admissible under the following circumstances: (1) the records must be kept pursuant to some routine procedure

designed to assure their accuracy, (2) they must be created for motives that would tend to assure accuracy (prepara- tion for litigation, for example, is not such a motive), and (3) they must not themselves be mere accumulations of hearsay or uninformed opinion.

* * * A typed summary of handwrit- ten business records created solely for litigation [is] inadmissible hearsay evi- dence. [This is] distinguishable from * * * records [that consist of ] electronically stored information and the summary [is] simply a printout of that information.

* * * * * * * Airline check-in and reservation

records and flight manifests that [are] kept in the ordinary course of business and printed at the government’s request [for a trial are admissible]. Computer data compiled and presented in computer printouts prepared specifically for trial is admissible under Rule 803(6), even though the printouts themselves are not kept in the ordinary course of business.

We find no abuse of discretion in admitting government Exhibits 500 and 500A under Rule 803(6). Although the

spreadsheets were formatted to be easier to understand and printed for litigation, the underlying records were kept in the ordinary course of business and the data was not modified or combined when entered into the spreadsheet.

* * * * The decision to provide the jury with

a copy of an indictment is committed to the district court’s sound discretion.

As a general rule, a trial court may, in the exercise of discretion, allow the indictment to be taken into the jury room. Likewise, a court may provide the jury copies of the indictment before trial, provided that the court gives specific instructions that the indictment is not evidence.

There was no abuse of discretion here. The court specifically instructed the jurors on two separate occasions that the indictment was not evidence or proof of any guilt. Even if the court’s lack of contemporaneous instructions was error, it was harmless.

For the foregoing reasons, Warner’s convictions are

AFFIRMED.

Legal Reasoning Questions

1. What three reasons did the defendant assert to support a request for a new trial? 2. What standard applies to an appellate court’s consideration of a contention that a trial court’s evidentiary ruling was in error? 3. What were the appellate court’s conclusions with respect to the trial court’s rulings in this case? What reasons support these

conclusions?

Case 10.3 Continued

Password Theft The more personal information a cyber criminal obtains, the easier it is for him or her to find a victim’s online user name at a particular Web site. Once the online user name has been compromised, it is easier to steal the victim’s password, which is often the last line of defense to financial information.

Numerous software programs aid identity thieves in illegally obtaining passwords. A technique called keystroke logging, for instance, relies on software that embeds itself in a victim’s computer and records every keystroke made on that computer. User names and passwords are then recorded and sold to the highest bidder. Internet users should also be wary of any links contained within e-mails sent from unknown sources. These links can sometimes be used to illegally obtain personal information.

Phishing A form of identity theft known as phish- ing has added a different wrinkle to the practice. In a ing has added a different wrinkle to the practice. In a ing phishing attack, the perpetrator “fishes” for financial data and passwords from consumers by posing as a legitimate business, such as a bank or credit-card company. The “phisher” sends an e-mail asking the recipient to update or confirm vital information. Often, the e-mail includes a threat that an account or some other service will be discontinued if the information is not provided. Once the unsuspecting individual enters the information, the phisher can sell it or use it to masquerade as that person or to drain his or her bank or credit account.

■ EXAMPLE 10.22 Customers of Wells Fargo Bank received official-looking e-mails telling them to type in personal information in an online form to complete a Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

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mandatory installation of a new Internet security certifi- cate. But the Web site was bogus. When people filled out the forms, their computers were infected and funneled their data to a computer server. The cyber criminals then sold the data. ■ Phishing scams have also spread to text messaging and social networking sites.

10–6c Hacking A hacker is someone who uses one computer to break hacker is someone who uses one computer to break hacker into another. The danger posed by hackers has increased significantly because of botnets, or networks of comput- ers that have been appropriated by hackers without the knowledge of their owners. A hacker may secretly install a program on thousands, even millions, of personal com- puter “robots,” or “bots.” The program, in turn, allows the hacker to forward transmissions to an even larger number of systems.

■ EXAMPLE 10.23 Almost as soon as Apple, Inc., introduced a new mobile-payment system in late 2014, cyber thieves began hacking into the company’s smart- phones and tablets to make purchases with stolen credit- card numbers. At about the same time, cyber criminals were stealing the credit-card data of at least 60 million Home Depot customers and illegally accessing the finan- cial information of 76 million JPMorgan Chase clients. In 2015, hackers stole the personal information of 19.7 million individuals from the U.S. Office of Personnel Management’s background-investigation databases.

It has also been demonstrated that hackers can take over the dashboard computer systems that control cars— General Motors’ OnStar system, for example. This risk of takeover extends to numerous wireless-enabled medical devices in use today, such as pacemakers, insulin pumps, and neurostimulators. A criminal could hack someone’s car or pacemaker with the intent of causing the person harm. ■

Malware Botnets are one of the latest forms of mal- ware, a term that refers to any program that is harmful to a computer or, by extension, a computer user. Malware can be programmed to perform a number of functions, such as prompting host computers to continually “crash” and reboot or otherwise infecting the systems.

One type of malware is a worm—a software program that is capable of reproducing itself as it spreads from one computer to the next. The Conflicker worm, for instance, spread to more than a million personal computers around the world within a three-week period. It was transmitted to some computers through the use of Facebook and Twitter.

A virus, another form of malware, is also able to repro- duce itself, but must be attached to an “infested” host file to travel from one computer network to another. For instance, hackers are now capable of corrupting banner

ads that use Adobe’s Flash Player. When an Internet user clicks on the banner ad, a virus is installed.

■ EXAMPLE 10.24 During the 2013 holiday season, a group of Eastern European hackers managed to gain access to Target’s computer system. Once “inside,” these hackers infected the in-store devices that Target custom- ers use to swipe their credit and debit cards with “mem- ory scraper” malware nicknamed Kaptoxa. Over the course of several weeks, the malware was used to steal the credit- and debit-card data of as many as 40 million Tar- get customers. Personal data such as passwords, phone numbers, and addresses were stolen from at least 70 mil- lion more customers. Some experts estimate that the inci- dent resulted in billions of dollars in losses to consumers, their banks, and others. ■

Service-Based Hacking Today, many companies offer “software as a service.” Instead of buying software to install on a computer, the user connects to Web-based soft- ware. The user can then write e-mails, edit spreadsheets, or perform other tasks using his or her Web browser.

Cyber criminals have adapted this distribution method to provide “crimeware as a service.” A would-be thief no longer has to be a computer hacker to create a botnet or steal banking information and credit-card numbers. He or she can rent the online services of cyber criminals to do the work for a small price. Fake security software (also known as scareware) is a common example. The thief can even target individual groups, such as U.S. physicians or British attorneys.

Cyberterrorism Cyberterrorists, as well as hackers, may target businesses. The goals of a hacking operation might include a wholesale theft of data, such as a mer- chant’s customer files, or the monitoring of a computer to discover a business firm’s plans and transactions. A cyber- terrorist might also want to insert false codes or data. For instance, the processing control system of a food manu- facturer could be changed to alter the levels of ingredients so that consumers of the food would become ill.

A cyberterrorist attack on a major financial institu- tion, such as the New York Stock Exchange or a large bank, could leave securities or money markets in flux. Such an attack could seriously affect U.S. citizens, busi- ness operations, and national security.

10–6d Prosecuting Cyber Crime Cyber crime has raised new issues in the investigation of crimes and the prosecution of offenders. Determining the “location” of a cyber crime and identifying a crimi- nal in cyberspace present significant challenges for law enforcement.Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

208 U N I T T W O The Public and International Environment

Jurisdiction and Identification Challenges A threshold issue is, of course, jurisdiction. Each state and nation has jurisdiction, or authority, over crimes com- mitted within its boundaries. But geographic boundaries simply do not apply in cyberspace. A person who com- mits an act against a business in California, where the act is a cyber crime, might never have set foot in California. Instead, the perpetrator might reside in another state, or even another nation, where the act may not be a crime. Indeed, many cyber crimes emanate from Russia and China.

Identifying the wrongdoer can also be difficult. Cyber criminals do not leave physical traces, such as fingerprints or DNA samples, as evidence of their crimes. Even elec- tronic “footprints” can be hard to find and follow. For instance, cyber criminals may employ software such as Tor to mask their IP addresses (codes that identify individual computers) and the IP addresses of those with whom they communicate. Law enforcement has to hire computer forensic experts to bypass the software and track down the criminal. For these reasons, laws written to protect physi- cal property are often difficult to apply in cyberspace.

The Computer Fraud and Abuse Act Perhaps the most significant federal statute specifically address- ing cyber crime is the Counterfeit Access Device and Computer Fraud and Abuse Act.28 This act is commonly known as the Computer Fraud and Abuse Act (CFAA).

Among other things, the CFAA provides that a per- son who accesses a computer online, without authority, to obtain classified, restricted, or protected data (or attempts to do so) is subject to criminal prosecution. Such data could include financial and credit records, medical records, legal files, military and national security files, and other confi- dential information. The data can be located in govern- ment or private computers. The crime has two elements: accessing a computer without authority and taking data.

The theft is a felony if it is committed for a commer- cial purpose or for private financial gain, or if the value of the stolen data (or computer time) exceeds $5,000. Pen- alties include fines and imprisonment for up to twenty years. A person who violates the CFAA can also be sued in a civil action for damages.

28. 18 U.S.C. Section 1030.

Debate This . . . Because of overcriminalization, particularly by the federal government, Americans may be breaking the law regularly without knowing it. Should Congress rescind many of the more than four thousand federal crimes now on the books?

Reviewing: Criminal Law and Cyber Crime

Edward Hanousek worked for Pacific & Arctic Railway and Navigation Company (P&A) as a roadmaster of the White Pass & Yukon Railroad in Alaska. Hanousek was responsible “for every detail of the safe and efficient maintenance and construction of track, structures and marine facilities of the entire railroad,” including special projects. One project was a rock quarry, known as “6-mile,” above the Skagway River. Next to the quarry, and just beneath the surface, ran a high-pressure oil pipeline owned by Pacific & Arctic Pipeline, Inc., P&A’s sister company. When the quarry’s backhoe operator punctured the pipeline, an estimated 1,000 to 5,000 gallons of oil were discharged into the river. Hanousek was charged with negligently discharging a harmful quantity of oil into a navigable water of the United States in viola- tion of the criminal provisions of the Clean Water Act (CWA). Using the information presented in the chapter, answer the following questions. 1. Did Hanousek have the required mental state (mens rea) to be convicted of a crime? Why or why not? 2. Which theory discussed in the chapter would enable a court to hold Hanousek criminally liable for violating the

statute if he participated in, directed, or merely knew about the specific violation? 3. Could the backhoe operator who punctured the pipeline also be charged with a crime in this situation? Explain. 4. Suppose that at trial, Hanousek argued that he should not be convicted because he was not aware of the require-

ments of the CWA. Would this defense be successful? Why or why not?

Terms and Concepts actus reus 189actus reus 189actus reus arson 194

beyond a reasonable doubt 187 botnet 207

C H A P T E R 1 0 Criminal Law and Cyber Crime 209

crime 187 cyber crime 204 cyber fraud 204 double jeopardy 201 duress 200 embezzlement 195 entrapment 200 exclusionary rule 202 felony 188 forgery 194 grand jury 204

hacker 207 identity theft 205 indictment 204 information 204 larceny 194 malware 207 mens rea 189mens rea 189mens rea misdemeanor 188 money laundering 197 necessity 198 petty o�ense 188

phishing 206 plea bargaining 200 probable cause 201 robbery 192 search warrant 201 self-defense 198 self-incrimination 200 virus 207 white-collar crime 195 worm 207

Issue Spotters 1. Dana takes her roommate’s credit card without permis-

sion, intending to charge expenses that she incurs on a vacation. Her first stop is a gas station, where she uses the card to pay for gas. With respect to the gas station, has she committed a crime? If so, what is it? (See Types of Crimes.)

2. Without permission, Ben downloads consumer credit files from a computer belonging to Consumer Credit Agency. He then sells the data to Dawn. Has Ben committed a crime? If so, what is it? (See Cyber Crime.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 10–1. Types of Cyber Crimes. The following situations are similar, but each represents a variation of a particular crime. Identify the crime and point out the differences in the variations. (See Cyber Crime.) (a) Chen, posing fraudulently as Diamond Credit Card Co.,

sends an e-mail to Emily, stating that the company has observed suspicious activity in her account and has frozen the account. The e-mail asks her to reregister her credit- card number and password to reopen the account.

(b) Claiming falsely to be Big Buy Retail Finance Co., Con- ner sends an e-mail to Dino, asking him to confirm or update his personal security information to prevent his Big Buy account from being discontinued.

(c) Felicia posts her résumé on GotWork.com, an online job- posting site, seeking a position in business and manage- rial finance and accounting. Hayden, who misrepresents himself as an employment officer with International Bank & Commerce Corp., sends her an e-mail asking for more personal information.

10–2. Cyber Scam. Kayla, a student at Learnwell Univer- sity, owes $20,000 in unpaid tuition. If Kayla does not pay the tuition, Learnwell will not allow her to graduate. To obtain the funds to pay the debt, she sends e-mails to people that she does not personally know asking for financial help to send Milo, her disabled child, to a special school. In reality, Kayla has no children. Is this a crime? If so, which one? (See Cyber Crime.)

Business Case Problems

10–3. Credit-Card Theft. Jacqueline Barden was shop- ping for school clothes with her children when her purse and automobile were taken. In Barden’s purse were her car keys, credit and debit cards, and the children’s Social Security cards and birth certi�cates, which were needed for enrollment at school. Immediately after the purse and car were stolen, Rebecca Mary Turner attempted to use Barden’s credit card at a local Exxon gas station, but the card was declined. �e gas station attendant recognized Turner because she had previ- ously written bad checks and used credit cards that did not belong to her.

Turner was later arrested while attempting to use one of Barden’s checks to pay for merchandise at a Wal-Mart—where the clerk also recognized Turner from prior criminal activity. Turner claimed that she had not stolen Barden’s purse or car. Instead, she said that a friend had told her he had some checks and credit cards and asked her to try using them at Wal-Mart. Turner was convicted at trial. She appealed, claiming that there was insufficient evidence that she committed credit- and debit-card theft. Was the evidence sufficient to uphold her conviction? Why or why not? [Turner v. State of Arkansas, 2012 Ark.App. 150 (2012)] (See Types of Crimes.)Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

210 U N I T T W O The Public and International Environment

10–4. Business Case Problem with Sample Answer— Criminal Liability. During the morning rush hour, David

Green threw bottles and plates from a twenty- sixth-�oor hotel balcony overlooking Seventh Avenue in New York City. A video of the incident also showed him doing cartwheels while holding a

beer bottle and sprinting toward the balcony while holding a glass steadily in his hand. When he saw police on the street below and on the roof of the building across the street, he sus- pended his antics but resumed tossing objects o� the balcony after the police left. He later admitted that he could recall what he had done, but claimed to have been intoxicated and said his only purpose was to amuse himself and his friends. Did Green have the mental state required to establish criminal liability? Discuss. [State of New York v. Green, 104 A.D.3d 126, 958 N.Y.S.2d 138 (1 Dept. 2013)] (See Criminal Liability.) • For a sample answer to Problem 10–4, go to Appendix E at

the end of this text.

10–5. White-Collar Crime. Matthew Simpson and others created and operated a series of corporate entities to defraud telecommunications companies, creditors, credit reporting agencies, and others. �rough these entities, Simpson and his confederates used routing codes and spoo�ng services to make long-distance calls appear to be local. �ey stole other �rms’ network capacity and diverted payments to themselves. �ey leased goods and services without paying for them. To hide their association with their corporate entities and with each other, they used false identities, addresses, and credit histories, and issued false bills, invoices, �nancial statements, and credit references. Did these acts constitute mail and wire fraud? Dis- cuss. [United States v. Simpson, 741 F.3d 539 (5th Cir. 2014)] (See Types of Crimes.) 10–6. Defenses to Criminal Liability. George Castro told Ambrosio Medrano that a bribe to a certain corrupt Los Angeles County o�cial would buy a contract with the county hospitals. To share in the deal, Medrano recruited Gustavo Buenrostro. In turn, Buenrostro contacted his friend James Barta, the owner of Sav–Rx, which provides prescription bene�t management ser- vices. Barta was asked to pay a “�nder’s fee” to Castro. He did not pay, even after frequent e-mails and calls with deadlines and ultimatums delivered over a period of months. Eventually, Barta wrote Castro a Sav–Rx check for $6,500, saying that it was to help his friend Buenrostro. Castro was an FBI agent, and the county o�cial and contract were �ctional. Barta was charged with conspiracy to commit bribery. At trial, the government conceded that Barta was not predisposed to commit the crime.

Could he be absolved of the charge on a defense of entrapment? Explain. [United States v. Barta, 776 F.3d 931 (7th Cir. 2015)] (See Defenses to Criminal Liability.) 10–7. Criminal Procedures. Federal o�cers obtained a warrant to arrest Kateena Norman on charges of credit-card fraud and identity theft. Evidence of the crime included vid- eos, photos, and a �ngerprint on a fraudulent check. A previ- ous search of Norman’s house had uncovered credit cards, new merchandise, and identifying information for other persons. An Internet account registered to the address had been used to apply for fraudulent credit cards, and a fraudulently obtained rental car was parked on the property. As the o�cers arrested Norman outside her house, they saw another woman and a caged pit bull inside. �ey further believed that Norman’s boy- friend, who had a criminal record and was also suspected of identify theft, could be there. In less than a minute, the o�cers searched only those areas within the house in which a person could hide. Would it be reasonable to admit evidence revealed in this “protective sweep” during Norman’s trial on the arrest charges? Discuss. [United States v. Norman, __ F.3d __, 2016 WL 324949 (11th Cir. 2016)] (See Criminal Procedures.) 10–8. A Question of Ethics—Criminal Process. Gary

Peters fraudulently told an undocumented immi- grant that Peters could help him obtain lawful status. Peters said that he knew immigration o�cials and asked for money to aid in the process. �e victim paid

Peters at least $25,000 in wire transfers and checks. Peters had others call the victim, falsely represent that they were agents with the U.S. Department of Homeland Security, and induce contin- ued payments. He threatened to contact authorities to detain or deport the victim and his wife. Peters was convicted of wire fraud in a federal district court. [ United States v. Peters, 597 Fed.Appx. 1033 (11th Cir. 2015)] (See Criminal Procedures.) (a) Peters had previously committed theft and fraud. The

court stated, “This is the person he is. He steals from his relatives. He steals from his business partner. He steals from immigrants. He steals from anybody he comes into contact with.” What does Peters’s conduct indicate about his ethics?

(b) Peters’s attorney argued that his client’s criminal history was partially due to “difficult personal times” caused by divorce, illness, and job loss. Despite this claim, Peters was sentenced to forty-eight months imprisonment, which exceeded the federal sentencing guidelines but was less than the statutory maximum of twenty years. Was this sentence too harsh? Was it too lenient? Discuss.

Legal Reasoning Group Activity 10–9. Cyber Crime. Cyber crime costs consumers millions of dollars per year, and it costs businesses, including banks and other credit-card issuers, even more. Nonetheless, when cyber criminals are caught and convicted, they are rarely ordered to pay restitution or sentenced to long prison terms. (See Cyber Crime.)

(a) One group should argue that stiffer sentences would reduce the amount of cyber crime.

(b) A second group should determine how businesspersons can best protect themselves from cyber crime and avoid the associated costs.

211

C H A P T E R 11

affairs with the desire of nations to benefit economically from trade and harmonious relations with one another. Sovereign nations can, and do, voluntarily agree to be governed in certain respects by international law, usu- ally for the purpose of facilitating international trade and commerce. As a result, a body of international law has evolved.

11–1a Sources of International Law Basically, there are three sources of international law: international customs, treaties and international agree- ments, and international organizations. We look at each of these sources here.

International Customs One important source of international law consists of the international customs that have evolved among nations in their relations with one another. Article 38(1) of the Statute of the Interna- tional Court of Justice refers to an international custom as “evidence of a general practice accepted as law.” The legal principles and doctrines that you will read about shortly are rooted in international customs and traditions that have evolved over time in the international arena.

11–1 International Law The major difference between international law and national law is that government authorities can enforce national law. What government, however, can enforce international law?

By definition, a nation is a sovereign entity—which means that there is no higher authority to which that nation must submit. If a nation violates an international law and persuasive tactics fail, other countries or interna- tional organizations have no recourse except to take coer- cive actions. Coercive actions might include economic sanctions, severance of diplomatic relations, boycotts, and, as a last resort, war against the violating nation.and, as a last resort, war against the violating nation.and, as a last resort, war against the violating nation.and, as a last resort, war against the violating nation.

■ EXAMPLE 11.1 In 2014, Russia sent troops into the neighboring nation of Ukraine and supported an election that allowed Crimea (part of Ukraine) to secede from Ukraine. Because Russia’s actions violated Ukraine’s independent sovereignty, the United States and the European Union imposed economic sanctions on Rus- sia. Nevertheless, Russia continued to support military action in Eastern Ukraine into 2017. ■

In essence, international law attempts to reconcile each country’s need to be the final authority over its own

C ommerce has always crossed national borders. But technol- ogy has fueled dramatic growth

in world trade and the emergence of a global business community. Exchanges of goods, services, and intellectual property on a global level are now rou- tine. Therefore, students of business law and the legal environment should be familiar with the laws pertaining to international business transactions.

Laws affecting the international legal environment of business include both international law and national

law. International law can be defined as a body of law—formed as a result of international customs, treaties, and organizations—that governs relations among or between nations. Interna- tional law may be created when indi- vidual nations agree to comply with certain standards (such as by signing a treaty). It may also be created when industries or nations establish interna- tional standards for private transac- tions that cross national borders (such as a law that prohibits importation of genetically modified organisms).

National law is the law of a par- ticular nation, such as Brazil, Ger- many, Japan, or the United States. In some ways, national laws that involve property rights, border searches, reg- ulations, and taxes effectively become international law when they are applied at a nation’s borders.

An emerging area of global impor- tance is space law, which governs humans’ activities in outer space. Space law also has both international and national components.

International and Space Law

212 U N I T T W O The Public and International Environment

Treaties and International Agreements Treaties and other explicit agreements between or among foreign nations provide another important source of international law. A treaty is an agreement or contract between two or treaty is an agreement or contract between two or treaty more nations that must be authorized and ratified by the supreme power of each nation. Under Article II, Section 2, of the U.S. Constitution, the president has the power “by and with the Advice and Consent of the Senate, to make Treaties, provided two-thirds of the Senators pres- ent concur.”

A bilateral agreement, as the term implies, is an agreebilateral agreement, as the term implies, is an agreebilateral - ment formed by two nations to govern their commer- cial exchanges or other relations with one another. A multilateral agreement is formed by several nations. For multilateral agreement is formed by several nations. For multilateral instance, regional trade associations such as the Andean Community, the Association of Southeast Asian Nations, and the European Union are the result of multilateral trade agreements.

International Organizations The term inter- national organization generally refers to an organiza- tion composed mainly of officials of member nations and usually established by treaty. The United States is a member of more than one hundred multilateral and bilateral organizations, including at least twenty through the United Nations.

Adopt Resolutions. International organizations adopt resolutions, declarations, and other types of standards that often require nations to behave in a particular man- ner. �e General Assembly of the United Nations, for instance, has adopted numerous nonbinding resolutions and declarations that embody principles of international law. Disputes with respect to these resolutions and dec- larations may be brought before the International Court of Justice. �at court, however, normally has authority to settle legal disputes only when nations voluntarily submit to its jurisdiction.

Create Uniform Rules. �e United Nations Commis- sion on International Trade Law has made considerable progress in establishing uniformity in international law as it relates to trade and commerce. One of the commission’s most signi�cant creations to date is the 1980 Convention on Contracts for the International Sale of Goods (CISG).

The CISG is similar to Article 2 of the Uniform Commercial Code in that it is designed to settle disputes between parties to sales contracts. It spells out the duties of international buyers and sellers that will apply if the parties have not agreed otherwise in their contracts. The

CISG governs only sales contracts between trading part- ners in nations that have ratified the CISG.

11–1b Common Law and Civil Law Systems

Companies operating in foreign nations are subject to the laws of those nations. In addition, international dis- putes are often resolved through the court systems of individual nations. Therefore, businesspersons should understand that legal systems around the globe gener- ally are divided into common law and common law and common law civil law systems. civil law systems. civil law Exhibit 11–1 lists some of the nations that use civil law systems and some that use common law systems.

Common Law Systems Recall that in a common law system, such as the United States, the courts inde- pendently develop the rules governing certain areas of law, such as torts and contracts. These common law rules apply to all areas not covered by statutory law. Although the common law doctrine of stare decisis obligates judges stare decisis obligates judges stare decisis to follow precedential decisions in their jurisdictions, courts may modify or even overturn precedents when deemed necessary.

Civil Law Systems In contrast to common law coun- tries, most European nations, as well as nations in Latin America, Africa, and Asia, base their legal systems on Roman civil law, or “code law.” The term civil law, as used here, refers not to civil as opposed to criminal law but to codified law—an ordered grouping of legal principles codified law—an ordered grouping of legal principles codified enacted into law by a legislature or other governing body.

In a civil law system, the primary source of law is a statutory code. Courts interpret the code and apply the rules to individual cases, but courts may not depart from the code and develop their own laws. Judicial precedents are not binding, as they are in a common law system. In theory, the law code sets forth all of the principles needed for the legal system. Trial procedures also differ in civil law systems. Unlike judges in common law systems, judges in civil systems often actively question witnesses.

Islamic Legal Systems A third, less prevalent, legal system is common in Islamic countries, where the law is often influenced by sharia, the religious law of Islam. Sharia is a comprehensive code of principles that governs Sharia is a comprehensive code of principles that governs Sharia both the public and the private lives of persons of the Islamic faith. Sharia directs many aspects of day-to-day Sharia directs many aspects of day-to-day Sharia life, including politics, economics, banking, business law, contract law, and social issues.

C H A P T E R 1 1 International and Space Law 213

Although sharia affects the legal codes of many Mussharia affects the legal codes of many Mus

affects the legal codes of many Mus affects the legal codes of many Mus

sharia - lim countries, the extent of its impact, as well as its inter- pretation, vary widely. In some Middle Eastern nations, aspects of sharia have been codified and are enforced by sharia have been codified and are enforced by

have been codified and are enforced by have been codified and are enforced by

sharia national judicial systems.

11–1c International Principles and Doctrines

Over time, a number of legal principles and doctrines have evolved in the international context. These prin- ciples and doctrines are employed—to a greater or lesser extent—by the courts of various nations to resolve or reduce conflicts that involve a foreign element. The three important legal principles discussed next are based primarily on courtesy and respect, and are applied in the interests of maintaining harmonious relations among nations.

The Principle of Comity The principle of comity basically refers to legal reciprocity. One nation will defer and give effect to the executive, legislative, and judicial acts of another country, as long as the acts are consistent with the law and public policy of the accommodating nation. For instance, a U.S. court ordinarily will recog- nize and enforce a default judgment from an Australian court because the legal procedures in Australia are com- patible with those in the United States. Nearly all nations recognize the validity of marriage decrees (at least those between a man and a woman) issued in another country.

■ CASE IN POINT 11.2 Karen Goldberg’s husband Karen Goldberg’s husband was killed in a terrorist bombing in Israel. She filed a lawsuit in a federal court in New York against UBS AG, a Switzerland-based global financial services company with many offices in the United States. Goldberg claimed that UBS was liable under the U.S. Anti-Terrorism Act for aiding and abetting in the murder of her husband. She

Australia Bangladesh Canada Ghana India Israel Jamaica Kenya

Malaysia New Zealand Nigeria Singapore United Kingdom United States Zambia

COMMON LAW

Argentina Austria Brazil Chile China Egypt Finland

France Germany Greece Indonesia Iran Italy Japan

Mexico Poland South Korea Sweden Tunisia Venezuela

CIVIL LAW

E X H I B I T 1 1 – 1 The Legal Systems of Selected Nations

214 U N I T T W O The Public and International Environment

argued that UBS was liable because it provided finan- cial services to the international terrorist organizations responsible for his murder.

UBS requested that the case be transferred to a court in Israel, which would offer a remedy “substantially the same” as the one available in the United States. The court refused, however. Transferring the case would require an Israeli court to take evidence and judge the emotional damage suffered by Goldberg, “raising distinct concerns of comity and enforceability.”1 ■

The Act of State Doctrine The act of state doctrine is another important international doctrine. It provides that the judicial branch of one country will not examine the validity of public acts committed by a recognized for- eign government within that government’s own territory.eign government within that government’s own territory.eign government within that government’s own territory.eign government within that government’s own territory.

■ CASE IN POINT 11.3 Spectrum Stores, Inc., a gas- oline retailer in the United States, filed a lawsuit in a U.S. court against Citgo Petroleum Corporation, which is owned by the government of Venezuela. Spectrum alleged that Citgo had conspired with other oil compa- nies in Venezuela and Saudi Arabia to limit production of crude oil and thereby fix the prices of petroleum prod- ucts sold in the United States. Because Citgo is owned by a foreign government, the U.S. court dismissed the case under the act of state doctrine. A government controls the natural resources, such as oil reserves, within its terri- tory. A U.S. court will not rule on the validity of a foreign government’s acts within its own territory.2 ■

When a Foreign Government Takes Private Prop- erty. �e act of state doctrine can have important conse- quences for individuals and �rms doing business with, and investing in, other countries. �is doctrine is frequently employed in cases involving expropriation or con�scation.

Expropriation occurs when a government seizes a privately owned business or privately owned goods for a proper public purpose and awards just compensation. When a government seizes private property for an ille- gal purpose and without just compensation, the taking is referred to as a confiscation. The line between these two forms of taking is sometimes blurred because of differing interpretations of what is illegal and what constitutes just compensation.

■ EXAMPLE 11.4 Flaherty, Inc., a U.S. company, owns a mine in Brazil. The government of Brazil seizes the mine for public use and claims that the profits Flaherty

1. Goldberg v. UBS AG, 690 F.Supp.2d 92 (E.D.N.Y. 2010). For another Goldberg v. UBS AG, 690 F.Supp.2d 92 (E.D.N.Y. 2010). For another Goldberg v. UBS AG case on the financing of terrorism and the Anti-Terrorism Act, see Linde v. Arab Bank, PLC, 706 F.3d 92 (2d Cir. 2013).

2. Spectrum Stores, Inc. v. Citgo Petroleum Corp., 632 F.3d 938 (5th Cir. 2011).

has already realized from the mine constitute just com- pensation. Flaherty disagrees, but the act of state doctrine may prevent the company’s recovery in a U.S. court. ■ Note that in a case alleging that a foreign government has wrongfully taken the plaintiff ’s property, the defendant government has the burden of proving that the taking was an expropriation, not a confiscation.

Doctrine May Immunize a Foreign Government’s Actions. When applicable, both the act of state doctrine and the doctrine of sovereign immunity, which we discuss next, tend to shield foreign nations from the jurisdiction of U.S. courts. As a result, �rms or individuals that own prop- erty overseas generally have little legal protection against government actions in the countries where they operate.

The Doctrine of Sovereign Immunity When certain conditions are satisfied, the doctrine of sovereign immunity exempts foreign nations from the jurisdiction immunity exempts foreign nations from the jurisdiction immunity of the U.S. courts. In 1976, Congress codified this rule in the Foreign Sovereign Immunities Act (FSIA).3

The FSIA exclusively governs the circumstances in which an action may be brought in the United States against a foreign nation, including attempts to attach a foreign nation’s property. Because the law is jurisdictional in nature, a plaintiff generally has the burden of showing that a defendant is not entitled to sovereign immunity.

When a Foreign State Will Not Be Immune. Section 1605 of the FSIA sets forth the major exceptions to the jurisdictional immunity of a foreign state. A foreign state is not immune from the jurisdiction of U.S. courts in the following situations: 1. When the foreign state has waived its immunity

either explicitly or by implication. 2. When the foreign state has engaged in commercial

activity within the United States or in commercial activity outside the United States that has “a direct effect in the United States.”

3. When the foreign state has committed a tort in the United States or has violated certain international laws.

4. When a foreign state that has been designated “a state sponsor of terrorism” is sued under the FSIA for “per- sonal injury or death that was caused by an act of torture” or a related act of terrorism.

The following case involved an action against a for- eign state that had been held liable under the FSIA’s exception from immunity for acts of terrorism.

3. 28 U.S.C. Sections 1602–1611.

C H A P T E R 1 1 International and Space Law 215

In the Language of the Court GRABER, Circuit Judge:

* * * * Approximately 90 United States

citizens (or the representatives of their estates) are attempting to collect on unsatisfied money judgments that they hold against the Islamic Republic of Iran for deaths and injuries suffered in terrorist attacks sponsored by Iran. The assets that are the subject of this * * * action are monies contractually owed to Bank Melli by Visa Inc. and Frank- lin Resources Inc. (“Franklin”). Bank Melli is an instrumentality of Iran [an entity controlled by Iran’s government]. It asserts that Plaintiffs cannot execute on the assets because Bank Melli enjoys sovereign immunity under the Foreign Sovereign Immunities Act of 1976 (“FSIA”).

* * * * The FSIA establishes * * * that

foreign states are immune from suit in United States courts. Congress enacted the statute to provide a comprehensive * * * set of legal standards governing claims of immunity in every civil action against a foreign state or its political sub- divisions, agencies, or instrumentalities.

The FSIA includes many exceptions to its general rule of immunity. Relevant here, in 1996, Congress added a new exception, stripping a foreign state of its sovereign immunity when (1) the United States officially designates the foreign state a state sponsor of terrorism and (2) the foreign state is sued “for personal injury or death that was caused by an act of torture, extrajudicial killing, aircraft sabotage, hostage taking, or the provi- sion of material support or resources for such an act.”

Iran was designated a terrorist party [by the U.S. Department of State]. That designation means that Iran is not enti- tled to sovereign immunity for claims under [the FSIA].

* * * *

* * * In 2008, Congress * * * added [Section 1610(g)] to the FSIA, which provides in part that

the property of a foreign state against which a judgment is entered under [FSIA] Section 1605A and the prop- erty of an agency or instrumentality of such a state * * * is subject to attach- ment * * * and execution upon that judgment.

* * * * [Maria Bennett was an American stu-

dent at Hebrew University in Jerusalem when she was killed in a terrorist attack sponsored by Iran. Her parents, Michael and Linda Bennett,] obtained a judg- ment [against Iran in a federal district court] for damages of nearly $13 million for Iran’s role in the [attack].

Bank Melli, Iran’s largest financial institution, is wholly owned by the gov- ernment of Iran. It is undisputed that Bank Melli qualifies as an instrumental- ity of Iran under the FSIA.

Visa and Franklin owe about $17.6 million to Bank Melli pursuant to a commercial relationship that involves the use of Visa credit cards in Iran. [The Bennetts] filed a complaint [in a federal district court] against Visa and Franklin, seeking to attach and execute against [the legal process of seizing property to ensure satisfaction of a debt] the * * * assets. Visa and Franklin responded by * * * naming as defendant Bank Melli * * * . Bank Melli * * * moved to dismiss the action.

* * * The district court denied the motion to dismiss. [Bank Melli appealed.]

* * * * * * * Bank Melli argues that its assets

cannot be attached or executed upon because the assets at issue in this case were not “used for a commercial activity in the United States,” a requirement in FSIA Section 1610(a), and Bank Melli has not itself “engaged in commercial

activity in the United States,” a require- ment in Section 1610(b). We are not persuaded.

We hold that Section 1610(g) contains a freestanding provision for attaching and executing against assets of a foreign state or its agencies or instrumentalities. Section 1610(g) cov- ers a different subject than Sections 1610(a) [and (b)]; by its express terms, it applies only to certain actions, specifi- cally, judgments “entered under Section 1605A.” In turn, Section 1605A revokes sovereign immunity for damages claims against a foreign state for personal injury or death caused by “torture, extrajudicial killing, aircraft sabotage, hostage taking, or the provision of material support” for such an act. By definition, such claims do not arise from commercial activity; they arise from acts of torture (and the like). Section 1610(g) requires only that a judgment under Section 1605A have been rendered against the foreign state; in that event, both the property of the foreign state and the property of an agency or instrumentality of that state are subject to attachment and execution. [Emphasis added.]

* * * * * * * If Section 1610(g) is inter-

preted to require that, to be subject to attachment and execution, property must be used by the foreign state for a commercial activity, or that the instru- mentality must be engaged in com- mercial activity in the United States, then we would have to read into Section 1610(g) a limitation that Congress did not insert. * * * Congress did not limit the type of property subject to attach- ment and execution under Section 1610(g) to property connected to com- mercial activity in the United States. The only requirement is that property be “the property of ” the foreign state or its instrumentality.

Case Analysis 11.1 Bennett v. Islamic Republic of Iran United States Court of Appeals, Ninth Circuit, __ F.3d __, 2016 WL 3257780 (2016).

216 U N I T T W O The Public and International Environment

Application of the Act. When courts apply the FSIA, questions frequently arise as to whether an entity is a “for- eign state” and what constitutes a “commercial activity.” Under Section 1603 of the FSIA, a foreign state includes foreign state includes foreign state both a political subdivision of a foreign state and an instru- mentality of a foreign state. An instrumentality includes instrumentality includes instrumentality any department or agency of any branch of a government.

Section 1603 broadly defines a commercial activity as commercial activity as commercial activity a regular course of commercial conduct, a transaction, or an act that is carried out by a foreign state within the United States. Section 1603, however, does not describe the particulars of what constitutes a commercial activity.

Thus, the courts are left to decide whether a particular activity is governmental or commercial in nature.

See Exhibit 11–2 for a graphic illustration of the three principles of international law just discussed.

11–2 Doing Business Internationally

A U.S. domestic firm can engage in international busi- ness transactions in a number of ways. The simplest way

* * * * * * * It is quite clear that [in

adding Section 1610(g) to the FSIA] Congress meant to expand successful

plaintiffs’ options for collecting judg- ments against state sponsors of terrorism.

* * * *

We hold [that] Section 1610(g) authorizes attachment and execution of the monies owed to Bank Melli.

AFFIRMED.

Legal Reasoning Questions

1. Could Bank Melli have successfully argued that Section 1610(g) does not permit the attachment and execution of the assets sought by the Bennetts because those assets are owned by Visa and Franklin, not the bank?

2. Why did Congress create an exception from immunity under the FSIA for foreign state sponsors of terrorism? 3. The Treaty of Amity between the United States and Iran requires that the United States respect the legal status of Iranian

companies and protect their property in accord with international law. The treaty also prohibits the U.S. government from discriminating against Iranian companies. Does this treaty conflict with Section 1610(g)? Discuss.

Case 11.1 Continued

THE ACT OF STASTAST TE DOCTRINEATE DOCTRINEA

U.S. courts will avoid passing judgment on the validity of public acts committed by a recognized foreign government within its own territory.

THE DOCTRINE OF SOVEREIGN IMMUNITY

Foreign nations are immune from U.S. jurisdiction under the Foreign Sovereign Immunities Act when certain circumstances are satisfied. Some major exceptions apply, however.

Example: A German governmental agency engages in commercial activity in New York. If a party in New York files a lawsuit against the agency, the foreign state is not immune from U.S. jurisdiction.

THE PRINCIPLE OF COMITY

Nations will defer to and give effect to the laws and judicial decrees of other nations when those laws are consistent with their own.

Example: A U.S. court will most likely uphold the validity of a contract created in England, because England´s legal procedures are compatible with those in the United States.

Example: A U.S. gas company files a lawsuit against a Saudi Arabian petroleum company, claiming a price- fixing conspiracy. A U.S. court will dismiss the case under the act of state doctrine because Saudi Arabia controls its own natural resources.

E X H I B I T 1 1 – 2 Examples of International Principles and Doctrines

C H A P T E R 1 1 International and Space Law 217

is for U.S. firms to export their goods and services to export their goods and services to export foreign markets. Alternatively, a U.S. firm can establish foreign production facilities to be closer to the foreign market or markets in which its products are sold. The advantages may include lower labor costs, fewer govern- ment regulations, and lower taxes and trade barriers. A domestic firm can also obtain revenues by licensing its technology to an existing foreign company or by sell- ing franchises to overseas entities. (In some situations,

domestic companies have profited by marketing goods, such as beer, as “imported,” when it is not, as discussed in this chapter’s Ethics Today feature.)Ethics Today feature.)Ethics Today

11–2a Exporting Exporting can take two forms: direct exporting and indi- rect exporting. Companies that export indirectly can make use of agency relationships or distributorships.

Is It Ethical (and Legal) to Brew “Imported” Beer Brands Domestically?

Imported beer represents over a quarter of total beer purchases in the United States. While imported beer generally costs more than domestic beer, those who purchase and con- sume it believe that its superior taste justifies the higher price.

When Imported Beer Really Isn’t Imported The label on Beck’s beer says: “German quality.” But for a number of years, Beck’s has been brewed in St. Louis, Missouri. The ads for Foster’s feature Australian countryside scenes and Australian accents. Foster’s is brewed in Fort Worth, Texas. Killian’s Irish Red is not brewed in Ireland. It is brewed in Colorado. Kirin sells itself as Japanese, but it is not made in Asia. It is brewed in Virginia and Southern California. The Japanese beer Sapporo that is sold in the United States is actually brewed in Canada.

A Violation of Country-of-Origin Labeling A number of lawsuits have been filed against the own- ers of imported beer brands brewed in the United States. Many of them have been class actions brought under state consumer protection laws involving country-of-origin labeling violations. One was filed against Anheuser-Busch Companies, LLC, for mislabel- ing the origin of its “imported” beers.a Attorneys for the plaintiffs argued that labels such as “brewed under the German Purity Law of 1516” and “originated in Bremen, German” were misleading, given that the beer was brewed in the United States. The defendants

argued that text on each bottle stated that the beer was a “Product of U.S.A.” The case was ultimately settled out of court. Under the settlement, purchasers of Beck’s beer could apply for up to $50 in refunds.

Other class action suits have been brought against other owners of imported beer brands. For example, a New York resident is suing

Miller Brewing Company as part of a class action over the fact that its Foster’s beer is not made in Australia. The brewing company argues that “it even employs an Australian brew master so that the beer taste is as true to its origin as possible.”

Country-of-Origin Labeling Lawsuits Can Go Both Ways Ironically, Anheuser-Busch is defending a class action lawsuit in California concerning a beer labeled as a product of the United States. The plaintiffs allege that the company has misled consumers by labeling Busch beer a U.S. product even though it is made with imported hops. This is a purported violation of the Cali- fornia Business and Professional Code. The code pro- hibits the use of an unqualified U.S.-origin claim when 100 percent of the product is not of U.S. origin.b

Critical Thinking Imported beer is not the only product whose labeling may be misleading. For instance, although BMW is a German brand, most BMW X3s and X5s purchased in the United States are actually manu- factured in South Carolina. Are there any legal or ethical issues involved?

ETHICS TODAY

a. Marty v. Anheuser-Busch Companies, LLC, Case No. 1:13-cv-23656, U.S. District Court for the Southern District of Florida.

b. Nixon v. Anheuser-Busch Companies, LLC, Case No. CGC-15-544985, Superior Court of California for the County of San Francisco.

218 U N I T T W O The Public and International Environment

Direct versus Indirect Exporting In direct export-direct export-direct export ing, a U.S. company signs a sales contract with a foreign purchaser that provides for the conditions of shipment and payment for the goods.

If sufficient business develops in a foreign country, a U.S. company may establish a specialized marketing organization there by appointing a foreign agent or a for- eign distributor. This is called indirect exporting.

Agency Relationships versus Distributorships When a U.S. firm engaged in indirect exporting wishes to limit its involvement in an international market, it will typically establish an agency relationship with a foreign firm. The foreign firm then acts as the U.S. firm’s agent and can enter contracts in the foreign location on behalf of the principal (the U.S. company).

When a foreign country represents a substantial mar- ket, a U.S. firm may wish to appoint a distributor located in that country. The U.S. firm and the distributor enter into a distribution agreement. This is a contract set- ting out the terms and conditions of the distributorship, such as price, currency of payment, guarantee of supply availability, and method of payment. Disputes concern- ing distribution agreements may involve jurisdictional or other issues, as well as contract law.

11–2b Manufacturing Abroad An alternative to direct or indirect exporting is the estab- lishment of foreign manufacturing facilities. Typically, U.S. firms establish manufacturing plants abroad when they believe that by doing so they will reduce costs. Costs for labor, shipping, and raw materials may be lower in foreign nations, which can enable the business to com- pete more effectively in foreign markets.

Foreign firms have done the same in the United States. Sony, Nissan, and other Japanese manufacturers, for instance, have established U.S. plants to avoid import duties that the U.S. Congress may impose on Japanese products entering this country.

There are several ways in which an American firm can manufacture in other countries. They include licensing and franchising, as well as investing in a wholly owned subsidiary or a joint venture.

Licensing A U.S. firm may license a foreign manufac- turing company to use its copyrighted, patented, or trade- marked intellectual property or trade secrets. Basically, licensing allows the foreign firm to use an established

brand name for a fee. A licensing agreement with a for- eign-based firm is much the same as any other licensing agreement. Its terms require a payment of royalties on some basis—such as so many cents per unit produced or a certain percentage of profits from units sold in a particu- lar geographic territory.lar geographic territory.lar geographic territory.lar geographic territory.

■ EXAMPLE 11.5 The Coca-Cola Bottling Company licenses firms worldwide to use (and keep confidential) its secret formula for the syrup in its soft drink. In return, the company receives a percentage of the income earned from the sale of Coca-Cola by those firms. ■

The firm that receives the license can take advantage of an established reputation for quality. The firm that grants the license receives income from the foreign sales of its products and also establishes a global reputation. Once a firm’s trademark is known worldwide, the demand for other products manufactured or sold by that firm may increase—obviously, an important consideration.

Franchising Franchising is a well-known form of licensing and is evident the world over. The owner of a trademark, trade name, or copyright (the franchisor) licenses another (the franchisee) to use the mark, name, or copyright, under certain conditions, in the selling of goods or services. Franchising allows the franchisor to maintain greater control over the business operation than is possible with most other licensing agreements. In return, the fran- chisee pays a fee, usually based on a monthly percentage of gross or net sales. Examples of international franchises include Holiday Inn and Hertz.

Subsidiaries Another way to expand into a foreign market is to establish a wholly owned subsidiary firm in a foreign country. In many European countries, a sub- sidiary would likely take the form of a société anonyme (S.A.), which is similar to a U.S. corporation. In German- speaking nations, it would be called an Aktiengesellschaft (A.G.). When a wholly owned subsidiary is established, the parent company remains in the United States. The parent maintains complete ownership of all of the facili- ties in the foreign country, as well as total authority and control over all phases of the operation.

Joint Ventures A U.S. firm can also expand into international markets through a joint venture. In a joint venture, the U.S. company owns only part of the opera- tion. The rest is owned either by local owners in the for- eign country or by another foreign entity. All of the firms involved in a joint venture share responsibilities, as well as profits and liabilities.

C H A P T E R 1 1 International and Space Law 219

11–3 Regulation of Specific Business Activities

Doing business abroad can affect the economies, foreign policies, domestic politics, and other national interests of the countries involved. For this reason, nations impose laws to restrict or facilitate international business. Con- trols may also be imposed by international agreements.

11–3a Investment Protections Firms that invest in foreign nations face the risk that the foreign government may expropriate the investment property. Expropriation, as mentioned earlier in this chapter, occurs when property is taken and the owner is paid just compensation for what is taken. This generally does not violate accepted principles of international law.

Confiscating property without compensation (or without adequate compensation), in contrast, normally violates international law. Few remedies are available for confiscation of property by a foreign government. Claims are often resolved by lump-sum settlements after negotia- tions between the United States and the taking nation.

Because the possibility of confiscation may deter potential investors, many countries guarantee compen- sation to foreign investors if their property is taken. A guaranty can be in the form of national constitutional or statutory laws or provisions in international treaties. As further protection for foreign investments, some countries provide insurance for their citizens’ investments abroad.

11–3b Export Controls Article I, Section 9, of the U.S. Constitution provides that “No Tax or Duty shall be laid on Articles exported from any State.” Thus, Congress cannot impose any export taxes.

Congress can, however, use a variety of other devices to restrict or encourage exports, including the following: 1. Export quotas. Congress sets export quotas, or limits,

on various items, such as grain being sold abroad. 2. Restrictions on technology exports. Under the Export

Administration Act of 1979,4 the flow of technologi- cally advanced products and technical data can be restricted.

3. Incentives and subsidies. The United States (and other nations) also uses incentives and subsidies to

4. 50 U.S.C. Sections 2401–2420.

stimulate exports and thereby aid domestic busi- nesses. ■ EXAMPLE 11.6 The Export Trading Com- pany Act5 encouraged U.S. banks to invest in export trading companies, which are formed when export- ing firms join together to export a line of goods. The Export-Import Bank of the United States provides financial assistance, primarily in the form of credit guaranties given to commercial bank, which in turn lend funds to U.S. exporting companies. ■

11–3c Import Controls All nations have restrictions on imports, and the United States is no exception. Restrictions include strict prohibi- tions, quotas, and tariffs.

Prohibitions Under the Trading with the Enemy Act,6 no goods may be imported from nations that have been designated enemies of the United States. Other laws prohibit the importation of illegal drugs, of agricultural products that pose dangers to domestic crops or animals, and of goods that infringe on U.S. patents. The Interna- tional Trade Commission is the government agency that investigates allegations that imported goods infringe U.S. patents and imposes penalties if necessary.

Quotas and Tariffs Limits on the amounts of goods that can be imported are known as import quotas. At one time, the United States had legal quotas on the number of automobiles that could be imported from Japan. Today, Japan “voluntarily” restricts the number of automobiles exported to the United States.

Tariffs are taxes on imports. A tariff is usually a per- centage of the value of the import, but it can be a flat rate per unit (such as per barrel of oil). Tariffs raise the prices of imported goods, causing some consumers to purchase domestically manufactured goods instead of imports.

Antidumping Duties The United States has laws specifically directed at what it sees as unfair international trade practices. Dumping, for example, is the sale of imported goods at “less than fair value.” Foreign firms that engage in dumping in the United States hope to undersell U.S. businesses and obtain a larger share of the U.S. market. To prevent this, an extra tariff—known as an antidumping duty—may be assessed on the imports.antidumping duty—may be assessed on the imports.antidumping duty

5. 15 U.S.C. Sections 4001, 4003. 6. 12 U.S.C. Section 95a.

220 U N I T T W O The Public and International Environment

Two U.S. government agencies are instrumental in imposing antidumping duties: the International Trade Commission (ITC) and the International Trade Admin- istration (ITA). The ITC assesses the effects of dumping on domestic businesses and then makes recommenda- tions to the president concerning temporary import restrictions. The ITA, which is part of the Department of Commerce, decides whether imports were sold at less than fair value.

Fair value is usually determined by the domestic Fair value is usually determined by the domestic Fair value price of the goods in the exporting country. The ITA’s determination of fair value establishes the amount of the antidumping duties. These duties are set to equal the dif-antidumping duties. These duties are set to equal the dif-antidumping duties. These duties are set to equal the dif ference between the price charged in the United States and the price charged in the exporting country. A duty may be retroactive to cover past dumping.

11–3d Minimizing Trade Barriers Restrictions on imports are also known as trade barri- ers. The elimination of trade barriers is sometimes seen as essential to the world’s economic well-being. Various regional trade agreements and associations also help to minimize trade barriers between nations.

The World Trade Organization Most of the world’s leading trading nations are members of the World Trade Organization (WTO), which was established in 1995. To minimize trade barriers among nations, each mem- ber country is required to grant normal trade relations (NTR) status to other member countries. This means that each member must treat other members at least as well as it treats the country that receives its most favor- able treatment with regard to imports or exports.

The European Union (EU) The European Union (EU) arose out of the 1957 Treaty of Rome. The treaty created the Common Market, a free trade zone compris- ing the nations of Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany. Today, the EU is a single integrated trading unit made up of twenty-seven European nations.

The EU has gone a long way toward creating a new body of law to govern all of the member nations. Its gov- erning authorities issue regulations, or directives, that define EU law in various areas, such as environmental law, product liability, anticompetitive practices, and corporations. The directives normally are binding on all member countries. Nevertheless, some of the EU’s

efforts to create uniform laws have been confounded by nationalism.

The North American Free Trade Agreement (NAFTA) The North American Free Trade Agree- ment (NAFTA) created a regional trading unit consist- ing of Canada, Mexico, and the United States. The goal of NAFTA was to eliminate tariffs among these three nations on substantially all goods by reducing the tariffs incrementally over a period of time.

NAFTA gives the three countries a competitive advantage by retaining tariffs on goods imported from countries outside the NAFTA trading unit. Addition- ally, NAFTA provides for the elimination of barriers that traditionally have prevented the cross-border movement of services, such as financial and transportation services. NAFTA also attempts to eliminate citizenship require- ments for the licensing of accountants, attorneys, physi- cians, and other professionals.

The Central America–Dominican Republic– United States Free Trade Agreement (CAFTA- DR) The Central America–Dominican Republic–United States Free Trade Agreement (CAFTA-DR) was formed by Costa Rica, the Dominican Republic, El Salvador, Guatemala, Honduras, Nicaragua, and the United States. Its purpose is to reduce trade tariffs and improve market access among all of the signatory nations. Legislatures from all seven countries have approved the CAFTA-DR, despite significant opposition in certain nations.

The Republic of Korea–United States Free Trade Agreement (KORUS FTA) The United States ratified its first free trade agreement with South Korea in 2011 called the Republic of Korea–United States Free Trade Agreement (KORUS FTA). Provisions in KORUS are aimed at eliminating 95 percent of each nation’s tar- iffs on industrial and consumer exports from the other nation.

KORUS was the largest free trade agreement that the United States had entered into since NAFTA. It was expected to boost U.S. exports and benefit U.S. automakers, farmers, ranchers, and manufacturers by enabling them to compete in new markets. To date, how- ever, exports have not increased as much as predicted.

The Trans-Pacific Partnership (TPP) The United States negotiated a 2015 trade agreement among twelve Pacific Rim countries called the Trans-Pacific Partnership

C H A P T E R 1 1 International and Space Law 221

(TPP).7 The agreement is aimed at increasing U.S. exports to China, Japan, and other Asian nations and eliminating or decreasing tariffs charged by those nations.

For instance, according to the United States Trade Office, 20 percent of U.S. farm income (roughly $150 billion) comes from agricultural exports, and one-third of those exports are to TPP countries. Yet, in the past, nations like Malaysia charged a 40 percent tariff on U.S. poultry. The TPP will eliminate almost all tariffs on U.S. farm products and textiles.

The TPP contains thirty chapters. Some of them are aimed at addressing new trade challenges, such as pro- tecting intellectual property rights and setting rules on digital trade. Others contain provisions that protect workers, as well as the environment. Still others deal with expediting customs procedures and establishing dispute settlement procedures.

Other Free Trade Agreements Congress has also ratified free trade agreements with Colombia and Pan- ama. The Colombian trade agreement includes a provi- sion requiring an exchange of tax information, and the Panama bill incorporates assurances on labor rights.

11–4 International Dispute Resolution

International contracts frequently include arbitration clauses. By means of such clauses, the parties agree in advance to be bound by the decision of a specified third party in the event of a dispute.

11–4a The New York Convention The United Nations Convention on the Recognition and Enforcement of Foreign Arbitral Awards (often referred to as the New York Convention) assists in the enforcement of arbitration clauses. (Specific trea- ties among nations may also include such provisions.) Basically, the convention requires courts in nations that have signed it to honor private agreements to arbitrate and recognize arbitration awards made in other con-

7. You can read this agreement on the United States Trade Representa- tive’s Web site at ustr.gov/trade-agreements/free-trade-agreements/ trans-pacific-partnership/TPP-Full-Text.

tracting states. The New York Convention has been implemented in nearly one hundred countries, includ- ing the United States.

Under the New York Convention, a court will compel the parties to arbitrate their dispute if all of the following are true: 1. There is a written (or recorded) agreement to arbi-

trate the matter. 2. The agreement provides for arbitration in a conven-

tion signatory nation. 3. The agreement arises out of a commercial legal

relationship. 4. One party to the agreement is not a U.S. citizen. In

other words, both parties cannot be U.S. citizens.

■ CASE IN POINT 11.7 Juridica Investments, Ltd. Juridica Investments, Ltd. (JIL), entered into a financing contract with S & T Oil Equipment & Machinery, Ltd., a U.S. company. The contract was signed and performed in Guernsey, which is a British Crown dependency in the English Channel. It included an arbitration clause. When a dispute arose between the parties, JIL initiated arbitration in Guern- sey, and S & T filed a suit in a U.S. court. JIL filed a motion to dismiss in favor of arbitration, which the court granted. S & T appealed. A federal appellate court affirmed and compelled arbitration under the New York Convention.8 ■

11–4b Effect of Choice-of-Law and Forum-Selection Clauses

If a sales contract does not include an arbitration clause, litigation may occur. When the contract contains forum- selection and choice-of-law clauses, the lawsuit will be heard by a court in the specified forum and decided according to that forum’s law.

As you may recall, a forum-selection clause indicates forum-selection clause indicates forum-selection clause what court, jurisdiction, or tribunal will decide any dis- putes arising under the contract. A choice-of-law clause designates the applicable law. Both are useful additions to international contracts.

In the following case, the court considered whether a party that had not signed a forum-selection clause was bound to it.

8. S & T Oil Equipment & Machinery, Ltd. v. Juridica Investments, Ltd., 456 Fed.Appx. 481 (5th Cir. 2012).

222 U N I T T W O The Public and International Environment

Background and Facts Moonmouth Co. SA bought stock in Carlyle Capital Corp., Ltd. (CCC), an investment fund, under a subscription agreement. Moonmouth was incorporated in the British Virgin Islands, and CCC was incorporated in Guernsey, a dependency of the United Kingdom. Carlyle Invest- ment Management, LLC, which owned CCC, signed the agreement on CCC’s behalf. Plaza Manage- ment Overseas SA signed on Moonmouth’s behalf. Plaza was Moonmouth’s director, and both were owned by Louis Reijtenbagh.

The agreement provided that “the courts of the State of Delaware shall have exclusive jurisdic- tion over any action . . . with respect to this Subscription Agreement.” Later, the global financial crisis depleted CCC’s cash reserves, and CCC entered liquidation (the process of liquidating its assets). Plaza then threatened to hold CCC liable for all damages that Moonmouth had sustained in connection with its investment. Carlyle and its owners filed a suit in a Delaware state court against Plaza and its owner to enforce the forum-selection clause. Plaza sought to move the case to a federal district court. That court remanded the case to the state court. Plaza appealed.

In the Language of the Court ROTH, Circuit Judge:

* * * * Delaware courts have set forth a three-part test for determining whether a non-signatory to an agree-

ment should be bound by its forum-selection clause: (1) is the forum-selection clause valid, (2) is the non-signatory a third-party beneficiary of the agreement or closely related to the agreement, and (3) does the claim at hand arise from the non-signatory’s status related to the agreement?

For the first element, forum-selection clauses are presumed to be valid. The clause is considered valid unless the challenging party clearly shows that enforcement would be unreasonable and unjust, or that the clause is invalid for such reasons as fraud or overreaching. [Emphasis added.]

With respect to the second element, even if defendants are not parties to the agreement or third-party beneficiaries of it, they may be bound by the forum-selection clause if they are closely related to the agreement in such a way that it would be foreseeable that they would be bound. In determining whether a non-signatory is closely related to a contract, courts consider the non-signatory’s ownership of the signatory, its involvement in the negotiations, the relationship between the two parties and whether the non-signatory received a direct benefit from the agreement.

* * * Plaza was Moonmouth’s director and it executed the Subscription Agreement on Moonmouth’s behalf. Plaza and Moonmouth are affiliated entities that are both owned and controlled by [Louis] Reijten- bagh. * * * Negotiations related to the Subscription Agreement were conducted by Moonmouth, Plaza, and Reijtenbagh. The Subscription Agreement states that the “source of funds” for Moonmouth’s investment in CCC was Plaza’s income. * * * Thus, * * * the three parties were closely related to the Subscription Agreement.

* * * * The third issue we consider in determining whether the forum clause may be enforced is whether the

claims against defendants arise from their status relating to the agreement. * * * * Here, Carlyle’s claims stem from Moonmouth’s initial investment in CCC. * * * The defendants

would not have any claims * * * but for the original Subscription Agreement that contains the forum- selection clause. It is clear that the relationship between plaintiffs and defendants * * * stem from the Subscription Agreement. Thus, the claims are “with respect to” the Subscription Agreement.

Decision and Remedy The U.S. Court of Appeals for the Third Circuit affirmed the lower court’s remand of the case to state court. Plaza was not a signatory to the subscription agreement but was held bound by the forum-selection clause because the clause was valid. Plaza was “closely related to the agreement,” and the claim arose from Plaza’s status related to it.

Critical Thinking • Legal Environment Would Plaza have been bound to the forum-selection clause if it had signed the

subscription agreement as Moonmouth’s director but had no other relation to the agreement? Discuss.

Carlyle Investment Management, LLC v. Moonmouth Co. SA United States Court of Appeals, Third Circuit, 779 F.3d 214 (2015).

Case 11.2

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11–5 U.S. Laws in a Global Context The globalization of business raises questions about the extraterritorial application of a nation’s laws—that is, the effect of the country’s laws outside its boundaries. To what extent do U.S. domestic laws apply to other nations’ businesses? To what extent do U.S. domestic laws apply to U.S. firms doing business abroad? Here, we discuss the extraterritorial application of certain U.S. laws, including antitrust laws, tort laws, and laws prohibiting employ- ment discrimination.

11–5a U.S. Antitrust Laws U.S. antitrust laws have a wide application. They may subject firms in foreign nations to their provisions, as subject firms in foreign nations to their provisions, as subject well as protect foreign consumers and competitors from protect foreign consumers and competitors from protect violations committed by U.S. citizens. Section 1 of the Sherman Act—the most important U.S. antitrust law— provides for the extraterritorial effect of the U.S. antitrust laws.

Any conspiracy that has a substantial effect on U.S. substantial effect on U.S. substantial effect commerce is within the reach of the Sherman Act. The law applies even if the violation occurs outside the United States, and foreign governments as well as businesses can be sued for violations. Before U.S. courts will exercise jurisdiction and apply antitrust laws, however, it must be shown that the alleged violation had a substantial effect on U.S. commerce.

■ EXAMPLE 11.8 An investigation by the U.S. gov- ernment revealed that a Tokyo-based auto-parts supplier, Furukawa Electric Company, and its executives had conspired with competitors in an international price- fixing agreement. The agreement lasted more than ten years and resulted in automobile manufacturers’ paying noncompetitive, higher prices for parts in cars sold to

U.S. consumers. Because the conspiracy had a substantial effect on U.S. commerce, the United States had jurisdic- tion to prosecute the case. In 2011, Furukawa agreed to plead guilty and pay a $200 million fine. The Furukawa executives from Japan also agreed to serve up to eighteen months in a U.S. prison and to cooperate fully with the ongoing investigation. ■

11–5b International Tort Claims The international application of tort liability is growing in significance and controversy. An increasing number of U.S. plaintiffs are suing foreign (or U.S.) entities for torts that these entities have allegedly committed over- seas. Often, these cases involve human rights violations by foreign governments.

The Alien Tort Claims Act (ATCA)9 allows even for- eign citizens to bring civil suits in U.S. courts for injuries caused by violations of the law of nations or a treaty of the United States. Foreign plaintiffs have increasingly used this act to bring actions against companies operating in nations such as Colombia, Ecuador, Egypt, Guatemala, India, Indonesia, Nigeria, and Saudi Arabia.10 Some of these cases have involved alleged environmental destruc- tion. Others have involved human rights violations and oppressive government regimes.

In the following Spotlight Case, the United States Supreme Court considers the parameters of the ATCA. The question is whether the statute allows U.S. courts to exercise jurisdiction over a cause of action based on conduct that occurred outside the United States.

9. 28 U.S.C. Section 1350. 10. See, for example, Kiobel v. Royal Dutch Petroleum Co., __ U.S. __, 133

S.Ct. 1659, 185 L.Ed. 671 (2013) on atrocities committed in Nigeria; and Khulumani v. Barclay National Bank, Ltd., 504 F.3d 254 (2007) on Khulumani v. Barclay National Bank, Ltd., 504 F.3d 254 (2007) on Khulumani v. Barclay National Bank, Ltd South Africa’s apartheid regime.

Background and Facts Barbara Bauman and twenty-one other residents of Argentina filed a suit in a federal district court in California against Daimler AG, a German company. They alleged that Mercedes-Benz (MB) Argentina, a subsidiary of Daimler, had collaborated with state security forces to kidnap, detain, torture, and kill certain MB Argentina workers. These workers included the plain- tiffs and some of their relatives. Their claims were asserted under the Alien Tort Claims Act.

Spotlight on International Torts

Case 11.3 Daimler Case 11.3 Daimler AGa v. Bauman Supreme Court of the United States, __ U.S. __, 134 S.Ct. 746, 187 L.Ed.2d 624 (2014).Supreme Court of the United States, __ U.S. __, 134 S.Ct. 746, 187 L.Ed.2d 624 (2014).Supreme Court of the United States, __ U.S. __, 134 S.Ct. 746, 187 L.Ed.2d 624 (2014).

Case 11.3 Continues

224 U N I T T W O The Public and International Environment

Personal jurisdiction was based on the California contacts of Mercedes-Benz USA (MBUSA), a Daimler subsidiary incorporated in Delaware with its principal place of business in New Jersey. MBUSA distributes Daimler-made vehicles to dealerships throughout the United States, including California. The district court dismissed the suit for lack of jurisdiction. The U.S. Court of Appeals for the Ninth Circuit reversed this ruling. Daimler appealed to the United States Supreme Court.

In the Language of the Court Justice GINSBURG delivered the opinion of the Court.

* * * * Even if we were to assume that MBUSA is at home in California, and further to assume MBUSA’s

contacts are imputable [attributable] to Daimler, there would still be no basis to subject Daimler to gen- eral jurisdiction in California, for Daimler’s slim contacts with the State hardly render it at home there.

* * * Only a limited set of affiliations with a forum will render a defendant amenable to all-purpose jurisdiction there. For an individual, the paradigm forum [the typical forum] for the exercise of general jurisdiction is the individual’s domicile; for a corporation, it is an equivalent place, one in which the cor- poration is fairly regarded as at home. With respect to a corporation, the place of incorporation and principal place of business are paradigm * * * bases for general jurisdiction. Those affiliations have the virtue of being unique—that is, each ordinarily indicates only one place—as well as easily ascertainable. These bases afford plaintiffs recourse to at least one clear and certain forum in which a corporate defendant may be sued on any and all claims. [Emphasis added.]

[This does not mean] that a corporation may be subject to general jurisdiction only in a forum where only in a forum where only it is incorporated or has its principal place of business * * * . [But] plaintiffs would have us look beyond the exemplar bases identified [above] and approve the exercise of general jurisdiction in every State in which a corporation engages in a substantial, continuous, and systematic course of business. That formu- lation, we hold, is unacceptably grasping.

* * * The inquiry * * * is not whether a foreign corporation’s in-forum contacts can be said to be in some sense continuous and systematic; it is whether that corporation’s affiliations with the State are so continuous and systematic as to render it essentially at home in the forum State.

Here, neither Daimler nor MBUSA is incorporated in California, nor does either entity have its principal place of business there. If Daimler’s California activities sufficed to allow adjudication of this Argentina-rooted case in California, the same global reach would presumably be available in every other State in which MBUSA’s sales are sizable. Such exorbitant exercises of all-purpose jurisdiction would scarcely permit out-of-state defendants to structure their primary conduct with some minimum assur- ance as to where that conduct will and will not render them liable to suit.

It was therefore [an] error for the Ninth Circuit to conclude that Daimler, even with MBUSA’s con- tacts attributed to it, was at home in California, and hence subject to suit there on claims by foreign plaintiffs having nothing to do with anything that occurred or had its principal impact in California.

Decision and Remedy The United States Supreme Court reversed the decision of the lower court. A fed- eral district court in California could not exercise jurisdiction over Daimler in this case, given the absence of any California connection to the atrocities, perpetrators, or victims described in the complaint.

Critical Thinking • Legal Environment What are the consequences for Daimler of the decision in this case? • Global If the Court had adopted the plaintiffs’ argument, how might U.S. citizens have been affected?

Case 11.3 Continued

11–5c Antidiscrimination Laws As you probably know, federal laws in the United States prohibit discrimination on the basis of race, color, national origin, religion, gender, age, and disability.

These laws, as they affect employment relationships, gen- erally apply extraterritorially.

Thus, U.S. employees working abroad for U.S. employers are protected under the Age Discrimination in

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Employment Act. Similarly, the Americans with Disabili- ties Act, which requires employers to accommodate the needs of workers with disabilities, applies to U.S. nation- als working abroad for U.S. firms.

In addition, the major U.S. law regulating employ- ment discrimination—Title VII of the Civil Rights Act— applies extraterritorially to all U.S. employees working for U.S. employers abroad. Generally, U.S. employers must abide by U.S. discrimination laws unless to do so would violate the laws of the country where their workplaces are located. This “foreign laws exception” allows employers to avoid being subjected to conflicting laws.

11–6 Space Law Space law consists of the international and national Space law consists of the international and national Space law laws that govern activities in outer space. For the first fifty years of space exploration, national governments conducted most of those activities. Thus, space law was directed primarily at governments and government activities. In the last decade, private companies have been preparing to undertake some space-related activities and open outer space to the rest of us. Space law, accordingly, faces new challenges.

11–6a International Space Law International space law consists of international treaties— primarily negotiated by the United Nations (U.N.)—and U.N. resolutions. These sources recognize fundamentally that activities conducted in outer space and the benefits derived from those activities should improve the welfare of all nations and all humanity.

The major space law treaties were concluded by the U.N. Committee on the Peaceful Uses of Outer Space (COPUS). COPUS also administers the treaties and advises the international community on space policy matters.

Exploration and Exploitation The foundation of international space law is the U.N. Treaty on Principles Governing the Activities of States in the Exploration and Use of Outer Space, including the Moon and Other Celestial Bodies.11 This treaty—generally referred to as the Outer Space Treaty—established the framework for later international agreements and U.N. resolutions.

The Outer Space Treaty expresses general principles that have been expanded and applied in subsequent

11. 18 U.S.T. 2410, T.I.A.S. 6347, 610 U.N.T.S. 205.

treaties. In Article I and Article II, outer space is declared to be free for the exploration and use of all nations. The moon, the planets, asteroids, and other celestial bodies are not subject to the appropriation of any single nation.12 In addition, space objects are to be used exclusively for peaceful purposes. No weapons of mass destruction are permitted in outer space under Article IV.13

According to Article VI, each nation is responsible for its activities in outer space, whether they are con- ducted by the government or by a private entity. In fact, the activities of private entities require authorization and supervision by a government. Article VIII provides that each nation retains jurisdiction and control over its space objects and the personnel on them. Article VII imposes on each nation liability for damage caused by its space objects. Finally, Article IX requires that space exploration be conducted so as to avoid “harmful contamination.”14

Astronauts and Space Objects The Outer Space Treaty was followed by several other agreements: • The Agreement on the Rescue of Astronauts, the

Return of Astronauts and the Return of Objects Launched into Outer Space (the Rescue Agreement).15

• The Convention on International Liability for Damage Caused by Space Objects (the Liability Convention).16

• The Convention on Registration of Objects Launched into Outer Space (the Registration Convention).17

The Rescue Agreement expands on Articles V and VIII of the Outer Space Treaty. It provides that each nation will undertake to rescue and assist astronauts in distress and return them to their “launching State.” All nations are to assist in recovering space objects that return to earth outside the territory of the launching state.

The Liability Convention elaborates on Article VII of the Outer Space Treaty. This agreement provides that a launching state is absolutely liable for personal injury and property damage caused by its space objects on the surface of the earth or to aircraft in flight. Liability for injury or damage in space is subject to a determination of fault. The convention also prescribes procedures for the settlement of claims for damages.

12. After the treaty entered into force, the United States and Russia con- ducted joint space activities.

13. Establishing military bases, testing weapons, and conducting military maneuvers are prohibited.

14. Other articles promote further international cooperation in the explora- tion and use of space.

15. 19 U.S.T. 7570, T.I.A.S. 6599, 672 U.N.T.S. 119. 16. 24 U.S.T. 2389, T.I.A.S. 7762, 961 U.N.T.S. 187. 17. 28 U.S.T. 695, T.I.A.S. 8480, 1023 U.N.T.S. 15.

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The Registration Convention provides for the man- datory registration of objects launched into outer space. Each launching state is to maintain a registry of the objects that it launches into space. The intent is to assist in the objects’ identification.

Space Debris An estimated 600,000 objects made by humans are in orbit around the earth. Most of these objects are no longer under any party’s control and are classified as space debris. In 2009, two orbiting satellites collided for the first time. Fragments generated by colli- sions are expected to be a significant source of space debris in the future. As noted previously, the Liability Conven- tion sets out principles of liability to apply in instances of injury or damage in space.

The U.N. has endorsed guidelines to reduce space debris.18 The guidelines, which reflect the current prac- tices of a number of national and international organiza- tions, apply to the planning, design, manufacture, and operational phases of spacecraft. Among other points, the guidelines suggest that systems should be designed not to release debris during normal operations. They also rec- ognize that some objects no longer in operation should be removed from orbit if this can be accomplished in a controlled manner.

11–6b U.S. Space Law In the United States, each government agency that oper- ates or authorizes spacecraft is responsible for comply- ing with U.S. law and international treaties. Federal law, state law, and more than half a century of common prac- tices in space-related industries also affect government and private space activities.

Commercial Spaceflight The Federal Aviation Administration (FAA) regulates private spaceports and the launch and reentry of private spacecraft under the Commercial Space Launch Act.19

The FAA is working to establish licensing and safety criteria for private spacecraft. Some states, including

18. Space Debris Mitigation Guidelines of the Committee on the Peace- ful Uses of Outer Space, G.A. Res. 62/217, U.N. GAOR, 50th Sess., U.N.Doc. A/62/20 (Dec. 22, 2007).

19. 51 U.S.C. Sections 50901 et seq.

Florida, New Mexico, Texas, and Virginia, limit the liability of space tourism providers under state tort law. But state legislatures and, ultimately, courts will need to consider other issues in this context, including insurance requirements and the enforceability of liability waivers.

In 2015, Congress passed landmark legislation aimed at encouraging commercial spaceflight companies. The U.S. Commercial Space Launch Competitiveness Act20 streamlines regulatory processes and promotes safety standards. In addition, the new law provides that if a U.S. citizen or company retrieves minerals or other resources from an asteroid or other space location, that person or company owns them.

Exports of Space Technology Currently, under U.S. regulations, all spacecraft are classified as “defense articles.” The defense classification restricts the transfer of space technology and related information to any foreign person or nation under the U.S. Department of State’s International Traffic in Arms Regulations.21 This restric- tion makes it difficult for U.S. space companies to com- pete in global space markets.

Property Rights to Space Resources Article II of the Outer Space Treaty bans the national appropriation of territory in space. If the United States cannot appropriate territory in space, then it cannot give U.S. citizens title to property associated with this territory. Under U.S. law, the government must have sovereignty over territory before it can confer title to associated property to its citizens.

Article VIII, however, provides that a state party to the treaty retains jurisdiction over objects on its space registry that are launched into space. In addition, Article IX prohibits interference with space activities. In effect, these provisions confer the protections associated with property rights on private space activities.

The 2015 U.S. Commercial Space Launch Competi- tiveness Act changed the law somewhat by granting pri- vate citizens property rights over asteroid resources that they obtain from space. The act specifically recognizes that the United States is not attempting to assert sovereignty or exclusive right or jurisdiction over any celestial body.

20. Pub. L. No. 114-90, 129 Stat. 704, November 25, 2015. 21. 22 C.F.R. Sections 120.1 et seq.

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Reviewing: International and Space Law

Robco, Inc., was a Florida arms dealer. The armed forces of Honduras contracted to purchase weapons from Robco over a six-year period. After the government was replaced and a democracy installed, the Honduran government sought to reduce the size of its military, and its relationship with Robco deteriorated. Honduras refused to honor the contract and purchase the inventory of arms, which Robco could sell only at a much lower price. Robco filed a suit in a federal district court in the United States to recover damages for this breach of contract by the government of Honduras. Using the information presented in the chapter, answer the following questions. 1. Should the Foreign Sovereign Immunities Act (FSIA) preclude this lawsuit? Why or why not? 2. Does the act of state doctrine bar Robco from seeking to enforce the contract? Explain. 3. Suppose that prior to this lawsuit, the new government of Honduras had enacted a law making it illegal to purchase

weapons from foreign arms dealers. What doctrine of deference might lead a U.S. court to dismiss Robco’s case in that situation?

4. Now suppose that the U.S. court hears the case and awards damages to Robco. The government of Honduras, however, has no assets in the United States that can be used to satisfy the judgment. Under which doctrine might Robco be able to collect the damages by asking another nation’s court to enforce the U.S. judgment?

Debate This . . . The U.S. federal courts are accepting too many lawsuits initiated by foreigners that concern matters not relevant to this country.

Terms and Concepts act of state doctrine 214 civil law system 212 comity 213 con�scation 214 distribution agreement 218 dumping 219 export 217

expropriation 214 international law 211 international organization 212 national law 211 normal trade relations

(NTR) status 220

quota 219 sovereign immunity 214 space law 225 tari� 219 treaty 212

Issue Spotters 1. Café Rojo, Ltd., an Ecuadoran firm, agrees to sell cof-Café Rojo, Ltd., an Ecuadoran firm, agrees to sell cof-Café Rojo, Ltd., an Ecuadoran firm, agrees to sell cof

fee beans to Dark Roast Coffee Company, a U.S. firm. Dark Roast accepts the beans but refuses to pay. Café Rojo sues Dark Roast in an Ecuadoran court and is awarded damages, but Dark Roast’s assets are in the United States. Under what circumstances would a U.S. court enforce the judgment of the Ecuadoran court? (See International Law.)

2. Gems International, Ltd., is a foreign firm that has a 12 percent share of the U.S. market for diamonds. To capture

a larger share, Gems offers its products at a below-cost discount to U.S. buyers (and inflates the prices in its own country to make up the difference). How can this attempt to undersell U.S. businesses be defeated? (See Regulation of Specific Business Activities.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 11–1. Doing Business Internationally. Macrotech, Inc., develops an innovative computer chip and obtains a patent on it. The firm markets the chip under the trademarked brand

name “Flash.” Macrotech wants to sell the chip to Nitron, Ltd., in Pacifica, a foreign country. Macrotech is concerned, however, that after an initial purchase, Nitron will duplicate

228 U N I T T W O The Public and International Environment

the chip, pirate it, and sell the pirated version to computer manufacturers in Pacifica. To avoid this possibility, Macro- tech could establish its own manufacturing facility in Paci- fica, but it does not want to do this. How can Macrotech, without establishing a manufacturing facility in Pacifica, pro- tect Flash from being pirated by Nitron? (See Doing Business Internationally.) 11–2. Dumping. The U.S. pineapple industry alleged that producers of canned pineapple from the Philippines were sell- ing their canned pineapple in the United States for less than its fair market value (dumping). In addition to canned pine- apple, the Philippine producers exported other products, such as pineapple juice and juice concentrate. These products used separate parts of the same fresh pineapple used for the canned pineapple. All these products shared raw material costs with the canned fruit, according to the producers’ own financial records. To determine fair value and antidumping duties, the pineapple industry argued that a court should calculate the Philippine producers’ cost of production and allocate a por- tion of the shared fruit costs to the canned fruit. The result

of this allocation showed that more than 90 percent of the canned fruit sales were below the cost of production. Is this a reasonable approach to determining the production costs and fair market value of canned pineapple in the United States? Why or why not? (See Regulation of Specific Business Activities.) 11–3. Sovereign Immunity. Taconic Plastics, Ltd., is a manufacturer incorporated in Ireland with its principal place of business in New York. Taconic enters into a contract with a German firm, Werner Voss Architects and Engineers, acting as an agent for the government of Saudi Arabia. The contract calls for Taconic to supply special material for tents designed to shelter religious pilgrims visiting holy sites in Saudi Ara- bia. Most of the material is made in, and shipped from, New York. The German company does not pay Taconic and files for bankruptcy. Taconic files a suit in a U.S. Court against the government of Saudi Arabia, seeking to collect $3 million. The defendant files a motion to dismiss the suit based on the doctrine of sovereign immunity. Under what circumstances does this doctrine apply? What are its exceptions? Should this suit be dismissed? Explain. (See International Law.)

Business Case Problems 11–4. Dumping. Nuclear power plants use low-enriched uranium (LEU) as a fuel. LEU consists of feed uranium enriched by energy to a certain assay—the percentage of the isotope necessary for a nuclear reaction. �e amount of energy required is described by an industry standard as a “separative work unit” (SWU). A nuclear utility may buy LEU from an enricher, or the utility may provide an enricher with feed uranium and pay for the SWUs necessary to produce LEU. Under an SWU contract, the LEU returned to the utility may not be exactly the uranium the utility provided. �is is because feed uranium is fungible and trades like a commodity (such as wheat or corn), and pro�table enrichment requires the constant processing of undi�erentiated stock. Foreign enrichers, including Eurodif, S.A., allegedly exported LEU to the United States and sold it for “less than fair value.” Did this constitute dumping? Explain. If so, what could be done to prevent it? [United States v. Eurodif, S.A., 555 U.S. 305, 129 S.Ct. 878, 172 L.Ed.2d 679 (2009)] (See Regulation of Speci�c Business Activities.)

11–5. Sovereign Immunity. In 1954, the government of Bolivia began expropriating land from Francisco Loza for public projects, including an international airport. �e gov- ernment directed the payment of compensation in exchange for at least some of his land. But the government never paid the full amount. Decades later, his heirs, Genoveva and Mar- cel Loza, who were both U.S. citizens, �led a suit in a federal district court in the United States against the government of Bolivia. �e Lozas sought damages for the taking. Can the court exercise jurisdiction? Explain. [Santivanez v. Estado Plurinacional de Bolivia, 512 Fed.Appx. 887 (11th Cir. 2013)] (See International Law.)

11–6. Business Case Problem with Sample Answer— Import Controls. �e Wind Tower Trade Coalition is an

association of domestic manufacturers of utility- scale wind towers. �e coalition �led a suit in the U.S. Court of International Trade against the U.S. Department of Commerce. It challenged the

Commerce Department’s decision to impose only prospective antidumping duties, rather than retrospective (retroactive) retrospective (retroactive) retrospective duties, on imports of utility-scale wind towers from China and Vietnam. �e department had found that the domestic industry had not su�ered any “material injury” or “threat of material injury” from such imports. It had further found that the industry would be protected by a prospective assessment. Can an antidumping duty be assessed retrospectively? If so, should it be assessed here? Discuss. [Wind Tower Trade Coali- tion v. United States, 741 F.3d 89 (Fed.Cir. 2014)] (See Regula- tion of Speci�c Business Activities.) • For a sample answer to Problem 11–6, go to Appendix E at

the end of this text.

11–7. The Principle of Comity. Holocaust survivors and the heirs of Holocaust victims �led a suit in a U.S. federal district court against the Hungarian national railway, the Hungarian national bank, and several private Hungarian banks. �e plainti�s alleged that the defendants had partici- pated in expropriating the property of Hungarian Jews who were victims of the Holocaust. �e claims arose from events in Hungary seventy years ago. �e plainti�s, however, had not exhausted remedies available through Hungarian courts. Indeed, they had not even attempted to seek remedies in Hun- garian courts, and they did not provide a legally compelling reason for their failure to do so. �e defendants asked the court

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to dismiss the suit. Does the principle of comity support the defendants’ request? Explain. [Fischer v. Magyar Államvasutak Zrt., 777 F.3d 847 (7th Cir. 2015)] (See International Law.) 11–8. International Law. For �fty years, the Soviet Union made and sold Stolichnaya vodka. At the time, VVO-SPI, a Soviet state enterprise, licensed the Stolichnaya trademark in the United States. When the Soviet Union collapsed, VVO– SPI was purportedly privatized and fell under the control of Spirits International B.V. (SPI). In 2000, a Russian court held that VVO-SPI had not been validly privatized under Russian law. �us, ownership of the Stolichnaya mark remained with the Soviet Union’s successor, the Russian Federation. �e Rus- sian Federation assigned the mark to Federal Treasury Enter- prise Sojuzplodoimport, OAO (FTE). FTE then �led a suit in a U.S. federal district court against SPI, asserting unlawful misappropriation and commercial exploitation of the mark in violation of the Lanham Act. Is the validity of the assignment of the mark to FTE a question to be determined by the court? Why or why not? [Federal Treasury Enterprise Sojuzplodoimport v. Spirits International B.V., 809 F.3d 737 (2d Cir. 2016)] (See International Law.) 11–9. A Question of Ethics—Terrorism. On December

21, 1988, Pan Am Flight 103 exploded 31,000 feet in the air over Lockerbie, Scotland. All 259 passen- gers and crew on board and 11 people on the ground were killed. Among those killed was Roger Hurst, a

U.S. citizen. An investigation determined that a portable radio- cassette player packed in a brown Samsonite suitcase smuggled

onto the plane was the source of the explosion. �e explosive device was constructed with a digital timer specially made for, and bought by, Libya. Abdel Basset Ali Al-Megrahi was convicted by the Scottish High Court of Justiciary on criminal charges that he had planned and executed the bombing.

Al-Megrahi was a Libyan government official, an employee of the Libyan Arab Airline (LAA), and purportedly a member of the Jamahiriya Security Organization (JSO), the Libyan intelligence service. Members of the victims’ families filed a suit in a U.S. district court against the JSO, the LAA, Al-Megrahi, and others. The plaintiffs claimed violations of U.S. federal law, including the Anti-Terrorism Act, and state law, including the intentional infliction of emotional distress. [ Hurst v. Socialist People’s Libinfliction of emotional distress. [ Hurst v. Socialist People’s Libinfliction of emotional distress. [ - yan Arab Jamahiriya, 474 F.Supp.2d 19 (D.D.C. 2007)] (See International Law.) (a) Under what doctrine, codified in which federal statute,

might the defendants claim to be immune from the juris- diction of a U.S. court? Should this law include an excep- tion for “state-sponsored terrorism”? Why or why not?

(b) The defendants agreed to pay $2.7 billion, or $10 million per victim, to settle all claims for “compensatory death damages.” The families of eleven victims, including Hurst, were excluded from the settlement because they were “not wrongful death beneficiaries under applicable state law.” These plaintiffs continued the suit. The defendants filed a motion to dismiss. Should the motion be granted on the ground that the settlement bars the plaintiffs’ claims? Explain.

Legal Reasoning Group Activity 11–10. Globalization. Assume that you are manufacturing iPad accessories and that your business is becoming more suc- cessful. You are now considering expanding operations into another country. (See Doing Business Internationally.) (a) One group will explore the costs and benefits of advertis-

ing on the Internet.

(b) Another group will consider whether to take in a partner from a foreign nation and will explain the benefits and risks of having a foreign partner.

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For almost ten years, a group of hackers in Russia and Ukraine attacked the computer systems of U.S. companies, including 7-Eleven, Inc., JetBlue Airways Corporation, and J.C. Penney Com- pany. The systems of firms based in other countries, including Visa Jordan and French retailer Carrefour SA, came under attack as well. The hackers stole more than 160 million credit- and debit-card numbers and breached 800,000 bank accounts.1 Among incidents of unauthorized access to company systems—not leaks of information from within—this was the biggest data breach of all time.

Businesses collect, process, and store confidential information on computer systems and transmit that data across networks to other computer systems. Data compromised by hackers affects all of these systems, and us as individuals, in ways that range from inconvenient to devas- tating. As the number of users and networks increases, the opportunities for breaches multiply.

Data Breaches A data breach is an event in which sensitive, protected, or confidential data are copied, transmitdata breach is an event in which sensitive, protected, or confidential data are copied, transmitdata breach - ted, viewed, stolen, or used by an individual unauthorized to do so. The data may include indi- viduals’ personal health information or personal identity information, such as birth dates and addresses, or a company’s intellectual property, including patents, copyrights, and trade secrets.

Most breaches reported in the media involve individuals’ private information, such as credit- card numbers. Loss of a business’s data often goes unreported, unless there is a potential for harm to private individuals, because the publicity can do more damage to the business than the loss of the data.

How Do They Do It? Hackers break into computer systems by exploiting vulnerabilities in software code. A hacker may spend days, weeks, or longer setting up a position within the sys- tem, creating escape routes, and stealing information. Data may be stolen through phishing or spoofing, or with the help of malware.

Users of a system themselves may unwittingly facilitate attacks by downloading files or soft- ware, opening e-mail attachments, clicking on ads, or visiting fraudulent sites. In fact, individu- als within an organization may cause as many as 37 percent of all data breaches.

Why Do They Do It? Normally, the focus of a hacker’s attack is to steal data and sell the infor- mation.2 With stolen personal information obtained from a hacker, a criminal can buy goods, empty bank accounts, or obtain funds in a number of ways. Intellectual property theft is a lead- ing cause of financial losses to businesses. Hackers often steal trade secrets and other intellectual property for competing businesses.

Cyber Security Cyber security consists of steps that can be taken to protect computers, networks, software, Cyber security consists of steps that can be taken to protect computers, networks, software, Cyber security and confidential data from unauthorized access, alteration, or destruction. As the number and

1. A total loss for all of the victims has not been determined, but three of the companies estimate their combined loss to be more than $300 million.

2. The hackers who committed the biggest data breach of all time sold U.S. citizens’ stolen credit-card numbers for ten dollars apiece.

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Continues

sophistication of attacks increases, ongoing attention to security is required to protect sensitive business and personal information.

Prevent Attacks Being vigilant in protecting information is an important way to prevent attacks. A business can encrypt data, install firewalls, and train employees to take appropriate steps to guard customers’ personal information and company trade secrets.

Notify Authorities and Victims If an attack does occur, a business should respond appropri- ately. Forty-seven states, the District of Columbia, Guam, Puerto Rico, and the Virgin Islands require businesses (and other entities) to notify individuals of data breaches involving their personal information.3 Businesses should also notify the appropriate authorities.

A breached business may offer to cover the cost of credit monitoring and identity-theft protection for those whose personal information was stolen. In any event, individuals who are the victims of identity theft should inform their banks of the theft, place fraud alerts on their credit files, and review their credit reports.

Prosecute Hackers Hackers who can be identified can be charged with computer crimes. That happened to the hackers who committed the biggest data breach of all time, described at the beginning of this feature. Five defendants were charged in a federal district court with unau- thorized access of protected computers, wire fraud, and conspiracy to commit those crimes.4 In 2015, one of the five, Vladimir Drinkman, pleaded guilty. Drinkman and two of the others, Alexandr Kalinin and Mikhail Rytikov, were charged in connection with other data breaches as well.

Recover Losses Traditional insurance policies for businesses typically exclude the risk of a data breach. Cyber security insurance is designed to protect against losses from a variety of online Cyber security insurance is designed to protect against losses from a variety of online Cyber security insurance incidents, including data breaches. The protection may cover costs arising from the destruction or theft of data, hacking, or denial of service attacks, as well as any related liability for privacy violations. Some policies limit coverage to $100 million.

Avoid Sanctions Earlier, we mentioned the importance of protecting data by preventing attacks. Attack prevention can have the added benefit of helping the business to avoid govern- ment sanctions.

A lack of security that allows hackers to steal customers’ personal data from a business’s com- puter system can be the ground for a suit by the Federal Trade Commission (FTC). The business may be liable for any resulting fraudulent charges to the customers’ accounts. The FTC may also impose a fine and oversee the company’s data protection for up to twenty years.

“A company does not act equitably when it publishes a privacy policy to attract customers who are concerned about data privacy, fails to make good on that promise by investing inad- equate resources in cybersecurity, exposes its unsuspecting customers to substantial financial injury, and retains the profits of their business.”5

3. See, for example, California Civil Code Sections 1798.29 and 1798.80 et seq. 4. These charges represent violations of the Computer Fraud and Abuse Act, 18 U.S.C. Section 1030; the Mail Fraud Act,

18 U.S.C. Sections 1343 and 1349; and 18 U.S.C. Section 371 (“Conspiracy to Commit Offense or to Defraud the United States”).

5. Federal Trade Commission v. Wyndham Worldwide Corp., 799 F.3d 236 (3d Cir. 2015).

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Ethical Connection Does a business have an ethical duty to prevent potential harm to its customers’ credit that may result from a data breach? Some courts have held that consumers whose data have been stolen from a business’s computer system can base a suit against the business on injuries consisting of lost time and money.6

The idea is that consumers whose data are stolen must spend time and money to resolve fraudulent charges and to protect against future identity theft and fraud. These individuals, after all, trusted the business with their information. They must now cancel or replace credit or debit cards and monitor credit reports even if actual fraud has not yet occurred.

As mentioned earlier, a business may offer credit monitoring and identity-theft protection after a breach. This offer indicates that the business recognizes a continuing risk of harm from the breach. It also supports the existence of an ethical duty on the part of the business to prevent this harm.

Ethics Question What is the extent of a business’s ethical obligation to protect the personal informa- tion of its customers and employees? Discuss.

Critical Thinking Most likely, hackers will always exist, attempting to breach computer systems using the most up-to-date technology. What can businesses do to prevent breaches to their systems?

6. See, for example, Remijas v. Neiman Marcus Group, LLC, 794 F.3d 688 (7th Cir. 2015). Some courts disagree—for example, see Reilly v. Ceridian Corp., 664 F.3d 38 (3d Cir. 2011).

U N I T T W O Application and Ethics

12. Formation of Traditional and E-Contracts

13. Contract Performance, Breach, and Remedies

14. Sales and Lease Contracts

15. Creditor-Debtor Relations and Bankruptcy

Unit Three

�e Commercial Environment

234

C H A P T E R 12

12–1b The Definition of a Contract A contract is “a promise or a set of promises for the contract is “a promise or a set of promises for the contract breach of which the law gives a remedy, or the perfor- mance of which the law in some way recognizes as a duty.”1 Put simply, a contract is an agreement that can be enforced in court. It is formed by two or more parties who agree to perform or to refrain from performing some act now or in the future.

Generally, contract disputes arise when there is a prom- ise of future performance. If the contractual promise is not fulfilled, the party who made it is subject to the sanctions of a court. That party may be required to pay damages for fail- ing to perform the contractual promise. In a few instances, the party may be required to perform the promised act.

1. Restatement (Second) of Contracts, Section 1. Restatements of the Law are Restatements of the Law are Restatements of the Law scholarly books that restate the existing common law principles distilled from court opinions as sets of rules on particular topics. Courts often refer to the Restatements for guidance. The Restatements for guidance. The Restatements Restatement dealing with con-Restatement dealing with con-Restatement tracts will be referred to throughout the material on contract law. Second in the title indicates that this Restatement is in its second edition. A third Restatement is in its second edition. A third Restatement edition is being drafted.

12–1 An Overview of Contract Law Before we look at the numerous rules that courts use to determine whether a particular promise will be enforced, it is necessary to understand some fundamental concepts of contract law. In this section, we describe the sources and general function of contract law and introduce the objective theory of contracts.

12–1a Sources of Contract Law The common law governs all contracts except when it has been modified or replaced by statutory law, such as the Uniform Commercial Code (UCC), or by adminis- trative agency regulations. Contracts relating to services, real estate, employment, and insurance, for instance, generally are governed by the common law of contracts.

Contracts for the sale and lease of goods, however, are governed by the UCC—to the extent that the UCC has modified general contract law. In the discussion of gen- eral contract law that follows, we indicate in footnotes the areas in which the UCC has significantly altered common law contract principles.

N o aspect of modern life is entirely free of contractual relationships. You acquire rights and obliga-

tions, for instance, when you borrow funds, buy or lease a house, obtain insurance, and purchase goods or ser-insurance, and purchase goods or ser-insurance, and purchase goods or ser vices. Contract law is designed to pro- vide stability and predictability, as well as certainty, in the marketplace.

Contract law deals with, among other things, the formation and keep- ing of promises. A promise is a dec- laration by a person (the promisor) promisor) promisor to do or not to do a certain act. As a result, the person to whom the prom- ise is made (the promisee) has a right

to expect or demand that something either will or will not happen in the future.

Like other types of law, contract law reflects our social values, inter- ests, and expectations at a given point in time. It shows, for instance, to what extent our society allows people to make promises or com- mitments that are legally binding. It distinguishes between promises that create only moral obligations (such as moral obligations (such as moral a promise to take a friend to lunch) and promises that are legally binding (such as a promise to pay for items ordered online).

Contract law also demonstrates which excuses our society accepts for breaking certain types of promises. In addition, it indicates which prom- ises are considered to be contrary to public policy—against the interests of society as a whole—and therefore legally invalid. When the person mak- ing a promise is a child or is mentally incompetent, for instance, a question will arise as to whether the promise should be enforced. Resolving such questions is the essence of contract law.

Formation of Traditional and E-Contracts

C H A P T E R 1 2 Formation of Traditional and E-Contracts 235

12–1c The Objective Theory of Contracts In determining whether a contract has been formed, the element of intent is of prime importance. In contract law, intent is determined by what is called the objective theory of contracts, not by the personal or subjective intent, or belief, of a party.

The theory is that a party’s intention to enter into a legally binding agreement, or contract, is judged by out- ward, objective facts. The facts are as interpreted by a reasonable person, rather than by the party’s own secret, reasonable person, rather than by the party’s own secret, reasonable subjective intentions. Objective facts may include: 1. What the party said when entering into the contract. 2. How the party acted or appeared (intent may be man-

ifested by conduct as well as by oral or written words). 3. The circumstances surrounding the transaction.

■ CASE IN POINT 12.1 Cornell University in New York offered Leslie Weston an associate professorship for an initial term of five years. The offer letter described the position as being “with tenure,” but it stated that the offer of tenure would have to be confirmed by the uni- versity’s review process after she was hired. For a variety of reasons, Weston delayed her tenure submission for five years and, when she finally submitted it, she was not awarded tenure.

Cornell gave Weston a two-year extension, this time as an “associate professor without tenure,” to allow her an opportunity to improve and resubmit her tenure package. Although she resubmitted her tenure request, it was again denied, resulting in her eventual termina- tion. Weston sued Cornell for breach of contract, and lost. The court held that Cornell’s two-year extension of Weston’s position had clearly modified the original contract by stating that she was working as an associ- ate professor “without tenure.” Weston’s subjective beliefs and unsupported arguments regarding the modification of her employment agreement were irrelevant.2 ■

12–1d Requirements of a Valid Contract The following list briefly describes the four requirements that must be met before a valid contract exists. If any of these elements is lacking, no contract will have been formed. (Each requirement will be explained more fully later in this chapter.) 1. Agreement. An agreement to form a contract includes

an offer and an offer and an offer acceptance. One party must offer to enter into a legal agreement, and another party must accept the terms of the offer.

2. Weston v. Cornell University, 136 A.D.3d 1094, 24 N.Y.S.3d 448 (N.Y.A.D. 2016).

2. Consideration. Any promises made by the parties to the contract must be supported by legally sufficient and bargained-for consideration (something of value received or promised, such as money, to convince a person to make a deal).

3. Contractual capacity. Both parties entering into the contract must have the contractual capacity to do so. capacity to do so. capacity The law must recognize them as possessing character- istics that qualify them as competent parties.

4. Legality. The contract’s purpose must be to accomplish some goal that is legal and not against public policy.

12–1e Defenses to the Enforceability of a Contract

Even if all of the requirements listed above are satis- fied, a contract may be unenforceable if the following requirements are not met. These requirements typically are raised as defenses to the enforceability of an otherwise defenses to the enforceability of an otherwise defenses valid contract. 1. Voluntary consent. The consent of both parties must

be voluntary. For instance, if a contract was formed as a result of fraud, undue influence, mistake, or duress, the contract may not be enforceable.

2. Form. The contract must be in whatever form the law requires. Some contracts must be in writing to be enforceable.

12–1f Types of Contracts There are many types of contracts. They are categorized based on legal distinctions as to their formation, perfor- mance, and enforceability.

Bilateral versus Unilateral Contracts Every con- tract involves at least two parties. The offeror is the party offeror is the party offeror making the offer. The offeree is the party to whom the offer is made. Whether the contract is classified as bilat-bilat-bilat eral or eral or eral unilateral depends on what the offeree must do to unilateral depends on what the offeree must do to unilateral accept the offer and bind the offeror to a contract.

If the offeree can accept simply by promising to perform, the contract is a bilateral contract. Hence, a bilateral contract is a “promise for a promise.” No per- formance, such as payment of funds or delivery of goods, need take place for a bilateral contract to be formed. The contract comes into existence at the moment the prom- ises are exchanged.

If the offer is phrased so that the offeree can accept the offer only by completing the contract performance, the contract is a unilateral contract. Hence, a unilateral

236 U N I T T H R E E The Commercial Environment

contract is a “promise for an act.” In other words, a uni- lateral contract is formed not at the moment when prom- ises are exchanged but at the moment when the contract is performed.performed.performed.

■ EXAMPLE 12.2 Reese says to Celia, “If you drive my car from New York to Los Angeles, I’ll give you $1,000.” Only on Celia’s completion of the act—bringing the car to Los Angeles—does she fully accept Reese’s offer to pay $1,000. If she chooses not to accept the offer to drive the car to Los Angeles, there are no legal consequences. ■

Formal versus Informal Contracts Formal con- tracts are contracts that require a special form or method of creation (formation) to be enforceable.3 One example is negotiable instruments, which include checks, drafts, promissory notes, bills of exchange, and certificates of deposit. Negotiable instruments are formal contracts because the Uniform Commercial Code (UCC) requires a special language to create them. Letters of credit, which are frequently used in international sales contracts, are another type of formal contract.

Informal contracts (also called simple contracts) include simple contracts) include simple contracts all other contracts. No special form is required (except for certain types of contracts that must be in writing), as the contracts are usually based on their substance rather than their form. Typically, businesspersons put their contracts in writing (including electronic records) to establish proof of a contract’s existence should disputes arise.

Express versus Implied Contracts Contracts may also be categorized as express or express or express implied. In an express contract, the terms of the agreement are fully and explic- itly stated in words, oral or written. A signed lease for an apartment or a house is an express written contract. If one classmate calls another on the phone and agrees to buy her textbooks from last semester for $200, an express oral contract has been made.

A contract that is implied from the conduct of the parties is called an implied contract (or sometimes an implied contract (or sometimes an implied contract implied-in-fact contract). This type of contract differs implied-in-fact contract). This type of contract differs implied-in-fact contract from an express contract in that the conduct of the par- ties, rather than their words, creates and defines the terms of the contract.

Requirements for Implied Contracts. For an implied contract to arise, certain requirements must be met. Nor- mally, if the following conditions exist, a court will hold that an implied contract was formed:

3. See Restatement (Second) of Contracts, Section 6, which explains that formal contracts include (1) contracts under seal, (2) recognizances, (3) negotiable instruments, and (4) letters of credit.

1. The plaintiff furnished some service or property. 2. The plaintiff expected to be paid for that service or

property, and the defendant knew or should have known that payment was expected.

3. The defendant had a chance to reject the services or property and did not.

■ EXAMPLE 12.3 Alex, a small-business owner, needs an accountant to complete his tax return. He drops by a local accountant’s office, explains his situation to the accountant, and learns what fees she charges. The next day, he returns and gives the receptionist all of the neces- sary documents to complete his return. Then he walks out without saying anything further to the accountant. In this situation, Alex has entered into an implied con- tract to pay the accountant the usual fees for her ser- vices. The contract is implied because of Alex’s conduct and hers. She expects to be paid for completing the tax return, and by bringing in the records she will need to do the job, Alex has implied an intent to pay her. ■

Mixed Contracts with Express and Implied Terms. Note that a contract may be a mixture of an express con- tract and an implied contract. In other words, a contract may contain some express terms and some implied terms. During the construction of a home, for instance, the homeowner often asks the builder to make changes in the original speci�cations.original speci�cations.original speci�cations.

■ CASE IN POINT 12.4 Lamar Hopkins hired Uhrhahn Construction & Design, Inc., for several projects in building his home. For each project, the parties signed a written contract that was based on a cost estimate and specifications and that required changes to the agreement to be in writing. While the work was in progress, how- ever, Hopkins repeatedly asked Uhrhahn to deviate from the contract specifications, which Uhrhahn did. None of these requests was made in writing.

One day, Hopkins asked Uhrhahn to use Durisol blocks instead of the cinder blocks specified in the origi- nal contract, indicating that the cost would be the same. Uhrhahn used the Durisol blocks but demanded extra payment when it became clear that the Durisol blocks were more complicated to install. Although Hopkins had paid for the other deviations from the contract that he had orally requested, he refused to pay Uhrhahn for the sub- stitution of the Durisol blocks. Uhrhahn sued for breach of contract. The court found that Hopkins, through his conduct, had waived the provision requiring written con- tract modification and created an implied contract to pay the extra cost of installing the Durisol blocks.4 ■

4. Uhrhahn Construction & Design, Inc. v. Hopkins, 179 P.3d 808 (Utah App. 2008).Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 1 2 Formation of Traditional and E-Contracts 237

Executed versus Executory Contracts Contracts are also classified according to the degree to which they have been performed. A contract that has been fully per- formed on both sides is called an executed contract. A contract that has not been fully performed by the parties is called an executory contract. If one party has fully performed but the other has not, the contract is said to be executed on the one side and executory on the other, but the contract is still classified as executory.

■ EXAMPLE 12.5 Jackson, Inc., agreed to buy ten tons of coal from the Northern Coal Company. Northern deliv- ered the coal to Jackson’s steel mill, where it is being burned. At this point, the contract is executed on the part of North- ern and executory on Jackson’s part. After Jackson pays Northern, the contract will be executed on both sides. ■

Enforceable versus Unenforceable Contracts A valid contract has the necessary elements to entitle at valid contract has the necessary elements to entitle at valid contract least one of the parties to enforce it in court. Those ele- ments, as mentioned earlier, consist of (1) an agreement (offer and acceptance), (2) supported by legally sufficient consideration, (3) made by parties who have the legal capacity to enter into the contract, and (4) a legal purpose.

Valid contracts may be enforceable or unenforce- able. An unenforceable contract is one that cannot be unenforceable contract is one that cannot be unenforceable contract enforced because of certain legal defenses against it. It is

not unenforceable because a party failed to satisfy a legal requirement of the contract. Rather, it is a valid con- tract rendered unenforceable by some statute or law. For instance, certain contracts must be in writing, and if they are not, they will not be enforceable except in certain exceptional circumstances.

Voidable Contracts. A voidable contract is a valid convoidable contract is a valid convoidable contract - tract but one that can be avoided at the option of one or both of the parties. �e party having the option can elect either to avoid any duty to perform or to ratify (make ratify (make ratify valid) the contract. If the contract is avoided, both parties are released from it. If it is rati�ed, both parties must fully perform their respective legal obligations. For instance, contracts made by minors generally are voidable at the option of the minor (with certain exceptions). Contracts made by mentally incompetent persons and intoxicated persons may also be voidable.

Void Contracts. A void contract is no contract at all. void contract is no contract at all. void contract None of the parties have any legal obligations if a contract is void. A contract can be void because one of the parties was determined by a court to be mentally incompetent, for instance, or because the purpose of the contract was illegal.

To review the various types of contracts, see Concept Summary 12.1.

Types of Contracts

Concept Summary 12.1

Bilateral—A promise for a promise.—A promise for a promise.— Unilateral—A promise for an act—that is, acceptance is the completed performanc—A promise for an act—that is, acceptance is the completed performanc— e of the act. Formal—Requires a special form for creationFormal—Requires a special form for creationFormal— . Informal—Requires no special form for creationInformal—Requires no special form for creationInformal— . Express—Formed by words, such as oral, written, or a combination.Express—Formed by words, such as oral, written, or a combination.Express— Implied—Formed by the conduct of the partiesImplied—Formed by the conduct of the partiesImplied— .

Formation ● ●

●

Valid—The contract has the necessary contractual elements: agreement (offeValid—The contract has the necessary contractual elements: agreement (offeValid— r and acceptance), consideration, legal capacity of the parties, and legal purpose. Voidable—One party has the option of avoiding or enforcing the contractual—One party has the option of avoiding or enforcing the contractual— obligation. Unenforceable—A contract exists, but it cannot be enforced because of a lega—A contract exists, but it cannot be enforced because of a lega— l defense. Void—No contract exists, or there is a contract without legal obligations.Void—No contract exists, or there is a contract without legal obligations.Void—

Enforceability ●

●

Executed—A fully performed contract.Executed—A fully performed contract.Executed— Executory—A contract not fully performed.Executory—A contract not fully performed.Executory—

Performance ● ●

238 U N I T T H R E E The Commercial Environment

12–2 Agreement An essential element for contract formation is agreement—the parties must agree on the terms of the agreement—the parties must agree on the terms of the agreement contract and manifest to each other their mutual assent (agreement) to the same bargain. Ordinarily, agreement is evidenced by two events: an offer and an offer and an offer acceptance. One party offers a certain bargain to another party, who then accepts that bargain. Once an agreement is reached, if the other elements of a contract (consideration, capac- ity, and legality) are present, a valid contract is formed.

12–2a Requirements of the Offer An offer is a promise or commitment to do or refrain offer is a promise or commitment to do or refrain offer from doing some specified action in the future. The party making an offer is called the offeror, and the party to whom the offer is made is called the offeree. Under the common law, three elements are necessary for an offer to be effective:

1. The offeror must have a serious intention to become bound by the offer.

2. The terms of the offer must be reasonably certain, or definite, so that the parties and the court can ascer- tain the terms of the contract.

3. The offer must be communicated to the offeree.

Once an effective offer has been made, the offeree’s acceptance of that offer creates a legally binding contract (providing the other essential elements for a valid and enforceable contract are present).

Intention The first requirement for an effective offer is a serious intent on the part of the offeror. Serious intent is not determined by the subjective intentions, beliefs, and assumptions of the offeror. Rather, it is determined by what a reasonable person in the offeree’s position would conclude that the offeror’s words and actions meant.

Offers made in obvious anger, jest, or undue excite- ment do not meet the serious-and-objective-intent test. A reasonable person would realize that such offers were not made seriously. Because these offers are not effective, an offeree’s acceptance does not create an agreement.

In the classic case presented next, the court consid- ered whether an offer made “after a few drinks” met the serious-and-objective-intent requirement.

Background and Facts W. O. Lucy, the plaintiff, filed a suit against A. H. and Ida Zehmer, the defendants, to compel the Zehmers to transfer title of their property, known as the Ferguson Farm, to the Lucys (W. O. and his wife) for $50,000, as the Zehmers had allegedly agreed to do. Lucy had known A. H. Zehmer for fifteen or twenty years and for the last eight years or so had been anxious to buy the Ferguson Farm from him. One night, Lucy stopped to visit the Zehmers in the combina- tion restaurant, filling station, and motor court they operated. While there, Lucy tried to buy the Ferguson Farm once again. This time he tried a new approach. According to the trial court transcript, Lucy said to Zehmer, “I bet you wouldn’t take $50,000 for that place.” Zehmer replied, “Yes, I would too; you wouldn’t give fifty.” Throughout the evening, the conversation returned to the sale of the Ferguson Farm for $50,000. All the while, the men continued to drink whiskey and engage in light conversation.

Eventually, Lucy enticed Zehmer to write up an agreement to the effect that the Zehmers would sell the Ferguson Farm to Lucy for $50,000 complete. Later, Lucy sued Zehmer to compel him to go through with the sale. Zehmer argued that he had been drunk and that the offer had been made in jest and hence was unenforceable. The trial court agreed with Zehmer, and Lucy appealed.

In the Language of the Court BUCHANAN, J. [Justice] delivered the opinion of the court.BUCHANAN, J. [Justice] delivered the opinion of the court.BUCHANAN

* * * * In his testimony, Zehmer claimed that he “was high as a Georgia pine,” and that the transaction “was

just a bunch of two doggoned drunks bluffing to see who could talk the biggest and say the most.” That claim is inconsistent with his attempt to testify in great detail as to what was said and what was done.

Classic Case 12.1 Lucy v. Zehmer Supreme Court of Appeals of Virginia, 196 Va. 493, 84 S.E.2d 516 (1954).

C H A P T E R 1 2 Formation of Traditional and E-Contracts 239

* * * * The appearance of the contract, the fact that it was under discussion for forty minutes or more before

it was signed; Lucy’s objection to the first draft because it was written in the singular, and he wanted Mrs. Zehmer to sign it also; the rewriting to meet that objection and the signing by Mrs. Zehmer; the discussion of what was to be included in the sale, the provision for the examination of the title, the completeness of the instrument that was executed, the taking possession of it by Lucy with no request or suggestion by either of the defendants that he give it back, are facts which furnish persuasive evidence that the execution of the contract was a serious business transaction rather than a casual, jesting matter as defendants now contend.

* * * * In the field of contracts, as generally elsewhere, we must look to the outward expression of a person as

manifesting his intention rather than to his secret and unexpressed intention. The law imputes to a person an intention corresponding to the reasonable meaning of his words and acts. [Emphasis added.]

* * * * Whether the writing signed by the defendants and now sought to be enforced by the complainants

was the result of a serious offer by Lucy and a serious acceptance by the defendants, or was a serious offer by Lucy and an acceptance in secret jest by the defendants, in either event it constituted a binding con- tract of sale between the parties.

Decision and Remedy The Supreme Court of Appeals of Virginia determined that the writing was an enforceable contract and reversed the ruling of the lower court. The Zehmers were required by court order to follow through with the sale of the Ferguson Farm to the Lucys.

Impact of This Case on Today’s Law This is a classic case in contract law because it illustrates so clearly the objective theory of contracts with respect to determining whether a serious offer was intended. Today, the courts continue to apply the objective theory of contracts and routinely cite Lucy v. Zehmer as a Lucy v. Zehmer as a Lucy v. Zehmer significant precedent in this area.

Critical Thinking • What If the Facts Were Different? Suppose that the day after Lucy signed the purchase agreement,

he decided that he did not want the farm after all, and Zehmer sued Lucy to perform the contract. Would this change in the facts alter the court’s decision that Lucy and Zehmer had created an enforceable contract? Why or why not?

Situations in Which Intent May Be Lacking The concept of intention can be further clarified by look- ing at statements that are not offers and situations in which not offers and situations in which not the parties’ intent to be bound might be questionable. 1. Expressions of opinion. An expression of opinion is not

an offer. It does not indicate an intention to enter into a binding agreement.

2. Statements of future intent. A statement of an inten- tion to do something in the future (such as “I plan to sell my Verizon stock”) is not an offer.

3. Preliminary negotiations. A request or invitation to negotiate is not an offer. It only expresses a willingness to discuss the possibility of entering into a contract. Statements such as “Will you sell your farm?” or “I wouldn’t sell my car for less than $8,000” are examples.

4. Invitations to bid. When a government entity or private firm needs to have construction work done,

contractors are invited to submit bids. The invitation to submit bids is not an offer. The bids that contrac- tors submit are offers, however, and the government entity or private firm can bind the contractor by accepting the bid.

5. Advertisements and price lists. In general, representa- tions made in advertisements and price lists are treated not as offers to contract but as invitations to negotiate.5

6. Live and online auctions. In a live auction, a seller “offers” goods for sale through an auctioneer, but this is not an offer to form a contract. Rather, it is an invitation asking bidders to submit offers. In the context of an auction, a bidder is the offeror, and the auctioneer is the offeree. The offer is accepted when the auctioneer strikes the hammer.

5. Restatement (Second) of Contracts, Section 26, Comment b.

Case 12.1 Continued

240 U N I T T H R E E The Commercial Environment

The most familiar type of auction today takes place online through Web sites like eBay and eBid. “Offers” to sell an item on these sites generally are treated as invitations to negotiate.

Agreements to Agree. Traditionally, agreements to agree—that is, agreements to agree to the material terms of a contract at some future date—were not considered to be binding contracts. �e modern view, however, is that agreements to agree may be enforceable agreements (con- tracts) if it is clear that the parties intended to be bound by the agreements. In other words, under the modern view the emphasis is on the parties’ intent rather than on form.

Preliminary Agreements. A preliminary agreement can constitute a binding contract if the parties have agreed on all essential terms and no disputed issues agreed on all essential terms and no disputed issues agreed on all essential terms and no disputed issues remain to be resolved. ■ CASE IN POINT 12.6 Basis Tech- nology Corporation created software and provided tech- nical services for a Japanese-language Web site belonging to Amazon.com, Inc. The agreement between the two companies allowed for separately negotiated contracts for additional services that Basis might provide to Amazon. Later, a dispute arose and Basis sued Amazon for vari- ous claims involving these contracts and for failure to pay for services performed by Basis. During the trial, the two parties appeared to reach an agreement to settle out of court via a series of e-mail exchanges outlining the settle- ment. When Amazon reneged, Basis served a motion to enforce the proposed settlement. The trial judge entered a judgment against Amazon, which appealed. The Appeals Court of Massachusetts affirmed the trial court’s finding that Amazon intended to be bound by the terms of the e-mail exchange, which contained a complete and unam- biguous statement of the parties’ settlement terms.6 ■

In contrast, if the parties agree on certain major terms but leave other terms open for further negotiation, a pre- liminary agreement is not binding. The parties are bound only in the sense that they have committed themselves to negotiate the undecided terms in good faith in an effort to reach a final agreement.

Definiteness of Terms The second requirement for an effective offer involves the definiteness of its terms. An offer must have reasonably definite terms so that a court can determine if a breach has occurred and give an appropriate remedy.7 The specific terms required depend, of course, on the type of contract. Generally, a contract

6. Basis Technology Corp. v. Amazon.com, Inc., 71 Mass.App.Ct. 29, 878 N.E.2d 952 (2008).

7. Restatement (Second) of Contracts, Section 33.

must include the following terms, either expressed in the contract or capable of being reasonably inferred from it: 1. The identification of the parties. 2. The identification of the object or subject matter of

the contract (also the quantity, when appropriate), including the work to be performed, with specific identification of such items as goods, services, and land.

3. The consideration to be paid. 4. The time of payment, delivery, or performance.

An offer may invite an acceptance to be worded in such specific terms that the contract is made definite. ■ EXAMPLE 12.7 Nintendo of America, Inc., contacts your Play 2 Nintendo of America, Inc., contacts your Play 2 Win Games store and offers to sell “from one to twenty- five Nintendo 3DS.XL gaming systems for $75 each. State number desired in acceptance.” You agree to buy twenty systems. Because the quantity is specified in the acceptance, the terms are definite, and the contract is enforceable. ■

When the parties have clearly manifested their intent to form a contract, courts sometimes are willing to sup- ply a missing term in a contract, especially a sales con- tract.8 But a court will not rewrite a contract if the parties’ expression of intent is too vague or uncertain to be given any precise meaning.

Communication The third requirement for an effec- tive offer is communication—the offer must be commu- nicated to the offeree. Ordinarily, one cannot agree to a nicated to the offeree. Ordinarily, one cannot agree to a nicated to the offeree. Ordinarily, one cannot agree to a bargain without knowing that it exists. bargain without knowing that it exists. ■ CASE IN POINT 12.8 Adwoa Gyabaah was hit by a bus owned by Riv- lab Transportation Corporation. Gyabaah filed a suit in a New York state court against the bus company. Rivlab’s insurer offered to tender the company’s policy limit of $1 million in full settlement of Gyabaah’s claims. On the advice of her attorney, Jeffrey Aronsky, Gyabaah signed a release (a contract forfeiting the right to pursue a legal claim) to obtain the settlement funds.

The release, however, was not sent to Rivlab or its insurer, National Casualty. Moreover, Gyabaah claimed that she had not decided whether to settle. Two months later, Gyabaah changed lawyers and changed her mind about signing the release. Her former attorney, Aronsky, filed a motion to enforce the release so that he could obtain his fees from the settlement funds. The court denied the motion, and Aronsky appealed. The review- ing court held that there was no binding settlement agreement. The release was never delivered to Rivlab

8. See UCC 2–204. Article 2 of the UCC modifies general contract law by requiring less specificity, or definiteness of terms, in sales and lease less specificity, or definiteness of terms, in sales and lease less contracts.

C H A P T E R 1 2 Formation of Traditional and E-Contracts 241

or its insurer nor was acceptance of the settlement offer otherwise communicated to them.9 ■

12–2b Termination of the Offer The communication of an effective offer to an offeree gives the offeree the power to transform the offer into a binding, legal obligation (a contract) by an acceptance. This power of acceptance does not continue forever, though. It can be terminated either by action of the par- ties or by operation of law.

Termination by Action of the Offeror �e o�eror’s act of revoking, or withdrawing, an o�er is known as revocation. Unless an o�er is irrevocable, the o�eror usually can revoke the o�er, as long as the revo- cation is communicated to the o�eree before the o�eree accepts. Revocation may be accomplished by either of the following: 1. Express repudiation of the offer (such as “I withdraw

my previous offer of October 17”). 2. Performance of acts that are inconsistent with the

existence of the offer and are made known to the offeree (for instance, selling the offered property to another person in the offeree’s presence).

In most states, a revocation becomes effective when the offeree or the offeree’s agent (a person acting on behalf agent (a person acting on behalf agent of the offeree) actually receives it. Therefore, a revocation sent via FedEx on April 1 and delivered at the offeree’s residence or place of business on April 3 becomes effec- tive on April 3.

Although most o�ers are revocable, some can be made irrevocable—that is, they cannot be revoked. One form of irrevocable o�er is an option contract. An option contract is created when an o�eror promises to hold an o�er open for a speci�ed period of time in return for a payment (con- sideration) given by the o�eree. An option contract takes away the o�eror’s power to revoke the o�er for the period of time speci�ed in the option.

Option contracts are frequently used in conjunction Option contracts are frequently used in conjunction Option contracts are frequently used in conjunction with the sale or lease of real estate. ■ EXAMPLE 12.9 Tyler agrees to lease a house from Jackson, the property owner. The lease contract includes a clause stating that Tyler is paying an additional $15,000 for an option to purchase the property within a specified period of time. If Tyler decides not to purchase the house after the specified period has lapsed, he loses the $15,000, and Jackson is free to sell the property to another buyer. ■

9. Gyabaah v. Rivlab Transportation Corp., 102 A.D.3d 451, 958 N.Y.S.2d 109 (N.Y.A.D. 2013).

Termination by Action of the Offeree If the offeree rejects the offer—by words or by conduct—the offer is terminated. Any subsequent attempt by the offeree to accept will be construed as a new offer, giving the origi- nal offeror (now the offeree) the power of acceptance.

Like a revocation, a rejection of an offer is effective only when it is actually received by the offeror or the offeror’s agent. ■ EXAMPLE 12.10 Goldfinch Farms offers to sell specialty Maitake mushrooms to a Japanese buyer, Kinoko Foods. If Kinoko rejects the offer by sending a letter via U.S. mail, the rejection will not be effective (and the offer will not be terminated) until Goldfinch receives the letter. ■

Inquiries about an Offer. Merely inquiring about the “�rmness” of an o�er does not constitute rejecthe “�rmness” of an o�er does not constitute rejecthe “�rmness” of an o�er does not constitute rejec- tion. ■ EXAMPLE 12.11 Raymond o�ers to buy Fran- cie’s digital pen for $100. She responds, “Is that your best o�er?” A reasonable person would conclude that Francie has not rejected the o�er but has merely made an inquiry. Francie could still accept and bind Raymond to the $100 price. ■

Counteroffer. A countero�er is a rejection of the origicountero�er is a rejection of the origicountero�er - nal o�er and the simultaneous making of a new o�er. nal o�er and the simultaneous making of a new o�er. nal o�er and the simultaneous making of a new o�er. ■ EXAMPLE 12.12 Burke o�ers to sell his home to Lang for Burke o�ers to sell his home to Lang for $270,000. Lang responds, “Your price is too high. I’ll o�er to purchase your house for $250,000.” Lang’s response is a countero�er because it rejects Burke’s o�er to sell at $270,000 and creates a new o�er by Lang to purchase the home for $250,000. ■

At common law, the mirror image rule requires the mirror image rule requires the mirror image rule offeree’s acceptance to match the offeror’s offer exactly—to mirror the offer. Any change in, or addition to, the terms of the original offer automatically terminates that offer and substitutes the counteroffer. The counteroffer, of course, need not be accepted, but if the original offeror does accept the terms of the counteroffer, a valid contract is created.10

Termination by Operation of Law The power of the offeree to transform the offer into a binding, legal obligation can be terminated by operation of law through the occurrence of any of the following events: 1. Lapse of time. 2. Destruction of the specific subject matter of the offer. 3. Death or incompetence of the offeror or the offeree. 4. Supervening illegality of the proposed contract.

10. The mirror image rule has been greatly modified in regard to sales con- tracts. Section 2–207 of the UCC provides that a contract is formed if the offeree makes a definite expression of acceptance (such as signing a form in the appropriate location), even though the terms of the accep- tance modify or add to the terms of the original offer.

242 U N I T T H R E E The Commercial Environment

Lapse of Time. An o�er terminates automatically by law when the period of time speci�ed in the o�er has passed. If speci�ed in the o�er has passed. If speci�ed in the o�er the o�er states that it will be left open until a particular date, then the o�er will terminate at midnight on that day. If the o�er states that it will be open for a number of days, this time period normally begins to run when the o�eree receives the o�er (not when it is formed or sent).receives the o�er (not when it is formed or sent).receives

If the offer does not specify a time for acceptance, the offer terminates at the end of a reasonable period of time. reasonable period of time. reasonable What constitutes a reasonable period of time depends on the subject matter of the contract, business and market conditions, and other relevant circumstances. An offer to sell farm produce, for instance, will terminate sooner than an offer to sell farm equipment. Farm produce is perishable and is also subject to greater fluctuations in market value.

Destruction, Death, or Incompetence. An o�er is auto- matically terminated if the speci�c subject matter of the o�er (such as a smartphone or a house) is destroyed before the o�er is accepted.11 Notice of the destruction is not required for the o�er to terminate. An offeree’s power of acceptance is also terminated when the offeror or offeree dies or is legally incapacitated—unless the offer is irrevocable.

Supervening Illegality. A statute or court decision that makes an o�er illegal automatically terminates the that makes an o�er illegal automatically terminates the that makes an o�er illegal automatically terminates the o�er. ■ EXAMPLE 12.13 Lee o�ers to lend Kim $10,000 at an annual interest rate of 15 percent. Before Kim can accept the o�er, a law is enacted that prohibits interest rates higher than 8 percent. Lee’s o�er is automatically terminated. (If the statute is enacted after Kim accepts the

11. Restatement (Second) of Contracts, Section 36.

o�er, a valid contract is formed, but the contract may still be unenforceable.) ■

Concept Summary 12.2 reviews the ways in which an offer can be terminated.

12–2c Acceptance Acceptance is a voluntary act by the offeree that shows assent (agreement) to the terms of an offer. The offeree’s act may consist of words or conduct. The acceptance must be unequivocal and must be communicated to the offeror. Generally, only the person to whom the offer is made or that person’s agent can accept the offer and create a binding contract.

Unequivocal Acceptance To exercise the power of acceptance effectively, the offeree must accept unequivo- cally. This is the mirror image rule previously discussed. An rule previously discussed. An rule acceptance may be unequivocal even though the offeree expresses dissatisfaction with the contract. For instance, “I accept the offer, but can you give me a better price?” is an effective acceptance.

An acceptance cannot impose new conditions or change the terms of the original offer. If it does, the acceptance may be considered a counteroffer, which is a rejection of the original offer. For instance, the statement “I accept the offer but only if I can pay on ninety days’ credit” is a counteroffer and not an unequivocal acceptance.

Note that even when the additional terms are con- strued as a counteroffer, the other party can accept the terms by words or by conduct. ■ CASE IN POINT 12.14 Lagrange Development is a nonprofit corporation in Ohio that acquires and rehabilitates real property. Sonja Brown presented Lagrange with a written offer to buy a

●

Methods by Which an Offer Can Be Terminated

Concept Summary 12.2

Revocation Rejection Counteroffer

By Action of the Parties

By Operation of Law Lapse of time Destruction of the subject matter Death or incompetence of the offeror or offeree Supervening illegality

C H A P T E R 1 2 Formation of Traditional and E-Contracts 243

particular house for $79,900. Lagrange’s executive direc- tor, Terry Glazer, penciled in modifications to the offer— an increased purchase price of $84,200 and a later date for acceptance. Glazer initialed the changes and signed the document.

Brown initialed the date change but not the price increase, and did not sign the revised document. Never- theless, Brown went through with the sale and received ownership of the property. When a dispute later arose as to the purchase price, a court found that Glazer’s modi- fication of the terms had constituted a counteroffer, which Brown had accepted by performance. Therefore, the contract was enforceable for the modified price of $84,200.12 ■

Silence as Acceptance Ordinarily, silence cannot constitute acceptance, even if the offeror states, “By your silence and inaction, you will be deemed to have accepted this offer.” An offeree should not be obligated to act affir- matively to reject an offer when no consideration (nothing of value) has passed to the offeree to impose such a duty.

In some instances, however, the offeree does have a duty to speak, and her or his silence or inaction

12. Brown v. Lagrange Development Corp., 2015 WL 223877 (Ohio App. 2015).

will operate as an acceptance. Silence can constitute an acceptance when the offeree has had prior dealings with acceptance when the offeree has had prior dealings with acceptance when the offeree has had prior dealings with the offeror. ■ EXAMPLE 12.15 Marabel’s restaurant routinely receives shipments of produce from a certain supplier. That supplier notifies Marabel’s that it is rais- ing its prices because its crops were damaged by a late freeze. If the restaurant does not respond in any way, the silence may operate as an acceptance, and the supplier will be justified in continuing regular shipments. ■

Communication of Acceptance Whether the offeror must be notified of the acceptance depends on the nature of the contract. In a unilateral contract, the full performance of some act is called for. Acceptance is usually evident, and notification is therefore unnecessary (unless the law requires it or the offeror asks for it). In a bilateral contract, in contrast, communication of accep- tance is necessary, because acceptance is in the form of a promise. The bilateral contract is formed when the promise is made rather than when the act is performed.

At issue in the following case was the validity and enforceability of a waiver of liability on the back page of a gym’s membership agreement. In this case, the court had to determine whether the circumstances indicated that the offeree’s acceptance of the agreement was unequivo- cal and clearly communicated.

In the Language of the Court Opinion by STABILE, J. [Judge]

* * * * [Melinda Hinkal filed a suit in a

Pennsylvania state court against personal trainer Gavin Pardoe and Gold’s Gym, Inc., alleging that] she sustained a seri- ous neck injury while using a piece of exercise equipment under * * * Pardoe’s direction [at Gold’s Gym. Hinkal] alleges that she suffered a rupture of the C5 disc in her neck requiring two separate surgeries. [Gold’s and Pardoe] filed a Motion for Summary Judgment [assert- ing] that as a member of Gold’s Gym [Hinkal] signed * * * a Membership Agreement [that] contains legally valid “waiver of liability” provisions, which in turn, bar [her] claims.

The trial court concluded that the waiver language set forth in Gold’s Membership Agreement was valid and enforceable.

[Hinkal] filed a timely appeal to this [state intermediate appellate] Court.

* * * * * * * Appellant [Hinkal] questions

whether the waiver on the back page of her membership agreement is valid and enforceable. The language on the back page of the agreement reads in pertinent part as follows:

WAIVER OF LIABILITY; ASSUMP- TION OF RISK: Member acknowl- edges that the use of Gold’s Gym’s facilities, equipment, services and programs involves an inherent risk of personal injury to Member. * * *

Member voluntarily agrees to assume all risks of personal injury to Member * * * and waives any and all claims or actions that Member may have against Gold’s Gym * * * and any * * * employees * * * for * * * injuries arising from use of any exer- cise equipment * * * in supervised or unsupervised activities.

The Gold’s Gym Membership Agreement signed by Appellant further instructs:

Do not sign this Agreement until you have read both sides. The terms on each side of this form are a part of this Agree- ment. * * * By signing this Agreement, Member acknowledges that This Agree- ment is a contract that will become legally binding upon its acceptance.

Case Analysis 12.2 Hinkal v. Pardoe Superior Court of Pennsylvania, 2016 PA Super 11, 133 A.3d 738 (2016).

244 U N I T T H R E E The Commercial Environment

The signature line follows immedi- ately and the words “Notice: See other side for important information” appear in bold typeface below the signature line.

* * * * * * * Appellant * * * asserts that her

claim is not barred by the “exclusion clause” on the back of the membership agreement. * * * Appellant contends the waiver is invalid because the waiver language appeared on the back of the agreement, she never read or was told to read the back of the agreement, and the clause was not “brought home” to her in a way that could suggest she was aware of the clause and its contents. However, * * * Appellant admitted she did not read the agreement prior to signing it. * * * Her failure to read her agreement does not render it either invalid or unenforceable. The law of Pennsylvania is clear. One who is about to sign a contract has a duty to read that contract first. * * * It is well established that, in the absence of fraud, the failure

to read a contract before signing it is an unavailing excuse or defense and cannot justify an avoidance, modification or nulli- fication of the contract. [Emphasis added.]

[To support her claim, Appellant cites Beck-Hummel v. Ski Shawnee, Inc., a previous case before this court, but] the signed Gold’s Gym membership agree- ment cannot be compared in any way to the unread and unsigned disclaimer on a ski facility ticket in [Beck-Hummel.]

* * * * * * * In [Beck-Hummel,] the release

provision was contained on the face of an entry ticket purchased for use of a ski facility. The ticket did not require a signature or an express acknowledgment that its terms were read and accepted before using the facility. Nothing about the ticket ensured that a purchaser would be aware of its release provision. The purchasers were mere recipients of the document. In short, there was not sufficient evidence to find conclusively

that there was a meeting of the minds that part of the consideration for use of the facility was acceptance of a release provision. In stark contrast, here there is a written, signed and acknowledged agreement between the parties.

* * * * Here, without reading it, Appel-

lant signed the membership agreement, which included an unambiguous direc- tive not to sign before reading both sides, a clear pronouncement that the terms on both sides of the form are part of the agreement, and a straightforward statement that the agreement constitutes the entire agreement between the parties. * * * We find no genuine issue as to any material fact or any error in the lower court’s determination that the waiver was valid and enforceable. Appellant is not entitled to relief based on [this] issue.

* * * * Order affirmed.

Legal Reasoning Questions

1. What indicated that the terms in the agreement at issue in this case were accepted? 2. What were the appellant’s arguments in support of her claim? Which of those contentions did the court imply was irrelevant? Why? 3. How did the court distinguish its conclusion in this case from its decision in Beck-Hummel?

Case 12.2 Continued

Mode and Timeliness of Acceptance In bilateral contracts, acceptance must be timely. The general rule is that acceptance in a bilateral contract is timely if it is made before the offer is terminated. Problems may arise, though, when the parties involved are not dealing face to face. In such situations, the offeree should use an autho- rized mode of communication.

The Mailbox Rule. Acceptance takes e�ect, thus complet- ing formation of the contract, at the time the o�eree sends or delivers the communication via the mode expressly or impliedly authorized by the o�eror. �is is the so-called mailbox rule, also called the deposited acceptance rule, which the majority of courts follow. Under this rule, if the authorized mode of communication is the mail, then an acceptance becomes valid when it is dispatched (placed in the control of the U.S. Postal Service)—not when it is not when it is not received by the o�eror. (Note, however, that if the o�er

stipulates when acceptance will be e�ective, then the o�er will not be e�ective until the time speci�ed.)

The mailbox rule does not apply to instantaneous forms of communication, such as when the parties are dealing face to face, by telephone, by fax, and (usually) by e-mail. Under the Uniform Electronic Transactions Act, e-mail is considered sent when it either leaves the control of the sender or is received by the recipient. This rule takes the place of the mailbox rule when the parties have agreed to conduct transactions electronically and allows an e-mail acceptance to become effective when sent.

Authorized Means of Acceptance. A means of com- municating acceptance can be expressly authorized by the o�eror or impliedly authorized by the facts and circum- stances of the situation. An acceptance sent by means not expressly or impliedly authorized normally is not e�ective until it is received by the o�eror.

C H A P T E R 1 2 Formation of Traditional and E-Contracts 245

When an offeror specifies how acceptance should be made (for instance, by overnight delivery), express autho- rization is said to exist. The contract is not formed unless the offeree uses that specified mode of acceptance. More- over, both offeror and offeree are bound in contract the moment this means of acceptance is employed.

If the offeror does not expressly authorize a certain mode of acceptance, then acceptance can be made by any reasonable means. Courts look at the prevailing business usages and the surrounding circumstances to determine whether the mode of acceptance used was reasonable. Usually, the offeror’s choice of a particular means in mak- ing the offer implies that the offeree can use the same or a faster means for acceptance. faster means for acceptance. faster means

Substitute Method of Acceptance. Sometimes, the o�eror authorizes a particular method of acceptance, but the o�eree accepts by a di�erent means. In that situation, the acceptance may still be e�ective if the substituted method serves the same purpose as the authorized means.

Acceptance by a substitute method is not effective on dispatch, however. No contract will be formed until on dispatch, however. No contract will be formed until on dispatch, however. No contract will be formed until the acceptance is received by the offeror.the acceptance is received by the offeror. ■ EXAMPLE 12.16 Bennion’s offer specifies acceptance via FedEx Bennion’s offer specifies acceptance via FedEx overnight delivery, but the offeree accepts instead by overnight delivery from UPS. The substitute method of acceptance will still be effective, but not until the offeror (Bennion) receives it from UPS. ■

12–3 E-Contracts Numerous contracts are formed online. Electronic con- tracts, or e-contracts, must meet the same basic require- ments (agreement, consideration, contractual capacity, and legality) as paper contracts. Disputes concerning e-contracts, however, tend to center on contract terms and whether the parties voluntarily agreed to those terms.

Online contracts may be formed not only for the sale of goods and services but also for licensing. The “sale” of software generally involves a license, or a right to use the software, rather than the passage of title (ownership rights) from the seller to the buyer. When you download a soft- ware application (app) on your smartphone, for instance, you typically must agree to the terms of use in a licensing agreement.

Although we typically refer to the offeror and the offeree as a seller and a seller and a seller buyer, in many online transac- tions these parties would be more accurately described as a licensor and a licensee.

12–3a Online Offers Sellers doing business via the Internet can protect them- selves against contract disputes and legal liability by creating offers that clearly spell out the terms that will govern their transactions if the offers are accepted. All important terms should be conspicuous and easy to view.

The seller’s Web site should include a hypertext link to a page containing the full contract so that potential buy- ers are made aware of the terms to which they are assent- ing. The contract generally must be displayed online in a readable format, such as a twelve-point typeface. All provisions should be reasonably clear.

Provisions to Include An important point to keep in mind is that the offeror (the seller) controls the offer and thus the resulting contract. The seller should therefore anticipate the terms he or she wants to include in a con- tract and provide for them in the offer. In some instances, a standardized contract form may suffice.

At a minimum, an online offer should include the fol- lowing provisions: 1. Acceptance of terms. A clause that clearly indicates

what constitutes the buyer’s agreement to the terms of the offer, such as a box containing the words “I accept” that the buyer can click.

2. Payment. A provision specifying how payment for the goods (including any applicable taxes) must be made.

3. Return policy. A statement of the seller’s refund and return policies.

4. Disclaimer. Disclaimers of liability for certain uses of the goods. For instance, an online seller of business forms may add a disclaimer that the seller does not accept responsibility for the buyer’s reliance on the forms rather than on an attorney’s advice.

5. Limitation on remedies. A provision specifying the remedies available to the buyer if the goods are found to be defective or if the contract is otherwise breached. Any limitation of remedies should be clearly spelled out.

6. Privacy policy. A statement indicating how the seller will use the information gathered about the buyer.

7. Dispute resolution. Provisions relating to dispute set- tlement, which we examine more closely in the fol- lowing section.

Dispute-Settlement Provisions Online offers fre- quently include provisions relating to dispute settlement. For instance, an offer might include an arbitration clause specifying that any dispute arising under the contract will be arbitrated in a designated forum. The parties might also select the forum and the law that will govern any disputes.

246 U N I T T H R E E The Commercial Environment

Forum-Selection Clause. Many online contracts contain a forum-selection clause indicating the forum, or locaforum-selection clause indicating the forum, or locaforum-selection clause - tion (such as a court or jurisdiction), in which contract disputes will be resolved. Signi�cant jurisdictional issues may arise when parties are at a great distance, as they often are when they form contracts via the Internet. A forum- selection clause will help to avert future jurisdictional problems and also help to ensure that the seller will not be required to appear in court in a distant state.be required to appear in court in a distant state.be required to appear in court in a distant state.

■ CASE IN POINT 12.17 Scott Rosendahl enrolled in Scott Rosendahl enrolled in an online college, Ashford University. He claimed that the school’s adviser had told him that Ashford offered one of the cheapest undergraduate degree programs in the country. In fact, it did not. Rosendahl later sued the school, claiming that it had violated unfair competition laws and false advertising laws and had engaged in fraud and negligent misrepresentation.

The university argued that its enrollment agreement clearly contained a requirement that all disputes be arbi- trated. Rosendahl, like other students, had electronically assented to this agreement when he enrolled. Ashford presented the online application forms to the court, and the court dismissed Rosendahl’s lawsuit. Rosendahl had agreed to arbitrate any disputes he had with Ashford.13 ■

Choice-of-Law Clause. Some online contracts may also include a choice-of-law clause, specifying that any contract dispute will be settled according to the law of a particu- lar jurisdiction, such as a state or country. Choice-of-law clauses are particularly common in international con- tracts, but they may also appear in e-contracts to specify which state’s laws will govern in the United States.

12–3b Online Acceptances The Restatement (Second) of Contracts, which is a compi- lation of common law contract principles, states that par- ties may agree to a contract “by written or spoken words or by other action or by failure to act.”14 The Uniform Commercial Code (UCC), which governs sales contracts, has a similar provision. Section 2–204 of the UCC states that any contract for the sale of goods “may be made in any manner sufficient to show agreement, including con- duct by both parties which recognizes the existence of such a contract.” The courts have used these provisions in determining what constitutes an online acceptance.

13. Rosendahl v. Bridgepoint Education, Inc., 2012 WL 667049 (S.D.Cal. 2012).

14. Restatement (Second) of Contracts, Section 19.

Click-On Agreements The courts have concluded that the act of clicking on a box labeled “I accept” or “I agree” can indicate acceptance of an online offer. The agreement resulting from such an acceptance is often called a click-on agreement (sometimes referred to as a click-on agreement (sometimes referred to as a click-on agreement click-on license or click-on license or click-on license click-wrap agreement).click-wrap agreement).click-wrap agreement

Generally, the law does not require that the parties have read all of the terms in a contract for it to be effec- tive. Therefore, clicking on a box that states “I agree” to certain terms can be enough. The terms may be con- tained on a Web site through which the buyer is obtain- ing goods or services. They may also appear on a screen when software is downloaded from the Internet.

■ CASE IN POINT 12.18 The “Terms of Use” that gov- ern Facebook users’ accounts include a forum-selection clause that provides for the resolution of all disputes in a court in Santa Clara County, California. To sign up for a Facebook account, a person must click on a box indicat- ing that he or she has agreed to this term.

Mustafa Fteja was an active user of facebook.com when his account was disabled. He sued Facebook in a federal court in New York, claiming that it had disabled his Facebook page without justification and for discrimi- natory reasons. Facebook filed a motion to transfer the case to California under the forum-selection clause. The court found that the clause in Facebook’s online contract was binding and transferred the case. When Fteja clicked on the button to accept the contract terms, he agreed to resolve all disputes with Facebook in Santa Clara County, California.15 ■

Shrink-Wrap Agreements With a shrink-wrap agreement (or agreement (or agreement shrink-wrap license), the terms are expressed shrink-wrap license), the terms are expressed shrink-wrap license inside the box in which the goods are packaged. (The term shrink-wrap refers to the plastic that covers the box.) Usually, the party who opens the box is told that she or he agrees to the terms by keeping whatever is in the box. Similarly, when a purchaser opens a software package, he or she agrees to abide by the terms of the limited license agreement.

In most instances, a shrink-wrap agreement is not between a retailer and a buyer, but is between the man- ufacturer of the hardware or software and the ultimate buyer-user of the product. The terms generally concern warranties, remedies, and other issues associated with the use of the product.

Shrink-Wrap Agreements and Enforceable Contract Terms. In some cases, the courts have enforced the terms of shrink-wrap agreements in the same way as the terms

C H A P T E R 1 2 Formation of Traditional and E-Contracts 247

of other contracts. �ese courts have reasoned that by including the terms with the product, the seller proposed a contract. �e buyer could accept this contract by using the product after having an opportunity to read the terms. �us, a buyer’s failure to object to terms contained within a shrink-wrapped software package may constitute an acceptance of the terms by conduct.

Shrink-Wrap Terms That May Not Be Enforced. Some- times, however, the courts have refused to enforce certain terms included in shrink-wrap agreements because the buyer did not expressly consent to them. An important factor is when the parties formed their contract.

If a buyer orders a product over the telephone, for instance, and is not informed of an arbitration clause or a forum-selection clause at that time, the buyer clearly has not expressly agreed to these terms. If the buyer discovers the clauses after the parties have entered into a contract, after the parties have entered into a contract, after a court may conclude that those terms were proposals for additional terms and were not part of the contract.

Browse-Wrap Terms Like the terms of click-on agreements, browse-wrap terms can occur in trans- actions conducted over the Internet. Unlike click-on agreements, however, browse-wrap terms do not require Internet users to assent to the terms before downloading or using certain software. In other words, a person can install the software without clicking “I agree” to the terms of a license. Browse-wrap terms are often unenforceable because they do not satisfy the agreement requirement of contract formation.

12–3c Federal Law on E-Signatures and E-Documents

An e-signature has been defined as “an electronic sound, symbol, or process attached to or logically associated with a record and executed or adopted by a person with the intent to sign the record.”16 In 2000, Congress enacted the Electronic Signatures in Global and National Com- merce Act (E-SIGN Act).17

The E-SIGN Act provides that no contract, record, or signature may be “denied legal effect” solely because it is in electronic form. In other words, under this law, an electronic signature is as valid as a signature on paper, and an e-document can be as enforceable as a paper one. For an e-signature to be enforceable, however, the contract- ing parties must have agreed to use electronic signatures.

16. This definition is from the Uniform Electronic Transactions Act, dis- cussed next.

17. 15 U.S.C. Sections 7001 et seq.

For an electronic document to be valid, it must be in a form that can be retained and accurately reproduced.

E-Signature Technologies Electronic documents can be signed in a number of ways. E-signature tech- nologies include encrypted digital signatures, names intended as signatures at the end of e-mail messages, and clicks on a Web page if the clicks include some means of identification.

Note that although courts do not question that docu- ments can be signed electronically under the E-SIGN Act, some courts will question the validity of the signa- tures themselves. For instance, a court might find that a typed name at the bottom of e-mail is not admissible as the person’s signature. For this reason, many businesses use special software, such as DocuSign or EchoSign, that is designed to create an e-signature that looks similar to a person’s handwritten signature.

Exclusions The E-SIGN Act does not apply to all types of documents. Documents that are exempt include court papers, divorce decrees, evictions, foreclosures, health- insurance terminations, prenuptial agreements, and wills. Also, the only agreements governed by the UCC that fall under this law are those covered by Articles 2 and 2A (sales and lease contracts) and UCC 1–107 and 1–206. Despite these limitations, the E-SIGN Act has signifi- cantly expanded online contracting.

12–3d The Uniform Electronic Transactions Act

The National Conference of Commissioners on Uniform State Laws and the American Law Institute promulgated the Uniform Electronic Transactions Act (UETA) in 1999. The UETA has been adopted, at least in part, by forty-eight states, resulting in more uniformity among state laws governing electronic transactions. Among other things, the UETA declares that a signature may not be denied legal effect or enforceability solely because it is in electronic form.

The primary purpose of the UETA is to remove barriers to e-commerce by giving the same legal effect to electronic records and signatures as is given to paper documents and signatures. As mentioned, the UETA broadly defines an e-signature as “an electronic sound, e-signature as “an electronic sound, e-signature symbol, or process attached to or logically associated with a record and executed or adopted by a person with the intent to sign the record.”18 A record is “information record is “information record

248 U N I T T H R E E The Commercial Environment

that is inscribed on a tangible medium or that is stored in an electronic or other medium and is retrievable in perceivable [visual] form.”19

The Scope and Applicability of the UETA The UETA does not create new rules for electronic contracts. Rather, it establishes that records, signatures, and con- tracts may not be denied enforceability solely due to their electronic form.

The UETA does not apply to all writings and signa- tures. It covers only electronic records and electronic sig- natures relating to a transaction. A transaction is defined as an interaction between two or more people relating to business, commercial, or governmental activities.20 The act specifically does not apply to wills or testamentary trusts or to transactions governed by the UCC (other than those covered by Articles 2 and 2A). In addition, the provisions of the UETA allow the states to exclude its application to other areas of law.

The UETA does not apply to a transaction unless each of the parties has previously agreed to conduct transac- tions by electronic means. The agreement may be explicit, or it may be implied by the conduct of the parties and the surrounding circumstances. It may sometimes be reason- able to infer that a person who gives out a business card with an e-mail address on it has consented to transact business electronically, for instance. Agreement may also be inferred from an e-mail or even a verbal communica- tion between the parties.

The Federal E-SIGN Act and the UETA The E-SIGN Act, discussed earlier, explicitly provides that if a state has enacted the uniform version of the UETA, that law is not preempted by the E-SIGN Act. In other words, if the state has enacted the UETA without modification, state law will govern. But many states have enacted non- uniform (modified) versions of the UETA, usually to exclude other areas of state law from the UETA’s terms. The E-SIGN Act specifies that those exclusions will be preempted to the extent that they are inconsistent with the E-SIGN Act’s provisions.

The E-SIGN Act also allows the states to enact alter- native requirements for the use of electronic records or electronic signatures. Generally, however, the require- ments must be consistent with the provisions of the E-SIGN Act and must specifically refer to the E-SIGN Act.

19. UETA 102(15). 20. UETA 2(12) and 3.

12–4 Consideration The fact that a promise has been made does not mean the promise can or will be enforced. Under the common law, a primary basis for the enforcement of promises is con- sideration. Consideration usually is defined as the value given in return for a promise (in a bilateral contract) or in return for a performance (in a unilateral contract). It is the inducement, price, or motive that causes a party to enter into an agreement. As long as consideration is pres- ent, the courts generally do not interfere with contracts based on the amount of consideration paid.

Often, consideration is broken down into two parts: (1) something of legally sufficient value must be given legally sufficient value must be given legally sufficient value in exchange for the promise, and (2) there must be a bargained-for exchange.

12–4a Legally Sufficient Value To be legally sufficient, consideration must be something of value in the eyes of the law and may consist of the following:

1. A promise to do something that one has no prior legal duty to do.

2. The performance of an action that one is otherwise not obligated to undertake.

3. The refraining from an action that one has a legal right to undertake (called a forbearance).

Consideration in bilateral contracts normally consists of a promise in return for a promise. In a contract for the sale of goods, for instance, the seller promises to ship specific goods to the buyer, and the buyer promises to pay for those goods. Each of these promises constitutes consideration for the contract.

In contrast, unilateral contracts involve a promise in In contrast, unilateral contracts involve a promise in In contrast, unilateral contracts involve a promise in return for a performance (an action). ■ EXAMPLE 12.19 Anita says to her neighbor, “When you finish painting the garage, I will pay you $800.” Anita’s neighbor paints the garage. The act of painting the garage is the consid- eration that creates Anita’s contractual obligation to pay her neighbor $800. ■

12–4b Bargained-for Exchange The second element of consideration is that it must provide the basis for the bargain struck between the contracting parties. That is, the item of value must be given or promised by the promisor (offeror) in return for the promisee’s promise, performance, or promise of performance. This element of bargained-for exchange

C H A P T E R 1 2 Formation of Traditional and E-Contracts 249

distinguishes contracts from gifts. distinguishes contracts from gifts. ■ CASE IN POINT 12.20 USS–POSCO Industries (UPI) hired Floyd Case as an entry-level laborer and side trim operator. Because UPI faced a shortage of skilled maintenance techni- cal electrical (MTE) workers, it decided to implement an educational program for its existing employees. UPI would cover the costs ($46,000) of a program that required 135 weeks of instruction, 90 weeks of on-the- job training, and 45 weeks of classroom work.

Case applied for and was accepted into the program. UPI paid his wages, benefits, and training expenses, but it did not guarantee him a position as an MTE worker. Case signed a reimbursement agreement to participate stating that if he voluntarily left UPI within 30 months after completing the program, he would (absent a com- pelling hardship) refund $30,000 to UPI. Two months after completing the program and starting work as an MTE worker, Case left UPI for a position with another employer as an electrician. He refused to refund $30,000 to UPI and UPI sued for breach.

Case argued that the reimbursement agreement lacked consideration because UPI had no obligation to keep Case employed, and thus there was no bargained-for exchange. The court disagreed. “The exchange, frankly, is obvious: Case got continued wages and fronted educa- tion costs, and UPI got Case’s agreement to repay those costs if he both completed the training and left the com- pany before it could benefit from the investment.” The court enforced the agreement and ordered Case to refund $30,000 to UPI.21 ■

12–4c Agreements That Lack Consideration

Sometimes, one of the parties (or both parties) to an agree- ment may think that consideration has been exchanged when in fact it has not. Here, we look at some situations in which the parties’ promises or actions do not qualify as contractual consideration.

Preexisting Duty Under most circumstances, a promise to do what one already has a legal duty to do does not constitute legally sufficient consideration. The preexisting legal duty may be imposed by law or may arise out of a previous contract.

If a party is already bound by contract to perform a certain duty, that duty cannot serve as consider- ation for a second contract. ■ EXAMPLE 12.21 Ajax Contractors begins construction on a seven-story office

21. USS–POSCO Industries v. Case, 244 Cal.App.4th 197, 197 Cal.Rptr.3d 791 (Div. 1 2016).

building and after three months demands an extra $75,000 on its contract. If the extra $75,000 is not paid, the contractor will stop working. The owner of the land, finding no one else to complete the construction, agrees to pay the extra $75,000. The agreement is unenforce- able because it is not supported by legally sufficient consideration. Ajax Contractors had a preexisting con- tractual duty to complete the building. ■

Unforeseen Difficulties. �e rule regarding preexist- ing duty is meant to prevent extortion and the so-called holdup game. Nonetheless, if, during performance of a contract, extraordinary di�culties arise that were totally unforeseen at the time the contract was formed, a court may allow an exception to the rule. �e key is whether the court �nds that the modi�cation is fair and equitable in view of circumstances not anticipated by the parties when the contract was made.

Suppose that in Example 12.21, Ajax Contractors had asked for the extra $75,000 because it encountered a rock formation that no one knew existed. If the landowner agrees to pay the extra $75,000 to excavate the rock and the court finds that it is fair to do so, Ajax Contractors can enforce the agreement. If rock formations are com- mon in the area, however, the court may determine that the contractor should have known of the risk. In that situation, the court may choose to apply the preexisting duty rule and prevent Ajax Contractors from obtaining the extra $75,000.

Rescission and New Contract. �e law recognizes that two parties can mutually agree to rescind, or cancel, their contract, at least to the extent that it is executory (still to be executory (still to be executory carried out). Rescission22 is the unmaking of a contract so as to return the parties to the positions they occupied before the contract was made.

Sometimes, parties rescind a contract and make a new contract at the same time. When this occurs, it is often difficult to determine whether there was consideration for the new contract, or whether the parties had a preex- isting duty under the previous contract. If a court finds there was a preexisting duty, then the new contract will be invalid because there was no consideration.

Past Consideration Promises made in return for actions or events that have already taken place are unen- forceable. These promises lack consideration in that the element of bargained-for exchange is missing. In short, you can bargain for something to take place now or in

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the future but not for something that has already taken place. Therefore, past consideration is no consideration.

■ CASE IN POINT 12.22 Jamil Blackmon became Jamil Blackmon became friends with Allen Iverson when Iverson was a high school student who showed tremendous promise as an athlete. One evening, Blackmon suggested that Iverson use “The Answer” as a nickname in the summer league basketball tournaments. Blackmon said that Iverson would be “The Answer” to all of the National Basketball Association’s woes. Later that night, Iverson said that he would give Blackmon 25 percent of any proceeds from the merchan- dising of products that used “The Answer” as a logo or a slogan. Because Iverson’s promise was made in return for past consideration, it was unenforceable. In effect, Iver- son stated his intention to give Blackmon a gift.23 ■

In a variety of situations, an employer will often ask a new employee to sign a noncompete agreement, also called a covenant not to compete. Under such an agreement, the employee agrees not to compete with the employer for a certain period of time after the employment relation- ship ends. When a current employee is required to sign a noncompete agreement, his or her employment is not sufficient consideration for the agreement, because the individual is already employed. To be valid, the agree- ment requires new consideration.

Illusory Promises If the terms of the contract express such uncertainty of performance that the promisor has not definitely promised to do anything, the promise is said to be illusory—without consideration and unenillusory—without consideration and unenillusory - forceable. A promise is illusory when it fails to bind the promisor.

23. Blackmon v. Iverson, 324 F.Supp.2d 602 (E.D.Pa. 2003).

■ EXAMPLE 12.23 The president of Tuscan Corpo- ration says to her employees, “If profits continue to be high, everyone will get a 10 percent bonus at the end of the year—if management agrees.” This is an illu- sory promise, or no promise at all, because performance depends solely on the discretion of management. There is no bargained-for consideration. The statement indicates only that management may or may not do something in the future. Therefore, even though the employees work hard and profits remain high, the company is not obli- gated to pay the bonus now or later. ■

Exhibit 12–1 illustrates some common situations in which promises or actions do not constitute contractual consideration.

12–4d Settlement of Claims Businesspersons and others often enter into contracts to settle legal claims. It is important to understand the nature of consideration given in these kinds of settle- ment agreements, or contracts. A claim may be settled through an accord and satisfaction, a release, or a covenant not to sue.

Accord and Satisfaction In an accord and satis- faction, a debtor offers to pay, and a creditor accepts, a lesser amount than the creditor originally claimed was owed. The accord is the agreement. In the accord, one accord is the agreement. In the accord, one accord party undertakes to give or perform, and the other to accept, in satisfaction of a claim, something other than that on which the parties originally agreed. Satisfaction is the performance (usually payment) that takes place after the accord is executed.

PAST CONSIDERAPAST CONSIDERAP TIONAST CONSIDERATIONAST CONSIDERA When a person makes a promise in return for actions or events that have already taken place, there is no consideration.

Example: A real estate agent sold a friend’s house without charging a commission, and in return, the friend promises to give the agent $1,000. The friend’s promise is simply an intention to give a gift.

ILLUSORY PROMISESILLUSORY PROMISESILLUSOR When a person expresses contract terms with such uncertainty that the terms are not definite, the promise is illusory.

Example: A storeowner promises a $500 bonus to each employee who works Christmas Day, as long as the owner feels that they did their jobs well. The owner’s promise is just a statement of something she may or may not do in the future.

PREEXISTING DUTY When a person already has a legal duty to perform an action, there is no legally sufficient consideration.

Example: A firefighter cannot receive a cash reward from a business owner for putting out a fire in a downtown commercial district. As a city employee, the firefighter had a duty to extinguish the fire.

E X H I B I T 1 2 – 1 Examples of Agreements That Lack Consideration

C H A P T E R 1 2 Formation of Traditional and E-Contracts 251

A basic rule is that there can be no satisfaction unless there is first an accord. In addition, for accord and satis- faction to occur, the amount of the debt must be in dispute.

Liquidated Debts. If a debt is liquidated, accord and satisfaction cannot take place. A liquidated debt is one liquidated debt is one liquidated debt whose amount has been ascertained, �xed, agreed on, settled, or exactly determined.

In most states, a creditor’s acceptance of a lesser sum than the entire amount of a liquidated debt is not satisnot satisnot - faction, and the balance of the debt is still legally owed. The reason for this rule is that the debtor has given no consideration to satisfy the obligation of paying the bal- ance to the creditor. The debtor had a preexisting legal obligation to pay the entire debt.

Unliquidated Debts. An unliquidated debt is the oppounliquidated debt is the oppounliquidated debt - site of a liquidated debt. �e amount of the debt is not settled, �xed, agreed on, ascertained, or determined, and reasonable persons may di�er over the amount owed. In these circumstances, acceptance of a lesser sum operates as satisfaction, or discharge, of the debt because there is valid consideration. �e parties give up a legal right to contest the amount in dispute.

Release A release is a contract in which one party for- feits the right to pursue a legal claim against the other party. It bars any further recovery beyond the terms stated in the release.

A release will generally be binding if it meets the fol- lowing requirements:

1. The agreement is made in good faith (honestly). 2. The release contract is in a signed writing (required

in many states). 3. The contract is accompanied by consideration.

Clearly, an individual is better off knowing the extent of his or her injuries or damages before signing a extent of his or her injuries or damages before signing a extent of his or her injuries or damages before signing a release. ■ EXAMPLE 12.24 Lupe’s car is damaged in an Lupe’s car is damaged in an automobile accident caused by Dexter’s negligence. Dex- ter offers to give her $3,000 if she will release him from further liability resulting from the accident. Lupe agrees and signs the release. If Lupe later discovers that it will cost $4,200 to repair her car, she normally cannot recover the additional amount from Dexter. ■

Covenant Not to Sue Unlike a release, a covenant not to sue does not always bar further recovery. The par- ties simply substitute a contractual obligation for some other type of legal action based on a valid claim. Suppose that, in Example 12.24, Lupe agrees with Dexter not to Example 12.24, Lupe agrees with Dexter not to Example 12.24 sue for damages in a tort action if he will pay for the dam- age to her car. If Dexter fails to pay for the repairs, Lupe can bring an action against him for breach of contract.

As the following case illustrates, a covenant not to sue can form the basis for a dismissal of the claims of either party to the covenant.

Background and Facts Nike, Inc., designs, makes, and sells athletic footwear, including a line of shoes known as “Air Force 1.” Already, LLC, also designs and markets athletic footwear, including the “Sugar” and “Soulja Boy” lines. Nike filed a suit in a federal district court against Already, alleging that Soulja Boys and Sugars infringed the Air Force 1 trademark. Already filed a counterclaim, contending that the Air Force 1 trademark was invalid. While the suit was pending, Nike issued a covenant not to sue. Nike promised not to raise any trademark claims against Already or any affiliated entity based on Already’s existing footwear designs or any future Already designs that constituted a “colorable imita- tion” of Already’s current products. Nike then filed a motion to dismiss its own claims and to dismiss Already’s counterclaim. Already opposed the dismissal of its counterclaim, but the court granted Nike’s motion. The U.S. Court of Appeals for the Second Circuit affirmed. Already appealed to the United States Supreme Court.

Spotlight on Nike

Case 12.3 Already, lready, LLC v. Nike, Inc. Supreme Court of the United States, __ U.S. __, 133 S.Ct. 721, 184 L.Ed.2d 553 (2013).Supreme Court of the United States, __ U.S. __, 133 S.Ct. 721, 184 L.Ed.2d 553 (2013).

Case 12.3 Continues

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In the Language of the Court Chief Justice ROBERTS delivered the opinion of the Court.ROBERTS delivered the opinion of the Court.ROBERTS

* * * * * * * A defendant cannot automatically moot a case simply by ending its unlawful conduct once sued.

[A matter is moot if it involves no actual controversy for the court to decide, and federal courts will dismoot if it involves no actual controversy for the court to decide, and federal courts will dismoot - miss moot cases.] Otherwise, a defendant could engage in unlawful conduct, stop when sued to have the case declared moot, then pick up where he left off, repeating this cycle until he achieves all his unlawful ends. Given this concern, * * * a defendant claiming that its voluntary compliance moots a case bears the formidable burden of showing that it is absolutely clear the allegedly wrongful behavior could not reasonably be expected to recur. [This is the voluntary cessation test. Emphasis added.]

* * * * We begin our analysis with the terms of the covenant:

[Nike] unconditionally and irrevocably covenants to refrain from making any claim(s) or demand(s) * * * any claim(s) or demand(s) * * * any against Already or any of its * * * related business entities * * * [including] distributors * * * and employees of any of its * * * related business entities * * * [including] distributors * * * and employees of any such entities and all customers * * * on account of any all customers * * * on account of any all possible cause of action based on or involving tradepossible cause of action based on or involving tradepossible - mark infringement * * * relating to the NIKE Mark based on the appearance of any of Already’s current and/any of Already’s current and/any or previous footwear product designs, and any colorable imitations thereof, regardless of whether that footany colorable imitations thereof, regardless of whether that footany - wear is produced * * * or otherwise used in commerce.

The breadth of this covenant suffices to meet the burden imposed by the voluntary cessation test. In addition, Nike originally argued that the Sugars and Soulja Boys infringed its trademark; in other

words, Nike believed those shoes were “colorable imitations” of the Air Force 1s. Nike’s covenant now allows Already to produce all of its existing footwear designs—including the Sugar and Soulja Boy—and any “colorable imitation” of those designs. * * * It is hard to imagine a scenario that would potentially infringe Nike’s trademark and yet not fall under the covenant. Nike, having taken the position in court that there is no prospect of such a shoe, would be hard pressed to assert the contrary down the road. If such a shoe exists, the parties have not pointed to it, there is no evidence that Already has dreamt of it, and we cannot conceive of it. It sits, as far as we can tell, on a shelf between Dorothy’s ruby slippers and Perseus’s winged sandals.

* * * * * * * Given the covenant’s broad language, and given that Already has asserted no concrete plans to

engage in conduct not covered by the covenant, we can conclude the case is moot because the challenged conduct cannot reasonably be expected to recur.

Decision and Remedy The United States Supreme Court affirmed the judgment of the lower court. Under the covenant not to sue, Nike could not file a claim for trademark infringement against Already, and Already could not assert that Nike’s trademark was invalid.

Critical Thinking • Economic Why would any party agree to a covenant not to sue? • Legal Environment Which types of contracts are similar to covenants not to sue? Explain.

Case 12.3 Continued

12–4e Promissory Estoppel Sometimes, individuals rely on promises to their detriment, and their reliance may form a basis for a court to infer con- tract rights and duties. Under the doctrine of promissory estoppel (also called estoppel (also called estoppel detrimental reliance), a person who detrimental reliance), a person who detrimental reliance has reasonably and substantially relied on the promise of another may be able to obtain some measure of recovery.

Promissory estoppel is applied in a wide variety of contexts in which a promise is otherwise unenforceable, such as when a promise is made without consideration. Under this doctrine, a court may enforce an otherwise unenforceable promise to avoid the injustice that would otherwise result. For the promissory estoppel doctrine to be applied, the following elements are required:

C H A P T E R 1 2 Formation of Traditional and E-Contracts 253

1. There must be a clear and definite promise. 2. The promisor should have expected that the prom-

isee would rely on the promise. 3. The promisee reasonably relied on the promise by

acting or refraining from some act. 4. The promisee’s reliance was definite and resulted in

substantial detriment. 5. Enforcement of the promise is necessary to avoid

injustice. If these requirements are met, a promise may be enforced

even though it is not supported by consideration.24 In essence, the promisor will be estopped (prevented) from estopped (prevented) from estopped asserting the lack of consideration as a defense.

12–5 Contractual Capacity In addition to agreement and consideration, for a con- tract to be deemed valid, the parties to the contract must have contractual capacity—the legal ability to enter contractual capacity—the legal ability to enter contractual capacity into a contractual relationship. Courts generally presume the existence of contractual capacity, but in some situa- tions, as when a person is young or mentally incompe- tent, capacity may be lacking or questionable.

12–5a Minors Today, in almost all states, the age of majority (when a age of majority (when a age of majority person is no longer a minor) for contractual purposes is eighteen years.25 In addition, some states provide for the termination of minority on marriage. Minority status may also be terminated by a minor’s emancipation, which occurs when a child’s parent or legal guardian relin- quishes the legal right to exercise control over the child. Normally, minors who leave home to support themselves are considered emancipated.

The general rule is that a minor can enter into any contract that an adult can, except contracts prohibited by law for minors (for instance, the purchase of tobacco or alcoholic beverages). A contract entered into by a minor, however, is voidable at the option of that minor, subject to certain exceptions.

The legal avoidance, or setting aside, of a contractual obligation is referred to as disaffirmance. To disaffirm, a minor must express his or her intent, through words or conduct, not to be bound to the contract.

24. Restatement (Second) of Contracts, Section 90. 25. The age of majority may still be twenty-one for other purposes, such as

the purchase and consumption of alcohol.

■ CASE IN POINT 12.25 S.L. was a female sixteen- year-old minor who worked at a KFC Restaurant oper- ated by PAK Foods Houston, LLC. PAK Foods’ policy was to resolve any dispute with an employee through arbitration. At the employer’s request, S.L. signed an acknowledgment of this policy. S.L. was injured on the job and subsequently terminated her employment. S.L.’s mother, Marissa Garcia, filed a suit on S.L.’s behalf in a Texas state court against PAK Foods to recover the medi- cal expenses for the injury. PAK Foods filed a motion to compel arbitration. The court denied the motion, and PAK Foods appealed. A state intermediate appellate court affirmed the decision. A minor may disaffirm a contract at his or her option. The court concluded that S.L. opted to disaffirm the agreement to arbitrate by terminating her employment and filing the lawsuit.26 ■

Note that an adult who enters into a contract with a minor cannot avoid his or her contractual duties on the ground that the minor can do so. Unless the minor exer- cises the option to disaffirm the contract, the adult party normally is bound by it.

12–5b Intoxication Intoxication is a condition in which a person’s normal capacity to act or think is inhibited by alcohol or some other drug. A contract entered into by an intoxicated per- son can be either voidable or valid (and thus enforceable).

If the person was sufficiently intoxicated to lack men- tal capacity, then the agreement may be voidable even if the intoxication was purely voluntary. If a contract is voidable because one party was intoxicated, that person has the option of disaffirming it while intoxicated and for a reasonable time after becoming sober. If, despite intoxi- cation, the person understood the legal consequences of the agreement, the contract will be enforceable.

Courts look at objective indications of the intoxicated person’s condition to determine if he or she possessed or lacked the required capacity. It is difficult to prove that a person’s judgment was so severely impaired that he or she could not comprehend the legal consequences of enter- ing into a contract. Therefore, courts rarely permit con- tracts to be avoided due to intoxication.

12–5c Mental Incompetence Contracts made by mentally incompetent persons can be void, voidable, or valid. If a court has previously determined that a person is mentally incompetent, any

26. PAK Foods Houston, LLC v. Garcia, 433 S.W.3d 171 (Tex.App.—Houston 2014).

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contract made by that person is void—no contract exists. void—no contract exists. void Only a guardian appointed by the court to represent a mentally incompetent person can enter into binding legal obligations on that person’s behalf.

If a court has not previously judged a person to be mentally incompetent but the person was incompetent at the time the contract was formed, the contract may be voidable.27 A contract is voidable if the person did not voidable if the person did not voidable know he or she was entering into the contract or lacked the mental capacity to comprehend its nature, purpose, and consequences.

A contract entered into by a mentally incompetent person (not previously declared incompetent) may also be valid if the person had capacity valid if the person had capacity valid at the time the contract was formed. Some people who are incompetent due to age or illness have lucid intervals—temporary periods of intervals—temporary periods of intervals sufficient intelligence, judgment, and will. During such intervals, they will be considered to have legal capacity to enter into contracts.

12–6 Legality For a contract to be valid and enforceable, it must be formed for a legal purpose. A contract to do something that is prohibited by federal or state statutory law is ille- gal and, as such, void from the outset and thus unen- forceable. Additionally, a contract to commit a tortious act (such as an agreement to engage in fraud) is contrary to public policy and therefore illegal and unenforceable.

12–6a Contracts Contrary to Statute Statutes often set forth rules specifying which terms and clauses may be included in contracts and which are pro- hibited. We now examine several ways in which contracts may be contrary to statute and thus illegal.

Contracts to Commit a Crime Any contract to commit a crime is in violation of a statute. Thus, a con- tract to sell illegal drugs in violation of criminal laws is unenforceable, as is a contract to cover up a corporation’s violation of an environmental or other law.

Sometimes, the object or performance of a contract is rendered illegal by a statute after the parties entered into after the parties entered into after the contract. In that situation, the contract is considered to be discharged by law.

27. This is the rule in the majority of states. See, for example, Hernandez v. Banks, 65 A.3d 59 (D.C. 2013).

Usury Almost every state has a statute that sets the max- imum rate of interest that can be charged for different types of transactions, including ordinary loans. A lender who makes a loan at an interest rate above the lawful max- imum commits usury.

Although usurious contracts are illegal, most states simply limit the interest that the lender may collect on the contract to the lawful maximum interest rate in that state. In a few states, the lender can recover the principal amount of the loan but no interest. In addition, states can make exceptions to facilitate business transactions. For instance, nearly all states allow higher-interest-rate loans for borrowers who could not otherwise obtain funds.

Gambling Gambling is the creation of risk for the pur- pose of assuming it. Any scheme that involves the distri- bution of property by chance among persons who have paid valuable consideration for the opportunity (chance) to receive the property is gambling.

Traditionally, the states deemed gambling contracts illegal and thus void. Today, many states allow (and reg- ulate) certain forms of gambling, such as horse racing, video poker machines, and charity-sponsored bingo. In addition, nearly all states allow state-operated lotteries and gambling on Native American reservations. Even in states that permit certain types of gambling, though, courts often find that gambling contracts are illegal.

Licensing Statutes All states require members of certain professions—including physicians, lawyers, real estate brokers, accountants, architects, electricians, and stockbrokers—to have licenses. Some licenses are obtained only after extensive schooling and examinations, which indicate to the public that a special skill has been acquired. Others require only that the applicant be of good moral character and pay a fee.

Whether a contract with an unlicensed person is legal and enforceable depends on the purpose of the licens- ing statute. If the statute’s purpose is to protect the pub- lic from unauthorized practitioners (such as unlicensed attorneys and electricians), then a contract involving an unlicensed practitioner is generally illegal and unenforce- able. If the statute’s purpose is merely to raise government revenues, however, a court may enforce the contract and fine the unlicensed person.

14–6b Contracts Contrary to Public Policy Although contracts involve private parties, some are not enforceable because of the negative impact they would have on society. These contracts are said to be contrary

C H A P T E R 1 2 Formation of Traditional and E-Contracts 255

to public policy. Examples include a contract to commit an immoral act, such as selling a child, and a contract that prohibits marriage. Business contracts that may be against public policy include contracts in restraint of trade and unconscionable contracts or clauses.

Contracts in Restraint of Trade The United States has a strong public policy favoring competition in the economy. Thus, contracts in restraint of trade (anticom- petitive agreements) generally are unenforceable because they are contrary to public policy. Typically, such con- tracts also violate one or more federal or state antitrust statutes.

An exception is recognized when the restraint is rea- sonable and is contained in an ancillary (secondary or subordinate) clause in a contract. Such restraints often are included in contracts for the sale of an ongoing busi- ness and in employment contracts.

Covenants Not to Compete and the Sale of an Ongo- ing Business. Many contracts involve a type of restraint called a covenant not to compete, or a restrictive cov- enant (promise). A covenant not to compete may be cre- ated when a merchant who sells a store agrees not to open a new store in a certain geographic area surrounding the old business. Such an agreement enables the seller to sell, and the purchaser to buy, the goodwill and reputation of an ongoing business without having to worry that the seller will open a competing business a block away. Provided the restrictive covenant is reasonable and is an ancillary part of the sale of an ongoing business, it is enforceable.

Covenants Not to Compete in Employment Contracts. Sometimes, agreements not to compete (also referred to as noncompete agreements) are included in employment noncompete agreements) are included in employment noncompete agreements contracts. People in middle- or upper-level management positions commonly agree not to work for competitors or not to start competing businesses for a speci�ed period of time after termination of employment.

Noncompete agreements are legal in most states so long as the specified period of time (of restraint) is not excessive in duration and the geographic restriction is reasonable. What constitutes a reasonable time period may be shorter in the online environment than in conventional employ- ment contracts. Because the geographical restrictions apply worldwide, the time restrictions may be shorter.

A restraint that is found to be overly broad will not be enforced. ■ CASE IN POINT 12.26 An insurance firm An insurance firm in New York City, Brown & Brown, Inc., hired Theresa Johnson to perform actuarial analysis. On her first day of work, Johnson was asked to sign a nonsolicitation cov- enant. The covenant prohibited her from soliciting or

servicing any of Brown’s clients for two years after the termination of her employment.

Less than five years later, when Johnson’s employment with Brown was terminated, she went to work for Lawley Benefits Group, LLC. Brown sued to enforce the cov- enant. A state appellate court ruled that the covenant was overly broad and unenforceable. It attempted to restrict Johnson from working for any of Brown’s clients, with- out regard to whether she had had a relationship with those clients.28 ■

Enforcement Issues. �e laws governing the enforceabil- ity of covenants not to compete vary signi�cantly from state to state. California prohibits the enforcement of cov- enants not to compete altogether. In some states, includ- ing Texas, such a covenant will not be enforced unless the employee has received some bene�t in return for signing the noncompete agreement. �is is true even if the cov- enant is reasonable as to time and area. If the employee receives no bene�t, the covenant will be deemed void.

Occasionally, depending on the jurisdiction, courts will reform covenants not to compete. If a covenant is found to be unreasonable in time or geographic area, the court may convert the terms into reasonable ones and then enforce the reformed covenant. Such court actions present a problem, though, in that the judge implicitly becomes a party to the contract. Consequently, courts usually resort to contract reformation only when neces- sary to prevent undue burdens or hardships.

Unconscionable Contracts or Clauses A court ordinarily does not look at the fairness or equity of a contract (or inquire into the adequacy of consideration). Persons are assumed to be reasonably intelligent, and the courts will not come to their aid just because they have made unwise or foolish bargains.

In certain circumstances, however, bargains are so oppressive that the courts relieve innocent parties of part or all of their duties. Such bargains are deemed unconscio- nable29 because they are so unscrupulous or grossly unfair as to be “void of conscience.” The Uniform Commercial Code (UCC) incorporates the concept of unconscionabil- ity in its provisions regarding the sale and lease of goods.30

A contract can be unconscionable on either proce- dural or substantive grounds. Procedural unconscionaProcedural unconscionaProcedural - bility often involves inconspicuous print, unintelligible language (“legalese”), or the lack of an opportunity to read the contract or ask questions about its meaning. This

28. Brown & Brown, Inc. v. Johnson, 115 A.D.3d 52, 980 N.Y.S.2d 631 (2014).

29. Pronounced un-kon-shun-uh-bul. 30. See UCC 2–302 and 2A–719.

256 U N I T T H R E E The Commercial Environment

type of unconscionability typically arises when a party’s lack of knowledge or understanding of the contract terms deprived him or her of any meaningful choice. Substan- tive unconscionability occurs when contracts, or portions tive unconscionability occurs when contracts, or portions tive of contracts, are oppressive or overly harsh. Courts gen- erally focus on provisions that deprive one party of the bene�ts of the agreement or leave that party without a remedy for nonperformance by the other.

Exculpatory Clauses Often closely related to the concept of unconscionability are exculpatory clauses, which release a party from liability in the event of mon- etary or physical injury no matter who is at fault. Indeed, courts sometimes refuse to enforce such clauses on the ground that they are unconscionable.

Often Violate Public Policy. Most courts view exculpa- tory clauses with disfavor. Exculpatory clauses found in rental agreements for commercial property are frequently held to be contrary to public policy, and such clauses are almost always unenforceable in residential property leases. Courts also usually hold that exculpatory clauses are against public policy in the employment context.

When Courts Will Enforce Exculpatory Clauses. Courts do enforce exculpatory clauses if they are reasonable, do not violate public policy, and do not protect parties from liability for intentional misconduct. �e language used must not be ambiguous, and the parties must have been in relatively equal bargaining positions.

Businesses such as health clubs, racetracks, amuse- ment parks, skiing facilities, horse-rental operations, golf- cart concessions, and skydiving organizations frequently use exculpatory clauses to limit their liability for patrons’ injuries. ■ CASE IN POINT 12.27 Colleen Holmes par Colleen Holmes par- ticipated in the Susan G. Komen Race for the Cure in St. Louis, Missouri. Her signed entry form included an exculpatory clause under which Holmes agreed to release the event sponsors from liability “for any injury or dam- ages I might suffer in connection with my participation in this Event.”

During the race, Holmes sustained injuries when she tripped and fell over an audiovisual box left on the ground by one of the sponsors. She filed a negligence suit against the sponsor whose employees had placed the box on the ground without barricades or warnings of its presence. The court held that the language used in the exculpatory clause clearly released all sponsors and their agents and employees from liability for future negligence. Holmes could not sue for the injuries she sustained dur- ing the race.31 ■

31. Holmes v. Multimedia KSDK, Inc., 395 S.W.3d 557, (Mo.App. 2013).

Courts also may enforce reasonable exculpatory clauses in loan documents, real estate contracts, and trust agreements. See this chapter’s Managerial Strategy feature for more about exculpatory clauses that will not be con- sidered unconscionable.

12–7 Form A contract that is otherwise valid may still be unen- forceable if it is not in the proper form. Certain types of contracts are required to be in writing or evidenced by a memorandum or electronic record. The writing require- ment does not mean that an agreement must be a formal written contract. An exchange of e-mails that evidences the parties’ agreement usually is sufficient, provided that they are “signed,” or agreed to, by the party against whom enforcement is sought.

Every state has a statute that stipulates what types of contracts must be in writing, often referred to as the Stat- ute of Frauds. The actual name of the Statute of Frauds is misleading because the statute does not apply to fraud. Rather, it denies enforceability to certain contracts that do not comply with its writing requirements.

The following types of contracts are generally required to be in writing or evidenced by a written memorandum or electronic record: 1. Contracts involving interests in land. 2. Contracts that cannot by their terms be performed by their terms be performed by their terms

within one year from the day after the date of one year from the day after the date of one year from the day after formation.

3. Collateral, or secondary, contracts, such as promises to answer for the debt or duty of another and prom- ises by the administrator or executor of an estate to pay a debt of the estate personally—that is, out of her or his own pocket.

4. Promises made in consideration of marriage. 5. Under the Uniform Commercial Code, contracts for

the sale of goods priced at $500 or more. A contract that is oral when it is required to be evi-

denced by a writing or an electronic record is voidable by a party who does not wish to follow through with the agreement.

12–8 Third Party Rights Once it has been determined that a valid and legally enforceable contract exists, attention can turn to the rights and duties of the parties to the contract. A contract

C H A P T E R 1 2 Formation of Traditional and E-Contracts 257

Creating Liability Waivers That Are Not Unconscionable

Blanket liability waivers that absolve a business from virtually every event, even those caused by the business’s own negligence, are usually unenforceable because they are unconscio- nable. Exculpatory waivers are common, nonetheless. We observe such waivers in gym memberships, on ski lift tickets, on admis- sions tickets to sporting events, and in simple contracts for the use of campgrounds.

Typically, courts view liability waivers as voluntarily bargained for whether or not they have been read. Thus, a waiver included in the fine print on the back of an admission ticket or on an entry sign to a sta- dium may be upheld. In general, if such waivers are unambiguous and conspicuous, the assumption is that patrons have had a chance to read them and have accepted their terms.

Activities with Inherent Risks

Cases challenging liability waivers have been brought against skydiving operations, skiing operations, bobsledding operations, white-water rafting compa- nies, and health clubs. For example, in Bergin v. Wild Mountain, Inc.,a an appellate court in Minnesota upheld a ski resort’s liability waiver.

In that case, the plaintiff hit a snowmaking mound, which was “an inherent risk of skiing.” Before the accident, the plaintiff had stated that he knew “that an inherent risk of serious injury in downhill skiing was hitting snowmaking mounds.” Furthermore, he had not rejected the season pass that contained the

resort’s exculpatory clause. Thus, the ski resort prevailed.

Overly Broad Waivers

While most liability waivers have survived legal challenges, some have not. In Bagley v. Mt. Bachelor, Inc.,b the Supreme Court of Oregon ruled against a ski resort’s “very broad” liability

waiver. The case involved an eighteen-year-old, Myles Bagley, who was paralyzed from the waist down after a snowboarding accident at Mt. Bachelor ski resort. The season pass that Bagley signed included a liability waiver. The waiver stated that the signer agreed not to sue the resort for injury even if “caused by negligence.”

Bagley argued that the resort had created a dan- gerous condition because of the way it had set up a particular ski jump. He sued for $21.5 million and even- tually won the right to go forward with his lawsuit. The Oregon Supreme Court found that, for various reasons, enforcement of the release would have been uncon- scionable. “Because the release is unenforceable, genu- ine issues of fact exist that preclude summary judgment in defendant’s favor.”

Business Questions 1. If you are running a business, why would you opt to

include overly broad waivers in your contracts with customers?

2. Under what circumstances would you, as a business owner, choose to aggressively defend your business against a customer’s liability lawsuit?

MANAGERIAL STRATEGY

a. 2014 WL 996788 (Minn.App. 2014). b. 356 Or. 543, 340 P.3d 27 (2014).

is a private agreement between the parties who have entered into it, and traditionally these parties alone have rights and liabilities under the contract. This principle is referred to as privity of contract. A third party—one third party—one third party who is not a direct party to a particular contract—nor- mally does not have rights under that contract.

There are exceptions to the rule of privity of contract. One exception allows a party to a contract to transfer the rights or duties arising from the contract to another person through an assignment (of rights) or a assignment (of rights) or a assignment delegation (of duties). Another exception involves a third party ben- eficiary contract—a contract in which the parties to the eficiary contract—a contract in which the parties to the eficiary contract contract intend that the contract benefit a third party.

In a bilateral contract, one party has a right to require right to require right the other to perform some task, and the other has a duty

to perform it. The transfer of contractual rights to a third rights to a third rights party is known as an assignment. The transfer of con- tractual duties to a third party is known as a duties to a third party is known as a duties delegation. An assignment or a delegation occurs after the original after the original after contract was made.

12–8a Assignments In an assignment, the party assigning the rights to a third party is known as the assignor,32 and the party receiving the rights is the assignee.33 When rights under a contract are assigned unconditionally, the rights of the assignor

32. Pronounced uh-sye-nore. 33. Pronounced uh-sye-nee.

258 U N I T T H R E E The Commercial Environment

are extinguished. The third party (the assignee) has a right to demand performance from the other original party to the contract. The assignee takes only those rights that the assignor originally had, however.

Assignments are important because they are used in many types of business financing. Banks, for instance, frequently assign their rights to receive payments under their loan contracts to other firms, which pay for those rights.

As a general rule, all rights can be assigned. Exceptions are made, however, under certain circumstances, includ- ing the following: 1. The assignment is prohibited by statute. 2. The contract is personal. 3. The assignment significantly changes the risk or

duties of the obligor (the person contractually obliobligor (the person contractually obliobligor - gated to perform).

4. The contract prohibits assignment.

12–8b Delegations Just as a party can transfer rights through an assignment, a party can also transfer duties. Duties are not assigned, however, they are delegated. The party delegating the duties is the delegator, and the party to whom the duties are delegated is the delegatee. Normally, a delegation of duties does not relieve the delegator of the obligation to perform in the event that the delegatee fails to do so.

No special form is required to create a valid delegation of duties. As long as the delegator expresses an intention to make the delegation, it is effective. The delegator need not even use the word delegate.

As a general rule, any duty can be delegated. There are, however, some circumstances in which delegation is prohibited: 1. When special trust has been placed in the obligor. 2. When performance depends on the personal skill or

talents of the obligor. 3. When performance by a third party will vary materi-

ally from that expected by the obligee (the person to obligee (the person to obligee whom an obligation is owed) under the contract.

4. When the contract expressly prohibits delegation by including an antidelegation clause.

If a delegation of duties is enforceable, the obligee must accept performance from the delegatee. As noted, a valid delegation of duties does not relieve the delegator of obligations under the contract. Although there are many exceptions, the general rule today is that the obligee can sue both the delegatee and the delegator if the duties are not performed.

12–8c Third Party Beneficiaries Another exception to the doctrine of privity of contract arises when the contract is intended to benefit a third party. When the original parties to the contract agree that the contract performance should be rendered to or directly benefit a third person, the third person becomes an intended third party beneficiary of the contract. As the intended beneficiary of the contract, the third party intended beneficiary of the contract, the third party intended beneficiary has legal rights and can sue the promisor directly for breach of the contract.

■ CASE IN POINT 12.28 The classic case that gave third party beneficiaries the right to bring a suit directly against a promisor was decided in 1859. The case involved three parties—Holly, Lawrence, and Fox. Holly had borrowed $300 from Lawrence. Shortly thereafter, Holly loaned $300 to Fox, who in return promised Holly that he would pay Holly’s debt to Lawrence on the fol- lowing day. When Lawrence failed to obtain the $300 from Fox, he sued Fox to recover the funds. The court had to decide whether Lawrence could sue Fox directly (rather than suing Holly). The court held that when “a promise [is] made for the benefit of another, he for whose benefit it is made may bring an action for its breach.”34 ■

The law distinguishes between intended beneficiaries intended beneficiaries intended and incidental beneficiaries. An incidental beneficiary incidental beneficiaries. An incidental beneficiary incidental is a third person who receives a benefit from a contract even though that person’s benefit is not the reason the contract was made. Because the benefit is unintentional, an incidental beneficiary cannot sue to enforce the con- tract. Only intended beneficiaries acquire legal rights in a contract.

34. Lawrence v. Fox, 20 N.Y. 268 (1859).

C H A P T E R 1 2 Formation of Traditional and E-Contracts 259

Reviewing: Formation of Traditional and E-Contracts

Shane Durbin wanted to have a recording studio custom-built in his home. He sent invitations to a number of local contractors to submit bids on the project. Rory Amstel submitted the lowest bid, which was $20,000 less than any of the other bids Durbin received. Durbin called Amstel to ascertain the type and quality of the materials that were included in the bid and to find out if he could substitute a superior brand of acoustic tiles for the same bid price. Amstel said he would have to check into the price difference. The parties also discussed a possible start date for construction. Two weeks later, Durbin changed his mind and decided not to go forward with his plan to build a recording studio. Amstel filed a suit against Durbin for breach of contract. Using the information presented in the chapter, answer the following questions. 1. Did Amstel’s bid meet the requirements of an offer? Explain. 2. Was there an acceptance of the offer? Why or why not? 3. How is an offer terminated? Assuming that Durbin did not inform Amstel that he was rejecting the offer, was the

offer terminated at any time described here? Explain.

Debate This . . . The terms and conditions in click-on agreements are so long and detailed that no one ever reads the agreements. Therefore, the act of clicking on “I agree” is not really an acceptance.

Terms and Concepts acceptance 242 accord and satisfaction 250 agreement 238 assignment 257 bilateral contract 235 browse-wrap terms 247 click-on agreement 246 consideration 248 contract 234 contractual capacity 253 countero�er 241 covenant not to compete 255 covenant not to sue 251 delegation 257 disa�rmance 253 e-contract 245 e-signature 247 estopped 253 exculpatory clause 256

executed contract 237 executory contract 237 express contract 236 forbearance 248 formal contract 236 forum-selection clause 246 implied contract 236 informal contract 236 intended bene�ciary 258 liquidated debt 251 mailbox rule 244 mirror image rule 241 objective theory of contracts 235 o�er 238 o�eror 235 o�eree 235 option contract 241 past consideration 250 privity of contract 257

promise 234 promissory estoppel 252 record 247 reformation 255 release 251 rescission 249 revocation 241 shrink-wrap agreement 246 Statute of Frauds 256 third party bene�ciary 258 unconscionable 255 unenforceable contract 237 unilateral contract 235 unliquidated debt 251 usury 254 valid contract 237 void contract 237 voidable contract 237

Issue Spotters 1. Applied Products, Inc., does business with Beltway Dis-

tributors, Inc., online. Under the Uniform Electronic Transactions Act, what determines the effect of the elec- tronic documents evidencing the parties’ deal? Is a party’s “signature” necessary? Explain. (See E-Contracts.)

2. Joan, who is sixteen years old, moves out of her parents’ home and signs a one-year lease for an apartment at

Kenwood Apartments. Joan’s parents tell her that she can return to live with them at any time. Unable to pay the rent, Joan moves back to her parents’ home two months later. Can Kenwood enforce the lease against Joan? Why or why not? (See Contractual Capacity.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

260 U N I T T H R E E The Commercial Environment

Business Scenarios 12–1. Unilateral Contract. Rocky Mountain Races, Inc., sponsors the “Pioneer Trail Ultramarathon,” with an adver- tised first prize of $10,000. The rules require the competitors to run 100 miles from the floor of Blackwater Canyon to the top of Pinnacle Mountain. The rules also provide that Rocky reserves the right to change the terms of the race at any time. Monica enters the race and is declared the winner. Rocky offers her a prize of $1,000 instead of $10,000. Did Rocky and Monica have a contract? Explain. (See An Overview of Contract Law.)

12–2. Preexisting Duty. Tabor is a buyer of file cabinets manufactured by Martin. Martin’s contract with Tabor calls for delivery of fifty file cabinets at $40 per cabinet in five equal installments. After delivery of two installments (twenty cabi- nets), Martin informs Tabor that because of inflation, Martin is losing money. Martin will promise to deliver the remaining thirty cabinets only if Tabor will pay $50 per cabinet. Tabor agrees in writing to do so. Discuss whether Martin can legally collect the additional $100 on delivery to Tabor of the next installment of ten cabinets. (See Consideration.)

Business Case Problems

12–3. Business Case Problem with Sample Answer— Online Acceptances. Heather Reasonover opted to try

Internet service from Clearwire Corp. Clearwire sent her a con�rmation e-mail and a modem. When Reasonover plugged in the modem, an “I accept terms” box appeared. Without clicking on

the box, Reasonover quit the page. She had not seen Clear- wire’s “Terms of Service,” accessible only through its Web site. Although the e-mail she received and the printed materials included with the model included URLs to the company’s Web site, neither URL gave direct access to the “Terms of Ser- vice.” A clause in the “Terms of Service” required subscribers to submit any dispute to arbitration. Is Reasonover bound to this clause? Why or why not? [Kwan v. Clearwire Corp., 2012 WL 32380 (W.D.Wash. 2012)] (See E-Contracts.) • For a sample answer to Problem 12–3, go to Appendix E at

the end of this text.

12–4. Spotlight on Kansas City Chiefs—Consider- ation. On Brenda Sniezek’s �rst day of work for the Kansas

City Chiefs Football Club, she signed a document that purported to compel arbitration of any dis- putes that she might have with the Chiefs. In the document, Sniezek agreed to comply at all times

with and be bound by the constitution and bylaws of the National Football League (NFL). She agreed to refer all dis- putes to the NFL Commissioner for a binding decision. On the Commissioner’s decision, she agreed to release the Chiefs and others from any related claims. Nowhere in the document did the Chiefs agree to do anything. Was there consideration for the arbitration provision? Explain. [Sniezek v. Kansas City Chiefs Football Club, 402 S.W.3d 580 (Mo.App. W.D. 2013)] (See Consideration.) 12–5. Requirements of the Offer. Technical Consumer Products, Inc. (TCP), makes and distributes energy-e�cient lighting products. Emily Bahr was TCP’s district sales man- ager in Minnesota, North Dakota, and South Dakota when the company announced the details of a bonus plan. A district sales manager who achieved 100 percent year-over-year sales growth and a 42 percent gross margin would earn 200 percent

of his or her base salary as a bonus. TCP retained absolute discretion to modify the plan. Bahr’s base salary was $42,500. Her �nal sales results for the year showed 113 percent year- over-year sales growth and a 42 percent gross margin. She anticipated a bonus of $85,945, but TCP could not a�ord to pay the bonuses as planned, and Bahr received only $34,229. In response to Bahr’s claim for breach of contract, TCP argued that the bonus plan was too inde�nite to be an o�er. Is TCP correct? Explain. [Bahr v. Technical Consumer Products, Inc., 601 Fed.Appx. 359 (6th Cir. 2015)] (See Agreement.)

12–6. Acceptance. Altisource Portfolio Solutions, Inc., is a global corporation that provides real property owners with a variety of services, including property preservation—repairs, debris removal, and so on. Lucas Contracting, Inc., is a small trade contractor in Carrollton, Ohio. On behalf of Altisource, Berghorst Enterprises, LLC, hired Lucas to perform preserva- tion work on certain foreclosed properties in eastern Ohio. When Berghorst did not pay for the work, Lucas �led a suit in an Ohio state court against Altisource. Before the trial, Lucas e-mailed the terms of a settlement. �e same day, Altisource e-mailed a response that did not challenge or contradict Lucas’s proposal and indicated agreement to it. Two days later, however, Altisource forwarded a settlement document that contained additional terms. Which proposal most likely satis- �es the element of agreement to establish a contract? Explain. [Lucas Contracting, Inc. v. Altisource Portfolio Solutions, Inc., __ Ohio App.3d __, 2016-Ohio-474, __ N.E.2d __ (2016)] (See Agreement.)

12–7. Agreements That Lack Consideration. Arkansas- Missouri Forest Products, LLC (Ark-Mo), sells supplies to make wood pallets. Blue Chip Manufacturing (BCM) makes pallets. Mark Garnett, an owner of Ark-Mo, and Stuart Lerner, an owner of BCM, went into business together. Garnett and Lerner agreed that Ark-Mo would have a 30-percent owner- ship interest in their future projects. When Lerner formed Blue Chip Recycling, LLC (BCR), to manage a pallet repair facility in California, however, he allocated only a 5-percent interest to Ark-Mo. Garnett objected. In a “Telephone Deal,” Lerner then promised Garnett that Ark-Mo would receive a

C H A P T E R 1 2 Formation of Traditional and E-Contracts 261

30-percent interest in their future projects in the Midwest, and Garnett agreed to forgo an ownership interest in BCR. But when Blue Chip III, LLC (BC III), was formed to operate a repair facility in the Midwest, Lerner told Garnett that he “was not getting anything.” Ark-Mo �led a suit in a Missouri state court against Lerner, alleging breach of contract. Was there consideration to support the Telephone Deal? Explain. [Arkansas-Missouri Forest Products, LLC v. Lerner, [Arkansas-Missouri Forest Products, LLC v. Lerner, [ 486 S.W.3d 438 (Mo.App.E.D. 2016)] (See Consideration.) 12–8. Legality. Sue Ann Apolinar hired a guide through Arkansas Valley Adventures, LLC, for a rafting excursion on the Arkansas River. At the out�tter’s o�ce, Apolinar signed a release that detailed potential hazards and risks, including “overturning,” “unpredictable currents,” “obstacles” in the water, and “drowning.” �e release clearly stated that her signature discharged Arkansas Valley from liability for all claims arising in connection with the trip. On the river, while attempting to maneuver around a rapid, the raft capsized. �e current swept Apolinar into a logjam where, despite e�orts to save her, she drowned. Her son, Jesus Espinoza, Jr., �led a suit

in a federal district court against the rafting company, alleging negligence. What are the arguments for and against enforcing the release that Apolinar signed? Discuss. [Espinoza v. Arkansas Valley Adventures, LLC, 809 F.3d 1150 (10th Cir. 2016)] (See Legality.) 12–9. A Question of Ethics—Promissory Estoppel.

Claudia Aceves borrowed from U.S. Bank to buy a home. Two years later, she could no longer a�ord the monthly payments. �e bank noti�ed her that it planned to foreclose on her home. (Foreclosure is a

process that allows a lender to repossess and sell the property that secures a loan.) Aceves �led for bankruptcy. �e bank o�ered to modify Aceves’s mortgage if she would forgo bankruptcy. She agreed. Once she withdrew the �ling, however, the bank fore- closed. [Aceves v. U.S. Bank, N.A., closed. [Aceves v. U.S. Bank, N.A., closed. [ 192 Cal.App.4th 218, 120 Cal.Rptr.3d 507 (2 Dist. 2011)] (See Cal.Rptr.3d 507 (2 Dist. 2011)] (See Cal.Rptr.3d 507 (2 Dist. 2011)] Consideration.) (a) Could Aceves succeed on a claim of promissory estoppel?

Why or why not?

(b) Did Aceves or U.S. Bank behave unethically? Discuss.

Legal Reasoning Group Activity 12–10. Covenants Not to Compete. Assume that you are part of a group of executives at a large software corporation. �e company is considering whether to incorporate covenants not to compete into its employment contracts. You know that there are some issues with the enforceability of these covenants, and you want to make an informed decision. (See Legality.) (a) One group should make a list of what interests are served

by enforcing covenants not to compete.

(b) A second group should create a list of what interests are served by refusing to enforce covenants not to compete.

(c) A third group is to consider whether a court should reform (and then enforce) a covenant not to compete that it determines is illegal. The group should create an argu- ment for and an argument against reformation.

262

C H A P T E R 1 3

Mistakes of fact occur in two forms—bilateral and bilateral and bilateral unilateral. A unilateral mistake is made by only one of one of one the parties. A bilateral, or mutual, mistake is made by both of the contracting parties. We look next at these both of the contracting parties. We look next at these both two types of mistakes and illustrate them graphically in Exhibit 13–1.

Unilateral Mistakes of Fact A unilateral mistake is made by only one of the parties. In general, a unilat- eral mistake does not give the mistaken party any right to relief from the contract. Normally, the contract is enforceable.

■ EXAMPLE 13.1 Elena intends to sell her jet ski for $2,500. When she learns that Chin is interested in buying a used jet ski, she sends him an e-mail offering to sell the jet ski to him. When typing the e-mail, how- ever, she mistakenly keys in the price of $1,500. Chin immediately sends Elena an e-mail reply accepting her offer. Even though Elena intended to sell her personal jet ski for $2,500, she has made a unilateral mistake and is bound by the contract to sell it to Chin for $1,500. ■

This general rule has at least two exceptions.1 The contract may not be enforceable if:

1. The Restatement (Second) of Contracts, Section 153, liberalizes the general rule to take into account the modern trend of allowing avoidance even though only one party has been mistaken.

13–1 Voluntary Consent An otherwise valid contract may still be unenforceable if the parties have not genuinely agreed to its terms. A lack of voluntary consent (assent) can be used as a defense to voluntary consent (assent) can be used as a defense to voluntary consent the contract’s enforceability.

Voluntary consent may be lacking because of a misVoluntary consent may be lacking because of a misVoluntary consent - take, misrepresentation, undue influence, or duress—in other words, because there is no true “meeting of the minds.” Generally, a party who demonstrates that he or she did not truly agree to the terms of a contract has a choice. That party can choose either to carry out the contract or to rescind (cancel) it and thus avoid the entire transaction.

13–1a Mistakes We all make mistakes, so it is not surprising that mistakes are made when contracts are formed. In certain circum- stances, contract law allows a contract to be avoided on the basis of mistake.

It is important to distinguish between mistakes of fact and fact and fact mistakes of value or quality. Only a mistake of fact makes a contract voidable. Also, the mistake must involve some material fact—a fact that a reasonable permaterial fact—a fact that a reasonable permaterial fact - son would consider important when determining his or her course of action.

I n a perfect world, every party who signed a contract would perform his or her duties completely and in

a timely fashion, thereby discharging the contract. The real world is more complicated. Events often occur that affect our performance or our ability to perform contractual duties.

In addition, the duty to perform under a contract is not always absolute. It may instead be conditioned on the conditioned on the conditioned

occurrence or nonoccurrence of a certain event. The legal environment of busi- ness requires the identification of some point at which the parties can reasonably know that their duties have ended.

Normally, people enter into con- tracts to secure some advantage. When it is no longer advantageous for a party to fulfill her or his contractual obligations, that party may breach, or fail to perform, the contract. Once

one party breaches the contract, the nonbreaching party can choose one or more of several remedies.

A remedy is the relief provided to remedy is the relief provided to remedy an innocent party when the other party has breached the contract. It is the means employed to enforce a right or to redress an injury. Remedies may include monetary damages, rescission and restitution, specific performance, and reformation.

Contract Performance, Breach, and Remedies

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 263

BILATERAL MISTAKE Both parties mistaken

UNILATERAL MISTAKE One party mistaken

Contract Can Be Rescinded by Either Party

• Other party knew or should have known that mistake was made or • Mistake was due to substantial mathematical

error, made inadvertently and without gross negligence

Contract Enforceable Unless—

MATERIAL MISTAKE OF

FACT

E X H I B I T 1 3 – 1 Mistakes of Fact

1. The other party to the contract knows or should have known that a mistake of fact was made.

2. The error was due to a substantial mathematical missubstantial mathematical missubstantial - take in addition, subtraction, division, or multiplica- tion and was made inadvertently and without gross (extreme) negligence. If, for instance, a contractor’s bid was significantly low because he or she made a mistake in addition when totaling the estimated costs, any contract resulting from the bid normally may be rescinded.

Of course, in both situations, the mistake must still involve some material fact.

Bilateral (Mutual) Mistakes of Fact A bilat- eral mistake is a “mutual misunderstanding concerning a basic assumption on which the contract was made.”2 Note that, as with unilateral mistakes, the mistake must be about a material fact.

When both parties are mistaken about the same material fact, the contract can be rescinded by either party. ■ CASE IN POINT 13.2 Coleman Holdings LP bought a parcel of real estate subject to setback restrictions imposed in a document entitled “Partial Release of Restrictions” that effectively precluded building a structure on the property. Lance and Joanne Eklund offered to buy the parcel from Coleman, intending to combine it with an adjacent parcel and build a home. Coleman gave the Eklunds a title report that referred to the “Partial Release of Restrictions,” but they were not given a copy of the release.

Mistakenly believing that the document released restric- tions on the property, the Eklunds did not investigate fur- ther. Meanwhile, Coleman also mistakenly believed that the setback restrictions had been removed. After buying the property and discovering the restrictions, the Eklunds

2. Restatement (Second) of Contracts, Section 152.

filed a suit in a Nevada state court against Coleman, seeking rescission of the sale. The court ordered the deal rescinded. The Nevada Supreme Court affirmed the order. “The parties made a mutual mistake in their mutual belief that the parcel had no setback restrictions.”3 ■

A word or term in a contract may be subject to more than one reasonable interpretation. If the parties to the contract attach materially different meanings to the term, a court may allow the contract to be rescinded because there has been no true “meeting of the minds.”

Mistakes of Value If a mistake concerns the future market value or quality of the object of the contract, the mistake is one of value, and the contract normally is enforceable. ■ EXAMPLE 13.3 Sung buys a violin Sung buys a violin from Bev for $250. Although the violin is very old, nei- ther party believes that it is valuable. Later, however, an antiques dealer informs the parties that the violin is rare and worth thousands of dollars. Here, both parties were mistaken, but the mistake is a mistake of value rather than value rather than value a mistake of fact. a mistake of fact. a mistake of Because mistakes of value do not warrant contract rescission, Bev cannot rescind the contract. ■

The reason that mistakes of value do not affect the enforceability of contracts is that value is variable. Depending on the time, place, and other circumstances, the same item may be worth considerably different amounts. When parties form a contract, their agreement establishes the value of the object of their transaction— for the moment. Each party is considered to have assumed the risk that the value will change in the future or prove to be different from what he or she thought. Without this rule, almost any party who did not receive what she or he considered a fair bargain could argue mistake.

3. Coleman Holdings Limited Partnership v. Eklund, 2015 WL 428567 (Nev.Coleman Holdings Limited Partnership v. Eklund, 2015 WL 428567 (Nev.Coleman Holdings Limited Partnership v. Eklund Sup.Ct. 2015).

264 U N I T T H R E E The Commercial Environment

Background and Facts Donald Trump and Michael Sexton formed Trump University, LLC—later known as Trump Entrepreneur Initiative, LLC (TEI)—to sell courses in real estate investing. To attract students, Trump made a promotional video. In it, he said, “We’re going to have professors that are absolutely terrific—terrific people, terrific brains, successful, the best. . . . All people that are hand- picked by me.”

New York Attorney General Eric Schneiderman brought a proceeding in a New York state court against TEI, Trump, and Sexton, alleging that they had operated an illegal educational institu- tion between 2005 and 2011. The attorney general sought an injunction, damages, penalties, and restitution under a state statute that provided for these remedies in cases of “persistent fraud.” TEI was charged with intentionally misleading more than 5,000 students, including over 600 New York residents, into paying as much as $35,000 each to participate in its programs. Among other things, according to the attorney general, Trump did not handpick the instructors as he claimed.

The court dismissed the claim on the ground that it exceeded a three-year limit imposed on all statutory causes of action. The court also held that the specific statute did not provide the state with an independent cause of action for fraud. The attorney general appealed.

In the Language of the Court MAZZARELLI, J.P. [Justice Presiding], RENWICK, SAXE, MOSKOWITZ, J.J. [Justices]

* * * * * * * [New York] Executive Law Section 63(12) states, in relevant part:

Whenever any person shall engage in repeated fraudulent or illegal acts or otherwise demonstrate persistent fraud or illegality in the carrying on, conducting or transaction of business, the attorney general may apply * * * to the supreme court of the state of New York * * * for an order enjoining the continuance of such busi- ness activity or of any fraudulent or illegal acts and directing restitution and damages * * * and the court may award [such] relief * * * as it may deem proper.

Schneiderman v. Trump Entrepreneur Initiative, LLC New York Supreme Court, Appellate Division, First Department, 137 A.D.3d 409, 26 N.Y.S.3d 66 (2016).

Case 13.1

13–1b Fraudulent Misrepresentation Although fraud is a tort, the presence of fraud also affects the authenticity of the innocent party’s consent to the contract. When an innocent party is fraudulently induced to enter into a contract, the contract usually can be avoided, because that party has not voluntarily consented to its terms.4 The innocent party can either rescind the contract and be restored to her or his original position or enforce the contract and seek damages for any harms resulting from the fraud.

Generally, fraudulent misrepresentation refers only to misrepresentation that is consciously false and is intended to mislead another. The person making the fraudulent misrepresentation knows or believes that the assertion is false or knows that she or he does not have a basis (stated or implied) for the assertion.5 Typically,

4. Restatement (Second) of Contracts, Sections 163 and 164. 5. Restatement (Second) of Contracts, Section 162.

fraudulent misrepresentation consists of the following elements:

1. A misrepresentation of a material fact must occur. 2. There must be an intent to deceive. 3. The innocent party must justifiably rely on the

misrepresentation. 4. To collect damages, a party must have been harmed

as a result of the misrepresentation.

Like other actions based in the common law, a cause of action based on fraud can be subject to a statute of limitations. Of course, a cause based on a statute can also be subject to a statute of limitations. The limitations periods governing these actions may be different. In the following case, the issue was which limit to apply to a specific fraud claim—the three-year limit that applied to certain statute-based actions or the six-year limit that applied to common law actions.

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 265

* * * * [In its ruling, the lower court cited People v. Charles Schwab & Co., Inc., 109 A.D.3d 445, 971

N.Y.S.2d 267 (1 Dept. 2013).] In Charles Schwab, the Attorney General had brought an enforcement action asserting claims under Section 63(12) * * * . The court dismissed the Section 63(12) claim.

On appeal to this Court, * * * we found that the court had properly dismissed that claim, stating that the section does not create independent claims, but merely authorizes the Attorney General to seek injunctive and other relief * * * in cases involving persistent fraud.

Although the holding of Charles Schwab purported to be based on the [New York] Court of Appeals’ Charles Schwab purported to be based on the [New York] Court of Appeals’ Charles Schwab ruling in State v. Cortelle Corp., 38 N.Y.2d 83, 378 N.Y.S.2d 654, 341 N.E.2d 223 (1975), Cortelle does Cortelle does Cortelle not, in fact, hold that the Attorney General cannot bring a standalone cause of action for fraud under Executive Law Section 63(12).

* * * * In Cortelle, the Court of Appeals [found] that * * * causes of action [under Section 63(12)] address-

ing * * * allegedly fraudulent practices did not rely on liabilities, penalties, or forfeitures created or imposed by statute. Specifically, Section 63(12) did not make unlawful the alleged fraudulent practices, but only provided standing in the Attorney General to seek redress and additional remedies for recognized wrongs which pre-existed the statute. [Emphasis added.]

* * * * * * * Other New York courts addressing that issue * * * have generally allowed for independent causes

of action for fraud under Section 63(12). * * * * Thus, Charles Schwab does not comport with prevailing authority.Charles Schwab does not comport with prevailing authority.Charles Schwab * * * Hence, we hold that the Attorney General is, in fact, authorized to bring a cause of action for

fraud under Section 63(12).

Decision and Remedy A state intermediate appellate court reversed the lower court’s dismissal of the fraud claim, holding that the three-year limit on statutory causes of action did not apply. Because material issues of fact still existed as to that claim, however, the court remanded the case for further proceedings.

Critical Thinking • Legal Environment The statute at the center of this case provides for remedies that may not be available at

common law. Why would those additional remedies be sought, and when would they most likely be awarded? • What If the Facts Were Different? Suppose that Trump University, or Trump Entrepreneur Initia-

tive, had offered courses in real estate investing only online. Would the result in this case have been differ- ent? Explain.

Case 13.1 Continued

Misrepresentation by Words or Conduct The first element of proving fraud is to show that misrepre- sentation of a material fact has occurred. This misrepre- sentation can occur by words or actions. For instance, the statement “This sculpture was created by Michelangelo” is a misrepresentation of fact if another artist sculpted the statue. Similarly, if a customer asks to see only paintings by Jasper Johns and the gallery owner immediately leads the customer to paintings that were not done by Johns, the owner’s actions can be a misrepresentation.

Misrepresentation also occurs when a party takes spe- cific action to conceal a fact that is material to the con- tract. Therefore, if a seller, by her or his actions, prevents a buyer from learning of some fact that is material to the contract, such behavior constitutes misrepresentation by conduct.

■ CASE IN POINT 13.4 Actor Tom Selleck contracted Actor Tom Selleck contracted to purchase a horse named Zorro for his daughter from Dolores Cuenca. Cuenca acted as though Zorro were fit to ride in competitions, when in reality the horse was unfit for this use because of a medical condition. Selleck filed a lawsuit against Cuenca for wrongfully concealing the horse’s condition and won. A jury awarded Selleck more than $187,000 for Cuenca’s misrepresentation by conduct.6 ■

Note that statements of opinion and representations of future facts (predictions) generally are not subject to claims of fraud. For instance, the statement “This land will be worth twice as much next year” is a statement

6. Selleck v. Cuenca, Case No. GIN056909, North County of San Diego, California, decided September 9, 2009.

266 U N I T T H R E E The Commercial Environment

of opinion, not fact. A fact is objective and verifiable, whereas an opinion is usually subject to debate. Con- tracting parties should know the difference and should not rely on statements of opinion. Nevertheless, in cer- tain situations, such as when a naïve purchaser relies on an opinion from an expert, the innocent party may be entitled to rescission.

Injury to the Innocent Party Most courts do not require a showing of injury when the action is to rescind the contract. These courts hold that because rescission returns the parties to the positions they held before the contract was made, a showing of injury to the innocent party is unnecessary.

In contrast, to recover damages caused by fraud, proof of harm is universally required. The measure of damages is ordinarily equal to the property’s value had it been delivered as represented, less the actual price paid for the property. (Additionally, because fraud actions necessar- ily involve wrongful conduct, courts may also sometimes award punitive damages, which are not ordinarily avail- able in contract actions.)

13–1c Undue Influence Undue influence arises from relationships in which one party can greatly influence another party, thus overcom- ing that party’s free will. A contract entered into under excessive or undue influence lacks voluntary consent and is therefore voidable.7

One Party Dominates the Other In various types of relationships, one party may have the opportunity to dominate and unfairly influence another party. Minors and elderly people, for instance, are often under the influ- ence of guardians (persons who are legally responsible for them). If a guardian induces a young or elderly ward (a person whom the guardian looks after) to enter into a contract that benefits the guardian, the guardian may have exerted undue influence. Undue influence can arise from a number of fiduciary relationships, such as physician- patient, parent-child, husband-wife, or guardian-ward situations.

The essential feature of undue influence is that the party being taken advantage of does not, in reality, exer- cise free will in entering into a contract. It is not enough that a person is elderly or suffers from some physical or mental impairment. There must be clear and convincing

7. Restatement (Second) of Contracts, Section 177.

evidence that the person did not act out of her or his free will.8 Similarly, the existence of a fiduciary relationship alone is insufficient to prove undue influence.

Presumption of Undue Influence in Certain Situations When the dominant party in a fiduciary relationship benefits from that relationship, a presump- tion of undue influence arises. The dominant party must exercise the utmost good faith in dealing with the other party. When a contract enriches the dominant party, the court will often presume that the contract was made presume that the contract was made presume under undue influence.

■ EXAMPLE 13.5 Erik is the guardian for Kinsley, his ward. Erik is the dominant party in this relationship. On Kinsley’s behalf, he enters into a contract from which he benefits financially. If Kinsley challenges the contract, the court will likely presume that the guardian has taken advan- tage of his ward. To rebut (refute) this presumption, Erik has to show that he made full disclosure to Kinsley and that consideration was present. He must also show that Kinsley received, if available, independent and competent advice before completing the transaction. Unless the presumption can be rebutted, the contract will be rescinded. ■

13–1d Duress Agreement to the terms of a contract is not voluntary if one of the parties is forced into the agreement. The use forced into the agreement. The use forced of threats to force a party to enter into a contract consti- tutes duress. Similarly, the use of blackmail or extortion to induce consent to a contract is duress. Duress is both a defense to the enforcement of a contract and a ground for the rescission of a contract.

To establish duress, there must be proof of a threat to do something that the threatening party has no right to do. Generally, for duress to occur, the threatened act must be wrongful or illegal. It also must render the per- son who is threatened incapable of exercising free will. A threat to exercise a legal right, such as the right to sue someone, ordinarily does not constitute duress.

13–1e Adhesion Contracts and Unconscionability

Sometimes, the terms of a contract are dictated by a party with overwhelming bargaining power. The signer must agree to those terms or go without the commod- ity or service in question. In these situations, questions

8. See, for example, Ayers v. Shaffer, 286 Va. 212, 748 S.E.2d 83 (2013). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 267

concerning voluntary consent may arise. (Many such contracts include arbitration provisions, as discussed in this chapter’s Ethics Today feature.)Ethics Today feature.)Ethics Today

Adhesion contracts are written exclusively by one exclusively by one exclusively party and presented to the other party on a take-it-or- leave-it basis. These contracts often use standard forms, which give the adhering party no opportunity to negoti- ate the contract terms.

Standard-form contracts often contain fine-print provisions that shift a risk ordinarily borne by one party to the other. A variety of businesses use such contracts. To avoid enforcement of the contract or of a particular clause, the plaintiff normally must show that the contract or particular term is unconscionable.

Forced Arbitration: Right or Wrong?

Knowingly or not, many consumers sign con- tracts that include arbitration clauses. Such clauses require that dissatisfied consumers submit to arbitration, rather than pursue litiga- tion through the court system. Not surpris- ingly, there is a growing movement in protest of arbitration clauses of this kind, which some believe are unfair to consumers.

Governing Arbitration Law For the most part, federal law encourages arbitration through the Federal Arbitration Act (FAA).a Gener- ally, federal courts have ruled in favor of contracts with arbitration clauses if those clauses provide a meaningful way for consumers to seek redress for alleged harms.

Over the past few years, the United States Supreme Court has held that the FAA preempts state courts’ interpretations of arbitration clauses. For instance, in AT&AT&AT T Mobility, LLC v. Concepcion,b the Court ruled that federal law preempts state laws that bar enforcement of arbitration clauses prohibiting class-action suits. Later, in DIRECTV, Inc. v. Imburgia,c the Court again upheld an arbitration clause, citing the Concepcion case. The Court stated that the FAA “is the law of the United States, and [the] Concepcion [case] is an authoritative interpretation of the act.” The Court stated that “the judges of every

State must follow it” because of the supremacy clause of the U.S. Constitution.

Federal Attempts to Circumvent the Supreme Court’s Decisions Even within the federal government, certain entities wish to reduce the use of arbitra- tion clauses in consumer contracts. In the fall

of 2015, the Consumer Financial Protection Bureau announced that it would seek to implement new rules barring contracts from substituting private arbi- tration for class-action litigation. Such rules would apply to checking accounts, credit cards, and other financial products. If that federal agency is successful, it will undoubtedly face litigation that will go to the Supreme Court.

Why Arbitration Is So Prevalent Many corporations favor arbitration clauses in con- sumer contracts because arbitration is less expensive than litigation. Arbitration is certainly the preferred remedy for disputes involving relatively small sums— disputes over cell phone contracts, for instance. While individuals may feel that they are at a disadvantage if they are forced to go to arbitration, for the economy as a whole, there are benefits. In particular, according to some estimates, the rate of growth in liability costs has fallen relative to the growth in the economy since 2003. Ultimately, consumers on average pay lower costs for products and services when corporations spend less on litigation.

Critical Thinking What might happen if arbitration clauses were prohibited in all consumer contracts?

ETHICS TODAY

a. 9 U.S.C. Sections 1 et seq. b. 563 U.S. 333, 131 S.Ct. 1740, 179 L.Ed.2d 742 (2011). See also

American Express Co. v. Italian Colors Restaurant, ___ U.S. ___, 133 American Express Co. v. Italian Colors Restaurant, ___ U.S. ___, 133 American Express Co. v. Italian Colors Restaurant S.Ct. 2304, 186 L.Ed.2d 417 (2013).

c. ___ U.S. ___, 135 S.Ct. 1547, 191 L.Ed.2d 636 (2015).

13–2 Performance and Discharge The most common way to discharge, or terminate, con- tractual duties is by the performance of those duties. For instance, a buyer and seller enter into an agreement via e-mail for the sale of a 2018 Lexus RX for $44,000. This contract will be discharged by performance when the buyer pays $44,000 to the seller and the seller transfers possession of the Lexus to the buyer.

Sometimes, of course, promises are not completely performed as stated in the contract, or one party refuses to perform. In addition, a party’s obligation to perform can be discharged in other ways, such as by agreement or by an event that makes performance impossible.

268 U N I T T H R E E The Commercial Environment

13–2a Conditions In most contracts, promises of performance are not expressly conditioned or qualified. Instead, they are abso- lute promises. They must be performed, or the parties promising the acts will be in breach of contract.

In some situations, however, performance is condi- tioned. A tioned. A tioned condition is a qualification in a contract based on a possible future event. The occurrence or nonoccur- rence of the event will trigger the performance of a legal obligation or terminate an existing obligation under a contract.9 If the condition is not satisfied, the obligations of the parties are discharged. A condition that must be fulfilled before a party’s performance can be required is called a condition precedent. The condition precedes the absolute duty to perform.

A contract to lease university housing, for instance, may be conditioned on the person’s being a student at may be conditioned on the person’s being a student at may be conditioned on the person’s being a student at may be conditioned on the person’s being a student at the university. ■ CASE IN POINT 13.6 James Maciel leased an apartment in a university-owned housing facil- ity for Regent University (RU) students in Virginia. The lease ran until the end of the fall semester. Maciel had an option to renew the lease semester by semester as long as he maintained his status as an RU student.

When Maciel told RU that he intended to withdraw, the university told him that he had to move out of the apartment by May 31, the final day of the semester. Maciel asked for two additional weeks, but the university denied the request. On June 1, RU changed the locks on the apartment. Maciel entered through a window and e-mailed the university that he planned to stay “for another one or two weeks.” He was convicted of trespass- ing. He appealed, arguing that he had “legal authority” to occupy the apartment. The reviewing court affirmed his conviction. “Regent’s deadline was consistent with the lease agreement, and Maciel’s eligibility to reside in student housing was conditioned upon his status as conditioned upon his status as conditioned a Regent student.” In other words, being enrolled as a student in RU was a condition precedent to living in its student housing.10 ■

13–2b Discharge by Performance The great majority of contracts, as noted earlier, are dis- charged by performance. The contract comes to an end when both parties fulfill their respective duties by per- forming the acts they have promised.

9. The Restatement (Second) of Contracts, Section 224, defines a condition as “an event, not certain to occur, which must occur, unless its nonoc- currence is excused, before performance under a contract becomes due.”

10. Maciel v. Commonwealth, 2011 WL 65942 (Va.App. 2011).

Performance can also be accomplished by tender. Ten- der is an unconditional offer to perform by a person who der is an unconditional offer to perform by a person who der is ready, willing, and able to do so. Therefore, a seller who places goods at the disposal of a buyer has tendered delivery and can demand payment. A buyer who offers to pay for goods has tendered payment and can demand delivery of the goods.

Once performance has been tendered, the party mak- ing the tender has done everything possible to carry out the terms of the contract. If the other party then refuses to perform, the party making the tender can sue for breach of contract. There are two basic types of performance— complete performance and substantial performance.

Complete Performance When a party performs exactly as agreed, there is no question as to whether the contract has been performed. When a party’s performance is perfect, it is said to be complete. Normally, conditions expressly stated in a contract must fully occur in all respects for complete performance (strict performance) of the con- tract to take place. Any deviation breaches the contract and discharges the other party’s obligation to perform.

Most construction contracts, for instance, require the builder to meet certain specifications. If the specifications are conditions, complete performance is required to avoid material breach (material breach will be discussed shortly). material breach will be discussed shortly). material breach If the conditions are met, the other party to the contract must then fulfill her or his obligation to pay the builder.

If the parties to the contract did not expressly make the specifications a condition, however, and the builder fails to meet the specifications, performance is not com- plete. What effect does such a failure have on the other party’s obligation to pay? The answer is part of the doc- trine of substantial performance.

Substantial Performance A party who in good faith performs substantially all of the terms of a contract can enforce the contract against the other party under the doctrine of substantial performance. The basic require- ments for performance to qualify as substantial perfor- mance are as follows:

1. The party must have performed in good faith. Inten- tional failure to comply with the contract terms is a breach of the contract.

2. The performance must not vary greatly from the performance promised in the contract. An omis- sion, variance, or defect in performance is considered minor if it can easily be remedied by compensation (monetary damages).

3. The performance must create substantially the same benefits as those promised in the contract.

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 269

Courts Must Decide. Courts decide whether the perfor- mance was substantial on a case-by-case basis, examin- ing all of the facts of the particular situation. ing all of the facts of the particular situation. ing all of the facts of the particular situation. ■ CASE IN POINT 13.7 Eugene Pegg had been an electrician in North Eugene Pegg had been an electrician in North Dakota for thirty years and had brought a large cus- tomer, Sungold, with him through several employ- ers. When an acquaintance, Kelly Kohn, started Kohn Electric, LLC, Pegg approached him to become partners.

Kohn and Pegg orally agreed that Pegg could become a partner in Kohn Electric if he contributed $10,000 in capital and the Sungold account. In return, Pegg was to receive 10 percent of the gross revenue generated by the Sungold account, among other things. Pegg paid $9,152.49 for a pickup truck titled in Kohn Electric’s name and paid for tools and equipment for the business. Later, the relationship soured, and Pegg quit. Pegg sued in a state court to recover the proceeds due under the agreement. Kohn denied that they were partners, but he paid Pegg $9,152.49 for the truck.

The state court found that there was an oral part- nership agreement and that Pegg had substantially per- formed by contributing the pickup and bringing in the Sungold account. Therefore, he was entitled to damages in an amount equal to 10 percent of the gross revenue generated from the Sungold account. The court’s deci- sion was affirmed on appeal.11 ■

Effect on Duty to Perform. If one party’s performance is substantial, the other party’s duty to perform remains absolute. In other words, the parties must continue per- forming under the contract. For instance, the party who substantially performed is entitled to payment. If perfor- mance is not substantial, there is a material breach (to be discussed shortly), and the nonbreaching party is excused from further performance.

Measure of Damages. Because substantial performance is not perfect, the other party is entitled to damages to compensate for the failure to comply with the contract. �e measure of the damages is the cost to bring the object of the contract into compliance with its terms, if that cost is reasonable under the circumstances.

What if the cost is unreasonable? Then the measure of damages is the difference in value between the per- formance rendered and the performance that would have been rendered if the contract had been performed completely.

■ CASE IN POINT 13.8 In a classic case, the plaintiff, Jacob & Youngs, Inc., was a builder that had contracted

11. Pegg v. Kohn, 861 N.W.2d 764, 2015 ND 79 (2015).

with George Kent to construct a country residence for him. A specification in the building contract required that “all wrought-iron pipe must be well galvanized, lap welded pipe of the grade known as ‘standard pipe’ of Reading manufacture.” Jacob & Youngs installed substan- tially similar pipe that was not of Reading manufacture. When Kent became aware of the difference, he ordered the builder to remove all of the plumbing and replace it with the Reading type. To do so would have required removing finished walls that encased the plumbing—an expensive and difficult task.

The builder explained that the plumbing was of the same quality, appearance, value, and cost as Reading pipe. When Kent nevertheless refused to pay the $3,483.46 still owed for the work, Jacob & Youngs sued to com- pel payment. The dispute ended up before the Court of Appeals of New York, the state’s highest court, which concluded that “the measure of the allowance is not the cost of replacement, which would be great, but the dif-cost of replacement, which would be great, but the dif-cost of replacement, which would be great, but the dif ference in value, which would be either nominal or noth- ing.” Therefore, New York’s highest court held that Jacob & Youngs had substantially performed the contract.12 ■

Performance to the Satisfaction of Another Contracts often state that completed work must person- ally satisfy one of the parties or a third person. When the subject matter of the contract is personal, the obligation is conditional, and performance must actually satisfy the party specified in the contract. For instance, contracts for portraits, works of art, and tailoring are considered per- sonal because they involve matters of personal taste. There- fore, only the personal satisfaction of the party fulfills the condition. (An exception exists, of course, if a court finds that the party is expressing dissatisfaction simply to avoid payment or otherwise is not acting in good faith.)

Most other contracts need to be performed only to the satisfaction of a reasonable person unless they expressly satisfaction of a reasonable person unless they expressly satisfaction of a reasonable person unless they state otherwise. When the subject matter of the contract is mechanical, courts are more likely to find that the per- forming party has performed satisfactorily if a reasonable forming party has performed satisfactorily if a reasonable forming party has performed satisfactorily if a reasonable person would be satisfied with what was done. ■ EXAM- PLE 13.9 Mason signs a contract with Jen to mount a Mason signs a contract with Jen to mount a new heat pump on a concrete platform to her satisfac- tion. Such a contract normally need only be performed to the satisfaction of a reasonable person. ■

Material Breach of Contract A breach of contract is the nonperformance of a contractual duty. The breach is material when performance is not at least substantial.material when performance is not at least substantial.material 13

12. Jacob & Youngs v. Kent, 230 N.Y. 239, 129 N.E. 889 (1921). Youngs v. Kent, 230 N.Y. 239, 129 N.E. 889 (1921). Youngs v. Kent 13. Restatement (Second) of Contracts, Section 241.

270 U N I T T H R E E The Commercial Environment

As mentioned earlier, when there is a material breach, the nonbreaching party is excused from the performance of contractual duties. That party can also sue the breaching party for damages resulting from the breach.party for damages resulting from the breach.party for damages resulting from the breach.party for damages resulting from the breach.

■ EXAMPLE 13.10 When country singer Garth Brooks’s mother died, he donated $500,000 to a hospi- tal in his hometown in Oklahoma to build a new wom- en’s health center named after his mother. After several years passed and the health center was not built, Brooks demanded a refund. The hospital refused, claiming that while it had promised to honor his mother in some way, it had not promised to build a women’s health center. Brooks sued for breach of contract. A jury determined

that the hospital’s failure to build a women’s health cen- ter and name it after Brooks’s mother was a material breach of the contract. The jury awarded Brooks $1 mil- lion in damages. ■

Material versus Minor Breach. If the breach is minor (not material), the nonbreaching party’s duty to perform is not entirely excused, but it can sometimes be suspended until the breach has been remedied. Once the minor breach has been cured, the nonbreaching party must resume performance of the contractual obligations.

Both parties in the following case were arguably in breach of their contract. Which party’s breach was material?

In the Language of the Court PER CURIAM. [By the Whole Court]

* * * * On May 24, 2010, plaintiffs Marc

and Bree Kohel entered into a sales contract with defendant Bergen Auto Enterprises, L.L.C. d/b/a Wayne Mazda Inc. (Wayne Mazda), for the purchase of a used 2009 Mazda. Plaintiffs agreed to pay $26,430.22 for the Mazda and were credited $7,000 as a trade-in, for their 2005 Nissan Altima. As plaintiffs still owed $8,118.28 on the Nissan, Wayne Mazda assessed plaintiffs a net pay-off of this amount and agreed to remit the bal- ance due to satisfy the outstanding lien.

Plaintiffs took possession of the Mazda with temporary plates and left the Nissan with defendant. A few days later, a representative of defendant advised plaintiffs that the Nissan’s vehicle identification tag (VIN tag) was missing. The representative claimed it was unable to sell the car and offered to rescind the transaction. Plaintiffs refused.

When the temporary plates on the Mazda expired on June 24, 2010, defen- dant refused to provide plaintiffs with the permanent plates they had paid for. In addition, defendant refused to pay off plaintiffs’ outstanding loan on the Nissan, as they had agreed. As a result,

plaintiffs were required to continue to make monthly payments on both the Nissan and the Mazda.

On July 28, 2010, plaintiffs filed a complaint in [a New Jersey state court] against Wayne Mazda * * * . Plaintiffs alleged breach of contract.

* * * * On February 2, 2012, the court

rendered an oral decision finding that there was a breach of contract by Wayne Mazda * * * . On February 17, 2012, the court entered judgment in the amount of $5,405.17 in favor of plaintiffs against Wayne Mazda. [The defendant appealed to a state intermediate appellate court.]

* * * * Defendant argues that plaintiffs’

delivery of the Nissan without a VIN tag was, itself, a breach of the contract of sale and precludes a finding that defendant breached the contract. How- ever, the trial court found that plaintiffs were not aware that the Nissan lacked a VIN tag when they offered it in trade. Moreover, defendant’s representatives examined the car twice before accept- ing it in trade and did not notice the missing VIN until they took the car to an auction where they tried to sell it. There is a material distinction in plain- tiffs’ conduct, which the court found

unintentional, and defendant’s refusal to release the permanent plates for which the plaintiffs had paid, an action the court concluded was done to maintain “leverage.” [Emphasis added.]

* * * The evidence * * * indicated that * * * the problem with the missing VIN tag could be rectified. Marc Kohel applied and paid for a replacement VIN tag at Meadowlands [Nissan for $35.31]. While he initially made some calls to Meadowlands, he did not follow up in obtaining the VIN tag after the person- nel at Wayne Mazda began refusing to take his calls.

* * * The court concluded that “Wayne Mazda didn’t handle this as— as adroitly [skillfully] as they could * * * .” Kevin DiPiano, identified in the complaint as the owner and/or CEO of Wayne Mazda, would not even take [the plaintiffs’] calls to discuss this matter. The court found:

Mr. DiPiano could have been a bet- ter businessman, could have been a little bit more compassionate or at least responsive, you know? He was not. He acted like he didn’t care. That obviously went a long way to infuriate the plaintiffs. I don’t blame them for being infuriated.

Case Analysis 13.2 Kohel v. Bergen Auto Enterprises, L.L.C. Superior Court of New Jersey, Appellate Division, ___ A.3d___, 2013 WL 439970 (2013).

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 271

Legal Reasoning Questions

1. What is a material breach of contract? When a material breach occurs, what are the nonbreaching party’s options? 2. What is a minor breach of contract? When a minor breach occurs, is the nonbreaching party excused from performance?

Explain. 3. In this case, the defendant—Wayne Mazda—argued that the plaintiffs should not be granted relief for the defendant’s breach.

What were the defendant’s main arguments in support of this position?

* * * * * * * Here, plaintiffs attempted to rem-

edy the VIN tag issue but this resolution was frustrated by defendant’s unreasonable

conduct. We thus reject defendant’s argu- ment that plaintiffs’ failure to obtain the replacement VIN tag amounted to a repu- diation of the contract.

* * * * Affirmed.

Case 13.2 Continued

Underlying Policy. Note that any breach entitles the non- breaching party to sue for damages, but only a material breach discharges the nonbreaching party from the con- tract. �e policy underlying these rules allows a contract to go forward when only minor problems occur but allows it to be terminated if major di�culties arise. Exhibit 13–2 reviews how performance can discharge a contract.

Anticipatory Repudiation Before either party to a contract has a duty to perform, one of the parties may refuse to carry out his or her contractual obligations. This is called anticipatory repudiation14 of the contract.

14. Restatement (Second) of Contracts, Section 253; Section 2–610 of the Uniform Commercial Code (UCC).

When an anticipatory repudiation occurs, it is treated as a material breach of the contract, and the nonbreach- ing party is permitted to bring an action for damages immediately. The nonbreaching party can file suit even though the scheduled time for performance under the contract may still be in the future. Until the nonbreach- ing party treats an early repudiation as a breach, however, the repudiating party can retract the anticipatory repu- diation by proper notice and restore the parties to their original obligations.15

An anticipatory repudiation is treated as a present, material breach for two reasons. First, the nonbreaching

15. See UCC 2–611.

Performance Tendered

Complete Performance

Material Breach

Substantial Performance

No breach—contract is discharged.

Contract is discharged. No further duty to perform. Party can sue immediately

for breach.

Duty to perform continues. Party can recover damages.

E X H I B I T 1 3 – 2 Discharge by Performance

272 U N I T T H R E E The Commercial Environment

party should not be required to remain ready and will- ing to perform when the other party has already repu- diated the contract. Second, the nonbreaching party should have the opportunity to seek a similar contract elsewhere and may have a duty to do so to minimize his or her loss.

Time for Performance If no time for performance is stated in a contract, a reasonable time is implied. If a reasonable time is implied. If a reasonable time specific time is stated, the parties must usually perform by that time. Unless time is expressly stated to be vital, though, a delay in performance will not destroy the per- forming party’s right to payment.

When time is expressly stated to be “of the essence” or vital, the parties normally must perform within the stated time period because the time element becomes a condition. Nevertheless, a court may find that a party who fails to complain about the other party’s delay has waived the breach of the time provision.

13–2c Discharge by Agreement Any contract can be discharged by agreement of the parties. The agreement can be contained in the original contract, or the parties can form a new contract for the express purpose of discharging the original contract.

Discharge by Mutual Rescission As mentioned previously, rescission is the process by which a contract is canceled or terminated and the parties are returned to the positions they occupied prior to forming it. For mutual rescission to take place, the parties must make another agreement that also satisfies the legal requirements for a contract. There must be an offer, an acceptance, and con- sideration. Ordinarily, if the parties agree to rescind the original contract, their promises not to perform the acts stipulated in the original contract will be legal consider- ation for the second contract (the rescission).

Agreements to rescind most executory contracts (in which neither party has performed) are enforceable, even if the agreement is made orally and even if the original agreement was in writing. Under the Uniform Commer- cial Code (UCC), however, agreements to rescind a sales contract must be in writing (or contained in an electronic record) when the contract requires a written rescission [UCC 2–209(2), (4)]. Agreements to rescind contracts involving transfers of realty also must be evidenced by a writing or record.

When one party has fully performed, an agreement to cancel the original contract normally will not be enforcenot be enforcenot - able unless there is additional consideration. Because the performing party has received no consideration for the

promise to call off the original bargain, additional con- sideration is necessary to support a rescission contract.

Discharge by Novation A contractual obligation may also be discharged through novation. A novation occurs when both of the parties to a contract agree to sub- stitute a third party for one of the original parties. The requirements of a novation are as follows: 1. A previous valid obligation. 2. An agreement by all parties to a new contract. 3. The extinguishing of the old obligation (discharge of

the prior party). 4. A new contract that is valid.

■ EXAMPLE 13.11 Union Corporation contracts to Union Corporation contracts to sell its pharmaceutical division to British Pharmaceuti- cals, Ltd. Before the transfer is completed, Union, British Pharmaceuticals, and a third company, Otis Chemicals, execute a new agreement to transfer all of British Phar- maceuticals’ rights and duties in the transaction to Otis Chemicals. As long as the new contract is supported by consideration, the novation will discharge the original contract (between Union and British Pharmaceuticals) and replace it with the new contract (between Union and Otis Chemicals). ■

A novation expressly or impliedly revokes and dis- charges a prior contract. The parties involved may expressly state in the new contract that the old contract is now discharged. If the parties do not expressly discharge the old contract, it will be impliedly discharged if the new contract’s terms are inconsistent with the old con- tract’s terms. It is this immediate discharge of the prior contract that distinguishes a novation from both an accord and satisfaction, discussed shortly, and an assign- ment of all rights.

Discharge by Settlement Agreement A com- promise, or settlement agreement, that arises out of a genuine dispute over the obligations under an existing contract will be recognized at law. The agreement will be substituted as a new contract and will either expressly or impliedly revoke and discharge the obligations under the prior contract. In contrast to a novation, a substi- tuted agreement does not involve a third party. Rather, the two original parties to the contract form a different agreement to substitute for the original one.

Discharge by Accord and Satisfaction In an accord and satisfaction, the parties agree to accept per- formance that is different from the performance origi- nally promised. An accord is a contract to perform some accord is a contract to perform some accord act to satisfy an existing contractual duty that is not yet

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 273

discharged. A satisfaction is the performance of the accord agreement. An accord and its satisfaction discharge the original contractual obligation.

Once the accord has been made, the original obliga- tion is merely suspended until the accord agreement is fully performed. If it is not performed, the obligee (the one to whom performance is owed) can file a lawsuit based on either the original obligation or the accord. based on either the original obligation or the accord. based on either the original obligation or the accord. based on either the original obligation or the accord.

■ EXAMPLE 13.12 Fahreed has a judgment against Fahreed has a judgment against Ling for $8,000. Later, both parties agree that the judg- ment can be satisfied by Ling’s transfer of his automobile to Fahreed. This agreement to accept the auto in lieu of $8,000 in cash is the accord. If Ling transfers the car to Fahreed, the accord is fully performed, and the debt is discharged. If Ling refuses to transfer the car, the accord is breached. Because the original obligation was merely suspended, Fahreed can sue Ling to enforce the origi- nal judgment for $8,000 in cash or bring an action for breach of the accord. ■

13–2d Discharge by Operation of Law Under specified circumstances, contractual duties may be discharged by operation of law. These circumstances include material alteration of the contract, the running of the statute of limitations, bankruptcy, and the impos- sibility or impracticability of performance.

Material Alteration of the Contract To discour- age parties from altering written contracts, the law allows an innocent party to be discharged when the other party has materially altered a written contract without consent. For instance, suppose that a party alters a material term of a contract, such as the stated quantity or price, without the knowledge or consent of the other party. In this situa- tion, the party who was unaware of the alteration can treat the contract as discharged.

Statutes of Limitations Statutes of limitations restrict the period during which a party can sue on a par- ticular cause of action. After the applicable limitations period has passed, a suit can no longer be brought. The limitations period for bringing suits for breach of oral contracts usually is two to three years, and for written contracts, four to five years. Parties generally have ten to twenty years to file for recovery of amounts awarded in judgments, depending on state law.

Lawsuits for breach of a contract for the sale of goods usually must be brought within four years after the cause of action has accrued [UCC 2–725]. A cause of action for a sales contract generally accrues when the breach occurs, even if the aggrieved party is not aware of the

breach. A breach of warranty normally occurs when the seller delivers the goods to the buyer. By their original agreement, the parties can reduce this four-year period to not less than one year, but they cannot agree to extend it.

Bankruptcy A proceeding in bankruptcy attempts to allocate the debtor’s assets to the creditors in a fair and equitable fashion. Once the assets have been allocated, the debtor receives a discharge in bankruptcy. A discharge in bankruptcy ordinarily prevents the creditors from enforc- ing most of the debtor’s contracts. Partial payment of a debt after discharge in bankruptcy will not revive the debt.after discharge in bankruptcy will not revive the debt.after

Impossibility of Performance After a contract has been made, supervening events (such as a fire) may make performance impossible in an objective sense. This is known as impossibility of performance and can dis- charge a contract. The doctrine of impossibility of per- formance applies only when the parties could not have reasonably foreseen, at the time the contract was formed, the event that rendered performance impossible. Perfor- mance may also become so difficult or costly due to some unforeseen event that a court will consider it commer- cially unfeasible, or impracticable, as will be discussed shortly.

Objective impossibility (“It can’t be done”) must be disObjective impossibility (“It can’t be done”) must be disObjective impossibility - tinguished from subjective impossibility (“I’m sorry, I simply subjective impossibility (“I’m sorry, I simply subjective impossibility can’t do it”). An example of subjective impossibility occurs when a party cannot deliver goods on time because of freight car shortages or cannot make payment on time because the bank is closed. In effect, in each of these situations the party is saying, “It is impossible for me to perform,” not me to perform,” not me “It is impossible for anyone to perform.” Accordingly, such anyone to perform.” Accordingly, such anyone excuses do not discharge a contract, and the nonperform- ing party is normally held in breach of contract.

When Performance Is Impossible. �ree basic types of situations may qualify as grounds for the discharge of contractual obligations based on impossibility of performance:16

1. When one of the parties to a personal contract dies or When one of the parties to a personal contract dies or When one of the parties to a personal contract dies or becomes incapacitated prior to performance. becomes incapacitated prior to performance. becomes incapacitated prior to performance. ■ EXAMPLE 13.13 Frederic, a famous dancer, contracts with Ethe Frederic, a famous dancer, contracts with Ethe- real Dancing Guild to play a leading role in its new ballet. Before the ballet can be performed, Frederic becomes ill and dies. His personal performance was essential to the completion of the contract. Thus, his death discharges the contract and his estate’s liability for his nonperformance. ■

274 U N I T T H R E E The Commercial Environment

2. When the specific subject matter of the contract is When the specific subject matter of the contract is When the specific subject matter of the contract is When the specific subject matter of the contract is destroyed. ■ EXAMPLE 13.14 A-1 Farm Equipment A-1 Farm Equipment agrees to sell Gunther the green tractor on its lot and promises to have the tractor ready for Gunther to pick up on Saturday. On Friday night, however, a truck veers off the nearby highway and smashes into the tractor, destroying it beyond repair. Because the con- tract was for this specific tractor, A-1’s performance is rendered impossible owing to the accident. ■

3. When a change in law renders performance illegal.When a change in law renders performance illegal.When a change in law renders performance illegal.When a change in law renders performance illegal. ■ CASE IN POINT 13.15 Scott Harvard was a senior executive officer of Hampton Roads Bankshares (HRB) in Virginia. Harvard’s employment con- tract included a “golden parachute”—a payment of approximately three times his average annual com- pensation if he quit. During the 2008 recession, Congress enacted the Emergency Economic Stabili- zation Act (EESA) to stabilize the financial system.17 The EESA included the Troubled Assets Relief Pro- gram (TARP), which allowed the government to buy “troubled assets” from financial institutions to pro- mote market stability. HRB participated in TARP.

Later, when Harvard quit the firm, HRB refused to pay him the golden parachute amount because it believed that the EESA had made it illegal for them to do so. Harvard sued HRB to obtain pay- ment. Ultimately, the Virginia Supreme Court ruled that payment of the golden parachute would violate the EESA, and therefore HRB’s obligation to pay it was discharged. Because the purpose of the contrac- tual obligation (providing a golden parachute) had been rendered illegal, performance was objectively impossible.18 ■

Temporary Impossibility. An occurrence or event that makes performance temporarily impossible operates to suspend performance until the impossibility ceases. Once the temporary event ends, the parties ordinarily must perform the contract as originally planned. perform the contract as originally planned. perform the contract as originally planned. ■ EXAMPLE 13.16 Mindy and Lyn Carr contract to rent a sailboat Mindy and Lyn Carr contract to rent a sailboat from Key West Rentals for a month-long trip. �e day before their trip is scheduled to begin, a hurricane hits the coast where the boat is docked, causing damage. �e hurricane makes performance temporarily impos- sible, and the Carrs postpone their trip. Once the repairs are made to the dock and the boat, however, Key West Rentals would be required to perform the contract as

17. 12 U.S.C. Section 5201. 18. Hampton Roads Bankshares, Inc. v. Harvard, 291 Va. 42, 781 S.E.2d 172 Hampton Roads Bankshares, Inc. v. Harvard, 291 Va. 42, 781 S.E.2d 172 Hampton Roads Bankshares, Inc. v. Harvard

(2016).

originally planned. �e Carrs have a right to rent the boat for a month for the previously agreed-on price. ■

Sometimes, the lapse of time and the change in cir- cumstances surrounding the contract make it substan- tially more burdensome for the parties to perform the promised acts. In that situation, a court might hold that the contract is discharged.

Commercial Impracticability Courts may also excuse parties from their performance when it becomes much more difficult or expensive than the parties origi- nally contemplated at the time the contract was formed. For instance, a contract could be discharged because a party would otherwise have had to pay ten times more than the original estimate to perform the contract.

For someone to invoke the doctrine of commercial impracticability successfully, however, the anticipated impracticability successfully, however, the anticipated impracticability performance must become significantly more difficult or significantly more difficult or significantly costly.19 In addition, the added burden of performing must not have been foreseeable by the parties when the contract was made.

Frustration of Purpose Closely allied with the doc- trine of commercial impracticability is the doctrine of frustration of purpose. In principle, a contract will be discharged if supervening circumstances make it impos- sible to attain the purpose both parties had in mind when they made the contract. As with commercial impractica- bility and impossibility, the supervening event must not have been reasonably foreseeable at the time the contract was formed.

There are some differences between these doctrines, however. Commercial impracticability usually involves an event that increases the cost or difficulty of perfor- mance. In contrast, frustration of purpose typically involves an event that decreases the value of what a party receives under the contract.

13–3 Damages A breach of contract entitles the nonbreaching party to sue for monetary damages. In contract law, damages compensate the nonbreaching party for the loss of the bargain (whereas tort law damages compensate for harm suffered as a result of another’s wrongful act). Often, courts say that innocent parties are to be placed in the position they would have occupied had the contract been fully performed.

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 275

Collecting damages through a court judgment requires litigation, however, which can be expensive and time consuming. In addition, court judgments are often dif-consuming. In addition, court judgments are often dif-consuming. In addition, court judgments are often dif ficult to enforce, particularly if the breaching party does not have sufficient assets to pay the damages awarded. For these reasons, most parties settle their lawsuits for damages (or other remedies) prior to trial.

13–3a Types of Damages There are four broad categories of damages: 1. Compensatory (to cover direct losses and costs). 2. Consequential (to cover indirect and foreseeable

losses). 3. Punitive (to punish and deter wrongdoing). 4. Nominal (to recognize wrongdoing when no mon-

etary loss is shown). Compensatory and punitive damages were discussed in the context of tort law. Here, we look at these types of damages, as well as consequential and nominal damages, in the context of contract law.

Compensatory Damages Damages that compen- sate the nonbreaching party for the loss of the bargain are known as compensatory damages. These damages compen- sate the injured party only for damages actually sustained and proved to have arisen directly from the loss of the bar- gain caused by the breach of contract. They simply replace what was lost because of the wrong or damage and, for this reason, are often said to “make the person whole.”

■ CASE IN POINT 13.17 Janet Murley was the vice Janet Murley was the vice president of marketing at Hallmark Cards, Inc., until Hallmark eliminated her position as part of a corporate restructuring. Murley and Hallmark entered into a sepa- ration agreement under which she agreed not to work in the greeting card industry for eighteen months and not to disclose or use any of Hallmark’s confidential infor- mation. In exchange, Hallmark gave Murley a $735,000 severance payment.

After eighteen months, Murley took a job with Recy- cled Paper Greetings (RPG) for $125,000 and disclosed confidential Hallmark information to RPG. Hallmark sued for breach of contract and won. The jury awarded $860,000 in damages (the $735,000 severance payment and $125,000 that Murley received from RPG). Murley appealed. The appellate court held that Hallmark was entitled only to the return of the $735,000 severance pay- ment. Hallmark was not entitled to the other $125,000 because that additional award would have left Hallmark better off than if Murley had not breached the contract.20 ■

20. Hallmark Cards, Inc. v. Murley, 703 F.3d 456 (8th Cir. 2013).

Standard Measure. �e standard measure of compensa- tory damages is the di�erence between the value of the breaching party’s promised performance under the con- tract and the value of her or his actual performance. �is amount is reduced by any loss that the injured party has avoided.

■ EXAMPLE 13.18 Randall contracts to perform cer- tain services exclusively for Hernandez during the month of March for $4,000. Hernandez cancels the contract and is in breach. Randall is able to find another job dur- ing March but can earn only $3,000. He can sue Her- nandez for breach and recover $1,000 as compensatory damages. Randall can also recover from Hernandez the amount that he spent to find the other job. ■ Expenses that are caused directly by a breach of contract—such as those incurred to obtain performance from another source—are known as incidental damages.

Note that the measure of compensatory damages often varies by type of contract. Certain types of con- tracts deserve special mention.

Sale of Goods. In a contract for the sale of goods, the usual measure of compensatory damages is an amount equal to the di�erence between the contract price and the market price [UCC 2–708, 2–713]. ■ EXAMPLE 13.19 Medik Laboratories contracts to buy ten model UTS network servers from Cal Industries for $4,000 each. Cal Industries, however, fails to deliver the ten servers to Medik. �e market price of the servers at the time Medik learns of the breach is $4,500. �erefore, Medik’s measure of damages is $5,000 (10 × $500), plus any incidental damages (expenses) caused by the breach. ■

Sometimes, the buyer breaches when the seller has not yet produced the goods. In that situation, compen- satory damages normally equal lost profits on the sale, not the difference between the contract price and the market price.

Sale of Land. Ordinarily, because each parcel of land is unique, the remedy for a seller’s breach of a contract for a sale of real estate is speci�c performance. �at is, the buyer is awarded the parcel of property for which she or he bargained. (Speci�c performance will be discussed more Speci�c performance will be discussed more Speci�c performance fully later in this chapter.) �e majority of states follow this rule.

When the buyer is the party in breach, the measure of buyer is the party in breach, the measure of buyer damages is typically the difference between the contract price and the market price of the land. The same mea- sure is used when specific performance is not available (because the seller has sold the property to someone else, for instance).

276 U N I T T H R E E The Commercial Environment

Construction Contracts. �e measure of damages in a building or construction contract varies depending on which party breaches and when the breach occurs.

1. Breach by owner. The owner may breach at three dif-The owner may breach at three dif-The owner may breach at three dif ferent stages—before, during, or after performance. If the owner breaches before performance has begun, the contractor can recover only the profits that would have been made on the contract. (Profits equal the total contract price less the cost of materials and labor.) If the owner breaches during performance, the contractor can recover the profits plus the costs incurred in partially constructing the building. If the owner breaches after the construction has been com- pleted, the contractor can recover the entire contract price, plus interest.

2. Breach by contractor. When the construction contrac- tor breaches the contract—either by failing to begin construction or by stopping work partway through the project—the measure of damages is the cost of completion. The cost of completion includes reason- able compensation for any delay in performance. If the contractor finishes late, the measure of damages is the loss of use.

3. Breach by both owner and contractor. When the per- formance of both parties—the construction contrac- tor and the owner—falls short of what their contract required, the courts attempt to strike a fair balance in awarding damages.

Consequential Damages Foreseeable damages that result from a party’s breach of contract are called conse- quential damages, or special damages. They differ from compensatory damages in that they are caused by special circumstances beyond the contract itself. They flow from the consequences, or results, of a breach. When a seller fails to deliver goods, knowing that the buyer is plan- ning to use or resell those goods immediately, a court may award consequential damages for the loss of profits from the planned resale.

■ EXAMPLE 13.20 Marty contracts to buy a cer- tain quantity of Quench, a specialty sports drink, from Nathan. Nathan knows that Marty has contracted with Ruthie to resell and ship the Quench within hours of its receipt. The beverage will then be sold to fans attending the Super Bowl. Nathan fails to deliver the Quench on time. Marty can recover the consequential damages—the loss of profits from the planned resale to Ruthie—caused by the nondelivery. (If Marty purchases Quench from another vender, he can also recover compensatory dam- ages for any difference between the contract price and the market price.) ■

For the nonbreaching party to recover consequential damages, the breaching party must have known (or had reason to know) that special circumstances would cause the nonbreaching party to suffer an additional loss.

Punitive Damages Punitive damages are very seldom awarded in lawsuits for breach of contract. Because puni- tive damages are designed to punish a wrongdoer and set an example to deter similar conduct in the future, they have no legitimate place in contract law. A contract is simply a civil relationship between the parties. The law may compensate one party for the loss of the bargain—no more and no less. When a person’s actions cause both a breach of contract and a tort (such as fraud), however, punitive damages may be available.

Nominal Damages When no actual damage or finan- cial loss results from a breach of contract and only a tech- nical injury is involved, the court may award nominal damages to the innocent party. Awards of nominal dam- ages are often small, such as one dollar, but they do estab- lish that the defendant acted wrongfully. Most lawsuits for nominal damages are brought as a matter of principle under the theory that a breach has occurred and some damages must be imposed regardless of actual loss.

13–3b Mitigation of Damages In most situations, when a breach of contract occurs, the innocent injured party is held to a duty to mitigate, or reduce, the damages that he or she suffers. Under this doctrine of mitigation of damages, the duty owed depends on the nature of the contract.

For instance, some states require a landlord to use rea- sonable means to find a new tenant if a tenant abandons the premises and fails to pay rent. If an acceptable tenant is found, the landlord is required to lease the premises to this tenant to mitigate the damages recoverable from the former tenant.

The former tenant is still liable for the difference between the amount of the rent under the original lease and the rent received from the new tenant. If the landlord has not taken reasonable steps to find a new tenant, a court will likely reduce any award made by the amount of rent the landlord could have received had he or she done so.

13–3c Liquidated Damages versus Penalties A liquidated damages provision in a contract specifies that a certain dollar amount is to be paid in the event of a future default or breach of contract. (future default or breach of contract. (future Liquidated means Liquidated means Liquidated determined, settled, or fixed.)

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 277

Liquidated damages differ from penalties. Like liqui- dated damages, a penalty specifies a certain amount to penalty specifies a certain amount to penalty be paid in the event of a default or breach of contract. Unlike liquidated damages, it is designed to penalize the breaching party, not to make the innocent party whole.

Liquidated damages provisions usually are enforce- able. In contrast, if a court finds that a provision calls for a penalty, the agreement as to the amount will not be enforced. Recovery will be limited to actual damages.

Enforceability To determine if a particular provision is for liquidated damages or for a penalty, a court must answer two questions:

1. When the contract was entered into, was it apparent that damages would be difficult to estimate in the event of a breach?

2. Was the amount set as damages a reasonable estimate and not excessive?

If the answers to both questions are yes, the provision normally will be enforced. If either answer is no, the pro- vision usually will not be enforced.

In the following Spotlight Case, the court had to decide whether a clause in a contract was an enforce- able liquidated damages provision or an unenforceable penalty.

Background and Facts Gene Ford signed a five-year contract with Kent State University in Ohio to work as the head coach for the men’s basketball team. The contract provided that if Ford quit before the end of the term, he would pay liquidated damages to the school. The amount was to equal his salary ($300,000) multiplied by the number of years remaining on the contract. Laing Kennedy, Kent State’s athletic director, told Ford that the contract would be renegotiated within a few years. Four years before the contract expired, however, Ford left Kent State and began to coach for Bradley University at an annual salary of $700,000. Kent State filed a suit in an Ohio state court against Ford, alleging breach of contract. The court enforced the liquidated damages clause and awarded the uni- versity $1.2 million. Ford appealed, arguing that the liquidated damages clause in his employment contract was an unenforceable penalty.

In the Language of the Court Diane V. GRENDELL, J. [Judge]

* * * * * * * The parties agreed on an amount of damages, stated in clear terms in Ford’s * * * employment

contract. * * * It is apparent that such damages were difficult, if not impossible, to determine. * * * The departure of a university’s head basketball coach may result in a decrease in ticket sales, impact the ability to successfully recruit players and community support for the team, and require a search for both a new coach and additional coaching staff. Many of these damages cannot be easily measured or proven. This is especially true given the nature of how such factors may change over the course of different coaches’ tenures with a sports program or team. [Emphasis added.]

* * * * * * * Kennedy’s statements to Ford that the contract would be renegotiated within a few years made

it clear that Kent State desired Ford to have long-term employment, which was necessary to establish the stability in the program that would benefit recruitment, retention of assistant coaching staff, and com- munity participation and involvement. The breach of the contract impacted all of these areas.

* * * * Regarding the alleged unreasonableness of the damages, * * * based on the record, we find that the

damages were reasonable. * * * Finding a coach of a similar skill and experience level as Ford, which was gained based partially on the investment of Kent State in his development, would have an increased cost. This is evident from the fact that Ford was able to more than double his yearly salary when hired by Bradley University. The salary Ford earned at Bradley shows the loss of market value in coaching

Spotlight on Liquidated Damages

Case 13.3 Kent Case 13.3 Kent State University v. Fordtate University v. Ford Court of Appeals of Ohio, Eleventh District, Portage County, 26 N.E.3d 868, 2015-Ohio-41 (2015).Court of Appeals of Ohio, Eleventh District, Portage County, 26 N.E.3d 868, 2015-Ohio-41 (2015).Court of Appeals of Ohio, Eleventh District, Portage County, 26 N.E.3d 868, 2015-Ohio-41 (2015).

278 U N I T T H R E E The Commercial Environment

experienced by Kent State, $400,000 per year, for four years. Although this may not have been known at the time the contract was executed, it could have been anticipated, and was presumably why Kent State wanted to renegotiate the contract * * * . There was also an asserted decrease in ticket sales, costs associ- ated with the trips for the coaching search, and additional potential sums that may be expended.

* * * * As discussed extensively above, there was justification for seeking liquidated damages to compensate for

Kent State’s losses, and, thus, there was a valid compensatory purpose for including the clause. * * * Given all of the circumstances and facts in this case, and the consideration of the factors above, we cannot find that the liquidated damages clause was a penalty. [Emphasis added.]

Decision and Remedy A state intermediate appellate court affirmed the lower court’s award. At the time Ford’s contract was entered into, ascertaining the damages resulting from a breach was “difficult, if not impossible.” The court found, “based on the record, . . . that the damages were reasonable.” Thus, the clause was not a penalty—it had “a valid compensatory purpose.”

Critical Thinking • Cultural How does a college basketball team’s record of wins and losses, and its ranking in its conference,

support the court’s decision in this case?

Case 13.3 Continued

Liquidated Damages Common in Certain Con- tracts Liquidated damages provisions are frequently used in construction contracts. For instance, a provision requiring a construction contractor to pay $300 for every day he or she is late in completing the project is a liqui- dated damages provision. Such provisions are also com- mon in contracts for the sale of goods [UCC 2–718(1)]. In addition, contracts with entertainers and professional athletes often include liquidated damages provisions.

13–4 Equitable Remedies Sometimes, damages are an inadequate remedy for a breach of contract. In these situations, the nonbreaching party may ask the court for an equitable remedy. Equi- table remedies include rescission and restitution, specific performance, and reformation.

13–4a Rescission and Restitution Rescission is essentially an action to undo, or terminate, a contract—to return the contracting parties to the posi- tions they occupied prior to the transaction.21 When

21. The rescission discussed here is unilateral rescission, in which only one party wants to undo the contract. In mutual rescission, both parties agree to undo the contract. Mutual rescission discharges the contract. Unilateral rescission generally is available as a remedy for breach of contract.

fraud, a mistake, duress, undue influence, misrepresenta- tion, or lack of capacity to contract is present, unilateral rescission is available. Rescission may also be available by statute. The failure of one party to perform entitles the other party to rescind the contract. The rescinding party must give prompt notice to the breaching party.

Generally, to rescind a contract, both parties must make restitution to each other by returning goods, property, or funds previously conveyed. If the property or goods can be returned, they must be. If the goods or property have been consumed, restitution must be made in an equivalent dollar amount.

Essentially, restitution involves the plaintiff ’s recap- ture of a benefit conferred on the defendant that has unjustly enriched her or him. ■ EXAMPLE 13.21 Katie contracts with Mikhail to design a house for her. Katie pays Mikhail $9,000 and agrees to make two more pay- ments of $9,000 (for a total of $27,000) as the design progresses. The next day, Mikhail calls Katie and tells her that he has taken a position with a large architectural firm in another state and cannot design the house. Katie decides to hire another architect that afternoon. Katie can obtain restitution of the $9,000. ■

Restitution may be appropriate when a contract is rescinded, but the right to restitution is not limited to rescission cases. Because an award of restitution basically returns something to its rightful owner, a party can seek restitution in actions for breach of contract, tort actions, and other types of actions.

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 279

13–4b Specific Performance The equitable remedy of specific performance calls for the performance of the act promised in the contract. This remedy is attractive to a nonbreaching party because it provides the exact bargain promised in the contract. It also avoids some of the problems inherent in a suit for damages, such as collecting a judgment and arranging another contract. In addition, the actual performance may be more valuable than the monetary damages.

Normally, however, specific performance will not be granted unless the party’s legal remedy (monetary dam- ages) is inadequate. For this reason, contracts for the sale of goods rarely qualify for specific performance. The legal remedy—monetary damages—is ordinarily adequate in such situations because substantially identical goods can be bought or sold in the market. Only if the goods are unique will a court grant specific performance. For instance, paintings, sculptures, or rare books or coins are so unique that monetary damages will not enable a buyer to obtain substantially identical substitutes in the market.

Sale of Land A court may grant specific performance to a buyer in an action for a breach of contract involv- ing the sale of land. In this situation, the legal remedy of monetary damages may not compensate the buyer ade- quately. After all, every parcel of land is unique: the same land in the same location obviously cannot be obtained elsewhere. Only when specific performance is unavailable (such as when the seller has sold the property to someone else) will monetary damages be awarded instead.

A seller of land can also seek specific performance of the contract. ■ CASE IN POINT 13.22 Developer Charles Developer Charles Ghidorzi formed Crabtree Ridge, LLC, for the sole pur- pose of purchasing twenty-three acres of vacant land from Cohan Lipp, LLC. Crabtree signed a contract agreeing to pay $3.1 million for the land, which would be developed and paid for in three phases. When an environmental sur- vey showed that the land might contain some wetlands that could not be developed, Crabtree backed out of the deal. Lipp sued Crabtree for breach of contract, seeking specific performance. The court held that Lipp was enti- tled to specific performance of the land-sale contract.22 ■

Contracts for Personal Services Contracts for personal services require one party to work personally for another party. Courts generally refuse to grant specific performance of personal-service contracts. One reason is that to order a party to perform personal services against

22. Cohan Lipp, LLC v. Crabtree Ridge, LLC, 358 Wis.2d 711, 856 N.W.2d Cohan Lipp, LLC v. Crabtree Ridge, LLC, 358 Wis.2d 711, 856 N.W.2d Cohan Lipp, LLC v. Crabtree Ridge, LLC 346 (2014).

his or her will amounts to a type of involuntary servitude (slavery) forbidden by the U.S. Constitution.

Moreover, the courts do not want to monitor contracts for personal services, which usually require the exercise of personal judgment or talent. ■ EXAMPLE 13.23 Nicole Nicole contracts with a surgeon to perform surgery to remove a tumor on her brain. If he refuses, the court would not compel (nor would Nicole want) the surgeon to perform under those circumstances. A court cannot ensure mean- ingful performance in such a situation. ■

13–4c Reformation Reformation is an equitable remedy used when the par- ties have imperfectly expressed their agreement in writimperfectly expressed their agreement in writimperfectly - ing. Reformation allows a court to rewrite the contract to reflect the parties’ true intentions.

Exhibit 13–3 graphically summarizes the remedies, including reformation, that are available to the non- breaching party.

Fraud or Mutual Mistake Is Present Courts order reformation most often when fraud or mutual mistake (such as a clerical error) is present. Typically, a party seeks reformation so that some other remedy may then be pursued.

■ EXAMPLE 13.24 If Carson contracts to buy a fork- lift from Yoshie but their contract mistakenly refers to a crane, a mutual mistake has occurred. Accordingly, a court can reform the contract so that it conforms to the parties’ intentions and accurately refers to the forklift being sold. ■

Written Contract Incorrectly States the Parties’ Oral Agreement A court will also reform a contract when two parties enter into a binding oral contract but later make an error when they attempt to put the terms into writing. Normally, a court will allow into evidence the correct terms of the oral contract, thereby reforming the written contract.

Covenants Not to Compete Courts also may reform contracts that contain a written covenant not to compete. Such covenants are often included in contracts for the sale of ongoing businesses and in employment contracts. The agreements restrict the area and time in which one party can directly compete with the other party.

A covenant not to compete may be for a valid and legit- imate purpose, but may impose unreasonable area or time restraints. In such instances, some courts will reform the restraints by making them reasonable and will then enforce

280 U N I T T H R E E The Commercial Environment

the entire contract as reformed. Other courts will throw out the entire restrictive covenant as illegal. Thus, when businesspersons create restrictive covenants, they must make sure that the restrictions imposed are reasonable.

■ CASE IN POINT 13.25 Cardiac Study Center, Inc., a medical practice group, hired Dr. Robert Emerick. Later, Emerick became a shareholder of Cardiac and signed an agreement that included a covenant not to compete. The covenant stated that a physician who left the group promised not to practice competitively in the surround- ing area for a period of five years.

After Cardiac began receiving complaints from patients and other physicians about Emerick, it termi- nated his employment. Emerick sued Cardiac, claiming that the covenant not to compete that he had signed was unreasonable and should be declared illegal. Ultimately, a state appellate court held that the covenant was both rea- sonable and enforceable. Cardiac had a legitimate inter- est in protecting its existing client base and prohibiting Emerick from taking its clients.23 ■

13–5 Waiver of Breach Under certain circumstances, a nonbreaching party may be willing to accept a defective performance of the con- tract. This knowing relinquishment of a legal right (that is, the right to require satisfactory and full performance) is called a waiver.

23. Emerick v. Cardiac Study Center, Inc., 166 Wash.App. 1039 (2012).

13–5a Consequences of a Waiver of Breach When a waiver of a breach of contract occurs, the party waiving the breach cannot take any later action on it. In effect, the waiver erases the past breach, and the contract continues as if the breach had never occurred. Of course, the waiver of breach of contract extends only to the mat- ter waived and not to the whole contract.

13–5b Reasons for Waiving a Breach Businesspersons often waive breaches of contract to obtain whatever benefit is still possible out of the con- tract. ■ EXAMPLE 13.26 A seller, Purdue Resources, contracts with a buyer, Bladco Enterprises, to deliver ten thousand tons of coal on or before November 1. The contract calls for Bladco to pay by November 10 for coal delivered. Because of a coal miners’ strike, coal is hard to find. Purdue breaches the contract by not tendering delivery until November 5. Bladco will likely choose to waive the seller’s breach, accept delivery of the coal, and pay as contracted. ■

13–5c Waiver of Breach and Subsequent Breaches

Ordinarily, a waiver by a contracting party will not oper- ate to waive subsequent, additional, or future breaches of contract. This is always true when the subsequent breaches are unrelated to the first breach. ■ EXAMPLE 13.27 Ashton owns a multimillion-dollar apartment complex that is under construction. Ashton allows the

DAMAGES • Compensatory • Consequential • Punitive (rare) • Nominal • Liquidated

REMEDIES AVAILABLE TO NONBREACHING PARTY

RESCISSION AND RESTITUTION

SPECIFIC PERFORMANCE

REFORMATION

E X H I B I T 1 3 – 3 Remedies for Breach of Contract

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 281

contractor to complete a stage of construction late. By doing so, Ashton waives his right to sue for the delay. Ashton does not, however, waive the right to sue for failure to comply with engineering specifications on the same job. ■

Pattern-of-Conduct Exception A waiver can extend to subsequent defective performance if a reasonable person would conclude that similar defective perfor- mance in the future will be acceptable. Therefore, a pattern of conduct that waives a number of successive n of conduct that waives a number of successive n of conduct breaches will operate as a continued waiver. To change this result, the nonbreaching party should give notice to the breaching party that full performance will be required in the future.

Effect on the Contract The party who has ren- dered defective or less-than-full performance remains liable for the damages caused by the breach of contract. In effect, the waiver operates to keep the contract going. The waiver prevents the nonbreaching party from declar- ing the contract at an end or rescinding the contract. The contract continues, but the nonbreaching party can recover damages caused by the defective or less-than-full performance.

13–6 Contract Provisions Limiting Remedies

A contract may include provisions stating that no dam- ages can be recovered for certain types of breaches or that damages will be limited to a maximum amount. A con- tract may also provide that the only remedy for breach is replacement, repair, or refund of the purchase price. Finally, a contract may provide that one party can seek injunctive relief if the other party breaches the contract.

Provisions stating that no damages can be recovered are called exculpatory clauses. Provisions that affect the availability of certain remedies are called limitation-of- liability clauses. The Uniform Commercial Code (UCC) provides that in a contract for the sale of goods, remedies can be limited [UCC 2–719(1)].

Whether a limitation-of-liability clause in a contract will be enforced depends on the type of breach that is excused by the provision. Normally, a provision excluding liability for fraudulent or intentional injury will not be enforced. Likewise, a clause excluding liability for illegal acts, acts that are contrary to public policy, or violations of law will not be enforced. A clause that excludes liability for negligence may be enforced in some situations when the parties have roughly equal bargaining positions.

Debate This . . . Courts should always uphold limitation-of-liability clauses, whether or not the two parties to the contract had equal bargaining power.contract had equal bargaining power.contract had equal bargaining power

Reviewing: Contract Performance, Breach, and Remedies

Val’s Foods signs a contract to buy 1,500 pounds of basil from Sun Farms, a small organic herb grower, as long as an independent organization inspects the crop and certifies that it contains no pesticide or herbicide residue. Val’s has a contract with several restaurant chains to supply pesto and intends to use Sun Farms’ basil in the pesto to fulfill these contracts. While Sun Farms is preparing to harvest the basil, an unexpected hailstorm destroys half the crop. Sun Farms attempts to purchase additional basil from other farms, but it is late in the season, and the price is twice the normal market price. Sun Farms is too small to absorb this cost and immediately notifies Val’s that it will not fulfill the con- tract. Using the information presented in the chapter, answer the following questions. 1. Suppose that the basil does not pass the chemical-residue inspection. Which concept discussed in the chapter might

allow Val’s to refuse to perform the contract in this situation? 2. Under which legal theory or theories might Sun Farms claim that its obligation under the contract has been dis-

charged by operation of law? Discuss fully. 3. Suppose that Sun Farms contacts every basil grower in the country and buys the last remaining chemical-free basil

anywhere. Nevertheless, Sun Farms is able to ship only 1,475 pounds to Val’s. Would this fulfill Sun Farms’ obliga- tions to Val’s? Why or why not?

4. Now suppose that Sun Farms sells its operations to Happy Valley Farms. As a part of the sale, all three parties agree that Happy Valley will provide the basil as stated under the original contract. What is this type of agreement called?

282 U N I T T H R E E The Commercial Environment

Terms and Concepts adhesion contract 267 anticipatory repudiation 271 bilateral mistake 263 breach of contract 269 commercial impracticability 274 condition 268 condition precedent 268 consequential damages 276 discharge 267 discharge in bankruptcy 273

duress 266 frustration of purpose 274 impossibility of performance 273 incidental damages 275 liquidated damages 276 mitigation of damages 276 mutual rescission 272 nominal damages 276 novation 272 penalty 277

performance 267 reformation 279 restitution 278 speci�c performance 279 tender 268 undue in�uence 266 unilateral mistake 262 voluntary consent 262 waiver 280

Issue Spotters 1. Ready Foods contracts to buy two hundred carloads of

frozen pizzas from Stealth Distributors. Before Ready or Stealth starts performing, can the parties call off the deal? What if Stealth has already shipped the pizzas? Explain your answers. (See Performance and Discharge.)

2. Greg contracts to build a storage shed for Haney, who pays Greg in advance, but Greg completes only half the work. Haney pays Ipswich $500 to finish the shed. If Haney sues Greg, what will be the measure of recovery? (See Damages.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 13–1. Undue Influence. Juan is an elderly man who lives with his nephew, Samuel. Juan is totally dependent on Sam- uel’s support. Samuel tells Juan that unless he transfers a tract of land he owns to Samuel for a price 35 percent below its market value, Samuel will no longer support and take care of him. Juan enters into the contract. Discuss fully whether Juan can set aside this contract. (See Voluntary Consent.)

13–2. Conditions of Performance. The Caplans con- tract with Faithful Construction, Inc., to build a house for

them for $360,000. The specifications state “all plumbing bowls and fixtures . . . to be Crane brand.” The Caplans leave on vacation, and during their absence, Faithful is unable to buy and install Crane plumbing fixtures. Instead, Faithful installs Kohler brand fixtures, an equivalent in the industry. On completion of the building contract, the Caplans inspect the work, discover the substitution, and refuse to accept the house, claiming Faithful has breached the conditions set forth in the specifications. Discuss fully the Caplans’ claim. (See Performance and Discharge.)

Business Case Problems 13–3. Limitation-of-Liability Clauses. Mia Eriksson was a seventeen-year-old competitor in horseback-riding events. Her riding coach was Kristi Nunnink. Eriksson signed an agreement that released Nunnink from all liability except for damages caused by Nunnink’s “direct, willful and wanton negligence.” During an event at Galway Downs in Temecula, California, Eriksson’s horse struck a hurdle. She fell from the horse and the horse fell on her, causing her death. Her parents, Karan and Stan Eriksson, �led a suit in a California state court against Nunnink for wrongful death. Is the limitation- of-liability agreement that Eriksson signed likely to be enforced in her parents’ case? If so, how will it a�ect their claim? Explain. [Eriksson v. Nunnink, 233 Cal.App.4th 708, 183 Cal.Rptr.3d 234 (4 Dist. 2015)] (See Contract Provisions Limiting Remedies.)

13–4. Business Case Problem with Sample Answer— Discharge by Operation of Law. Dr. Jake Lambert signed

an employment agreement with Baptist Health Services, Inc., to provide cardiothoracic surgery services to Baptist Memorial Hospital–North Mississippi, Inc., in Oxford, Mississippi. Com-

plaints about Lambert’s behavior arose almost immediately. He was evaluated by a team of doctors and psychologists, who diagnosed him as su�ering from obsessive-compulsive person- ality disorder and concluded that he was un�t to practice medicine. Based on this conclusion, the hospital suspended his sta� privileges. Citing the suspension, Baptist Health Ser- vices claimed that Lambert had breached his employment contract. What is Lambert’s best defense to this claim? Explain. [Baptist Memorial Hospital–North Mississippi, Inc. v. Lambert,

C H A P T E R 1 3 Contract Performance, Breach, and Remedies 283

157 So.3d 109 (Miss.App. 2015)] (See Performance and Discharge.) • For a sample answer to Problem 13–4, go to Appendix E at

the end of this text.

13–5. Fraudulent Misrepresentation. Vianna Stibal owns and operates the �etaHealing Institute of Knowledge (THInK) in Idaho Falls, Idaho. �etaHealing is Stibal’s “self- discovered” healing method. In her book Go Up and Seek God, Stibal stated that she had been diagnosed with cancer and had cured herself using �etaHealing. But Stibal’s representation that she cured herself of cancer was false, and she knew it—her medical records did not con�rm a cancer diagnosis. Believ- ing Stibal’s claim, Kara Alexander traveled from New York to Idaho to pay for, and attend, classes in �etaHealing from Stibal. Later, Alexander began to question the validity of her THinK degree. What are the elements of a cause of action for fraudulent misrepresentation? Do the facts in this situation meet these requirements? Discuss. [Alexander v. Stibal, meet these requirements? Discuss. [Alexander v. Stibal, meet these requirements? Discuss. [ 160 Idaho 10, 368 P.3d 630 (2016)] (See Voluntary Consent.) 13–6. Damages. Robert Morris was a licensed insurance agent working for his father’s independent insurance agency when he contacted Farmers Insurance Exchange in Alabama about becoming a Farmers agent. According to Farmers’ com- pany policy, Morris was an unsuitable candidate due to his relationship with his father’s agency. But no Farmers repre- sentative told Morris of this policy, and none of the docu- ments that he signed expressed it. Farmers trained Morris and appointed him its agent. About three years later, however, Farmers terminated the appointment for “a con�ict of interest because his father was in the insurance business.” Morris �led a suit in an Alabama state court against Farmers, claiming that he had been fraudulently induced to leave his father’s agency to work for Farmers. If Morris was successful, what type of damages was he most likely awarded? What was the measure of damages? Discuss. [Farmers Insurance Exchange v. Morris, __ So.3d __, 2016 WL 661671 (Ala. 2016)] (See Damages.) 13–7. Conditions. H&J Ditching & Excavating, Inc., was hired by JRSF, LLC, to perform excavating and grading work on Terra Firma, a residential construction project in West Knox County, Tennessee. Cornerstone Community Bank �nanced the project with a loan to JRSF. As the work pro- gressed, H&J received payments totaling 90 percent of the price on its contract. JRSF then defaulted on the loan from

Cornerstone, and Cornerstone foreclosed and took possession of the property. H&J �led a suit in a Tennessee state court against the bank to recover the �nal payment on its contract. �e bank responded that H&J had not received its payment because it had failed to obtain an engineer’s certi�cate of �nal completion, a condition under its contract with JRSF. H&J responded that it had completed all the work it had contracted to do. What type of contract condition does obtaining the engineer’s certi�cate represent? Is H&J entitled to the �nal payment? Discuss. [H&H&H J Ditching &J Ditching & & Excavating, Inc. v. Cor- nerstone Community Bank, __ S.W.3d __, 2016 WL 675554 (Tenn.App. 2016)] (See Performance and Discharge.)

13–8. A Question of Ethics—Remedies. On a weekday, Tamara Cohen, a real estate broker, showed a town- house owned by Ray and Harriet Mayer to Jessica Seinfeld, the wife of comedian Jerry Seinfeld. On the weekend, when Cohen was unavailable because her

religious beliefs prevented her from working, the Seinfelds revis- ited the townhouse on their own and agreed to buy it. �e con- tract stated that the “buyers will pay buyer’s real estate broker’s fees.” [Cohen v. Seinfeld, [Cohen v. Seinfeld, [ 15 Misc.3d 1118(A), 839 N.Y.S.2d 432 (Sup. 2007)] (See 432 (Sup. 2007)] (See 432 (Sup. 2007)] Equitable Remedies.)

(a) Is Cohen entitled to payment even though she was not available to show the townhouse to the Seinfelds on the weekend? Explain.

(b) What obligation do parties involved in business deals owe to each other with respect to their religious beliefs? How might the situation in this case have been avoided?

13–9. Special Case Analysis—Material Breach. Go to Case Analysis 13.2, Kohel v. Bergen Auto Enterprises, L.L.C. Kohel v. Bergen Auto Enterprises, L.L.C. Kohel v. Bergen Auto Enterprises, L.L.C Read the excerpt, and answer the following questions. (a) Issue: This case involved allegations of breach of contract

involving which parties and for what actions? (b) Rule of Law: What is the difference between a material

breach and a minor breach of contract? (c) Applying the Rule of Law: How did the court determine

which party was in material breach of the contract in this case?

(d) Conclusion: Was the defendant liable for breach? Why or why not?

Legal Reasoning Group Activity 13–10. Anticipatory Repudiation. ABC Clothiers, Inc., has a contract with Taylor & Sons, a retailer, to deliver one thou- sand summer suits to Taylor’s place of business on or before May 1. On April 1, Taylor receives a letter from ABC informing him that ABC will not be able to make the delivery as scheduled. Taylor is very upset, as he had planned a big ad campaign and wants to sue ABC right away. (See Performance and Discharge.) (a) The first group will discuss whether Taylor can imme-

diately sue ABC for breach of contract (on April 2).

(b) Now suppose that Taylor’s son, Tom, tells his father that they cannot file a lawsuit until ABC actually fails to deliver the suits on May 1. The second group will decide who is correct, Taylor senior or Tom.

(c) Assume that Taylor & Sons can either file immediately or wait until ABC fails to deliver the goods. The third group will evaluate which course of action is better, given the circumstances.

284

W hen we turn to contracts for the sale and lease of goods, we move away from com-

mon law principles and into the area of statutory law. State statutory law governing sales and lease transac- tions is based on the Uniform Com- mercial Code (UCC), which has been adopted as law by all of the states.1

Of all the attempts to produce a uniform body of laws relating

1. Louisiana has not adopted Articles 2 and 2A, however.however.

to commercial transactions in the United States, none has been as successful as the UCC. It is the single most comprehensive codi- fication of the broad spectrum of laws involved in a total commercial transaction.

The goal of the UCC is to sim- plify and to streamline commercial transactions. The UCC allows parties to form sales and lease contracts, including those entered into online, without observing the same degree of

formality used in forming other types of contracts.

Today, businesses often engage in sales and lease transactions on a global scale. The United Nations Convention on Contracts for the International Sale of Goods (CISG) governs international sales contracts. The CISG is a model uniform law that applies only when a nation has adopted it, just as the UCC applies only to the extent that it has been adopted by a state.

Sales and Lease Contracts

C H A P T E R 14

In general, the rule is that whenever a conflict arises between a common law contract rule and the state statu- tory law based on the UCC, the UCC controls. Thus, when a UCC provision addresses a certain issue, the UCC rule governs. When the UCC is silent, the com- mon law governs. The relationship between general contract law and the law governing sales of goods is illus- trated in Exhibit 14–1.

In regard to Article 2, keep two points in mind.

1. Article 2 deals with the sale of goods. It does not deal with real property (real estate), services, or intangible property such as stocks and bonds. Thus, if the sub- ject matter of a dispute is goods, the UCC governs. If it is real estate or services, the common law applies.

2. In some situations, the rules can vary depending on whether the buyer or the seller is a merchant.

We look now at how the UCC defines a sale, goods, and merchant status.

What Is a Sale? The UCC defines a sale as “the pass- ing of title [evidence of ownership rights] from the seller to the buyer for a price” [UCC 2–106(1)]. The price may be payable in cash or in other goods or services.

What Are Goods? To be characterized as a good, an item of property must be tangible, and it must be movable.

14–1 The Scope of Articles 2 (Sales) and 2A (Leases)

The UCC attempts to provide a consistent and integrated framework of rules to deal with all the phases ordinarily arising in a commercial sales transaction from start to finarising in a commercial sales transaction from start to finarising - ish. Article 2 of the UCC sets forth the requirements for sales contracts, as well as the duties and obligations of the parties involved in the sales contract. Article 2A covers similar issues for lease contracts. Bear in mind, however, that the parties to sales or lease contracts are free to agree to terms different from those stated in the UCC.

14–1a Article 2—The Sale of Goods Article 2 of the UCC (as adopted by state statutes) gov- erns sales contracts, or contracts for the sale of goods. To facilitate commercial transactions, Article 2 modifies some of the common law contract requirements that were discussed in the previous chapters.

To the extent that it has not been modified by the UCC, however, the common law of contracts also applies to sales contracts. In other words, the common law requirements for a valid contract—agreement consider- ation, capacity, and legality—are also applicable to sales contracts.

C H A P T E R 1 4 Sales and Lease Contracts 285

Tangible property has physical existence—it can be Tangible property has physical existence—it can be Tangible property touched or seen. Intangible property—such as corporate Intangible property—such as corporate Intangible property stocks and bonds, patents and copyrights, and ordinary contract rights—has only conceptual existence and thus does not come under Article 2. A movable item can be movable item can be movable carried from place to place. Hence, real estate is excluded from Article 2.

Goods Associated with Real Estate. Goods associated with real estate often do fall within the scope of Article 2, however [UCC 2–107]. For instance, a contract for the sale of minerals, oil, or gas is a contract for the sale of goods if severance, or separation, is to be made by the seller. Similarly, a contract for the sale of growing crops or tim- ber to be cut is a contract for the sale of goods regardless of who severs them from the land.

Goods and Services Combined. When contracts involve a combination of goods and services, courts generally use the predominant-factor test to determine whether a con- tract is primarily for the sale of goods or the sale of services.2 If a court decides that a mixed contract is primarily a goods contract, any dispute, even a dispute over the sevices any dispute, even a dispute over the sevices any portion, will be decided under the UCC.

2. UCC 2–314(1) does stipulate that serving food or drinks is a “sale of goods” for purposes of the implied warranty of merchantability, which will be discussed in the context of warranties. The UCC also specifies that selling unborn animals or rare coins qualifies as a “sale of goods.”

■ CASE IN POINT 14.1 H & C Ag Services, LLC, H & C Ag Services, LLC, entered into a contract with Ohio Fresh Eggs, LLC, that referred to “manure brokering services.” H & C agreed to pay Ohio Fresh “service fees” for “all available ton- nage per year of manure,” which would then be resold to other parties. But the parties’ contract did not specify the amount of manure. When Ohio Fresh did not carry out the contract, H & C sued for breach. A jury ruled that the primary purpose of the contract was for “manure bro- kering” (a service) rather than the “purchase of manure” (goods) and thus the UCC did not apply. The state trial court awarded H & C more than $2.5 million in dam- ages. Ohio Fresh appealed.

The reviewing court held that the UCC governed the parties’ contract under the predominant-factor test. The purpose of the contract was for the sale of goods—the manure—not the removal or resale of it. Despite the con- tract’s use of the words brokering and brokering and brokering service fees, H & C was clearly the buyer of manure from Ohio Fresh, who was the seller. Therefore, the UCC applied. Because the quantity term was left open, the parties had not agreed on not agreed on not an essential term. This meant that the contract was not enforceable under the UCC (open terms are discussed later in this chapter). Therefore, the appellate court reversed the lower court’s decision and held in favor of Ohio Fresh.3 ■

3. H & C Ag Services, LLC v. Ohio Fresh Eggs, LLC, 41 N.E.3d 915 (Ohio App. 2015).

C o nt ro l s

C o n t r o l

Relevant Common Law Not Modified by the UCC

Contracts for the Sale and Lease of Goods

Nonsales Contracts (contracts outside the UCC, primarily contracts

for services and for real estate)

Statutory Law (UCC Articles 2 and 2A)

General Contract Law

E X H I B I T 1 4 – 1 The Law Governing Contracts This exhibit graphically illustrates the relationship between general contract law and statutory law (UCC Articles 2 and 2A) governing contracts for the sale and lease of goods. Sales contracts are not governed exclusively by Article 2 of the UCC but are also governed by general contract law whenever it is relevant and has not been modified by the UCC.

286 U N I T T H R E E The Commercial Environment

Who Is a Merchant? Article 2 governs the sale of goods in general. It applies to sales transactions between all buy-in general. It applies to sales transactions between all buy-in general. It applies to sales transactions between all buy ers and sellers. In a limited number of instances, though, the UCC presumes that special business standards ought to be imposed because of merchants’ relatively high degree of commercial expertise.4 Such standards do not apply to the casual or inexperienced seller or buyer (consumer).

Section 2–104 sets forth three ways in which mer- chant status can arise:

1. A merchant is a person who deals in goods of the kind involved in the sales contract. Thus, a retailer, a wholesaler, or a manufacturer is a merchant of the goods sold in his or her business. A merchant for one type of goods is not necessarily a merchant for another type. For instance, a sporting goods retailer is a merchant when selling tennis rackets but not when selling a used computer.

2. A merchant is a person who, by occupation, holds himself or herself out as having knowledge and skill unique to the practices or goods involved in the transaction. This broad definition may include banks or universities as merchants.

3. A person who employs a merchant as a broker, agent, or other intermediary has the status of merchant in that transaction. Hence, if an art collector hires a broker to purchase or sell art for her, the collector is consid- ered a merchant in the transaction.

In summary, a person is a merchant when she or he, merchant when she or he, merchant acting in a mercantile capacity, possesses or uses an exper- tise specifically related to the goods being sold. This basic distinction is not always clear-cut. For instance, state courts appear to be split on whether farmers should be considered merchants.

14–1b Article 2A—Leases Leases of personal property (goods such as automobiles and industrial equipment) have become increasingly common. In this context, a lease is a transfer of the right to possess and use goods for a period of time in exchange for pay- ment. A lessor is one who transfers the right to the posseslessor is one who transfers the right to the posseslessor - sion and use of goods to a lessee [UCC 2A–103(1)(k), (p)]. lessee [UCC 2A–103(1)(k), (p)]. lessee A lessee is the one who is leasing goods from a lessor.

Article 2A covers any transaction that creates a lease of goods or a sublease of goods [UCC 2A–102, 2A–103(1) (k)]. Article 2A is essentially a repetition of Article 2, except that it applies to leases of goods rather than sales of goods

4. The provisions that apply only to merchants deal principally with the Statute of Frauds, firm offers, confirmatory memoranda, warranties, and contract modification, as will be discussed later in this chapter.

and thus varies to reflect differences between sales and lease transactions. (Note that Article 2A is not concerned with leases of real property, such as land or buildings.)

14–2 The Formation of Sales and Lease Contracts

In regard to the formation of sales and lease contracts, the UCC modifies the common law in several ways. Remem- ber, though, that parties to sales and lease contracts are basically free to establish whatever terms they wish.

The UCC comes into play when the parties either fail to provide certain terms in their contract or wish to change the effect of the UCC’s terms in the contract’s application. The UCC makes this very clear by its repeated use of such phrases as “unless the parties other- wise agree” and “absent a contrary agreement by the parties.”

14–2a Offer In general contract law, the moment a definite offer is met by an unqualified acceptance, a binding contract is formed. In commercial sales transactions, the verbal exchanges, correspondence, and actions of the parties may not reveal exactly when a binding contractual obliga- tion arises. The UCC states that an agreement sufficient to constitute a contract can exist even if the moment of its making is undetermined [UCC 2–204(2), 2A–204(2)].

Open Terms According to general contract law, an offer must be definite enough for the parties (and the courts) to ascertain its essential terms when it is accepted. In contrast, the UCC states that a sales or lease contract will not fail for indefiniteness even if one or more terms are left open as long as both of the following are true:both of the following are true:both 1. The parties intended to make a contract. 2. There is a reasonably certain basis for the court to

grant an appropriate remedy [UCC 2–204(3), 2A–204(3)].

The UCC provides numerous open-term provisions that can be used to fill the gaps in a contract. For instance, if the parties have not agreed on a price, the court will determine a “reasonable price at the time for delivery” [UCC 2–305(1)]. When the parties do not specify pay-[UCC 2–305(1)]. When the parties do not specify pay-[UCC 2–305(1)]. When the parties do not specify pay ment terms, payment is due at the time and place at which the buyer is to receive the goods [UCC 2–310(a)]. When no delivery terms are speci�ed, the buyer normally takes delivery at the seller’s place of business [UCC 2–308(a)].

C H A P T E R 1 4 Sales and Lease Contracts 287

Keep in mind, though, that if too many terms are left open, a court may find that the parties did not intend to form a contract. Also, the quantity of goods involved usuquantity of goods involved usuquantity - ally must be expressly stated in the contract. If the quan- tity term is left open, the courts will have no basis for determining a remedy. The UCC recognizes two excep- tions to this rule in requirements and output contracts [UCC 2–306(1)].

Requirements Contracts. Requirements contracts are common in the business world and normally are enforce- able. In a requirements contract, the buyer agrees to purchase and the seller agrees to sell all or up to a stated amount of what the buyer requires.

■ EXAMPLE 14.2 Newport Cannery forms a contract with Victor Tu. The cannery agrees to purchase from Tu, and Tu agrees to sell to the cannery, all of the green beans that the cannery requires during the following summer. There is implicit consideration in this contract because the buyer (the cannery) gives up the right to buy goods (green beans) from any other seller. This forfeited right creates a legal detriment—that is, consideration. detriment—that is, consideration. detriment ■

If, however, the buyer promises to purchase only if he or she wishes to do so, the promise is illusory (without wishes to do so, the promise is illusory (without wishes consideration) and unenforceable by either party. Simi- larly, if the buyer reserves the right to buy the goods from someone other than the seller, the promise is unenforce- able (illusory) as a requirements contract.

Output Contracts. In an output contract, the seller agrees to sell and the buyer agrees to buy all or up to a agrees to sell and the buyer agrees to buy all or up to a agrees to sell and the buyer agrees to buy all or up to a agrees to sell and the buyer agrees to buy all or up to a stated amount of what the seller produces. ■ EXAMPLE 14.3 Ruth Sewell has planted two acres of organic toma Ruth Sewell has planted two acres of organic toma- toes. Bella Union, a local restaurant, agrees to buy all of the tomatoes that Sewell produces that year to use at the restaurant. Again, because the seller essentially forfeits the right to sell goods to another buyer, there is implicit con- sideration in an output contract. ■

The UCC imposes a good faith limitation on require- ments and output contracts. The quantity under such contracts is the amount of requirements or the amount of output that occurs during a normal production period. normal production period. normal The actual quantity purchased or sold cannot be unrea- sonably disproportionate to normal or comparable prior requirements or output [UCC 2–306(1)].

Merchant’s Firm Offer Under regular contract prin- ciples, an offer can be revoked at any time before accep- tance. The major common law exception is an option contract, in which the offeree pays consideration for the contract, in which the offeree pays consideration for the contract offeror’s irrevocable promise to keep the offer open for a stated period. The UCC creates a second exception for

firm offers made by a merchant concerning the sale or lease of goods (regardless of whether or not the offeree is a merchant).

A firm offer arises when a merchant-offeror gives firm offer arises when a merchant-offeror gives firm offer assurances in a signed writing that the offer will remain assurances in a signed writing that the offer will remain assurances in a signed writing open. The merchant’s firm offer is irrevocable without the necessity of consideration5 for the stated period or, if no definite period is stated, a reasonable period (neither to exceed three months) [UCC 2–205, 2A–205].

To qualify as a �rm o�er, the o�er must be: 1. Written (or electronically recorded, such as in an

e-mail). 2. Signed by the offeror (including e-signatures).

■ EXAMPLE 14.4 Osaka, a used-car dealer, e-mails a letter to Gomez on January 1, stating, “I have a used 2016 Toyota RAV4 on the lot that I’ll sell you for $22,000 any time between now and January 31.” This e-mail creates a firm offer, and Osaka will be liable for breach of contract if he sells the RAV4 to another person before January 31. ■

14–2b Acceptance Acceptance of an offer to buy, sell, or lease goods gener- ally may be made in any reasonable manner and by any reasonable means. The UCC permits acceptance of an offer to buy goods “either by a prompt promise to ship promise to ship promise or by the prompt or current shipment of conforming or nonconforming goods” [UCC 2–206(1)(b)]. Conforming goods accord with the contract’s terms, whereas goods accord with the contract’s terms, whereas goods noncon- forming goods do not.forming goods do not.forming goods

The prompt shipment of nonconforming goods con- stitutes both an acceptance, which creates a contract, and a breach of that contract. This rule does not apply if the seller seasonably (within a reasonable amount of time) seasonably (within a reasonable amount of time) seasonably notifies the buyer that the nonconforming shipment is offered only as an accommodation, or as a favor. The notice of accommodation must clearly indicate to the buyer that the shipment does not constitute an accep- tance and that, therefore, no contract has been formed.

■ EXAMPLE 14.5 McFarren Pharmacy orders five McFarren Pharmacy orders five cases of Johnson & Johnson 3-by-5-inch gauze pads from H.T. Medical Supply, Inc. If H.T. ships five cases of Xeroform 3-by-5-inch gauze pads instead, the ship- ment acts as both an acceptance of McFarren’s offer and a breach of the resulting contract. McFarren may sue H.T. for any appropriate damages. If, however, H.T. notifies McFarren that the Xeroform pads are being shipped as an accommodation—because H.T. has only Xeroform pads

5. If the offeree pays consideration, then an option contract (not a mer- chant’s firm offer) is formed.

288 U N I T T H R E E The Commercial Environment

in stock—the shipment does not act as an acceptance. Instead, it constitutes a counteroffer, and a contract will be formed only if McFarren accepts the Xeroform gauze pads. ■

Communication of Acceptance Under the com- mon law, because a unilateral offer invites acceptance by performance, the offeree need not notify the offeror of performance unless the offeror would not otherwise know about it. In other words, a unilateral offer can be accepted by beginning performance.

The UCC is more stringent than the common law in this regard because it requires notification. Under the UCC, if the offeror is not notified within a reasonable time that the offeree has accepted the contract by beginning performance, then the offeror can treat the offer as having lapsed before acceptance [UCC 2–206(2), 2A–206(2)].

Additional Terms Recall that under the common law, the mirror image rule requires that the terms of the accepthe mirror image rule requires that the terms of the accepthe mirror image rule requires that the terms of the accepthe mirror image rule requires that the terms of the accep- tance exactly match those of the offer. ■ EXAMPLE 14.6 Adderson e-mails an offer to sell twenty Samsung Galaxy model S2 tablets to Beale. If Beale accepts the offer but changes it to require model S4 tablets, then there is no contract if the mirror image rule applies. ■

To avoid such problems, the UCC dispenses with the mirror image rule. Under the UCC, a contract is formed if the offeree’s response indicates a definite acceptance of definite acceptance of definite the offer, even if the acceptance includes terms additional to or different from those contained in the offer [UCC to or different from those contained in the offer [UCC to or different from those contained in the offer 2–207(1)]. Whether the additional terms become part of the contract depends, in part, on whether the parties are nonmerchants or merchants.

Rules When One Party or Both Parties Are Nonmer- chants. If one (or both) of the parties is a nonmerchant, the contract is formed according to the terms of the origi- nal o�er. �e contract does not include any of the addi- tional terms in the acceptance [UCC 2–207(2)].

■ CASE IN POINT 14.7 OfficeSupplyStore.com sells office supplies on the Web. Employees of the Kansas City School District in Missouri ordered $17,642.54 worth of office supplies—without the authority or approval of their employer—from the Web site. The invoices accom- panying the goods contained a forum-selection clausepanying the goods contained a forum-selection clausepanying the goods contained a that forum-selection clause that forum-selection clause required all disputes to be resolved in California.

When the goods were not paid for, Office Supply filed suit in California. The Kansas City School District objected, arguing that the forum-selection clause was not binding. The court held that the forum-selection clause

was not part of the parties’ contract. The clause was an additional term included in the invoices delivered to a nonmerchant buyer (the school district) with the pur- chased goods. Therefore, the clause did not become part of the contract unless the buyer expressly agreed, which did not happen in this case.6 ■

Rules When Both Parties Are Merchants. �e UCC includes a special rule for merchants to avoid the “bat- tle of the forms,” which occurs when two merchants exchange separate standard forms containing di�erent contract terms.

Under UCC 2–207(2), in contracts between mer- chants, the additional terms automatically become part of automatically become part of automatically the contract unless one of the following conditions arises:unless one of the following conditions arises:unless 1. The original offer expressly limited acceptance to its

terms. 2. The new or changed terms materially alter the

contract. 3. The offeror objects to the new or changed terms

within a reasonable period of time. When determining whether an alteration is material,

courts consider several factors. Generally, if the modifica- tion does not involve any unreasonable element of sur- prise or hardship for the offeror, a court will hold that the modification did not materially alter the contract. Courts also consider the parties’ prior dealings.

Conditioned on Offeror’s Assent. �e o�eree’s response is not an acceptance if it contains additional or di�erent terms and is expressly conditioned on the o�eror’s assent to conditioned on the o�eror’s assent to conditioned those terms [UCC 2–207(1)]. �is is true whether or not the parties are merchants.

Additional Terms May Be Stricken. �e UCC provides yet another option for dealing with con�icting terms in the parties’ writings. Section 2–207(3) states that conduct by both parties that recognizes the existence of a contract is su�cient to establish a contract for sale. �is is so even if the writings of the parties do not otherwise establish a contract. In this situation, “the terms of the particular contract will consist of those terms on which the writ- ings of the parties agree, together with any supplemen- tary terms incorporated under any other provisions of this Act.” In a dispute over contract terms, this provision allows a court simply to strike from the contract those terms on which the parties do not agree.

6. OfficeSupplyStore.com v. Kansas City School Board, 334S.W.3d 574 (Kan. OfficeSupplyStore.com v. Kansas City School Board, 334S.W.3d 574 (Kan. OfficeSupplyStore.com v. Kansas City School Board 2011).

C H A P T E R 1 4 Sales and Lease Contracts 289

As noted previously, the fact that a merchant’s accep- tance frequently contains terms that add to or even con- flict with those of the offer is often referred to as the “battle of the forms.” Although the UCC tries to elimi- nate this battle, the problem of differing contract terms still arises in commercial settings, particularly when stan- dard forms (for placing and confirming orders) are used.

14–2c Consideration The common law rule that a contract requires consider- ation also applies to sales and lease contracts. Unlike the common law, however, the UCC does not require a con- tract modification to be supported by new consideration. The UCC states that an agreement modifying a contract for the sale or lease of goods “needs no consideration to be binding” [UCC 2–209(1), 2A–208(1)]. Of course, any contract modification must be made in good faith [UCC 1–304].

In some situations, an agreement to modify a sales or lease contract without consideration must be in writing

to be enforceable. For instance, if the contract itself speci- fies that any changes to the contract must be in a signed writing, only those changes agreed to in a signed writing are enforceable.

Sometimes, when a consumer (nonmerchant) is buy- ing goods from a merchant-seller, the merchant supplies a form that contains a prohibition against oral modifica- tion. In those situations, the consumer must sign a sepa- rate acknowledgment of the clause for it to be enforceable [UCC 2–209(2), 2A–208(2)]. Also, any modification that makes a sales contract come under Article 2’s writ- ing requirement (its Statute of Frauds, discussed next) usually requires a writing (or electronic record) to be enforceable.

See Concept Summary 14.1 for a review of the UCC’s rules on offer, acceptance, and consideration.

14–2d The Statute of Frauds The UCC contains Statute of Frauds provisions cover- ing sales and lease contracts. Under these provisions,

Offer, Acceptance, and Consideration under the UCC

Concept Summary 14.1

Not all terms have to be included for a contract to be formed. The price does not have to be included for a contract to be formed. Particulars of performance can be left open. An offer by a merchant in a signed writing with assurances that the offer will not be withdrawn is irrevocable without consideration (for up to three months).

OffeOffeOf r

Acceptance may be made by any reasonable means of communication. It is effective when dispatched. An offer can be made by a promise to ship or by the shipment of conforming goods, or by prompt shipment of nonconforming goods unless accompanied by a notice of accommodation. Acceptance by performance requires notice within a reasonable time. Otherwise, the offer can be treated as lapsed. A definite expression of acceptance creates a contract even if the terms of the acceptance differ from those of the offer (unless acceptance is expressly conditioned on consent to the additional or different terms).

Acceptance

A modification of a contract for the sale or lease of goods does not requiremodification of a contract for the sale or lease of goods does not requiremodification consideration as long as it is made in good faith.

Consideration

●

290 U N I T T H R E E The Commercial Environment

sales contracts for goods priced at $500 or more and lease contracts requiring total payments of $1,000 or more must be in writing to be enforceable [UCC 2–201(1), 2A–201(1)]. (These low threshold amounts may eventu- ally be raised.)

Sufficiency of the Writing A writing, including an e-mail or other electronic record, will be sufficient to sat- isfy the UCC’s Statute of Frauds as long as it: 1. Indicates that the parties intended to form a contract. 2. Is signed by the party (or agent of the party) against

whom enforcement is sought. (Remember that a typed name can qualify as a signature on an elec- tronic record.)

The contract normally will not be enforceable beyond the quantity of goods shown in the writing, however. All other terms can be proved in court by oral testimony. For leases, the writing must reasonably identify and describe the goods leased and the lease term.

Special Rules for Contracts between Mer- chants The UCC provides a special rule for merchants in sales transactions (there is no corresponding rule that applies to leases under Article 2A). Merchants can satisfy the Statute of Frauds if, after the parties have agreed orally, one of the merchants sends a signed written confirmation to the other merchant within a reasonable time.

The communication must indicate the terms of the agreement, and the merchant receiving the confirmation must have reason to know of its contents. Unless the mer- chant who receives the confirmation gives written notice of objection to its contents within ten days after receipt, the writing is sufficient against the receiving merchant, even though she or he has not signed it [UCC 2–201(2)].even though she or he has not signed it [UCC 2–201(2)].even though she or he has not signed it [UCC 2–201(2)].even though she or he has not signed it [UCC 2–201(2)].

■ EXAMPLE 14.8 Alfonso is a merchant-buyer in Cleveland. He contracts over the telephone to purchase $6,000 worth of spare aircraft parts from Goldstein, a merchant-seller in New York City. Two days later, Gold- stein e-mails a signed confirmation detailing the terms of the oral contract, and Alfonso subsequently receives it. Alfonso does not notify Goldstein in writing that he objects to the contents of the confirmation within ten days of receipt. Therefore, Alfonso cannot raise the Stat- ute of Frauds as a defense against the enforcement of the oral contract. ■

Exceptions The UCC defines three exceptions to the writing requirements of the Statute of Frauds [UCC 2–201(3), 2A–201(4)].

1. Specially manufactured goods. An oral contract will still be enforceable if it is for goods that are specially manufactured for a particular buyer and the seller has substantially started manufacturing the goods.

2. Admissions. When the party against whom enforce- ment is sought admits to making an oral contract, the contract is enforceable, but only as to the quantity of goods that the party admitted. ■ CASE IN POINT 14.9 Gerald Lindgren, a farmer, agreed by phone to sell his crops to Glacial Plains Cooperative. The parties reached four oral agreements: two for the delivery of soybeans and two for the delivery of corn. Lindgren made the soybean deliveries and part of the first corn delivery, but he sold the rest of his corn to another dealer. Glacial Plains bought corn elsewhere, paying a higher price, and then sued Lindgren for breach of contract. In papers filed with the court, Lindgren acknowledged his oral agreements with Glacial Plains and admitted that he did not fully perform. The court applied the admissions exception and held that the four agreements were enforceable.7 ■

3. Partial performance. An oral contract that has been partially performed (such as when some of the con- tracted goods have been paid for and accepted) will be enforceable to the extent that it has been performed.

The exceptions just discussed and other ways in which sales law differs from general contract law are summa- rized in Exhibit 14–2.

14–2e Unconscionability An unconscionable contract is one that is so unfair and one sided that it would be unreasonable to enforce it. The UCC allows a court to evaluate a contract or any clause in a contract, and if the court deems it to have been unconscionable at the time it was made, the court can do any of the following [UCC 2–302, 2A–108]: 1. Refuse to enforce the contract. 2. Enforce the remainder of the contract without the

unconscionable part. 3. Limit the application of the unconscionable term to

avoid an unconscionable result. The following classic case illustrates an early applica-

tion of the UCC’s unconscionability provisions.

7. Glacial Plains Cooperative v. Lindgren, 759 N.W.2d 661 (Minn.App. 2009).

C H A P T E R 1 4 Sales and Lease Contracts 291

Background and Facts The Joneses agreed to purchase a freezer for $900 as the result of a sales- person’s visit to their home. Tax and financing charges raised the total price to $1,234.80. Later, the Joneses, who had made payments totaling $619.88, brought a suit in a New York state court to have Joneses, who had made payments totaling $619.88, brought a suit in a New York state court to have Joneses, who had made payments totaling $619.88, brought a suit in a New Y the purchase contract declared unconscionable under the UCC. At trial, the freezer was found to have a maximum retail value of approximately $300.

In the Language of the Court Sol M. WACHTLER, Justice.

* * * * * * * [Section 2–302 of the UCC] authorizes the court to find, as a matter of law, that a contract or

a clause of a contract was “unconscionable at the time it was made,” and upon so finding the court may refuse to enforce the contract, excise the objectionable clause or limit the application of the clause to avoid an unconscionable result.

* * * * * * * The question which presents itself is whether or not, under the circumstances of this case, the

sale of a freezer unit having a retail value of $300 for $900 ($1,439.69 including credit charges and $18 sales tax) is unconscionable as a matter of law.

Concededly, deciding [this case] is substantially easier than explaining it. No doubt, the mathemati- cal disparity between $300, which presumably includes a reasonable profit margin, and $900, which is exorbitant on its face, carries the greatest weight. Credit charges alone exceed by more than $100 the retail value of the freezer. These alone may be sufficient to sustain the decision. Yet, a caveat [warning] is warranted lest we reduce the import of Section 2–302 solely to a mathematical ratio formula. It may, at times, be that; yet it may also be much more. The very limited financial resources of the purchaser, known to the sellers at the time of the sale, is entitled to weight in the balance. Indeed, the value dispar- ity itself leads inevitably to the felt conclusion that knowing advantage was taken of the plaintiffs. In addition, the meaningfulness of choice essential to the making of a contract can be negated by a gross inequal- ity of bargaining power. [Emphasis added.]

* * * * * * * The defendant has already been amply compensated. In accordance with the statute, the appli-

cation of the payment provision should be limited to amounts already paid by the plaintiffs and the contract be reformed and amended by changing the payments called for therein to equal the amount of payment actually so paid by the plaintiffs.

Decision and Remedy The court held that the contract was not enforceable and reformed the contract so that no further payments were required.

Impact of This Case on Today’s Law This early classic case illustrates the approach that many courts take today when deciding whether a sales contract is unconscionable—an approach that focuses on “excessive” price and unequal bargaining power. Most of the litigants who have used UCC 2–302 success- fully could demonstrate both an absence of meaningful choice and contract terms that were unreasonably favorable to the other party.favorable to the other party.favorable to the other party

Critical Thinking • Social Why would the seller’s knowledge of the buyers’ limited resources support a finding of

unconscionability?

Classic Case 14.1 Jones v. Star Credit Corp. Supreme Court of New York, Nassau County, 59 Misc.2d 189, 298 N.Y.S.2d 264 (1969).

292 U N I T T H R E E The Commercial Environment

Contract Terms

AcceptanceAcceptance

Contract Modification

IrrevocableIrrevocable Offers

Statute of Frauds Requirements

CONTRACT LAW

Open terms are acceptable if parties intended to form a contract, but the contract is not enforceable beyond quantity term.

Additional terms will not negate acceptance unless acceptance is expressly conditioned on assent to the additional terms.

Modification does not require consideration.

Merchants’ firm offers (without consideration).

Contract must contain all material terms.

Mirror image rule applies. If additional terms are added in acceptance, a counteroffer is created.

Modification requires consideration.

Option contracts (with consideration).

All material terms must be included in the writing. Writing is required only for sale of goods priced at $500 or more, but the contract is not enforceable beyond the quantity specified. Merchants can satisfy the writing requirement by a confirmation evidencing their agreement. Exceptions: 1. Specially manufactured goods. 2. Admissions by party against whom enforcement

is sought. 3. Partial performance.

SALES LAW

E X H I B I T 1 4 – 2 Major Differences between Contract Law and Sales Law

14–3 Title, Risk, and Insurable Interest

Before the creation of the UCC, title—the right of owntitle—the right of owntitle - ership—controlled all issues of rights and remedies of the parties to a sales contract. It was frequently difficult to determine when title actually passed from the seller to the buyer, however. It was also difficult to predict which party a court would decide had title at the time of a loss.

Because of such problems, the UCC has separated the question of title as much as possible from the question of the rights and obligations of buyers, sellers, and third parties. In some situations, title is still relevant under the UCC, and the UCC has special rules for determining who has title. (These rules do not apply to leased goods, obviously, because title remains with the lessor, or owner, of the goods.) In most situations, however, the UCC has replaced the concept of title with three other concepts: identification, risk of loss, and insurable interest.

14–3a Identification Before any interest in goods can pass from the seller or lessor to the buyer or lessee, the goods must be (1) in exis- tence and (2) identified to the contract [UCC 2–105(2)]. Identification takes place when specific goods are des- ignated as the subject matter of a sales or lease contract.

Title and risk of loss cannot pass to the buyer from the seller unless the goods are identified to the contract. (As mentioned, title to leased goods remains with the lessor.) Identification is significant because it gives the buyer or lessee the right to insure (or to have an insurable interest in) the goods and the right to recover from third parties who damage the goods.

The parties can agree in their contract on when iden- tification will take place. (This type of agreement will not effectively pass title and risk of loss to the buyer on future goods, such as unborn cattle, however.) If the parties do not so specify, the UCC provisions discussed here determine when identification takes place [UCC 2–501(1), 2A–217].

C H A P T E R 1 4 Sales and Lease Contracts 293

Existing Goods If the contract calls for the sale or lease of specific and determined goods that are already in existence, identification takes place at the time the contract is made. ■ EXAMPLE 14.10 Litco Company contracts to lease a fleet of five cars designated by their vehicle identification numbers (VINs). Because the cars are identified by their VINs, identification has taken place, and Litco acquires an insurable interest in the cars at the time of contracting. ■

Future Goods Any goods that are not in existence at the time of contracting are known as future goods. The following rules apply to identification of future goods: 1. If a sale or lease involves unborn animals to be born

within twelve months after contracting, identifica- tion takes place when the animals are conceived.

2. If a sale involves crops that are to be harvested within twelve months (or the next harvest sea- son occurring after contracting, whichever is lon- ger), identification takes place when the crops are planted. Otherwise, identification takes place when the crops begin to grow.

3. In a sale or lease of any other future goods, iden- tification occurs when the seller or lessor ships, marks, or otherwise designates the goods as those to which the contract refers. Future goods that fall into this category might include solar panels that are to be designed and manufactured after a contract is signed for their purchase.8

8. In re Zhejiang Photovoltaic Co., Ltd., ___ Bankr. ___, 2015 WL 2260647 (D.N.J. 2015). For a case involving a boat, see In re Carman, 399 Bankr. 158 (D.Md. 2009).

Goods That Are Part of a Larger Mass Goods that are part of a larger mass are identified when the goods are marked, shipped, or somehow designated by the seller or lessor as the particular goods to pass under the seller or lessor as the particular goods to pass under the seller or lessor as the particular goods to pass under the seller or lessor as the particular goods to pass under the contract. ■ EXAMPLE 14.11 Briggs orders 10,000 Briggs orders 10,000 pairs of men’s jeans from a lot that contains 90,000 arti- cles of clothing for men, women, and children. Until the seller separates the 10,000 pairs of men’s jeans from the other items, title and risk of loss remain with the seller. ■

A common exception to this rule involves fungible goods. Fungible goods are goods that are alike natu- rally, by agreement, or by trade usage. Typical examples include specific grades or types of wheat, petroleum, and cooking oil, which usually are stored in large contain- ers. Owners of fungible goods typically hold title as ten- ants in common (owners with an undivided share of the whole), which facilitates further sales. A seller-owner can pass title and risk of loss to the buyer without actually separating the goods. The buyer replaces the seller as an owner in common [UCC 2–105(4)].

■ EXAMPLE 14.12 Alvarez, Braudel, and Carpenter are farmers. They deposit, respectively, 5,000 bushels, 3,000 bushels, and 2,000 bushels of grain of the same grade and quality in a grain elevator. The three become owners in common, with Alvarez owning 50 percent of the 10,000 bushels, Braudel 30 percent, and Carpenter 20 percent. Alvarez contracts to sell her 5,000 bushels of grain to Treyton. Because the goods are fungible, she can pass title and risk of loss to Treyton without physically separating the 5,000 bushels. Treyton now becomes an owner in common with Braudel and Carpenter. ■

It is important to emphasize that what makes goods fungible is not simply that they are alike, but that they are of an identical grade or type. This distinction is illusidentical grade or type. This distinction is illusidentical - trated by the facts in the following case.

In the Language of the Court SAXE, J. [Judge]SAXE, J. [Judge]SAXE

* * * * * * * Plaintiffs allege that the * * *

defendants provided their customers (plaintiffs) with inferior, adulterated

heating oil, i.e. that the fuel oil that was delivered to them contained oils of lesser value mixed into the ordered grade of fuel oil, so that the delivered product did not meet the standards of the parties’ contracts.

* * * * * * * A sample of

No. 4 fuel oil deliv- ered by Castle [Oil Corporation] to a Manhattan [New York] building owned by plaintiff BMW Group LLC * * *

Case Analysis 14.2 BMW Group, LLC v. Castle Oil Corp. New York Supreme Court, Appellate Division, First Department, 139 A.D.3d 78, 29, N.Y.S.3d 253 (2016).

294 U N I T T H R E E The Commercial Environment

Legal Reasoning Questions

1. What did the contracts between the plaintiffs and the defendants require the defendants to do? What goods did the contracts involve? What standards applied to the goods?

2. What was the plaintiffs’ complaint? Why was this important? 3. What did the trial and appellate courts conclude with respect to the plaintiffs’ allegations? Why?

did not conform to the specifications for No. 4 fuel oil [which BMW had ordered from Castle].

* * * * * * * Mid Island L.P. and Carnegie

Park Associates, L.P. own and manage residential and commercial buildings in the New York metropolitan area * * * . They allege that they contracted with Hess [Corporation] for the purchase of No. 4 and No. 6 fuel oil * * * , but received a blend containing waste oil.

* * * * [BMW and the other property own-

ers filed a suit in a New York state court against Castle and Hess. Each defen- dant] moved to dismiss the complaint against it. The * * * court granted those motions * * * . It agreed with defendants that the complaints, while alleging that a blended fuel oil was delivered to plain- tiffs, did not allege that any injury was caused to them by the use or the burn- ing of this blended oil. [The plaintiffs appealed.]

* * * * The issue is whether * * * plaintiffs’

claims amount to merely “theoretical nonconformities” that do not justify a claim for breach of warranty or breach of contract.

* * * * * * * If the goods that are delivered do

not conform to the goods contemplated by the sale contract, the purchaser has a cause of action under the Uniform Commercial Code. [Emphasis added.]

An issue is raised as to whether plaintiffs successfully alleged that the delivered goods were nonconforming.

* * * The Administrative Code of the City of New York * * * defines “heating oil” as “oil refined for the purpose of

use as a fuel for combustion in a heating system and that meets the specifications of the American Society for Testing and Materials * * * .” The applicable Ameri- can Society of Testing and Materials (ASTM) specifications for fuel oil * * * establish detailed requirements for the different grades of oil, using such cate- gories as minimum flash point tempera- ture, viscosity, density, and maximum percentages of ash and sulfur.

Plaintiffs essentially allege that, con- sistent with the ASTM specifications, as well as common commercial usage, and pursuant to the UCC, customers purchasing goods described as No. 4 and No. 6 fuel oil are entitled to presume that they are receiving 100% fuel oil of the specified grade, and not a product consisting of a blend of No. 4 or No. 6 fuel oil with some other types of oil that do not meet the criteria of those ASTM specifications.

More specifically, plaintiffs in the Castle Oil matter allege that “Castle intentionally adulterates its fuel oil prod- ucts by using other, cheaper oils (primar- ily used motor and lubricating oil) as filler, resulting in an inferior blended petroleum product.” They explain that lubricating oil and fuel oil are different chemical substances, and that lubricating oils are designed with a higher boiling point than fuel oil and do not burn effi- ciently at temperatures typical in non- industrial heating systems. Additionally, because lubricating oils contain chemical additives not found in fuel oil, burning them in heating systems such as those in plaintiffs’ buildings will tend to pro- duce more soot and particulate matter pollution, reducing the efficiency of the heating system and creating an increased

risk of fire. They also assert that while regulations permit used lubricating oil to be re-refined and used as fuel in high- temperature industrial settings, the used lubricating oil purchased by Castle to blend with its fuel oil was never refined for use as fuel.

Plaintiffs in the Hess matter assert that * * * the Hess fuel oil [was mixed] with 15–25% “waste oil” as that term is defined in the Rules of the New York State Department of Environmental Conservation: “Used and/or reprocessed engine lubricating oil and/or any other used oil, including but not limited to, fuel oil, engine oil, gear oil, cutting oil, transmission fluid, hydraulic fluid, dielectric fluid, oil storage tank residue, animal oil and vegetable oil, which has not subsequently been re-refined.” They also assert that the waste oil con- taminants impair the performance of the heating systems into which they are introduced, and that fuel oil adulterated with waste oil has a lower heat content than No. 4 and No. 6 fuel oil, so that they (the customers) needed to pur- chase more oil than they would have if they had received 100% fuel oil.

* * * * * * * Since we must infer from the

complaint that plaintiffs received noncon- forming oil deliveries of lesser value than those they contracted and paid for, causes of action for breach of contract and breach of warranty—including plaintiffs’ dam- ages—are stated in each action. [Emphasis added.]

* * * * Accordingly, the order of the [lower

court] to dismiss the complaint, should be reversed, on the law, * * * and the motions denied.

Case 14.2 Continued

C H A P T E R 1 4 Sales and Lease Contracts 295

14–3b When Title Passes Once goods exist and are identified, the provisions of UCC 2–401 apply to the passage of title “unless otherwise explicitly agreed.”

Without an explicit agreement to the contrary, title passes to the buyer at the time and the place the seller performs

by delivering the goods [UCC 2–401(2)]. For instance, if a by delivering the goods [UCC 2–401(2)]. For instance, if a by delivering the goods person buys cattle at a livestock auction, title will pass to the buyer when the cattle are physically delivered to him or her (unless otherwise agreed). (In the future, the deliv- ery of goods may sometimes be accomplished by drones, as discussed in this chapter’s Managerial Strategy feature.)Managerial Strategy feature.)Managerial Strategy

Commercial Use of Drones

The commercial use of drones—small, pilotless aerial vehicles—has, until recently, been on hold in the United States. Possible commercial uses of drones are numerous—railroad track inspection, oil and gas pipeline review, real estate videos for use by brokers, discovery for land boundary disputes, and many others. In addition, businesses have begun making plans to use drones for delivery of goods. Amazon is develop- ing Amazon Prime Air, a drone-based delivery service. Google Project Wing is another drone-based service that is under development.

The Federal Aviation Administration Rules

The problem has been the Federal Aviation Adminis- tration (FAA). The FAA claims authority to regulate all unmanned aircraft systems (UASs). In 2012, Congress mandated the FAA “to establish a roadmap for getting UASs integrated into the national air space.” Not until 2015, however, did the FAA issue its proposed rules on commercial drone use, and these rules still have not been finalized.a

The FAA’s rules require operators to apply for a license to use drones commercially. Drone flights are limited to daylight hours, and drones will not be allowed to go above five hundred feet or faster than one hundred miles per hour. The proposed rules also require that licensed drone operators maintain a continuous visual line of sight with the drones during operation.

Since the rules were proposed, the FAA has received thousands of applications from small businesses seeking licenses to use UASs. It approves nearly fifty applica- tions a week. Drones are widely used by the agricultural industry for general aerial surveying and by the real estate profession for general aerial photography. The lack of final regulations is delaying commercial drone delivery in the United States, however, although drone delivery service is widely available in Australia and China.

In 2016, a government-sponsored commit- tee recommended to the FAA that commercial operators could fly small drones over people and even crowds. There would be numerous restrictions, though, that would deal with the size of the drones, the minimum height that they could fly above the ground, and others.

Court Actions

In the past, the FAA has attempted to fine other-than- recreational users of drones. One case involved Texas EquuSearch, a group that searches for missing persons. The organization requested an emergency injunc- tion after receiving an e-mail from an FAA employee indicating that its drone use was illegal. The U.S. Court of Appeals for the District of Columbia Circuit refused to act on the suit. The court stated that the e-mail from the FAA did not have legal effect and therefore was not subject to judicial review.b

In a case involving an administrative hearing, the FAA assessed a civil penalty against Raphael Pirker for careless and reckless operation of an unmanned air- craft. Pirker flew a drone over the University of Virginia in 2011 while filming a video advertisement for the medical school. Pirker appealed to the National Trans- portation Safety Board Office of Administrative Law Judges. He prevailed in early 2014.c

Business Questions 1. What benefits can delivery by commercial drone pro-

vide to consumers? 2. Why might the United States be slow to adopt com-

mercial drone delivery in comparison with some other nations?

MANAGERIAL STRATEGY

a. The interim rule is Registration and Marking Requirements for Small Unmanned Aircraft, 70 Fed.Reg. 78594-01.

b. Texas EquuSearch Mounted Search and Recovery Team, RP Search Services, Inc., v. Federal Aviation Administration, 2014 WL 2860332 (C.A.D.C. 2014).

c. Huerta v. Pirker, Decisional Order of National Transportation Safety Board Office of Administrative Judges, 2014 WL 3388631 (N.T.S.B. March 6, 2014).

296 U N I T T H R E E The Commercial Environment

■ CASE IN POINT 14.13 Timothy Allen contracted with Indy Route 66 Cycles, Inc., to have a motorcycle cus- tom built for him. Indy built the motorcycle and issued a “Certificate of Origin.” Later, federal law enforcement officers arrested Allen on drug charges and seized his property, including the Indy-made cycle, which officers found at the home of Allen’s sister, Tena. The government alleged that the motorcycle was subject to forfeiture as the proceeds of drug trafficking. Indy filed a claim against the government, arguing that it owned the cycle because it still possessed the “Certificate of Origin.” The court applied UCC Section 2–401(2) and ruled in favor of the government. Testimony by Indy’s former vice president was “inconclusive” but implied that Indy had delivered the motorcycle to Allen. Indy had given up possession of the cycle to Allen, and this was sufficient to pass title, even though Indy had kept a “Certificate of Origin.”9 ■

Shipment and Destination Contracts Unless otherwise agreed, delivery arrangements can determine when title passes from the seller to the buyer. In a ship- ment contract, the seller is required or authorized to ship goods by carrier, such as a trucking company. The seller is required only to deliver the goods into the hands of the carrier, and title passes to the buyer at the time and place of shipment [UCC 2–401(2)(a)]. Generally, all contracts are assumed to be shipment contracts if nothing to the con- trary is stated in the contract.

In a destination contract, the seller is required to deliver the goods to a particular destination, usually directly to the buyer, but sometimes to another party des- ignated by the buyer. Title passes to the buyer when the goods are tendered at that destination [UCC 2–401(2)(b)]. tendered at that destination [UCC 2–401(2)(b)]. tendered Tender of delivery occurs when the seller places or holds Tender of delivery occurs when the seller places or holds Tender of delivery conforming goods at the buyer’s disposal (with any nec- essary notice), enabling the buyer to take possession [UCC 2–503(1)].

Delivery without Movement of the Goods Sometimes, a sales contract does not call for the seller to ship or deliver the goods (such as when the buyer is to pick up the goods). In that situation, the passage of title depends on whether the seller must deliver a docu- ment of title, such as a bill of lading or a warehouse receipt, to the buyer. A bill of lading is a receipt for bill of lading is a receipt for bill of lading goods that is signed by a carrier and serves as a contract for the transportation of the goods. A warehouse receipt is a receipt issued by a warehouser for goods stored in a warehouse.

9. United States v. 2007 Custom Motorcycle, 2011 WL 232331 (D.Ariz. 2011).

When a Title Document Is Required. When a title docu- ment is required, title passes to the buyer when and where the document is delivered. �us, if the goods are stored in a warehouse, title passes to the buyer when the appropriate documents are delivered to the buyer. �e goods never move. In fact, the buyer can choose to leave the goods at the same warehouse for a period of time, and the buyer’s title to those goods will be una�ected.

When a Title Document Is Not Required. When no document of title is required and the goods are identi�ed to the contract, title passes at the time and place the sales contract is made. If the goods have not been identi�ed, title does not pass until identi�cation occurs.

■ CASE IN POINT 14.14 Under a contract with Cheran Investments, LLC, Blasini, Inc., agreed to buy the busi- ness assets of the Attic Bar & Grill in Omaha, Nebraska. The contract required Blasini to make a down payment and monthly payments until the price was fully paid. Bla- sini obtained insurance on the property from Nautilus Insurance Co. Before the purchase price had been fully paid, a fire damaged the “personal property” (the business assets, such as furniture and equipment) in the Attic. The insurance company filed a suit to determine which party was entitled to the insurance proceeds for the damage. The court concluded that Blasini had “failed to consum- mate the purchase agreement” and declared Cheran the owner of the personal property. Blasini appealed.

A state intermediate appellate court reversed the lower court’s ruling. The court based its reasoning on UCC Section 2–401. The goods in question had already been identified at the time of contracting, and no docu- ments were to be delivered. Thus, title passed at the time and place of contracting. In other words, the sale of the Attic’s assets passed title to the assets to Blasini, who became the owner.10 ■

14–3c Risk of Loss At the various stages of a sale or lease transaction, the question may arise as to who bears the risk of loss. In other words, who suffers the financial loss if the goods are damaged, destroyed, or lost in transit? Under the UCC, risk of loss does not necessarily pass with title. When risk of loss passes from a seller or lessor to a buyer or lessee is generally determined by the contract between the parties.

Sometimes, the contract states expressly when the risk of loss passes. At other times, it does not, and a court

10. Nautilus Insurance Co. v. Cheran Investments, LLC, 2014 WL 292809 (Neb.App. 2014).

C H A P T E R 1 4 Sales and Lease Contracts 297

must interpret the existing terms to determine whether the risk has passed. When no provision in the contract indicates when risk passes, the UCC provides special rules, based on delivery terms, to guide the courts.

Delivery with Movement of the Goods— Carrier Cases When the contract involves movement of the goods via a common carrier but does not specify when risk of loss passes, the courts first look for specific delivery terms in the contract. For instance, the term F.O.B. (free on board) indicates that the selling prices of goods includes transportation costs to the specific F.O.B. place named in the contract. The seller pays the expenses and carries the risk of loss to the F.O.B. place named [UCC 2–319(1)]. Unless the parties agree otherwise, such terms will determine which party will pay the costs of delivering the goods and who will bear the risk of loss. If the contract does not include delivery terms, then the courts must decide whether the contract is a shipment or a destination contract.

Shipment Contracts. In a shipment contract, the seller or lessor is required or authorized to ship goods by carrier, but is not required to deliver them to a particular destina- tion. �e risk of loss in a shipment contract passes to the buyer or lessee when the goods are delivered to the carrier [UCC 2–509(1)(a), 2A–219(2)(a)].

■ EXAMPLE 14.15 Pitman, a seller in Texas, sells Pitman, a seller in Texas, sells five hundred cases of grapefruit to a buyer in New York, F.O.B. Houston (free on board in Houston). This term means that the buyer pays the transportation charges from Houston. The contract authorizes shipment by carrier. It does not require that the seller tender the grapefruit in New York. Risk passes to the buyer when conforming goods are properly placed in the possession of the carrier. If the goods are damaged in transit, the loss is the buyer’s. (Actually, buyers have recourse against carriers, subject to certain limitations, and they usually insure the goods from the time the goods leave the seller.) ■

Destination Contracts. In a destination contract, the risk of loss passes to the buyer or lessee when the goods are tendered to the buyer or lessee at the speci�ed destination [UCC 2–509(1)(b), 2A–219(2)(b)]. In Example 14.15, if Example 14.15, if Example 14.15 the contract had been a destination contract, F.O.B. New York, risk of loss during transit to New York would have been the seller’s. Risk of loss would not have passed to the buyer until the carrier tendered the grapefruit to the buyer in New York.

Whether a contract is a shipment contract or a desti- nation contract can have significant consequences for the parties. When an agreement is ambiguous as to whether

it is a shipment or a destination contract, courts normally will presume that it is a shipment contract. Thus, the parties must use clear and explicit language to overcome this presumption and create a destination contract.

Delivery without Movement of the Goods The UCC also addresses situations in which the contract does not require the goods to be shipped or moved. Fre- quently, the buyer or lessee is to pick up the goods from the seller or lessor, or the goods are to be held by a bailee. A bailment is a temporary delivery of personal property, bailment is a temporary delivery of personal property, bailment without passage of title, into the care of another, called a bailee. Under the UCC, a bailee is a party who—by a bill of lading, warehouse receipt, or other document of title—acknowledges possession of goods and/or con- tracts to deliver them. For instance, a warehousing com- pany or a trucking company may be a bailee.

Goods Held by the Seller. When the seller keeps the goods for pickup, a document of title usually is not used. If the seller is not a merchant, the risk of loss to goods held by the seller passes to the buyer on tender of delivery [UCC 2–509(3)]. �us, the seller bears the risk of loss until he or she makes the goods available to the buyer and noti�es the buyer that the goods are ready to be picked up. If the seller is a merchant, risk of loss to goods held by the seller passes to the buyer when the buyer actually takes physical possession of the goods [UCC 2–509(3)]. In other physical possession of the goods [UCC 2–509(3)]. In other physical possession of the goods words, the merchant bears the risk of loss between the time the contract is formed and the time the buyer picks up the goods.up the goods.up the goods.up the goods.

■ CASE IN POINT 14.16 Roger Adams bought a pre- assembled table saw from Sears Roebuck and Company. The saw weighed 288 pounds. When Adams went to the loading area to pick up the saw, a Sears employee used a hydraulic lift to elevate it to the height of Adams’s pickup bed. Adams then pulled the saw onto the truck. Once the saw was loaded, the employee went back inside the store (and did not secure the saw).

Adams, who was standing in the bed of his truck, took a step and lost his balance. He grabbed the saw to steady himself. Both he and the saw fell off the truck, and he was injured. Adams sued Sears, alleging negligence, but the court granted summary judgment in favor of Sears. Sears was under no duty to help Adams secure the saw in the truck, so the employee had not been negligent. Once the truck was loaded, the risk of loss (or injury) passed to Adams under the UCC because he had taken physical possession of the goods.11 ■

298 U N I T T H R E E The Commercial Environment

Goods Held by a Bailee. When a bailee is holding goods that are to be delivered under a contract without being moved, the goods are usually represented by a document of title. �e title document may be written on paper or evidenced by an electronic record.

When goods are held by a bailee, risk of loss passes to the buyer when one of the following occurs: 1. The buyer receives a negotiable document of title for

the goods. 2. The bailee acknowledges the buyer’s right to possess

the goods. 3. The buyer receives a nonnegotiable document of title,

and the buyer has had a and the buyer has had a and reasonable time to present the document to the bailee and demand the goods. If the bailee refuses to honor the document, the risk of loss remains with the seller [UCC 2–503(4)(b), 2–509(2)].

With respect to leases, if goods held by a bailee are to be delivered without being moved, the risk of loss passes to the lessee on acknowledgment by the bailee of the lessee’s right to possession of the goods [UCC 2A–219(2)(b)].

Risk of Loss When a Sales or Lease Contract Is Breached When a sales or lease contract is breached, the transfer of risk operates differently depending on which party breaches. Generally, the party in breach bears the risk of loss.

When the seller or lessor breaches and the goods are so nonconforming that the buyer has the right to reject them, the risk of loss does not pass to the buyer. With nonconforming goods, the risk of loss does not pass to the buyer until either:

1. The defects are cured (that is, the goods are repaired, cured (that is, the goods are repaired, cured replaced, or discounted in price by the seller).

2. The buyer accepts the goods in spite of their defects (thus waiving the right to reject).

When the buyer or lessee breaches, the general rule is that the risk of loss immediately shifts to the buyer or immediately shifts to the buyer or immediately shifts lessee. This rule has three important limitations [UCC 2–510(3), 2A–220(2)]:

1. The seller or lessor must already have identified the contract goods.

2. The buyer or lessee bears the risk for only a com- mercially reasonable time after the seller or lessor has learned of the breach.

3. The buyer or lessee is liable only to the extent of any deficiency in the seller’s or lessor’s insurance coverage.

14–3d Insurable Interest Parties to sales and lease contracts often obtain insurance coverage to protect against damage, loss, or destruction of goods. Any party purchasing insurance, however, must have a sufficient interest in the insured item to obtain a valid policy. Insurance laws—not the UCC—determine sufficiency. The UCC is helpful, though, because it con- tains certain rules regarding insurable interests in goods.

A buyer or lessee has an insurable interest in insurable interest in insurable interest identi- fied goods. The moment the contract goods are identified by the seller or lessor, the buyer or lessee has a property interest in them. That interest allows the buyer or les- see to obtain the necessary insurance coverage for those goods even before the risk of loss has passed [UCC 2–501(1), 2A–218(1)].

A seller has an insurable interest in goods as long as he or she retains title to the goods. Even after title passes to a buyer, a seller who has a security interest (a right to security interest (a right to security interest secure payment) in the goods still has an insurable inter- est [UCC 2–501(2)]. Thus, both the buyer and the seller can have an insurable interest in identical goods at the same time. Of course, the buyer or seller must sustain an actual loss to have the right to recover from an insurance company.

In regard to leases, the lessor retains an insurable inter- est in leased goods unless the lessee exercises an option to buy. In that event, the risk of loss passes to the lessee [UCC 2A–218(3)].

14–4 Performance and Breach of Sales and Lease Contracts

The performance that is required of the parties under a sales or lease contract consists of the duties and obli- gations each party has under the terms of the contract. The basic obligation of the seller or lessor is to transfer and deliver conforming goods. The basic obligation of the buyer or lessee is to accept and pay for conforming goods in accept and pay for conforming goods in accept and pay for conforming goods accordance with the contract [UCC 2–301, 2A–516(1)].

Overall performance of a sales or lease contract is con- trolled by the agreement between the parties. When the contract is unclear and disputes arise, the courts look to the UCC and impose standards of good faith and com- mercial reasonableness.

The obligations of good faith and commercial rea- sonableness underlie every sales and lease contract. The

C H A P T E R 1 4 Sales and Lease Contracts 299

UCC’s good faith provision, which can never be dis- claimed, reads as follows: “Every contract or duty within this Act imposes an obligation of good faith in its perfor- mance or enforcement” [UCC 1–304]. Good faith means honesty in fact. For a merchant, it means honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade [UCC 2–103(1)(b)].

14–4a Obligations of the Seller or Lessor The basic duty of the seller or lessor is to deliver the goods called for under the contract to the buyer or lessee. Goods that conform to the contract description in every way are called conforming goods. To fulfill the contract, the seller or lessor must either deliver or tender delivery of conforming goods to the buyer or lessee.

Tender of delivery occurs when the seller or lessor Tender of delivery occurs when the seller or lessor Tender of delivery makes conforming goods available and gives the buyer or lessee whatever notification is reasonably necessary to enable the buyer or lessee to take delivery [UCC 2–503(1), 2A–508(1)].

Tender must occur at a reasonable hour and in a reasonable hour and in a reasonable hour reason- able manner. For instance, a seller cannot call the buyer at 2:00 a.m. and say, “The goods are ready. I’ll give you twenty minutes to get them.” Unless the parties have agreed otherwise, the goods must be tendered for deliv- ery at a reasonable hour and kept available for a reason- able time to enable the buyer to take possession [UCC 2–503(1)(a)].

Normally, all goods called for by a contract must be tendered in a single delivery unless the parties have agreed on delivery in several lots or installments (disinstallments (disinstallments - cussed shortly) [UCC 2–307, 2–612, 2A–510].

Place of Delivery The buyer and seller (or lessor and lessee) may agree that the goods will be delivered to a particular destination where the buyer or lessee will take possession. If the contract does not indicate where the goods will be delivered, then the place for delivery will be one of the following:

1. The seller’s place of business. 2. The seller’s residence, if the seller has no business loca-

tion [UCC 2–308(a)]. 3. The location of the goods, if both parties know at

the time of contracting that the goods are located somewhere other than the seller’s business [UCC 2–308(b)].

■ EXAMPLE 14.17 Li Wan and Boyd both live in San Francisco. In San Francisco, Li Wan contracts to sell Boyd five used trucks, which both parties know are located in a Chicago warehouse. If nothing more is speci- fied in the contract, the place of delivery for the trucks is Chicago. Li Wan may tender delivery by giving Boyd either a negotiable or a nonnegotiable document of title. Alternatively, Li Wan may obtain the bailee’s (warehous- er’s) acknowledgment that Boyd is entitled to possession [UCC 2–503(4)]. ■

Delivery via Carrier When the parties intended the goods to be moved by a carrier, the seller fulfills the obli- gation to deliver the goods through either a shipment contract or a destination contract.

Shipment Contracts. Recall that a shipment contract requires or authorizes the seller to ship goods by a car- rier, rather than to deliver them at a particular destination [UCC 2–319, 2–509(1)(a)]. Under a shipment contract, unless otherwise agreed, the seller must do the following:

1. Place the goods into the hands of the carrier. 2. Make a contract for their transportation that is rea-

sonable according to the nature of the goods and their value. (For instance, certain types of goods need refrigeration in transit.)

3. Obtain and promptly deliver or tender to the buyer any documents necessary to enable the buyer to obtain possession of the goods from the carrier.

4. Promptly notify the buyer that shipment has been made [UCC 2–504].

If the seller does not make a reasonable contract for transportation or notify the buyer of the shipment, the buyer can reject the goods, but only if a buyer can reject the goods, but only if a buyer can reject the goods, but only if a buyer can reject the goods, but only if a material loss or a material loss or a material loss significant delay results. significant delay results. significant delay ■ EXAMPLE 14.18 Zigi’s Organic Zigi’s Organic Fruits sells strawberries to Lozier under a shipment con- tract. If Zigi’s does not arrange for refrigerated transpor- tation and the berries spoil during transport, a material loss to Lozier will likely result. ■ Of course, the parties are free to make agreements that alter the UCC’s rules and allow the buyer to reject goods for other reasons.

Destination Contracts. In a destination contract, In a destination contract, In a the seller agrees to deliver conforming goods to the buyer at a particular destination. �e goods must be tendered at a reasonable hour and held at the buyer’s disposal for a reasonable length of time. �e seller must also give the

300 U N I T T H R E E The Commercial Environment

buyer appropriate notice and any necessary documents to enable the buyer to obtain delivery from the carrier [UCC 2–503].

The Perfect Tender Rule The seller or lessor has an obligation to ship or tender conforming goods. The buyer or lessee is then obligated to accept and pay for the goods according to the contract terms [UCC 2–507].

Under the common law, the seller was obligated to deliver goods that conformed with the terms of the con- tract in every detail. Minor defects in performance were compensable under the doctrine of substantial perfor- mance. The UCC adopted the perfect tender rule. It states that if goods or tender of delivery fails in any respect to conform to the contract, the buyer or lessee may accept the goods, reject the entire shipment, or accept part and reject part [UCC 2–601, 2A–509].

The corollary to this rule is that if the goods con- form in every respect, the buyer or lessee does not have a right to reject the goods. ■ CASE IN POINT 14.19 U.S. U.S. Golf & Tennis Centers, Inc., agreed to buy 96,000 golf balls from Wilson Sporting Goods Company for a total price of $20,000. Wilson represented that U.S. Golf was receiving its lowest price ($5 per two-dozen unit).

Wilson shipped golf balls to U.S. Golf that con- formed to the contract in quantity and quality, but it did not receive payment. U.S. Golf claimed that it had learned that Wilson had sold the product for $2 per unit to another buyer. U.S. Golf asked Wilson to reduce the contract price of the balls to $4 per unit. Wilson refused and filed a suit. The court ruled in favor of Wilson. Because it was undisputed that the shipment of golf balls conformed to the contract specifications, U.S. Golf was obligated to accept the goods and pay the agreed- on price.12 ■

Exceptions to the Perfect Tender Rule Because of the rigidity of the perfect tender rule, several excep- tions to the rule have been created. For instance, excep- tions to the perfect tender rule may be established by agreement. The parties may agree that defective goods or parts will not be rejected if the seller or lessor is able to repair or replace them within a reasonable period of time. In this situation, the perfect tender rule does not apply.

Cure. �e UCC does not speci�cally de�ne the term cure, but it refers to the right of the seller or lessor to repair, adjust, or replace defective or nonconforming goods [UCC 2–508, 2A–513].

12. Wilson Sporting Goods Co. v. U.S. Golf and Tennis Centers, Inc., 2012 WL 601804 (Tenn.App. 2012).

The seller or lessor has a right to attempt to “cure” a defect when the following are true: 1. A delivery is rejected because the goods were

nonconforming. 2. The time for performance has not yet expired. 3. The seller or lessor provides timely notice to the

buyer or lessee of the intention to cure. 4. The cure can be made within the contract time for

performance. Even if the contract time for performance has expired,

the seller or lessor can still cure if he or she had reason- able grounds to believe that the nonconforming tender would be acceptable to the buyer or lessee [UCC 2–508(2), would be acceptable to the buyer or lessee [UCC 2–508(2), would be acceptable to the buyer or lessee 2A–513(2)].

The right to cure substantially restricts the right of the buyer or lessee to reject goods. To reject, the buyer or lessee must inform the seller or lessor of the particular defect.

Substitution of Carriers. Sometimes, an agreed-on man- ner of delivery (such as the use of a particular carrier) becomes impracticable or unavailable through no fault of either party. In that situation, if a commercially reason- able substitute is available, this substitute performance is su�cient tender to the buyer and must be used [UCC 2–614(1)]. �e seller or lessor is required to arrange for a substitute carrier and normally is responsible for any addi- tional shipping costs (unless the contract states otherwise).

Commercial Impracticability. Occurrences unforeseen by either party when a contract was made (such as a hurri- cane or an oil embargo) may make performance commer- cially impracticable. When this occurs, the perfect tender rule no longer applies. �e seller or lessor must, however, notify the buyer or lessee as soon as practicable that there will be a delay or nondelivery [UCC 2–615, 2A–405].

Commercial impracticability arises only when the parties, at the time the contract was made, had no rea- son to anticipate that the event would occur. It does not extend to problems that could have been foreseen, such as an increase in cost resulting from inflation.as an increase in cost resulting from inflation.as an increase in cost resulting from inflation.as an increase in cost resulting from inflation.

■ CASE IN POINT 14.20 In a classic 1970s case, Maple In a classic 1970s case, Maple Farms, Inc., entered a contract to supply a school district in New York with milk for one school year. The con- tract price was the market price of milk in June, but by December, the price of raw milk had increased by 23 per- cent. Maple Farms stood to lose $7,350 on this contract (and more on similar contracts with other school dis- tricts). To avoid performing the contract, Maple Farms filed a suit and claimed that the unanticipated increases in a seller’s costs made performance “impracticable.” A

C H A P T E R 1 4 Sales and Lease Contracts 301

New York trial court disagreed. Because inflation and fluctuating prices could have been foreseen, they did not render performance of this contract impracticable. The court granted summary judgment in favor of the school district.13 ■

Destruction of Identified Goods. Sometimes, an unex- pected event, such as a �re, totally destroys goods through no fault of either party before risk passes to the buyer or lessee. In such a situation, if the goods were identi�ed at the time the contract was formed, the parties are excused from performance [UCC 2–613, 2A–221]. If the goods are only partially destroyed, however, the buyer or lessee can inspect them and either treat the contract as void or accept the damaged goods with a reduction in the con- tract price.

Assurance and Cooperation. If one party has “reason- able grounds” to believe that the other party will not per- form, the �rst party may in writing “demand adequate in writing “demand adequate in writing assurance of due performance” from the other party. Until such assurance is received, the �rst party may “suspend” further performance without liability. What constitutes “reasonable grounds” is determined by commercial stan- dards. If the requested assurances are not forthcoming within a reasonable time (not to exceed thirty days), the failure to respond may be treated as a repudiation of the contract [UCC 2–609, 2A–401].

Sometimes, the performance of one party depends on the cooperation of the other. When cooperation is not forthcoming, the first party can either proceed to per- form the contract in any reasonable manner or suspend performance without liability and hold the uncoopera- tive party in breach [UCC 2–311(3)].

14–4b Obligations of the Buyer or Lessee The main obligation of the buyer or lessee under a sales or lease contract is to pay for the goods tendered. Once the seller or lessor has adequately tendered delivery, the buyer or lessee is obligated to accept the goods and pay for them according to the terms of the contract.

Payment In the absence of any specific agreements, the buyer or lessee must make payment at the time and place the goods are received [UCC 2–310(a), 2A–516(1)]. received [UCC 2–310(a), 2A–516(1)]. received When a sale is made on credit, the buyer is obligated to pay according to the specified credit terms (for example, 60, 90, or 120 days), not when the goods are received.

13. Maple Farms, Inc. v. City School District of Elmira, 76 Misc.2d 1080, 352 N.Y.S.2d 784 (1974).

The credit period usually begins on the date of shipment [UCC 2–310(d)]. Under a lease contract, a lessee must make the lease payment that was specified in the contract [UCC 2A–516(1)].

Payment can be made by any means agreed on between the parties—cash or any other method generally acceptable in the commercial world. If the seller demands cash, the seller must permit the buyer reasonable time to obtain it [UCC 2–511].

Right of Inspection Unless the parties otherwise agree, or for C.O.D. (collect on delivery) transactions, the buyer or lessee has an absolute right to inspect the goods before making payment. This right allows the buyer or lessee to verify that the goods tendered or delivered conform to the contract. If the goods are not as ordered, the buyer or lessee has no duty to pay. An opportunity for inspection is therefore a condition precedent to the right of the seller or lessor to enforce payment [UCC to the right of the seller or lessor to enforce payment [UCC to the right of the seller or lessor to enforce payment 2–513(1), 2A–515(1)].

Inspection can take place at any reasonable place and time and in any reasonable manner. Generally, what is reasonable is determined by custom of the trade, past practices of the parties, and the like. The buyer bears the costs of inspecting the goods but can recover the costs from the seller if the goods do not conform and are rejected [UCC 2–513(2)].rejected [UCC 2–513(2)].rejected [UCC 2–513(2)].rejected [UCC 2–513(2)].

■ CASE IN POINT 14.21 Jessie Romero offered to Jessie Romero offered to deliver two trade-in vehicles to Scoggin-Dickey Chevro- let Buick, Inc., in exchange for a 2006 Silverado pickup. Scoggin-Dickey agreed. The parties negotiated a price, including a value for the trade-in vehicles, plus cash. Romero paid the cash and took the 2006 Silverado (but the dealer kept the title to it). Several weeks later, Romero delivered the two trade-in vehicles.

On inspecting the trade-in vehicles, Scoggin-Dickey found that they had little value. One of them did not even run. The dealer repossessed the Silverado. Romero sued for breach of contract, claiming that the dealer had no right to reject the trade-in vehicles after the contract was signed. The court held that the contract for the sale was not completed until Romero traded in the two vehi- cles. Scoggin-Dickey had a right to inspect them and did so within a reasonable time after they were delivered. The dealership was entitled to reject the trade-in vehicles and keep the 2006 Silverado, but it had to refund Romero’s cash and return the trade-in vehicles.14 ■

14. Romero v. Scoggin-Dickey Chevrolet Buick, Inc., 2010 WL 456910 (Tex. Civ.App.—Amarillo 2010).

302 U N I T T H R E E The Commercial Environment

Acceptance After having had a reasonable opportu- nity to inspect the goods, the buyer or lessee can demon- strate acceptance in any of the following ways: 1. The buyer or lessee indicates (by words or conduct)

to the seller or lessor that the goods are conforming or that he or she will retain them in spite of their nonconformity [UCC 2–606(1)(a), 2A–515(1)(a)].

2. The buyer or lessee fails to reject the goods within a rea- sonable period of time [UCC 2–602(1), 2–606(1)(b), 2A–515(1)(b)].

3. In sales contracts, the buyer will be deemed to have accepted the goods if he or she performs any act inconsistent with the seller’s ownership. For instance, any use or resale of the goods—except for the limited purpose of testing or inspecting the goods—generally constitutes an acceptance [UCC 2–606(1)(c)].

If some of the goods delivered do not conform to the contract and the seller or lessor has failed to cure, the buyer or lessee can make a partial acceptance [UCC partial acceptance [UCC partial 2–601(c), 2A–509(1)]. The same is true if the noncon- formity was not reasonably discoverable before accep- tance. (In the latter situation, the buyer or lessee may be able to revoke the acceptance, as will be discussed later in this chapter.)

A buyer or lessee cannot accept less than a single commercial unit, however. The UCC defines a commer- cial unit as a unit of goods that, by commercial usage, cial unit as a unit of goods that, by commercial usage, cial unit is viewed as a “single whole” for purposes of sale. A commercial unit cannot be divided without materially impairing the character of the unit, its market value, or its use [UCC 2–105(6), 2A–103(1)(c)]. A commercial unit can be a single article (such as a machine), a set of articles (such as a suite of furniture), a quantity (such as a bale, a gross, or a carload), or any other unit treated in the trade as a single whole.

14–4c Anticipatory Repudiation What if, before the time for contract performance, one party clearly communicates to the other the intention not to perform? Such an action is a breach of the contract by anticipatory repudiation. When anticipatory repudia- tion occurs, the nonbreaching party has a choice of two responses:

1. Treat the repudiation as a final breach by pursuing a remedy.

2. Wait to see if the repudiating party will decide to honor the contract despite the avowed intention to renege [UCC 2–610, 2A–402].

In either situation, the nonbreaching party may suspend performance.

The UCC permits the breaching party to “retract” his or her repudiation (subject to some limitations). This can be done by any method that clearly indicates the party’s intent to perform. Once retraction is made, the rights of the repudiating party under the contract are reinstated. There can be no retraction, however, if since the time of the repudiation the other party has canceled or materially changed position or otherwise indicated that the repu- diation is final [UCC 2–611, 2A–403].

14–5 Remedies for Breach of Sales and Lease Contracts

Sometimes, circumstances make it difficult for a party to carry out the promised performance, leading to a breach of the contract. When a breach occurs, the aggrieved (wronged) party looks for remedies. Note that in con- trast to the common law of contracts, remedies under the UCC are cumulative in nature—meaning that the aggrieved party is not limited to one exclusive remedy.

14–5a Remedies of the Seller or Lessor When the buyer or lessee is in breach, the remedies avail- able to the seller or lessor depend on the circumstances existing at the time of the breach. If the goods are in the buyer’s or lessee’s possession, the seller or lessor can sue to recover the purchase price or lease payment due, plus incidental damages [UCC 2–709(1), 2A-529(1)]. If the buyer or lessee breaches the contract before the goods have been delivered, the seller or lessor has the right to pursue the remedies discussed next.

The Right to Cancel the Contract If the buyer or lessee breaches the contract, the seller or lessor can choose to simply cancel the contract [UCC 2–703(f ), 2A–523(1)(a)]. The seller or lessor must notify the buyer or lessee of the cancellation, and at that point all remaining obligations of the seller or lessor are discharged. The buyer or lessee is not discharged from all remaining obligations, however. She or he is in breach, and the seller or lessor can pursue remedies available under the UCC for breach.

The Right to Withhold Delivery In general, sellers and lessors can withhold delivery or discontinue perfor- mance of their obligations under sales or lease contracts when the buyers or lessees are in breach [UCC 2–703(a), 2A–523(1)(c)]. This is true whether a buyer or lessee has wrongfully rejected or revoked acceptance of contract Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 1 4 Sales and Lease Contracts 303

goods (discussed later), failed to make a payment, or repudiated the contract. The seller or lessor can also refuse to deliver the goods to a buyer or lessee who is insolvent (unable to pay debts as they become due) unless the buyer or lessee pays in cash [UCC 2–702(1), 2A–525(1)].

The Right to Resell or Dispose of the Goods When a buyer or lessee breaches or repudiates the con- tract while the seller or lessor is in possession of the goods, the seller or lessor can resell or dispose of the goods. Any resale of the goods must be made in good faith and in a commercially reasonable manner. The seller must give the original buyer reasonable notice of the resale, unless the goods are perishable or will rapidly decline in value [UCC 2–706(2), (3)].

The seller can retain any profits made as a result of the sale and can hold the buyer or lessee liable for any loss [UCC 2–703(d), 2–706(1), 2A–523(1)(e), 2A–527(1)]. (Here, a loss is any deficiency between the resale price and the contract price.) In lease transactions, the lessor can lease the goods to another party and recover damages from the original lessee. Damages include any unpaid lease pay- ments up to the time the new lease begins. The lessor can also recover any deficiency between the lease payments due under the original lease and those due under the new lease, along with incidental damages [UCC 2A–527(2)].

When the goods contracted for are unfinished at the time of the breach, the seller or lessor can do either of the following: 1. Cease manufacturing the goods and resell them for

scrap or salvage value. 2. Complete the manufacture, resell or dispose of the

goods, and hold the buyer or lessee liable for any deficiency.

In choosing between these two alternatives, the seller or lessor must exercise reasonable commercial judgment in order to mitigate the loss and obtain maximum value from the unfinished goods [UCC 2–704(2), 2A–524(2)].

The Right to Recover Damages for the Buyer’s Nonacceptance If a buyer or lessee repudiates a con- tract or wrongfully refuses to accept the goods, a seller or lessor can bring an action to recover the damages sus- tained. Ordinarily, the amount of damages equals the dif-tained. Ordinarily, the amount of damages equals the dif-tained. Ordinarily, the amount of damages equals the dif ference between the contract price or lease payments and the market price or lease payments at the time and place of tender of the goods, plus incidental damages [UCC 2–708(1), 2A–528(1)].

When the ordinary measure of damages is inadequate to put the seller or lessor in as good a position as the buyer’s or lessee’s performance would have, the UCC provides an alternative. In that situation, the proper

measure of damages is the lost profits of the seller or les- sor, including a reasonable allowance for overhead and other expenses [UCC 2–708(2), 2A–528(2)].

The Right to Stop Delivery of Goods in Transit When the seller or lessor has delivered the goods to a car- rier or a bailee but the buyer or lessee has not yet received them, the goods are said to be in transit. If the seller or lessor learns that the buyer or lessee is insolvent, the seller or lessor can stop the delivery of the goods still in transit, regardless of the quantity of goods shipped. If the buyer or lessee is in breach but is not insolvent, the seller or lessor can stop the goods in transit only if the quantity shipped is at least a carload, a truckload, a planeload, or a larger shipment [UCC 2–705(1), 2A–526(1)].

To stop delivery, the seller or lessor must timely notify the carrier or other bailee that the goods are to be notify the carrier or other bailee that the goods are to be notify returned or held for the seller or lessor. If the carrier has sufficient time to stop delivery, the goods must be held and delivered according to the instructions of the seller or lessor. The seller or lessor is liable to the carrier for any additional costs incurred [UCC 2–705(3), 2A–526(3)].

Once the seller or lessor reclaims the goods in transit, she or he can pursue the remedies allowed to sellers and lessors when the goods are in their possession.

14–5b Remedies of the Buyer or Lessee Like the remedies available to sellers and lessors, the remedies available to buyers and lessees depend on the circumstances at the time of the breach. If the seller or lessor refuses to deliver the goods to the buyer or lessee, the basic remedies available to the buyer or lessee include those discussed next.

The Right to Cancel the Contract When a seller or lessor fails to make proper delivery or repudiates the contract, the buyer or lessee can cancel, or rescind, the contract. The buyer or lessee is relieved of any further obligations under the contract but retains all rights to other remedies against the seller or lessor [UCC 2–711(1), 2A–508(1)(a)]. (The right to cancel the contract is also available to a buyer or lessee who has rightfully rejected goods or revoked acceptance, as will be discussed shortly.)

The Right to Obtain the Goods upon Insolvency If a buyer or lessee has partially or fully paid for goods that are in the possession of a seller or lessor who becomes insolvent, the buyer or lessee can obtain the goods. The seller or lessor must have become insolvent within ten days after receiving the first payment, and the goods must be identified to the contract. To exercise this right, the Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

304 U N I T T H R E E The Commercial Environment

buyer or lessee must pay the seller or lessor any unpaid balance of the purchase price or lease payments [UCC 2–502, 2A–522].

The Right to Obtain Specific Performance A buyer or lessee can obtain specific performance if the goods are unique or the remedy at law (monetary dam- ages) is inadequate [UCC 2–716(1), 2A–521(1)]. Ordi- narily, an award of damages is sufficient to place a buyer or lessee in the position she or he would have occupied if the seller or lessor had fully performed.

When the contract is for the purchase of a particular work of art or a similarly unique item, however, damages may not be sufficient. Under these circumstances, equity requires that the seller or lessor perform exactly by deliv- ering the particular goods identified to the contract (the remedy of specific performance).

The Right of Cover In certain situations, buyers and lessees can protect themselves by obtaining cover—that is, cover—that is, cover by buying or leasing substitute goods for those that were due under the contract. This option is available when the seller or lessor repudiates the contract or fails to deliver the goods, or when a buyer or lessee has rightfully rejected goods or revoked acceptance. In purchasing or leasing substitute goods, the buyer or lessee must act in good faith and without unreasonable delay [UCC 2–712, 2A–518].

After obtaining substitute goods, the buyer or lessee can recover from the seller or lessor: 1. The difference between the cost of cover and the con-

tract price (or lease payments). 2. Incidental damages that resulted from the breach. 3. Consequential damages to compensate for indirect Consequential damages to compensate for indirect Consequential damages

losses (such as lost profits) resulting from the breach that were reasonably foreseeable at the time of contract formation. The amount of consequential damages is reduced by any amount the buyer or lessee saved as a result of the breach. (For instance, the buyer might obtain cover without having to pay delivery charges that were part of the original sales contract.)

Buyers and lessees are not required to cover, and fail- ure to do so will not bar them from using any other rem- edies available under the UCC. A buyer or lessee who fails to cover, however, risks collecting a lower amount of consequential damages. A court may reduce the con- sequential damages by the amount of the loss that could have been avoided had the buyer or lessee purchased or leased substitute goods.

The Right to Replevy Goods Buyers and lessees also have the right to replevy goods. Replevin15 is an action to recover identified goods in the hands of a party who is unlawfully withholding them. Under the UCC, a buyer or lessee can replevy goods identified to the contract if the seller or lessor has repudiated or breached the contract. To maintain an action to replevy goods, buyers and lessees must usually show that they were unable to cover for the goods after making a reasonable effort [UCC 2–716(3), 2A–521(3)].

The Right to Recover Damages If a seller or lessor repudiates the contract or fails to deliver the goods, the buyer or lessee can sue for damages. For the buyer, the measure of recovery is the difference between the contract price and the market price of the goods at the time the buyer learned of the breach. For the lessee, the measure is learned of the breach. For the lessee, the measure is learned the difference between the lease payments and the lease payments that could be obtained for the goods at the time the lessee learned of the breach. The market price or market lease payments are determined at the place where the seller or lessor was supposed to deliver the goods. The buyer or lessee can also recover incidental and consequen- tial damages less the expenses that were saved as a result of the breach [UCC 2–713, 2A–519].

■ CASE IN POINT 14.22 Les Entreprises Jacques Les Entreprises Jacques Defour & Fils, Inc., contracted to buy a thirty-thousand- gallon industrial tank from Dinsick Equipment Corpo- ration for $70,000. Les Entreprises hired Xaak Trans- port, Inc., to pick up the tank, but when Xaak arrived at the pickup location, there was no tank. Les Entreprises paid Xaak $7,459 for its services and filed a suit against Dinsick.

The court awarded compensatory damages of $70,000 for the tank and incidental damages of $7,459 for the transport. Dinsick failed to tender or deliver the tank, or to refund the price. The shipping costs were a necessary part of performance, so this was a reasonable expense.16 ■

The Right to Reject the Goods If either the goods or their tender fails to conform to the contract in any respect, the buyer or lessee can reject all of the goods or any commercial unit of the goods [UCC 2–601, 2A–509]. On rejecting the goods, the buyer or lessee may obtain

15. Pronounced ruh-plehPronounced ruh-plehPronounced ruh- -vun, derived from the Old French word plevir, meaning “to pledge.”

16. Les Entreprises Jacques Defour & Fils, Inc. v. Dinsick Equipment Corp., 2011 WL 307501 (N.D.Ill. 2011).

C H A P T E R 1 4 Sales and Lease Contracts 305

cover or cancel the contract, and may seek damages just as if the seller or lessor had refused to deliver the goods.

The buyer or lessee must reject the goods within a reasonable amount of time after delivery or tender of delivery and must seasonably notify the seller or lessor [UCC 2–602(1), 2A–509(2)]. If the buyer or lessee fails to reject the goods within a reasonable amount of time, acceptance will be presumed.

When rejecting goods, the buyer or lessee must also designate defects that are ascertainable by reasonable inspection. Failure to do so precludes the buyer or lessee from using such defects to justify rejection or to establish breach if the seller or lessor could have cured the defects [UCC 2–605, 2A–514]. A merchant-buyer or lessee has a good faith obligation to follow any reasonable instructions received from the seller or lessor with respect to the goods [UCC 2–603, 2A–511].

Revocation of Acceptance Acceptance of the goods precludes the buyer or lessee from exercising the right of rejection. It does not necessarily prevent the buyer or les- see from pursuing other remedies, however. In certain cir- cumstances, a buyer or lessee is permitted to revoke his or revoke his or revoke her acceptance of the goods.

Acceptance of a lot or a commercial unit can be revoked if the nonconformity substantially impairs the value of the substantially impairs the value of the substantially lot or unit and if one of the following factors is present:and if one of the following factors is present:and

1. Acceptance was based on the reasonable assumption that the nonconformity would be cured, and it has not been cured within a reasonable period of time [UCC 2–608(1)(a), 2A–517(1)(a)].

2. The failure of the buyer or lessee to discover the nonconformity was reasonably induced either by the difficulty of discovery before acceptance or by assur- ances made by the seller or lessor [UCC 2–608(1)(b), 2A–517(1)(b)]. ■ CASE IN POINT 14.23 Armadillo Distribution Armadillo Distribution

Enterprises, Inc., is a major distributor of musical instru- ments. Armadillo contracted with a Chinese corporation, Hai Yun Musical Instruments Manufacture Co., Ltd., to manufacture one thousand drum kits. Hai Yun had made drums for Armadillo in the past. Hai Yun furnished sam- ples for Armadillo’s approval prior to manufacturing the kits. After Armadillo inspected and approved the sam- ples, Hai Yun delivered five shipping containers of drum kits, and Armadillo began distribution.

Armadillo soon started receiving numerous com- plaints from its retail outlet customers concerning

product returns due to cosmetic and structural defects in the drum kits. Armadillo immediately inspected the remaining four shipment containers and discovered that a high percentage of the drum kits were defective and unfit for commercial distribution. Armadillo revoked its acceptance of the kits and filed a suit in federal court for breach of contract. The district court ruled that Hai Yun had breached the contract by delivering nonconforming goods. The court awarded Armadillo nearly $90,000 in direct and incidental damages.17 ■

Revocation of acceptance is not effective until notice is given to the seller or lessor. Notice must occur within a reasonable time after the buyer or lessee either discov- ers or should have discovered the grounds for revocation. should have discovered the grounds for revocation. should have discovered Additionally, revocation must occur before the goods have undergone any substantial change (such as spoilage) not caused by their own defects [UCC 2–608(2), 2A–517(4)]. Once acceptance is revoked, the buyer or lessee can pur- sue remedies, just as if the goods had been rejected.

The Right to Recover Damages for Accepted Goods A buyer or lessee who has accepted nonconforming goods may also keep the goods and recover damages [UCC 2–714(1), 2A–519(3)]. To do so, the buyer or lessee must notify the seller or lessor of the breach and specify the defects within a reasonable time after the defect was or should have been discovered.

When the goods delivered are not as promised, the measure of damages generally equals the difference between the value of the goods as accepted and their value if they had been delivered as warranted. An excep- tion occurs if special circumstances show proximately caused damages of a different amount [UCC 2–714(2), 2A–519(4)]. The buyer or lessee is also entitled to inci- dental and consequential damages when appropriate [UCC 2–714(3), 2A–519].

Is two years after a sale of goods a reasonable time period in which to discover a defect in those goods and notify the seller of a breach? That was the question in the following case.

17. Armadillo Distribution Enterprises, Inc. v. Hai Yun Musical Instruments Manufacture Co. Ltd., ___ F.Supp.3d ___, 2015 WL 6750813 (M.D.Fla. Manufacture Co. Ltd., ___ F.Supp.3d ___, 2015 WL 6750813 (M.D.Fla. Manufacture Co. Ltd 2015).

306 U N I T T H R E E The Commercial Environment

Background and Facts In 1995, James Fitl attended a sports-card show in San Francisco, Cali- fornia, where he met Mark Strek, doing business as Star Cards of San Francisco, an exhibitor at the show. Later, on Strek’s representation that a certain 1952 Mickey Mantle Topps baseball card was in near-mint condition, Fitl bought the card from Strek for $17,750. Strek delivered it to Fitl in Omaha, Nebraska, and Fitl placed it in a safe-deposit box. In May 1997, Fitl sent the card to Professional Sports Authenticators (PSA), a sports-card grading

service. PSA told Fitl that the card was ungradable because it had been discolored and doctored. Fitl complained to Strek, who replied that Fitl should have initiated a return of the card sooner. Accord- ing to Strek, “a typical grace period for the unconditional return of a card [was within] 7 days to 1 month” of its receipt. In August, Fitl sent the card to ASA Accugrade, Inc. (ASA), another grading service, for a second opinion of the value. ASA also concluded that the card had been refinished and trimmed. Fitl filed a suit in a Nebraska state court against Strek, seeking damages. The court awarded Fitl $17,750, plus his court costs. Strek appealed to the Nebraska Supreme Court.

In the Language of the Court WRIGHT, J. [Judge]

* * * * Strek claims that the [trial] court erred in determining that notification of the defective condition of

the baseball card 2 years after the date of purchase was timely pursuant to [UCC] 2–607(3)(a). * * * The [trial] court found that Fitl had notified Strek within a reasonable time after discovery of

the breach. Therefore, our review is whether the [trial] court’s finding as to the reasonableness of the notice was clearly erroneous.

Section 2–607(3)(a) states: “Where a tender has been accepted * * * the buyer must within a reason- able time after he discovers or should have discovered any breach notify the seller of breach or be barred from any remedy.” [Under UCC 1–204(2),] “what is a reasonable time for taking any action depends on the nature, purpose and circumstances of such action.” [Emphasis added.]nature, purpose and circumstances of such action.” [Emphasis added.]nature, purpose and circumstances of such action.”

The notice requirement set forth in Section 2–607(3)(a) serves three purposes. * * * The most important one is to enable the seller to make efforts to cure the breach by making

adjustments or replacements in order to minimize the buyer’s damages and the seller’s liability. A second policy is to provide the seller a reasonable opportunity to learn the facts so that he may adequately pre- pare for negotiation and defend himself in a suit. A third policy * * * is the same as the policy behind statutes of limitation: to provide a seller with a terminal point in time for liability.

* * * A party is justified in relying upon a representation made to the party as a positive statement of fact when an investigation would be required to ascertain its falsity. In order for Fitl to have determined that the baseball card had been altered, he would have been required to conduct an investigation. We find that he was not required to do so. Once Fitl learned that the baseball card had been altered, he gave notice to Strek. [Emphasis added.]

* * * One of the most important policies behind the notice requirement * * * is to allow the seller to cure the breach by making adjustments or replacements to minimize the buyer’s damages and the seller’s liability. However, even if Fitl had learned immediately upon taking possession of the baseball card that it was not authentic and had notified Strek at that time, there is no evidence that Strek could have made any adjustment or taken any action that would have minimized his liability. In its altered condition, the baseball card was worthless.

* * * Earlier notification would not have helped Strek prepare for negotiation or defend himself in a suit because the damage to Fitl could not be repaired. Thus, the policies behind the notice requirement, to allow the seller to correct a defect, to prepare for negotiation and litigation, and to protect against

Spotlight on Baseball Cards

Case 14.3 Fitl v. StrekCase 14.3 Fitl v. Strek Supreme Court of Nebraska, 269 Neb. 51, 690 N.W.2d 605 (2005).Supreme Court of Nebraska, 269 Neb. 51, 690 N.W.2d 605 (2005).

C H A P T E R 1 4 Sales and Lease Contracts 307

14–6 Warranties In sales and lease law, a warranty is an assurance or guar- antee by the seller or lessor about the quality and fea- tures of the goods being sold or leased. The Uniform Commercial Code (UCC) has numerous rules govern- ing product warranties. Articles 2 (on sales) and 2A (on leases) designate several types of warranties that can arise in a sales or lease contract, including warranties of title, express warranties, and implied warranties.

Because a warranty imposes a duty on the seller or les- sor, a breach of warranty is a breach of the seller’s or les- sor’s promise. Assuming that the parties have not agreed to limit or modify the remedies available, if the seller or lessor breaches a warranty, the buyer or lessee can sue to recover damages. Under some circumstances, a breach of warranty can allow the buyer or lessee to rescind (cancel) the agreement.

14–6a Warranties of Title Under the UCC, three types of title warranties—good Under the UCC, three types of title warranties—good Under the UCC, three types of title warranties— title, no liens, and no infringements—can automatically no infringements—can automatically no infringements arise in sales and lease contracts [UCC 2–312, 2A–211]. Normally, a seller or lessor can disclaim or modify these title warranties only by including specific language in the specific language in the specific language contract. For instance, sellers may assert that they are transferring only such rights, title, and interest as they have in the goods.

In most sales, sellers warrant that they have good and valid title to the goods sold and that the transfer of the

title is rightful [UCC 2–312(1)(a)]. A second warranty of title protects buyers and lessees who are unaware of any encumbrances (claims or liabilities—usually called liens18) against goods at the time the contract is made [UCC 2–312(1)(b), 2A–211(1)]. This war- ranty protects buyers who, for instance, unknowingly purchase goods that are subject to a creditor’s security interest. (A security interest in this context is an intersecurity interest in this context is an intersecurity interest - est in the goods that secures payment or performance of an obligation.) If a creditor legally repossesses the goods from a buyer who had no actual knowledge of the security interest, the buyer can recover from the seller for breach of warranty. (In contrast, a buyer who has actual knowledge of a security interest has no recourse against a knowledge of a security interest has no recourse against a knowledge of a security interest seller.) Article 2A affords similar protection for lessees [UCC 2A–211(1)].

A third type of warranty of title arises automatically when the seller or lessor is a merchant. A merchant-seller or lessor warrants that the buyer or lessee takes the goods free of infringements from any copyright, trademark, or patfree of infringements from any copyright, trademark, or patfree of infringements - ent claims of a third person [UCC 2–312(3), 2A–211(2)].

14–6b Express Warranties A seller or lessor can create an express warranty by makexpress warranty by makexpress warranty - ing representations concerning the quality, condition, description, or performance potential of the goods.

Under UCC 2–313 and 2A–210, express warranties arise when a seller or lessor indicates any of the following:

18. Pronounced leens.

stale claims at a time beyond which an investigation can be completed, were not unfairly prejudiced by the lack of an earlier notice to Strek. Any problem Strek may have had with the party from whom he obtained the baseball card was a separate matter from his transaction with Fitl, and an investigation into the source of the altered card would not have minimized Fitl’s damages.

Decision and Remedy The state supreme court affirmed the decision of the lower court. Under the circumstances, notice of a defect in the card two years after its purchase was reasonable. The buyer had reasonably relied on the seller’s representation that the card was “authentic” (which it was not), and when the defects were discovered, the buyer had given timely notice.

Critical Thinking • What If the Facts Were Different? Suppose that Fitl and Strek had included in their deal a written

clause requiring Fitl to give notice of any defect in the card within “7 days to 1 month” of its receipt. Would the result have been different? Why or why not?

• Legal Environment What might a court award to a buyer who prevails in a dispute such as the one in this case?

Case 14.3 Continued

308 U N I T T H R E E The Commercial Environment

1. That the goods conform to any affirmation (decla- ration that something is true) of fact or promise that the seller or lessor makes to the buyer or lessee about the goods. Such affirmations or promises are usually made during the bargaining process when a seller or lessor makes representations about a product.

2. That the goods conform to any description of them. 3. That the goods conform to any sample or model of the sample or model of the sample or model

goods shown to the buyer or lessee. Express warranties can be found in a seller’s or lessor’s advertisement, brochure, or promotional materials, in addition to being made orally or in an express warranty provision in a sales or lease contract.

Basis of the Bargain To create an express warranty, a seller or lessor does not have to use formal words, such as warrant or warrant or warrant guarantee. It is only necessary that a reason- able buyer or lessee would regard the representation as being part of the basis of the bargain [UCC 2–313(2), 2A–210(2)].

The UCC does not explicitly define the phrase “basis of the bargain.” Generally, it means that the buyer or les- see must have relied on the representation at the time of entering into the agreement. Therefore, a court must determine whether each representation was made at such a time and in such a way that it induced the buyer or les- see to enter into the contract.

Statements of Opinion and Value Only state- ments of fact create express warranties. A seller or les- sor who states an opinion about or recommends the goods thus does not create an express warranty [UCC 2–313(2), 2A–210(2)].

■ CASE IN POINT 14.24 Kathleen Arthur underwent a surgical procedure for neck pain. Her surgeon implanted an Infuse Bone Graft device made by Medtronic, Inc. Although the device was not approved for this use, a sales representative for Medtronic allegedly had told the sur- geon that the Infuse device could be appropriate for this surgery.

The surgery did not resolve Arthur’s neck pain, and she developed numbness in her arm and fingers. She filed a breach of warranty claim against Medtronic, alleging that the salesperson’s statements created an express war- ranty. The court dismissed Arthur’s case, however. The alleged statements of a sales representative on whether it was “appropriate” to use the Infuse device in such a procedure were opinion and did not create an express warranty.19 ■

19. Arthur v. Medtronic, Inc., 123 F.Supp.3d 1145 (E.D.Mo. 2015).

Similarly, a seller or lessor who makes a statement about the value or worth of the goods (such as “this is worth a fortune”) does not create an express warranty. If the seller or lessor is an expert, however, and gives an opinion as an expert to a layperson, then a warranty may be created.

14–6c Implied Warranties An implied warranty is one that implied warranty is one that implied warranty the law derives by infer- ence from the nature of the transaction or the relative sit- uations or circumstances of the parties. Under the UCC, merchants impliedly warrant that the goods they sell or lease are merchantable and, in certain circumstances, fit for a particular purpose.

Implied Warranty of Merchantability Every sale or lease of goods made by a merchant who deals in goods of the kind sold or leased automatically gives rise to an implied warranty of merchantability [UCC 2–314, implied warranty of merchantability [UCC 2–314, implied warranty of merchantability 2A–212]. Thus, a merchant who is in the business of selling ski equipment makes an implied warranty of mer- chantability every time he sells a pair of skis. A neighbor selling her skis at a garage sale does not (because she is not in the business of selling goods of this type).

To be merchantable, goods must be “reasonably fit for the ordinary purposes for which such goods are used.” They must be of at least average, fair, or medium-grade quality. “Merchantable” food, for instance, is food that is fit to eat on the basis of consumer expectations. The goods must also be adequately packaged and labeled. In addition, they must conform to the promises or affirma- tions of fact made on the container or label, if any.

The implied warranty of merchantability may be breached when the warrantor has unsuccessfully attempted to repair or replace defective parts. ■ CASE IN POINT 14.25 Ilan Brand leased a new Hyundai Genesis from Ilan Brand leased a new Hyundai Genesis from Allen Hyundai. The next day, when he was driving on an interstate highway, the sunroof began opening and closing, although Brand was not pushing the sunroof buttons. He immediately returned the vehicle to the Hyundai dealer. He was told it had a defective sunroof switch, which would be repaired within 24 hours. In spite of the dealer’s assurances, however, the problem was not repaired. Ten days later, Brand—who still had not been able to pick up the vehicle—attempted to rescind the lease. Hyundai would not allow him to do so.

Brand then filed an action for breach of the implied warranty of merchantability in state court. The trial court dismissed the case, but the appellate court reversed. The reviewing court held that a reasonable jury could conclude

C H A P T E R 1 4 Sales and Lease Contracts 309

that the opening and closing of the sunroof constituted a safety hazard and therefore breached the implied war- ranty of merchantability. The court remanded the case for a jury trial.20 ■

Implied Warranty of Fitness for a Particular Purpose The implied warranty of fitness for a par- ticular purpose arises in the sale or lease of goods when a seller or lessor (merchant or nonmerchant) knows both of the following:

1. The particular purpose for which a buyer or lessee will use the goods.

2. That the buyer or lessee is relying on the skill and judgment of the seller or lessor to select suitable goods [UCC 2–315, 2A–213].

A “particular purpose” of the buyer or lessee differs from the “ordinary purpose for which goods are used” (merchantability). Goods can be merchantable but unfit for a particular purpose.for a particular purpose.for a particular purpose.for a particular purpose.

■ EXAMPLE 14.26 Sheryl needs a gallon of paint to Sheryl needs a gallon of paint to match the color of her living room walls—a light shade somewhere between coral and peach. She takes a sample to Sherwin-Williams and requests a gallon of paint of that color. Instead, the salesperson gives her a gallon of bright blue paint. Here, the salesperson has not breached any warranty of implied merchantability—the bright blue paint is of high quality and suitable for interior walls. The salesperson has breached an implied warranty of fitness for a particular purpose, though, because the paint is not the right color for Sheryl’s purpose (to match her living room walls). ■

A seller or lessor need not have actual knowledge of the buyer’s or lessee’s particular purpose. It is sufficient if a seller or lessor “has reason to know” the purpose and that the buyer or lessee is relying on her or his judgment or skill in selecting or furnishing suitable goods.

Warranties Implied from Prior Dealings or Trade Custom Implied warranties can also arise (or be excluded or modified) as a result of course of dealing or usage of trade [UCC 2–314(3), 2A–212(3)]. Without evidence to the contrary, when both parties to a sales or lease contract have knowledge of a well-recognized trade custom, the courts will infer that both parties intended for that custom to apply to their contract.for that custom to apply to their contract.for that custom to apply to their contract.for that custom to apply to their contract.

■ EXAMPLE 14.27 Industry-wide custom is to lubri Industry-wide custom is to lubri- cate a new car before it is delivered. If a dealer fails to lubricate a car, the dealer can be held liable to a buyer

20. Brand v. Hyundai Motor America, 226 Cal.App.4th 1538, 173 Cal.Rptr.3d 454 (4th Dist. 2014).

for damages resulting from the breach of an implied war- ranty. (This would also be negligence on the part of the dealer.) ■

14–6d Warranty Disclaimers The UCC generally permits warranties to be disclaimed or limited by specific and unambiguous language, pro- vided that this is done in a manner that protects the buyer or lessee from surprise. The manner in which a seller or lessor can disclaim warranties varies with the type of warranty. A seller or lessor can disclaim all oral express warranties by including in the contract a writ- ten disclaimer. The disclaimer must be in language that is clear and conspicuous and must be called to a buyer’s or lessee’s attention [UCC 2–316(1), 2A–214(1)]. This allows the seller or lessor to avoid false allegations that oral warranties were made. Note that a buyer or lessee must be made aware of any warranty disclaimers or mod- ifications at the time the contract is formed.

Normally, unless circumstances indicate otherwise, the implied warranties of merchantability and fitness are disclaimed by an expression such as “as is” or “with all faults.” Both parties must be able to clearly understand from the language used that there are no implied warran- ties [UCC 2–316(3)(a), 2A–214(3)(a)]. (Note, however, that some states have passed consumer protection stat- utes that forbid “as is” sales or make it illegal to disclaim warranties of merchantability on consumer goods.)

To specifically disclaim an implied warranty of mer- chantability, a seller or lessor must mention the word mer- chantability. The disclaimer need not be written, but if it is, the writing must be conspicuous or displayed in such a way that a reasonable person would notice it [UCC 2–316(2), 2A–214(4)]. To disclaim an implied warranty of fitness for a particular purpose, the disclaimer must be in a writing and must be conspicuous. The writing does not have to mention the word fitness. It is sufficient if, for instance, the disclaimer states, “There are no warranties that extend beyond the description on the face hereof.”

14–7 Contracts for the International Sale of Goods

International sales contracts between firms or individuals located in different countries may be governed by the 1980 United Nations Convention on Contracts for the Interna- tional Sale of Goods (CISG). The CISG governs interna- tional contracts only if the countries of the parties to the

310 U N I T T H R E E The Commercial Environment

contract have ratified the CISG and if the parties have not agreed that some other law will govern their contract.

The CISG had been adopted by eighty-four coun- tries, including the United States, Canada, some Central and South American countries, China, most European nations, Japan, and Mexico. That means that the CISG is the uniform international sales law of countries that account for more than two-thirds of all global trade. (The appendix at the end of this chapter shows an actual international sales contract used by the Starbucks Coffee Company.)

14–7a Applicability of the CISG Essentially, the CISG is to international sales contracts what Article 2 of the UCC is to domestic sales contracts. Whenever the parties to international transactions have failed to specify in writing the precise terms of a contract, the CISG will be applied.

Unlike the UCC, however, the CISG does not apply to consumer sales. Neither the UCC nor the CISG applies to contracts for services.

Businesspersons must take special care when drafting international sales contracts to avoid problems caused by distance, including language differences and differences in national laws. For instance, a choice-of-language clause designates the official language by which the contract will be interpreted in the event of a dispute. A choice- of-law clause designates the applicable law governing the of-law clause designates the applicable law governing the of-law clause contract.

14–7b A Comparison of CISG and UCC Provisions The provisions of the CISG, although similar for the most part to those of the UCC, differ from them in some

respects. Major differences exist between the CISG and the UCC in regard to the mirror image rule and irrevo- cable offers, for instance. If the CISG and the UCC con- flict, the CISG applies (because it is a treaty of the U.S. national government and therefore is supreme).

Under the UCC, an acceptance that contains addi- tional terms can still result in the formation of a contract, unless the additional terms are conditioned on the con- sent of the offeror. In other words, the UCC does away with the mirror image rule in domestic sales contracts.

Under the CISG, however, if the acceptance con- tains additional terms that materially alter the contract, no contract will be formed. Thus, if an additional term relates to payment, quality, quantity, price, or the settle- ment of disputes, the CISG considers the added term a material alteration. In effect, then, the CISG requires that the terms of the acceptance mirror those of the offer.

The UCC provides that a merchant’s firm offer is irrevocable, even without consideration, if the merchant gives assurances in a signed writing. In contrast, under Article 16(2) of the CISG, an offer can become irrevo- cable without a signed writing if the offeror simply states orally that the offer is irrevocable or if the offeree reason- ably relies on the offer as being irrevocable.

14–7c Remedies for Breach The CISG provides international sellers and buyers with remedies very similar to those available under the UCC. Article 74 of the CISG provides for monetary damages, including foreseeable consequential damages, on a con- tract’s breach. As under the UCC, the measure of dam- ages normally is the difference between the contract price and the market price of the goods. The CISG also allows for specific performance as a remedy under Article 28.

C H A P T E R 1 4 Sales and Lease Contracts 311

Debate This . . . The UCC should require the same degree of definiteness of terms, especially with respect to price and quantity, as contract law does.

Reviewing: Sales and Lease Contracts

Guy Holcomb owns and operates Oasis Goodtime Emporium, an adult entertainment establishment. Holcomb wanted to create an adult Internet system for Oasis that would offer customers adult-theme videos and “live” chat room programs using performers at the club. On May 10, Holcomb signed a work order authorizing Thomas Consulting Group (TCG) “to deliver a working prototype of a customer chat system, demonstrating the integration of live video and chatting in a Web browser.” In exchange for creating the prototype, Holcomb agreed to pay TCG $64,697. On May 20, Holcomb signed an additional work order in the amount of $12,943 for TCG to install a customized firewall system. The work orders stated that Holcomb would make monthly installment payments to TCG, and both parties expected the work would be finished by September.

Due to unforeseen problems largely attributable to system configuration and software incompatibility, the project required more time than anticipated. By the end of the summer, the Web site was still not ready, and Holcomb had fallen behind in his payments to TCG. TCG threatened to cease work and file a suit for breach of contract unless the bill was paid. Rather than make further payments, Holcomb wanted to abandon the Web site project. Using the infor- mation presented in the chapter, answer the following questions. 1. Would a court be likely to decide that the transaction between Holcomb and TCG was covered by the Uniform

Commercial Code (UCC)? Why or why not?Commercial Code (UCC)? Why or why not? 2. Would a court be likely to consider Holcomb a merchant under the UCC? Why or why not? 3. Did the parties have a valid contract under the UCC? Were any terms left open in the contract? If so, which terms?

How would a court deal with open terms? 4. Suppose that Holcomb and TCG meet in October in an attempt to resolve their problems. At that time, the parties

reach an oral agreement that TCG will continue to work without demanding full payment of the past due amounts and Holcomb will pay TCG $5,000 per week. Assuming the contract falls under the UCC, is the oral agreement enforceable? Why or why not?

Terms and Concepts bailment 297 conforming goods 299 cover 304 cure 300 destination contract 296 document of title 296 express warranty 307 �rm o�er 287 fungible goods 293 identi�cation 292

implied warranty 308 implied warranty of �tness for a

particular purpose 309 implied warranty of

merchantability 308 insurable interest 298 intangible property 285 merchant 286 output contract 287 perfect tender rule 300

predominant-factor test 285 replevin 304 requirements contract 287 sale 284 sales contract 284 seasonably 287 shipment contract 296 tangible property 285 tender of delivery 299

312 U N I T T H R E E The Commercial Environment

Issue Spotters 1. E-Design, Inc., orders 150 computer desks. Fav-O-Rite

Supplies, Inc., ships 150 printer stands. Is this an accep- tance of the offer or a counteroffer? If it is an acceptance, is it a breach of the contract? Why or why not? What if Fav-O-Rite told E-Design it was sending the printer stands as “an accommodation”? (See The Formation of Sales and Lease Contracts.)

2. Brite Images agrees to sell Poster Planet five thousand post- ers of celebrities, to be delivered on May 1. On April 1, Brite repudiates the contract. Poster Planet informs Brite that it expects delivery. Can Poster Planet sue Brite with- out waiting until May 1? Why or why not? (See Perfor- mance and Breach of Sales and Lease Contracts.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 14–1. Merchant’s Firm Offer. On May 1, Jennings, a car dealer, e-mails Wheeler and says, “I have a 1955 Thunderbird convertible in mint condition that I will sell you for $13,500 at any time before June 9. [Signed] Peter Jennings.” By May 15, having heard nothing from Wheeler, Jennings sells the car to another. On May 29, Wheeler accepts Jennings’s offer and tenders $13,500. When told Jennings has sold the car to another, Wheeler claims Jennings has breached their contract. Is Jennings in breach? Explain. (See The Formation of Sales and Lease Contracts.) 14–2. Anticipatory Repudiation. Moore contracted in writing to sell her 2017 Hyundai Santa Fe to Hammer for

$18,500. Moore agreed to deliver the car on Wednesday, and Hammer promised to pay the $18,500 on the following Fri- day. On Tuesday, Hammer informed Moore that he would not be buying the car after all. By Friday, Hammer had changed his mind again and tendered $18,500 to Moore. Moore, although she had not sold the car to another party, refused the tender and refused to deliver. Hammer claimed that Moore had breached their contract. Moore contended that Hammer’s repudiation released her from her duty to perform under the contract. Who is correct, and why? (See Performance and Breach of Sales and Lease Contracts.)

Business Case Problems 14–3. Spotlight on Apple—Implied Warranties. Alan

Vitt purchased an iBook G4 laptop computer from Apple, Inc. Shortly after the one-year war- ranty expired, the laptop failed to work due to a weakness in the product manufacture. Vitt sued

Apple, arguing that the laptop should have lasted “at least a couple of years,” which Vitt believed was a reasonable con- sumer expectation for a laptop. Vitt claimed that Apple’s descriptions of the laptop as “durable,” “rugged,” “reliable,” and “high performance” were a�rmative statements concern- ing the quality and performance of the laptop, which Apple did not meet. How should the court rule? Why? [Vitt v. Apple Computer, Inc., 469 Fed.Appx. 605 (9th Cir. 2011)] (See Warranties.) 14–4. Remedies for Breach. LO Ventures, LLC, doing business as Reefpoint Brewhouse in Racine, Wisconsin, con- tracted with Forman Awnings and Construction, LLC, for the fabrication and installation of an awning system over an out- door seating area. After the system was complete, Reefpoint expressed concerns about the workmanship but did not give Forman a chance to make repairs. �e brewhouse used the awning for two months and then had it removed so that siding on the building could be replaced. �e parties disagreed about whether cracked and broken welds observed after the removal of the system were due to shoddy workmanship. Reefpoint

paid only $400 on the contract price of $8,161. Can Reef-paid only $400 on the contract price of $8,161. Can Reef-paid only $400 on the contract price of $8,161. Can Reef point rescind the contract and obtain a return of its $400? Is Forman entitled to recover the di�erence between Reefpoint’s payment and the contract price? Discuss. [Forman Awnings and Construction, LLC v. LO Ventures, LLC, 360 Wis.2d 492, 864 N.W.2d 121 (2015)] (See Remedies for Breach of Sales and Lease Contracts.) 14–5. Business Case Problem with Sample Answer— Goods and Services Combined. Allied Shelving and

Equipment, Inc., sells and installs shelving sys- tems. National Deli, LLC, contracted with Allied to provide and install a parallel rack system (a series of large shelves) in National’s warehouse. Both par-

ties were dissatis�ed with the result. National �led a suit in a Florida state court against Allied, which �led a counterclaim. Each contended that the other had materially breached the contract. �e court applied common law contract principles to rule in National’s favor on both claims. Allied appealed, argu- ing that the court should have applied the UCC. When does a court apply common law principles to a contract that involves both goods and services? In this case, why might an appellate court rule that the UCC should be applied instead? Explain. [Allied Shelving and Equipment, Inc. v. National Deli, LLC,[Allied Shelving and Equipment, Inc. v. National Deli, LLC,[ 40 Fla. L. Weekly D145, 154 So.3d 482 (Dist.App. 2015)] (See �e Scope of Articles 2 and 2A.)

C H A P T E R 1 4 Sales and Lease Contracts 313

• For a sample answer to Problem 14–5, go to Appendix E at the end of this text.

14–6. Acceptance. New England Precision Grinding, Inc. (NEPG), sells precision medical parts in Massachusetts. NEPG agreed to supply Kyphon, Inc., with stylets and nozzles. NEPG contracted with Simply Surgical, LLC, to obtain the parts from Iscon Surgicals, Ltd. �e contract did not mention Kyphon or require Kyphon’s acceptance of the parts. Before shipping, Iscon would certify that the parts conformed to NEPG’s speci�cations. On receiving the parts, NEPG would certify that they conformed to Kyphon’s speci�cations. On delivery, Kyphon would also inspect the parts. After about half a dozen transactions, NEPG’s payments to Simply Surgi- cal lagged, and the seller refused to make further deliveries. NEPG �led a suit in a Massachusetts state court against Sim- ply Surgical, alleging breach of contract. NEPG claimed that Kyphon had rejected some of the parts, which gave NEPG the right not to pay for them. Do the UCC’s rules with respect to acceptance support or undercut the parties’ actions? Discuss. [New England Precision Grinding, Inc. v. Simply Surgical, LLC, 89 Mass.App.Ct.176, 46 N.E.3d 590 (2016)] (See �e Forma- tion of Sales and Lease Contracts.) 14–7. Express Warranties. Charity Bell bought a used Toyota Avalon from Awny Gobran of Gobran Auto Sales, Inc. �e odometer showed that the car had been driven 147,000 miles. Bell asked whether it had been in any accidents. Gobran replied that it was in good condition. �e parties signed a war- ranty disclaimer that the vehicle was sold “as is.” Problems with the car arose the same day as the purchase. Gobran made a few ine�ectual attempts to repair it before refusing to do more. Meanwhile, Bell obtained a vehicle history report from Carfax, which showed that the Avalon had been damaged in an acci- dent and that its last reported odometer reading was 237,271. Was the “as is” disclaimer su�cient to put Bell on notice that the odometer reading could be false and that the car might have been in an accident? Can Gobran avoid any liability that might otherwise be imposed because Bell did not obtain the Carfax report until after she bought the car? Discuss. [after she bought the car? Discuss. [after Gobran Auto Sales Inc. v. Bell, 335 Ga.App. 873, 783 S.E.2d 389 (2016)] (See Warranties.) 14–8. Remedies of the Buyer or Lessee. M. C. and Linda Morris own a home in Gulfport, Mississippi, that was

extensively damaged in Hurricane Katrina. �e Morrises contracted with Inside Outside, Inc. (IO), to rebuild their kitchen. When the new kitchen cabinets were delivered, some defects were apparent, and as installation progressed, oth- ers were revealed. IO ordered replacement parts to cure the defects. Before the parts arrived, however, the parties’ relation- ship deteriorated, and IO o�ered to remove the cabinets and refund the price. �e Morrises also asked to be repaid for the installation fee. IO refused but emphasized that it was will- ing to ful�ll its contractual obligations. At this point, are the Morrises entitled to revoke their acceptance of the cabinets? Why or why not? [Morris v. Inside Outside, Inc., 185 So.3d 413 (Miss.App. 2016)] (See Remedies for Breach of Sales and Lease Contracts.)

14–9. A Question of Ethics—Revocation of Accep- tance. Scotwood Industries, Inc., sells calcium chloride �ake for

use in ice melt products. Between July and September 2004, Scotwood delivered thirty-seven shipments of �ake to Frank Miller & Sons, Inc. After each deliv- ery, Scotwood billed Miller, which paid thirty-�ve of

the invoices and processed 30 to 50 percent of the �ake. In August, Miller began complaining about the product’s quality. Scotwood assured Miller that it would remedy the situation. Finally, in October, Miller told Scotwood, “�is is totally unacceptable. We are willing to discuss Scotwood picking up the material.” Miller claimed that the �ake was substantially defective because it was chunked. Calcium chloride maintains its purity for up to �ve years, but if it is exposed to and absorbs moisture, it chunks and becomes unusable. Scotwood sued to collect payment on the unpaid invoices. In response, Miller �led a counterclaim in a federal dis- trict court for breach of contract, seeking to recover based on revo- cation of acceptance, among other things. [Scotwood Industries, [Scotwood Industries, [ Inc. v. Frank Miller & Sons, Inc., 435 F.Supp.2d 1160 (D.Kan. 2006)] (See Remedies for Breach of Sales and Lease Contracts.)

(a) What is revocation of acceptance? How does a buyer effectively exercise this option? Do the facts in this case support this theory as a ground for Miller to recover dam- ages? Why or why not?

(b) Is there an ethical basis for allowing a buyer to revoke acceptance of goods and recover damages? If so, is there an ethical limit to this right? Discuss.

Legal Reasoning Group Activity 14–10. Warranties. Milan purchased sa�ron extract, mar- keted as “America’s Hottest New Way to a Flat Belly,” online from Dr. Chen. �e Web site stated that recently published studies showed a signi�cant weight loss (more than 25 per- cent) for people who used pure sa�ron extract as a supple- ment without diet and exercise. Dr. Chen said that the sa�ron suppresses appetite by increasing levels of serotonin, which reduces emotional eating. Milan took the extract as directed without any resulting weight loss. (See Warranties.)

(a) The first group will determine whether Dr. Chen’s Web site made any express warranty on the saffron extract or its effectiveness in causing weight loss.

(b) The second group will discuss whether the implied war- ranty of merchantability applies to the purchase of weight- loss supplements.

(c) The third group will decide if Dr. Chen’s sale of saffron extract breached the implied warranty of fitness for a par- ticular purpose.

U N I T T H R E E

OVERLAND COFFEE IMPORT CONTRACT OF THE

GREEN COFFEE ASSOCIATION OF Contract Seller’s No.: ________________

NEW YORK CITY, INC.* Buyer’s No.: _______________________ Date: _____________________________

SOLD BY: _________________________________________________________________________________________ TO: _________________________________________________________________________________________

Bags QUANTITY: ______________________ (____) Tons of ______________________________________________ coffee

weighing about__________________________ per bag. PACKAGING: Coffee must be packed in clean sound bags of uniform size made of sisal, henequen, jute, burlap, or similar

woven material, without inner lining or outer covering of any material properly sewn by hand and/or machine. Bulk shipments are allowed if agreed by mutual consent of Buyer and Seller.

DESCRIPTION: _________________________________________________________________________________________ _________________________________________________________________________________________ _________________________________________________________________________________________

PRICE: At _____________________________________U.S. Currency, per _______________net, (U.S. Funds) Upon delivery in Bonded Public Warehouse at ____________________________________________________

(City and State) PAYMENT: _________________________________________________________________________________________

_________________________________________________________________________________________ _________________________________________________________________________________________

Bill and tender to DATE when all import requirements and governmental regulations have been satisfied, and coffee delivered or discharged (as per contract terms). Seller is obliged to give the Buyer two (2) calendar days free time in Bonded Public Warehouse following but not including date of tender.

ARRIVAL: During _________________ via _______________________________________________________________ (Period) (Method of Transportation) from ____________________________________ for arrival at ______________________________________ (Country of Exportation) (Country of Importation) Partial shipments permitted.

ADVICE OF Advice of arrival with warehouse name and location, together with the quantity, description, marks and place of ARRIVAL: entry, must be transmitted directly, or through Seller’s Agent/Broker, to the Buyer or his Agent/ Broker. Advice

will be given as soon as known but not later than the fifth business day following arrival at the named warehouse. Such advice may be given verbally with written confirmation to be sent the same day.

WEIGHTS: (1) DELIVERED WEIGHTS: Coffee covered by this contract is to be weighed at location named in tender. Actual tare to be allowed. (2) SHIPPING WEIGHTS: Coffee covered by this contract is sold on shipping weights. Any loss in weight exceeding ________ percent at location named in tender is for account of Seller at contract price.

(3) Coffee is to be weighed within fifteen (15) calendar days after tender. Weighing expenses, if any, for account of ______________________________________________________________(Seller or Buyer)

MARKINGS: Bags to be branded in English with the name of Country of Origin and otherwise to comply with laws and regulations of the Country of Importation, in effect at the time of entry, governing marking of import merchandise. Any expense incurred by failure to comply with these regulations to be borne by Exporter/Seller.

RULINGS: The “Rulings on Coffee Contracts” of the Green Coffee Association of New York City, Inc., in effect on the date this contract is made, is incorporated for all purposes as a part of this agreement, and together herewith, constitute the entire contract. No variation or addition hereto shall be valid unless signed by the parties to the contract. Seller guarantees that the terms printed on the reverse hereof, which by reference are made a part hereof, are identical with the terms as printed in By-Laws and Rules of the Green Coffee Association of New York City, Inc., heretofore adopted. Exceptions to this guarantee are: ACCEPTED: COMMISSION TO BE PAID BY: _____________________________________ _________________________________________

Seller BY__________________________________

Agent _____________________________________

Buyer BY__________________________________ _________________________________________

Agent Broker(s) When this contract is executed by a person acting for another, such person hereby represents that he is fully authorized to commit his principal.

Bags

* Reprinted with permission of The Green Coffee Association of New York City, Inc.

504617Contract Seller’s No.: ________________504617Contract Seller’s No.: ________________ P9264Buyer’s No.: _______________________P9264Buyer’s No.: _______________________

10/11/18Date: _____________________________10/11/18Date: _____________________________ XYZ Co. Starbucks

Five Hundred______________________ (____) Tons of ______________________________________________ coffeeFive Hundred______________________ (____) Tons of ______________________________________________ coffee500______________________ (____) Tons of ______________________________________________ coffee500______________________ (____) Tons of ______________________________________________ coffeeMexican______________________ (____) Tons of ______________________________________________ coffeeMexican______________________ (____) Tons of ______________________________________________ coffee 152.117 lbs.weighing about__________________________ per bag.152.117 lbs.weighing about__________________________ per bag.

High grown Mexican Altura_________________________________________________________________________________________High grown Mexican Altura_________________________________________________________________________________________

Ten/$10.00 dollarsAt _____________________________________U.S. Currency, per _______________net, (U.S. Funds)Ten/$10.00 dollarsAt _____________________________________U.S. Currency, per _______________net, (U.S. Funds)lb.At _____________________________________U.S. Currency, per _______________net, (U.S. Funds)lb.At _____________________________________U.S. Currency, per _______________net, (U.S. Funds) Upon delivery in Bonded Public Warehouse at ____________________________________________________Laredo, TXUpon delivery in Bonded Public Warehouse at ____________________________________________________Laredo, TXUpon delivery in Bonded Public Warehouse at ____________________________________________________

Cash against warehouse receipts_________________________________________________________________________________________Cash against warehouse receipts_________________________________________________________________________________________

DecemberDuring _________________ via _______________________________________________________________DecemberDuring _________________ via _______________________________________________________________truckDuring _________________ via _______________________________________________________________truckDuring _________________ via _______________________________________________________________

Mexicofrom ____________________________________ for arrival at ______________________________________Mexicofrom ____________________________________ for arrival at ______________________________________Laredo, TX, USAfrom ____________________________________ for arrival at ______________________________________Laredo, TX, USAfrom ____________________________________ for arrival at ______________________________________

1/2weight exceeding ________ percent at location named in tender is for account of Seller at contract price.1/2weight exceeding ________ percent at location named in tender is for account of Seller at contract price.

Selleraccount of ______________________________________________________________(Seller or Buyer)Selleraccount of ______________________________________________________________(Seller or Buyer)

XYZ Co. Seller

Starbucks

BY__________________________________ ABC Brokerage_________________________________________ABC Brokerage_________________________________________

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A P P E N D I X T O C H A P T E R 14 An Example of a Contract for the International Sale of Coffee

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(Continued)

This is a contract for a sale of coffee to be imported internationally. If the parties have their principal places of business located in imported internationally. If the parties have their principal places of business located in imported different countries, the contract may be subject to the United Nations Convention on Contracts for the International Sale of Goods (CISG). If the parties’ principal places of business are located in the United States, the contract may be subject to the Uniform Commercial Code (UCC).

Quantity is one of the most important terms to include in a contract. Without it, a court may not be able to enforce the contract.

Weight per unit (bag) can be exactly stated or approximately stated. If it is not so stated, usage of trade in international contracts determines standards of weight.

Packaging requirements can be conditions for acceptance and payment. Bulk shipments are not permitted without the consent of the buyer.

A description of the coffee and the “Markings” constitute express warranties. International contracts rely more heavily on descriptions and models or samples than do warranties in contracts for the domestic sales of goods.

Under the UCC, parties may enter into a valid contract even though the price is not set. Under the CISG, a contract must provide for an exact determination of the price.

The terms of payment may take one of two forms: credit or cash. Credit terms can be complicated. A cash term can be simple, and payment can be made by any means acceptable in the ordinary course of business (for example, a personal check or a letter of credit). If the seller insists on actual cash, the buyer must be given a reasonable time to get it.

Tender means the seller has placed goods that conform to the contract at the buyer’s disposition. This contract requires that the Tender means the seller has placed goods that conform to the contract at the buyer’s disposition. This contract requires that the Tender coffee meet all import regulations and that it be ready for pickup by the buyer at a “Bonded Public Warehouse.” (A bonded warehouse is a place in which goods can be stored without payment of taxes until the goods are removed.)

The delivery date is significant because, if it is not met, the buyer may hold the seller in breach of the contract. Under this contract, the seller is given a “period” within which to deliver the goods, instead of a specific day. The seller is also given some time to rectify goods that do not pass inspection (see the “Guarantee” clause on page two of the contract).

As part of a proper tender, the seller (or its agent) must inform the buyer (or its agent) when the goods have arrived at their destination.

In some contracts, delivered and shipping weights can be important. During shipping, some loss can be attributed to the type of goods (spoilage of fresh produce, for example) or to the transportation itself. A seller and buyer can agree on the extent to which either of them will bear such losses.

Documents are often incorporated in a contract by reference, because including them word for word can make a contract difficult to read. If the document is later revised, the entire contract might have to be reworked. Documents that are typically incorporated by reference include detailed payment and delivery terms, special provisions, and sets of rules, codes, and standards.

In international sales transactions, and for domestic deals involving certain products, brokers are used to form the contracts. When so used, the brokers are entitled to a commission.

U N I T T H R E E

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TERMS AND CONDITIONS ARBITRATION: All controversies relating to, in connection with, or arising out of this contract, its modification, making or the authority or obliga-

tions of the signatories hereto, and whether involving the principals, agents, brokers, or others who actually subscribe hereto, shall be settled by arbitration in accordance with the “Rules of Arbitration” of the Green Coffee Association of New York City, Inc., as they exist at the time of the arbitration (including provisions as to payment of fees and expenses). Arbitration is the sole remedy hereunder, and it shall be held in accordance with the law of New York State, and judgment of any award may be entered in the courts of that State, or in any other court of competent jurisdiction. All notices or judicial service in reference to arbitration or enforcement shall be deemed given if transmitted as required by the aforesaid rules.

GUARANTEE: (a) If all or any of the coffee is refused admission into the country of importation by reason of any violation of governmental laws or acts, which violation existed at the time the coffee arrived at Bonded Public Warehouse, seller is required, as to the amount not admitted and as soon as possible, to deliver replacement coffee in conformity to all terms and conditions of this contract, excepting only the Arrival terms, but not later than thirty (30) days after the date of the violation notice. Any payment made and expenses incurred for any coffee denied entry shall be refunded within ten (10) calendar days of denial of entry, and payment shall be made for the replacement delivery in accordance with the terms of this contract. Consequently, if Buyer removes the coffee from the Bonded Public Warehouse, Seller’s responsibility as to such portion hereunder ceases. (b) Contracts containing the overstamp “No Pass–No Sale” on the face of the contract shall be interpreted to mean: If any or all of the coffee is not admitted into the country of Importation in its original condition by reason of failure to meet requirements of the government’s laws or Acts, the contract shall be deemed null and void as to that portion of the coffee which is not admitted in its original condition. Any payment made and expenses incurred for any coffee denied entry shall be refunded within ten (10) calendar days of denial of entry.

CONTINGENCY: This contract is not contingent upon any other contract.

CLAIMS: Coffee shall be considered accepted as to quality unless within fifteen (15) calendar days after delivery at Bonded Public Warehouse or within fifteen (15) calendar days after all Government clearances have been received, whichever is later, either: (a) Claims are settled by the parties hereto, or, (b)Arbitration proceedings have been filed by one of the parties in accordance with the provisions hereof. (c) If neither (a) nor (b) has been done in the stated period or if any portion of the coffee has been removed from the Bonded Public Warehouse before representative sealed samples have been drawn by the Green Coffee Association of New York City, Inc., in accordance with its rules, Seller’s responsibility for quality claims ceases for that portion so removed. (d) Any question of quality submitted to arbitration shall be a matter of allowance only, unless otherwise provided in the contract.

DELIVERY: (a) No more than three (3) chops may be tendered for each lot of 250 bags. (b) Each chop of coffee tendered is to be uniform in grade and appearance. All expense necessary to make coffee uniform shall be for account of seller. (c) Notice of arrival and/or sampling order constitutes a tender, and must be given not later than the fifth business day following arrival at Bonded Public Warehouse stated on the contract.

INSURANCE: Seller is responsible for any loss or damage, or both, until Delivery and Discharge of coffee at the Bonded Public Warehouse in the Country of Importation.

All Insurance Risks, costs and responsibility are for Seller’s Account until Delivery and Discharge of coffee at the Bonded Public Warehouse in the Country of Importation.

Buyer’s insurance responsibility begins from the day of importation or from the day of tender, whichever is later.

FREIGHT: Seller to provide and pay for all transportation and related expenses to the Bonded Public Warehouse in the Country of Importation.

EXPORT Exporter is to pay all Export taxes, duties or other fees or charges, if any, levied because of exportation. DUTIES/TAXES: IMPORT Any Duty or Tax whatsoever, imposed by the government or any authority of the Country of Importation, shall be borne DUTIES/TAXES: by the Importer/Buyer.

INSOLVENCY If, at any time before the contract is fully executed, either party hereto shall meet with creditors because of inability generally OR FINANCIAL to make payment of obligations when due, or shall suspend such payments, fail to meet his general trade obligations in the FAILURE OF regular course of business, shall file a petition in bankruptcy or, for an arrangement, shall become insolvent, or commit an act of BUYER bankruptcy, then the other party may at his option, expressed in writing, declare the aforesaid to constitute a breach and default OR SELLER: of this contract, and may, in addition to other remedies, decline to deliver further or make payment or may sell or purchase for the

defaulter’s account, and may collect damage for any injury or loss, or shall account for the profit, if any, occasioned by such sale or purchase.

This clause is subject to the provisions of (11 USC 365 (e) 1) if invoked.

BREACH OR In the event either party hereto fails to perform, or breaches or repudiates this agreement, the other party shall subject to the DEFAULT OF specific provisions of this contract be entitled to the remedies and relief provided for by the Uniform Commercial Code of the CONTRACT: State of New York. The computation and ascertainment of damages, or the determination of any other dispute as to relief, shall be

made by the arbitrators in accordance with the Arbitration Clause herein.

Consequential damages shall not, however, be allowed.

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Arbitration is the settling of a dispute by submitting it to a disinterested party (other than a court), which renders a decision. The procedures and costs can be provided for in an arbitration clause or incorporated through other documents. To enforce an award rendered in an arbitration, the winning party can “enter” (submit) the award in a court “of competent jurisdiction.”

When goods are imported internationally, they must meet certain import requirements before being released to the buyer. Because of this, buyers frequently want a guaranty clause that covers the goods not admitted into the country. The clause may either require the seller to replace the goods within a stated time or allow the contract for those goods not admitted to be void.

In the “Claims” clause, the parties agree that the buyer has a certain time within which to reject the goods. The right to reject is a right by law and does not need to be stated in a contract. If the buyer does not exercise the right within the time specified in the contract, the goods will be considered accepted.

Many international contracts include definitions of terms so that the parties understand what they mean. Some terms are used in a particular industry in a specific way. Here, the word chop refers to a unit of like-grade coffee beans. The buyer has a right to inspect (“sample”) the coffee. If the coffee does not conform to the contract, the seller must correct the nonconformity.

The “Delivery,” “Insurance,” and “Freight” clauses, with the “Arrival” clause on page one of the contract, indicate that this is a destination contract. The seller has the obligation to deliver the goods to the destination, not simply deliver them into the hands of a carrier. Under this contract, the destination is a “Bonded Public Warehouse” in a specific location. The seller bears the risk of loss until the goods are delivered at their destination. Typically, the seller will have bought insurance to cover the risk.

Delivery terms are commonly placed in all sales contracts. Such terms determine who pays freight and other costs and, in the absence of an agreement specifying otherwise, who bears the risk of loss. International contracts may use these delivery terms, or they may use INCOTERMS, which are published by the International Chamber of Commerce. For example, the INCOTERM DDP (delivered duty paid) requires the seller to arrange shipment, obtain and pay for import or export permits, and get the goods through customs to a named destination.

Exported and imported goods are subject to duties, taxes, and other charges imposed by the governments of the countries involved. International contracts spell out who is responsible for these charges.

This clause protects a party if the other party should become financially unable to fulfill the obligations under the contract. Thus, if the seller cannot afford to deliver, or the buyer cannot afford to pay, for the stated reasons, the other party can consider the contract breached. This right is subject to “11 USC 365(e)(1),” which refers to a specific provision of the U.S. Bankruptcy Code dealing with executory contracts.

In the “Breach or Default of Contract” clause, the parties agree that the remedies under this contract are the remedies (except for consequential damages) provided by the UCC, as in effect in the state of New York. The amount and “ascertainment” of damages, as well as other disputes about relief, are to be determined by arbitration.

Three clauses frequently included in international contracts are omitted here. There is no choice-of-language clause designating the official language to be used in interpreting the contract terms. There is no choice-of-forum clause designating the place in which disputes will be litigated, except for arbitration (law of New York State). Finally, there is no force majeure clause relieving the sellers or buyers from nonperformance due to events beyond their control.

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Mechanic’s Liens Sometimes, a person who has con- tracted for labor, services, or materials to be furnished for making improvements on real property does not imme- diately pay for the improvements. When that happens, the creditor can place a mechanic’s lien on the property.mechanic’s lien on the property.mechanic’s lien

A mechanic’s lien creates a special type of debtor- creditor relationship in which the real estate itself becomes security for the debt. If the property owner fails to pay the debt, the lienholder is technically entitled to foreclose on the real estate and sell it. (Foreclosure is the Foreclosure is the Foreclosure process by which a creditor legally takes a debtor’s prop- erty to satisfy a debt.) The sale proceeds are then used to pay the debt and the costs of the legal proceedings. The surplus, if any, is paid to the former owner.

In the real world, however, small-amount mechanic’s liens are rarely the basis of foreclosure. Rather, these liens simply remain on the books of the state until the house is sold. At closing (when the sale is finalized), the seller agrees to pay any mechanic’s liens out of the proceeds of the sale before the seller receives any of the funds.

State law governs the procedures that must be followed to create a mechanic’s (or other statutory) lien. Generally, the lienholder must file a written notice of lien within a specific time period (usually within 60 to 120 days) from the last date that material or labor was provided.

In the following case, the state mechanic’s lien statute required the lien to be filed no more than 90 days after “the completion of the work.” The contractor that filed the lien and the owner of the project against which the lien was filed disputed the meaning of the term “completion.”

15–1 Laws Assisting Creditors Normally, creditors have no problem collecting the debts owed to them. When disputes arise over the amount owed, however, or when the debtor simply cannot or will not pay, what happens? What remedies are available to creditors when a debtor defaults (fails to pay as prom- ised)? Here, we discuss some basic laws that assist the debtor and creditor in resolving their dispute.

The remedies we discuss next are available regardless of whether a creditor is secured or unsecured. Secured creditors are those whose loans are backed by creditors are those whose loans are backed by creditors collateral, which is specific property (such as a car or a house) pledged by a borrower to ensure repayment. The loans made by unsecured creditors, such as companies that pro- vide credit cards, are not backed by collateral.

15–1a Liens A lien is an encumbrance on (claim against) property to satisfy a debt or protect a claim for the payment of a debt. Liens may arise under the common law (usually by possession of the property) or under statutory law. Mechanic’s liens are statutory liens, whereas Mechanic’s liens are statutory liens, whereas Mechanic’s liens artisan’s liens were recognized at common law. liens were recognized at common law. liens Judicial liens may be used by a creditor to collect on a debt before or after a judgment is entered by a court. Liens are a very important tool for creditors because they gener- ally take priority over other claims against the same property.

M any people in today’s econ- omy are struggling to pay their debts. Although in

the old days, debtors were punished and sometimes even sent to prison for failing to pay what they owed, debtors today rarely go to jail. They have many other options, including

bankruptcy—the last resort in resolvbankruptcy—the last resort in resolvbankruptcy - ing debtor-creditor problems.

Bankruptcy relief is provided under federal law. Although state laws may play a role in bankruptcy proceed- ings, particularly state laws governing property, the governing law is based on federal legislation.

The right to petition for bankruptcy relief under federal law is an essential aspect of our capitalistic society, in which we have great opportunities for financial success but may also encoun- ter financial difficulties. Therefore, every businessperson should have some understanding of this topic.

Creditor-Debtor Relations and Bankruptcy

C H A P T E R 15

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 319

In the Language of the Court MAURO, J. [Judge]

* * * * Castellino [Villas, LLC] and Picerne

[Construction Corporation] entered into an agreement in which Picerne would build an apartment complex called Castellino Villas at Laguna West (project or property) in the City of Elk Grove [California] (the City). The proj- ect consisted of 11 apartment buildings, separate garages, a clubhouse, and other facilities.

* * * * The City issued certificates of occu-

pancy for the 11 buildings within the project * * * after a city inspector con- ducted a final inspection of each build- ing. The first certificates of occupancy were issued on May 3, 2006. The final certificate of occupancy was issued on July 25, 2006.

Picerne employees and subcontrac- tors continued to perform work at the project after July 25, 2006.

* * * * [John] Olsen [Castellino’s representa-

tive for the project] signed a document titled “Owner’s Acceptance of Site” for Castellino on September 8, 2006.

* * * * Castellino began renting apartments

at the property in October 2006. Picerne recorded a claim of mechan-

ic’s lien on November 28, 2006. Picerne filed a complaint [in a

California state court] to foreclose its mechanic’s lien on December 29, 2006.

* * * * * * * The trial court * * * determined

* * * Picerne is entitled to foreclose its lien. * * * * [On appeal to this court] Castellino

* * * contends Picerne does not have a valid mechanic’s lien because Picerne did not record a claim of mechanic’s lien within 90 days after substantial comple- tion of the project.

* * * * In order to have a valid mechanic’s

lien, a claimant must record a claim of lien within a prescribed period of time after completion of the work of improvement * * * . The failure of a claimant to timely record a claim of lien precludes the enforce- ment of a mechanic’s lien. [Emphasis added.]

[When Picerne filed its lien, mechanic’s liens were governed by Cali- fornia Civil Code Section 3115, which] provided, “Each original contractor [a contractor who has a direct contractual relationship with the owner for the work], in order to enforce a lien, must record his claim of lien after he com- pletes his contract and before the expira- tion of 90 days after the completion of the work of improvement.” [According to Section 3116, the term “work of improvement” means the entire structure or scheme of improvement as a whole.]

* * * The [California State] Leg- islature defined the term completion as “actual completion of the work of improvement.” In addition, * * * deemed to be equivalent to a completion [was] the acceptance by the owner or his agent of the work of improvement.

Substantial evidence supports the trial court’s finding that the owner accepted the project as of September 8, 2006. * * * Picerne timely recorded its claim of mechanic’s lien within 90 days after September 8, 2006.

* * * * Castellino * * * nevertheless claims

that the time for Picerne to record its claim of mechanic’s lien began to run before September 8, 2006. [Castellino] asserts the phrase “completion of the work of improvement” in Section 3115 means substantial completion of the work of improvement, and the project was substantially completed by July 25, 2006, when the City issued the final cer- tificate of occupancy.

There are cases construing the * * * mechanic’s lien stat- ute which interpreted “completion” as substantial completion.

* * * * [But these cases were decided before

the Legislature amended Section 3115 to define] completion of the work of improvement as actual completion of the work of improvement * * * . The Legislature did not define “completion of the work of improvement” as substan- tial completion. Courts have looked at whether the work at issue was required under the claimant’s contract in deter- mining whether a work of improvement was completed.

Castellino argues that interpreting the term “completion” * * * to mean substantial completion would be sound public policy because it would ensure transparency, visibility, objectivity, and certainty in the relationship between the contractor and the owner in the filing of mechanic’s liens. However, following the language of the statute by construing “completion” as “actual completion” does not create uncertainty when reference can be made to the parties’ agreement and the labor and materials furnished. Moreover, * * * deemed equivalent to completion [is] acceptance of the work of improvement.

In addition, contrary to Castellino’s argument, public policy supports the interpretation of completion as actual completion in this specific context. The mechanic’s lien statute is intended [primar- ily to benefit] persons who perform labor or furnish materials for works of improve- ment, and it is to be liberally construed for the protection of laborers and material suppliers, with doubts concerning the meaning of the statute generally resolved in favor of the lien claimant. Interpreting

Case Analysis 15.1 Picerne Construction Corp. v. Villas California Court of Appeal, Third District, 244 Cal.App.4th 1201, 199 Cal.Rptr.3d 257 (2016).

Case 15.1 Continues

320 U N I T T H R E E The Commercial Environment

Artisan’s Liens When a debtor fails to pay for labor and materials furnished for the repair or improvement of personal property, a creditor can recover payment through personal property, a creditor can recover payment through personal an artisan’s lien. As mentioned, artisan’s liens usually take priority over other creditors’ claims to the same property.1

Lienholder Must Retain Possession. In contrast to a mechanic’s lien, an artisan’s lien is possessory. �at is, the lienholder ordinarily must have retained possession of the property and have expressly or impliedly agreed to provide the services on a cash, not a credit, basis. �e lien remains in existence as long as the lienholder maintains possession, and the lien is terminated once possession is voluntarily surrendered, unless the surrender is only temporary.surrendered, unless the surrender is only temporary.surrendered, unless the surrender is only temporary.surrendered, unless the surrender is only temporary.2

■ CASE IN POINT 15.1 Carrollton Exempted Village Carrollton Exempted Village School District (in Ohio) hired Clean Vehicle Solutions America, LLC (CVSA, based in New York), to convert ten school buses from diesel to compressed natural gas.

1. An artisan’s lien has priority over a filed statutory lien (such as a title lien on an automobile or a lien filed under Article 9 of the UCC) and a bailee’s lien (such as a storage lien).

2. Involuntary surrender of possession by a lienholder, such as when a police officer seizes goods from a lienholder, does not terminate the lien.

The contract price was $660,000. The district paid a $400,000 deposit and agreed to pay installments of $26,000 to CVSA after the delivery of each converted bus. After the first two buses were delivered, the district refused to continue the contract, claiming that the con- version made the two buses unsafe to drive.

Both parties filed breach of contract lawsuits. CVSA also asserted an artisan’s lien over two other buses that it still had in its possession because it had started con- verting them to natural gas and spent $65,000 doing so. Regardless of the outcome in the parties’ lawsuits, CVSA has an artisan’s lien that gives it a priority claim to those two buses so long as they remain in its possession. The buses will act as security for the district’s payment of at least the amount CVSA has spent converting them to natural gas.3 ■

Foreclosure on Personal Property. Modern statutes permit the holder of an artisan’s lien to foreclose and sell the property subject to the lien to satisfy the debt. As with

3. Clean Vehicle Solutions America, LLC v. Carrollton Exempted Village School District Board of Education, 2015 WL 5459852 (S.D.N.Y. 2015).

completion as actual completion gives lien claimants the maximum amount of time to assert their rights before such rights are cut off, whereas interpreting completion as substantial completion could cut off mechanic’s lien rights much earlier. The interpretation espoused by Castellino would contravene the purpose of California’s mechanic’s lien law to protect the right to payment of those who have furnished labor or materials to works of improvement. Our construc- tion of the term “completion” * * * effec- tuates the intent of the mechanic’s lien law. [Emphasis added.]

Substantial evidence supports the trial court’s findings that even though the City had issued certificates of

occupancy for the 11 buildings within the project, roof and stairway work required under the general contract continued between July 25, 2006 and September 19, 2006. Elizar Ortiz [an installer employed by Picerne’s stairway subcontractor] testified he worked 221⁄1⁄1 2⁄2⁄ hours on September 15, 18, and 19, 2006, installing grip tape on all of the stairs at the project. The general contract called for the installation of anti-slip grip tape on all concrete stair treads. Ortiz’s testimony established the work he per- formed on September 15, 18, and 19, 2006 was not corrective or repair work.

The president of Picerne’s roofing subcontractor testified his company performed roofing work at the project

after July 25, 2006. He said such work included straightening out some of the valleys in the roofs, installing nailers and hips on the roof ridges, and nailing trim. * * * The roof and stairway work performed after July 25, 2006, is not comparable to adding a few strokes of paint or turning a screw.

Picerne recorded a claim of mechan- ic’s lien * * * within 90 days of the date Castellino accepted the project and when the stairway and roofing subcontractors performed work required under their contracts. Accordingly, the trial court did not err in concluding Picerne timely recorded its claim of mechanic’s lien.

* * * * * * * The judgment is affirmed.

Legal Reasoning Questions

1. How did the California legislature define the term “completion”? Was this definition clear? Discuss. 2. How did the owner of the project at the center of this case want the court to interpret “completion”? What arguments support

this contention? 3. Ultimately, how did the court define “completion”? Why?

Case 15.1 Continued

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 321

a mechanic’s lien, the lienholder is required to give notice to the owner of the property before the foreclosure and sale. �e sale proceeds are used to pay the debt and the costs of the legal proceedings, and the surplus, if any, is paid to the former owner.

Judicial Liens When a debt is past due, a creditor can bring a legal action against the debtor to collect the debt. If the action is successful, the court awards the creditor a judgment against the debtor (usually for the amount of the debt plus any interest and legal costs incurred). Frequently, however, the creditor is unable to collect the awarded amount.

To ensure that a judgment in the creditor’s favor will be collectible, the creditor may request that certain prop- erty of the debtor be seized to satisfy the debt. (As will be discussed, under state or federal statutes, some kinds of property are exempt from attachment by creditors.) A court’s order to seize the debtor’s property is known as a writ of attachment if it is issued before a judgment. If the writ of attachment if it is issued before a judgment. If the writ of attachment order is issued after a judgment, it is referred to as a writ of execution.

Writ of Attachment. In the context of judicial liens, attachment refers to a court-ordered seizure and taking attachment refers to a court-ordered seizure and taking attachment into custody of property before a judgment is obtained on a past-due debt. Because attachment is a prejudgment remedy, it occurs either at the time a lawsuit is �led or immediately afterward.

A creditor must comply with the specific state’s statu- tory restrictions and requirements. The due process clause of the Fourteenth Amendment to the U.S. Constitution requires that the debtor be given notice and an opportu- nity to be heard. The creditor must have an enforceable right to payment of the debt under law and must follow certain procedures. Otherwise, the creditor can be liable for damages for wrongful attachment.

The typical procedure for attachment is as follows: 1. The creditor files with the court an affidavit (a writaffidavit (a writaffidavit -

ten statement, made under oath). The affidavit states that the debtor has failed to pay and indicates the statutory grounds under which attachment is sought.

2. The creditor must post a bond to cover at least the court costs, the value of the property attached, and the value of the loss of use of that property suffered by the debtor.

3. When the court is satisfied that all the requirements have been met, it issues a writ of attachment. The writ directs the sheriff or other officer to seize the debtor’s nonexempt property. If the creditor prevails at trial, the seized property can be sold to satisfy the judgment.

Writ of Execution. If a creditor wins a judgment against a debtor and the debtor will not or cannot pay the amount due, the creditor can request a writ of execution from the court. A writ of execution is an order that directs the sheri� to seize (levy) and sell any of the debtor’s nonex- empt real or personal property. �e writ applies only to property that is within the court’s geographic jurisdiction (usually the county in which the courthouse is located).

The proceeds of the sale are used to pay the judgment, accrued interest, and costs of the sale. Any excess is paid to the debtor. The debtor can pay the judgment and redeem the nonexempt property at any time before the sale takes place. (Because of exemption laws and bank- ruptcy laws, however, many judgments are practically uncollectible.)

15–1b Garnishment An order for garnishment permits a creditor to collect a garnishment permits a creditor to collect a garnishment debt by seizing property of the debtor that is being held by a third party. As a result of a garnishment proceeding, for instance, the debtor’s employer may be ordered by the court to turn over a portion of the debtor’s wages to pay the debt. Many other types of property can be garnished as well, including funds in a bank account, tax refunds, pensions, and trust funds. It is only necessary that the property is not exempt from garnishment and is in the possession of a third party.possession of a third party.possession of a third party.possession of a third party.

■ CASE IN POINT 15.2 When Edward G. Tinsley When Edward G. Tinsley divorced Michelle Townsend, they entered into a marital settlement contract. They agreed to sell the marital home and split the proceeds evenly. But Tinsley refused to coop- erate with the sale. A court therefore appointed a trustee to sell the house for them and ordered the sheriff to evict Tinsley. Tinsley then conveyed the house to a trust estab- lished in his name. Even after the sheriff evicted Tinsley from the house and changed the locks, Tinsley managed to move back in and change the locks again.

Tinsley was arrested for trespassing and charged with contempt of court (for disobeying court orders). In the meantime, Tinsley secretly sold the home for $150,000 and deposited the proceeds into a bank account held in the name of Edward G. Tinsley Living Trust at SunTrust Bank. After learning of the sale, the court-appointed trustee obtained a writ of garnishment on all of Tins- ley’s and his trust’s bank accounts at SunTrust Bank. Despite numerous objections from Tinsley (and a trial and appeal), Sun Trust eventually complied with the gar- nishment order and sent all the funds to the trustee.4 ■

4. Tinsley v. SunTrust Bank, 2016 WL 687545 (Md.App. 2016).

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Procedures Garnishment can be a prejudgment rem- edy, requiring a hearing before a court, but it is most often a postjudgment remedy. State law governs garnish- ment actions, so the specific procedures vary from state to state.

In some states, the judgment creditor needs to obtain only one order of garnishment, which will then apply continuously to the judgment debtor’s wages until the entire debt is paid. In other states, the judgment creditor must go back to court for a separate order of garnishment for each pay period.

Laws Limiting the Amount of Wages Subject to Garnishment Both federal and state laws limit the amount that can be taken from a debtor’s weekly take- home pay through garnishment proceedings.5 Federal law provides a minimal framework to protect debtors from losing all their income to pay judgment debts.6 State laws also provide dollar exemptions, and these amounts are often larger than those provided by federal law.

Under federal law, an employer cannot dismiss an employee because his or her wages are being garnished.

15–1c Creditors’ Composition Agreements Creditors may contract with the debtor for discharge of the debtor’s liquidated debts (debts that are definite, or fixed, in amount) on payment of a sum less than that owed. These agreements are referred to as creditors’ composition agreements (or composition agreements) composition agreements) composition agreements and usually are held to be enforceable unless they are formed under duress.

15–1d Suretyship and Guaranty When a third person promises to pay a debt owed by another in the event that the debtor does not pay, either a suretyship or a guaranty relationship is created. Exhibit guaranty relationship is created. Exhibit guaranty 15–1 illustrates these relationships. The third person’s creditworthiness becomes the security for the debt owed.

Suretyship and guaranty provide creditors with the right to seek payment from the third party if the pri- mary debtor, or principal, defaults on her or his obli- gations. Normally a guaranty must be in writing to

5. A few states (such as Texas) do not permit garnishment of wages by pri- vate parties except under a child-support order.

6. For instance, the federal Consumer Credit Protection Act, 15 U.S.C. Sec- tions 1601–1693r, provides that a debtor can retain either 75 percent of his or her disposable earnings per week or an amount equivalent to thirty hours of work paid at federal minimum wage rates, whichever is greater.

be enforceable under the Statute of Frauds, unless its main purpose is to benefit the guarantor. Traditionally, a suretyship agreement did not require a writing to be enforceable, and oral surety agreements were sufficient. Today, however, some states require a writing to enforce a suretyship.

At common law, there were significant differences in the liability of a surety and a guarantor. Today, however, the distinctions outlined here have been abolished in some states.

Suretyship A contract of strict suretyship is a promise made by a third person to be responsible for the debtor’s obligation. It is an express contract between the surety (the third party) and the creditor.

In the strictest sense, the surety is primarily liable for the debt of the principal. The creditor can demand pay- ment from the surety from the moment the debt is due. The creditor need not exhaust all legal remedies against the principal debtor before holding the surety responsible for payment.

■ EXAMPLE 15.3 Roberto Delmar wants to borrow from the bank to buy a used car. Because Roberto is still in college, the bank will not lend him the funds with- out a cosigner. Roberto’s father, José Delmar, who has dealt with the bank before, agrees to cosign the note, thereby becoming a surety who is jointly liable for pay- ment of the debt. When José Delmar cosigns the note, he becomes primarily liable to the bank. On the note’s due date, the bank can seek payment from either Roberto or José Delmar, or both jointly. ■

Guaranty With a suretyship arrangement, the surety is primarily liable for the debtor’s obligation. With a primarily liable for the debtor’s obligation. With a primarily

E X H I B I T 1 5 – 1 Suretyship and Guaranty Parties

Primary Liability to Creditor or

Secondary Liability to Creditor

C R E D I T O R D E B T O R

P R I N C I P A L

S U R E T Y O R

G U A R A N T O R

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 323

guaranty arrangement, the guarantor—the third person guarantor—the third person guarantor making the guaranty—is secondarily liable.secondarily liable.secondarily

The guarantor can be required to pay the obliga- tion only after the principal debtor defaults, and usually only after the creditor has made an attempt to collect from the debtor. The guaranty contract terms deter- mine the extent and time of the guarantor’s liability.mine the extent and time of the guarantor’s liability.mine the extent and time of the guarantor’s liability.mine the extent and time of the guarantor’s liability.

■ CASE IN POINT 15.4 To finance a development To finance a development project in Delaware, Brandywine Partners, LLC, bor- rowed $15.9 million from HSBC Realty Credit Corp. (USA). As part of the deal, Brian O’Neill, principal for Brandywine, signed a guaranty that designated him the “primary obligor” for $8.1 million of the loan. Brandy- wine defaulted, and HSBC filed a suit in a federal district court against O’Neill to recover on the guaranty. O’Neill filed a counterclaim, alleging that HSBC had fraudu- lently induced him to sign the guaranty.

O’Neill argued that the loan agreement valued the property at $26.5 million and that HSBC knew this was not the property’s real value. O’Neill also claimed that the parties had agreed that if Brandywine defaulted, HSBC could recover its loan by selling the property—before try- ing to collect from the guaranty.

The court ruled in favor of HSBC and dismissed O’Neill’s counterclaim. A federal appellate court affirmed. The guaranty stated that O’Neill was familiar with the value of the property, that he was not relying on it as an inducement to sign the guaranty, and that HSBC made no representations to induce him to sign. The guaranty also provided that HSBC could enforce its rights against him without trying to recover on the property first.7 ■

Actions That Release the Surety and the Guar- antor Basically, the same actions will release either a surety or a guarantor from an obligation. For simplicity, this subsection and the following subsections will refer just to sureties, but remember that the same rules gener- ally apply to guarantors. 1. Material modification. Making any material modifi-

cation to the terms of the original contract without the surety’s consent will discharge the surety’s obliga- tion. (The extent to which the surety is discharged depends on whether he or she was compensated and the amount of loss suffered from the modification. For instance, a father who receives no consideration for acting as a surety on his daughter’s loan will be completely discharged if the loan contract is modi- fied without his consent.)

7. HSBC Realty Credit Corp. (USA) v. O’Neill, 745 F.3d 564 (1st Cir. 2014).

2. Surrender of property. If a creditor surrenders the col- lateral to the debtor or impairs the collateral without the surety’s consent, these acts can reduce the obliga- tion of the surety. If the creditor’s actions reduce the value of the property used as collateral, the surety is released to the extent of any loss suffered.

3. Payment or tender of payment. Naturally, any pay- ment of the principal obligation by the debtor or by another person on the debtor’s behalf will discharge the surety from the obligation. Even if the creditor refused to accept the payment when it was tendered, if the creditor knew about the suretyship, the obli- gation of the surety can be discharged.

Defenses of the Surety and the Guarantor Generally, the surety or guarantor can also assert any of the defenses available to the principal debtor to avoid lia- bility on the obligation to the creditor. A few exceptions do exist, however. They apply to both sureties and guar- antors, but again, for simplicity, we refer just to sureties. 1. Incapacity and bankruptcy. Incapacity and bankruptcy

are personal defenses, which can be asserted only by the person who is affected. Therefore, the surety can- not assert the principal debtor’s incapacity or bank- ruptcy as a defense. (A surety may assert his or her own incapacity or bankruptcy as a defense, of course.)

2. Statute of limitations. The surety cannot assert the statute of limitations as a defense. (In contrast, the principal debtor can claim the statute of limitations as a defense to payment.)

3. Fraud. If the creditor fraudulently induced the per- son to act as a surety on the debt, the surety or guar- antor can assert fraud as a defense. In most states, the creditor must inform the surety, before the formation of the suretyship contract, of material facts known by the creditor that would substantially increase the surety’s risk. Failure to so inform may constitute fraud and render the suretyship obligation voidable.

Rights of the Surety and the Guarantor When the surety or guarantor pays the debt owed to the creditor, he or she acquires certain rights, as discussed next. Again, for simplicity, the discussion refers just to sureties.

The Right of Subrogation. �e surety has the legal right of subrogation. Simply stated, this means that any right that the creditor had against the debtor now becomes the right of the surety. Included are creditor rights in bank- ruptcy, rights to collateral possessed by the creditor, and rights to judgments obtained by the creditor. In short, the

324 U N I T T H R E E The Commercial Environment

surety now stands in the shoes of the creditor and may pursue any remedies that were available to the creditor against the debtor.

The Right of Reimbursement. �e surety has a right of reimbursement from the debtor. Basically, the surety is reimbursement from the debtor. Basically, the surety is reimbursement entitled to receive from the debtor all outlays made on behalf of the suretyship arrangement. Such outlays can include expenses incurred as well as the actual amount of the debt paid to the creditor.

The Right of Contribution. Two or more sureties are called co-sureties. When a co-surety pays more than her or his proportionate share on a debtor’s default, she or he has a right of contribution. �at means the co-surety is entitled to recover from the other co-sureties the amount paid above the surety’s obligation. Generally, a co-surety’s liability either is determined by agreement or, in the absence of agreement, is set at the maximum liability under the suretyship contract.

■ EXAMPLE 15.5 Yasser and Itzhak, two co-sureties, are obligated under a suretyship contract to guarantee Jules’s debt. Itzhak’s maximum liability is $15,000, and Yasser’s is $10,000. Jules owes $10,000 and is in default. Itzhak pays the creditor the entire $10,000.

In the absence of an agreement to the contrary, Itzhak can recover $4,000 from Yasser. The amount of the debt that Yasser agreed to cover ($10,000) is divided by the total amount that he and Itzhak together agreed to cover ($25,000). The result is multiplied by the amount of the default, yielding the amount that Yasser owes—($10,000 ÷ $25,000) × $10,000 = $4,000. ■

15–2 Mortgages When individuals purchase real property, they typically make a down payment in cash and borrow the remaindown payment in cash and borrow the remaindown payment - ing funds from a financial institution. The borrowed funds are secured by a mortgage—a written instrument that gives the creditor a lien on the debtor’s real prop- erty as security for payment of a debt. The creditor is the mortgagee, and the debtor is the mortgagor.

15–2a Fixed-Rate versus Adjustable-Rate Mortgages

Lenders offer various types of mortgages to meet the needs of different borrowers, but a basic distinction is whether the interest rate is fixed or variable. A fixed-rate mortgage

has a fixed, or unchanging, rate of interest, so the pay- ments remain the same for the duration of the loan. Lend- ers determine the interest rate for a standard fixed-rate mortgage loan based on a variety of factors, including the borrower’s credit history, credit score, income, and debts.

With an adjustable-rate mortgage (ARM), the rate of interest paid by the borrower changes periodically. Typi- cally, the initial interest rate for an ARM is set at a relatively low fixed rate for a specified period, such as a year or three years. After that time, the interest rate adjusts annually or by some other period, such as biannually or monthly. The interest rate adjustment is calculated by adding a cer- tain number of percentage points (called the margin) to an index rate (one of various government interest rates).

ARMs contractually shift the risk that the interest rate will change from the lender to the borrower. Borrow- ers will have lower initial payments if they are willing to assume the risk of interest rate increases.

15–2b Mortgage Provisions Because a mortgage involves a transfer of real property, it must be in writing to comply with the Statute of Frauds. Mortgages normally are lengthy and formal documents containing many provisions, including the following: 1. The terms of the underlying loan. These include the

loan amount, the interest rate, the period of repay- ment, and other important financial terms, such as the margin and index rate for an ARM.

2. A prepayment penalty clause. A prepayment penalty clause requires the borrower to pay a penalty if the mortgage is repaid in full within a certain period. A prepayment penalty helps to protect the lender should the borrower refinance within a short time after obtaining a mortgage.

3. Provisions relating to the maintenance of the property. Because the mortgage conveys an interest in the property to the lender, the lender often requires the borrower to maintain the property to protect the lender’s investment.

4. A statement obligating the borrower to maintain home- owner’s insurance on the property. Homeowner’s insur- ance protects the lender’s interest in the event of a loss due to certain hazards, such as fire or storm damage.

5. A list of the non-loan financial obligations to be borne by the borrower. For instance, the borrower typically is required to pay all property taxes, assessments, and other claims against the property.

6. Creditor protections. When creditors extend mort- gages, they are advancing a significant amount of funds for a number of years. Consequently, creditors

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 325

usually require debtors to obtain mortgage insur- ance if they do not make a down payment of at least 20 percent of the purchase price.

Creditors record the mortgage with the appropriate office in the county where the property is located, so that their interest in the property is officially on record.

15–2c Mortgage Foreclosure If the homeowner defaults, or fails to make the mortgage payments, the lender has the right to foreclose on the mortgaged property. Foreclosure is the legal process by which the lender repossesses and auctions off the prop- erty that has secured the loan. The lender must strictly comply with the state statute governing foreclosures.

Foreclosure is expensive and time consuming. It generally benefits neither the borrowers, who lose their homes, nor the lenders, which face the prospect of losses on their loans. Therefore, both lenders and borrowers are motivated to avoid foreclosure proceedings if pos- sible. Methods of avoiding foreclosure include forbear- ance, workout agreements, and short sales. (In addition, a defaulting borrower can redeem the property before a foreclosure sale by paying the full amount of the debt, plus any interest and costs that have accrued.)

A forbearance is a postponement of part or all of the payments on a loan for a limited time. This option works well when the debtor can solve the problem by securing a new job, selling the property, or finding another accept- able solution.

A workout agreement is a contract that describes the workout agreement is a contract that describes the workout agreement respective rights and responsibilities of the borrower and the lender as they try to resolve the default. Usually, the lender agrees to delay seeking foreclosure. In exchange, the borrower provides additional financial information that might be used to modify the mortgage.

A lender may sometimes agree to a short sale, which is a sale of the property for less than the balance due on the mort- gage loan. Typically, the borrower has to show some hardship, such as the loss of a job, a decline in the value of the home, a divorce, or a death in the household. The lender often has approval rights in a short sale, so the sale process may take much longer than an ordinary real estate transaction.

15–3 Protection for Debtors The law protects debtors as well as creditors. Consumer protection statutes protect debtors’ rights, for instance, and bankruptcy laws are designed specifically to assist

debtors in need of help. In addition, in most states, cer- tain types of real and personal property are exempt from execution or attachment. State exemption statutes usu- ally include both real and personal property.

15–3a Exempted Real Property Probably the most familiar exemption is the homestead exemption. The purpose of the homestead exemption is to ensure that the debtor will retain some form of shelter.

The General Rule Each state permits the debtor to retain the family home, either in its entirety or up to a specified dollar amount, free from the claims of unsecured creditors or trustees in bankruptcy. (Note that federal bankruptcy law places a cap on the amount that debtors filing bankruptcy can claim is exempt under their states’ homestead exemption.)homestead exemption.)homestead exemption.)homestead exemption.)

■ EXAMPLE 15.6 Vince Beere owes Chris Veltman $40,000. The debt is the subject of a lawsuit, and the court awards Veltman a judgment of $40,000 against Beere. Beere’s homestead is valued at $50,000, and the homestead exemption is $25,000. There are no outstand- ing mortgages or other liens on his homestead. To satisfy the judgment debt, Beere’s family home is sold at public auction for $45,000. The proceeds of the sale are distrib- uted as follows: 1. Beere is given $25,000 as his homestead exemption. 2. Veltman is paid $20,000 toward the judgment debt,

leaving a $20,000 deficiency judgment (that is, “left- over debt”). The deficiency judgment can be satis- fied from any other nonexempt property (personal or real) that Beere may own, if permitted by state law. ■

Limitations In a few states, statutes allow the home- stead exemption only if the judgment debtor has a family. If a judgment debtor does not have a family, a creditor may be entitled to collect the full amount realized from the sale of the debtor’s home. In addition, the homestead exemption interacts with other areas of law and can some- times operate to cancel out a portion of a lien on a debt- or’s real property.

15–3b Exempted Personal Property Personal property that is most often exempt from satis- faction of judgment debts includes the following: 1. Household furniture up to a specified dollar amount. 2. Clothing and certain personal possessions, such as

326 U N I T T H R E E The Commercial Environment

3. A vehicle (or vehicles) for transportation (at least up to a specified dollar amount).

4. Certain classified animals, usually livestock but including pets.

5. Equipment that the debtor uses in a business or trade, such as tools or professional instruments, up to a specified dollar amount.

15–4 Bankruptcy Law Article I, Section 8, of the U.S. Constitution gave Con- gress the power to establish “uniform laws on the subject of bankruptcies throughout the United States.” Federal bankruptcy legislation was first enacted in 1898 and since then has undergone several modifications, most recently in the 2005 Bankruptcy Reform Act.8 Federal bankruptcy laws (as amended) are called the Bankruptcy Code or, more simply, the Code.

Bankruptcy law in the United States has two main goals: 1. To protect a debtor by giving him or her a fresh start

without creditors’ claims. 2. To ensure equitable treatment of creditors who are

competing for a debtor’s assets. Thus, the law attempts to balance the rights of the debtor and of the creditors.

Although the twin goals of bankruptcy remain the same, the balance between them shifted somewhat after the 2005 reform legislation. That law was enacted, in part, because of the growing concern that the law allowed too many debtors to avoid paying their debts. Thus, a major goal of the reforms was to require more consumers to pay as many of their debts as possible instead of having those debts fully extinguished in bankruptcy.

15–4a Bankruptcy Courts Bankruptcy proceedings are held in federal bankruptcy courts, which are under the authority of U.S. district courts. Rulings from bankruptcy courts can be appealed to the district courts.

A bankruptcy court can conduct a jury trial if the appropriate district court has authorized it and the par- ties to the bankruptcy consent. Bankruptcy courts follow the Federal Rules of Bankruptcy Procedure rather than the Federal Rules of Civil Procedure. Bankruptcy court judges are appointed for terms of fourteen years.

8. The full title of the act was the Bankruptcy Abuse Prevention and Con- sumer Protection Act, Pub. L. No. 109-8, 119 Stat. 23 (April 20, 2005).

15–4b Types of Bankruptcy Relief The Bankruptcy Code is contained in Title 11 of the United States Code and has eight chapters. Chapters 1, United States Code and has eight chapters. Chapters 1, United States Code 3, and 5 of the Code contain general definitional provi- sions, as well as provisions governing case administration, creditors, the debtor, and the estate. These three chapters normally apply to all kinds of bankruptcies.

Four chapters of the Code set forth the most impor- tant types of relief that debtors can seek: 1. Chapter 7 provides for liquidation proceedings (the

selling of all nonexempt assets and the distribution of the proceeds to the debtor’s creditors).

2. Chapter 11 governs reorganizations. 3. Chapter 12 (for family farmers and family fishermen)

and 13 (for individuals) provide for the adjustment of debts by persons with regular incomes.9

Note that a debtor (except for a municipality) need not be insolvent10 to file for bankruptcy relief under the Bankruptcy Code. Anyone obligated to a creditor can declare bankruptcy.

15–4c Special Requirements for Consumer-Debtors

A consumer-debtor is a debtor whose debts result pri- marily from the purchase of goods for personal, family, or household use. The Bankruptcy Code requires that the clerk of the court give all consumer-debtors written notice of the general purpose, benefits, and costs of each chapter under which they might proceed. In addition, the clerk must provide consumer-debtors with informa- tion on the types of services available from credit coun- seling agencies.

15–5 Liquidation Proceedings Liquidation under Chapter 7 of the Bankruptcy Code is probably the most familiar type of bankruptcy pro- ceeding and is often referred to as an ordinary, or

9. There are no Chapters 2, 4, 6, 8, or 10 in Title 11. Such “gaps” are not uncommon in the United States Code. They occur because chapter numbers (or other subdivisional unit numbers) are sometimes reserved for future use when a statute is enacted. (A gap may also appear if a law has been repealed.)

10. The inability to pay debts as they become due is known as equitable insolvency. Balance sheet insolvency, which exists when a debtor’s Balance sheet insolvency, which exists when a debtor’s Balance sheet liabilities exceed assets, is not the test. Thus, debtors whose cash-flow problems become severe may petition for bankruptcy voluntarily or be forced into involuntary bankruptcy even though their assets far exceed their liabilities.

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 327

straight, bankruptcy. Put simply, a debtor in a liquida- tion bankruptcy turns all assets over to a bankruptcy trustee, a person appointed by the court to manage the debtor’s funds. The trustee sells the nonexempt assets and distributes the proceeds to creditors. With certain exceptions, the remaining debts are then discharged (extinguished), and the debtor is relieved of the obliga- tion to pay the debts.

Any “person”—defined as including individuals, partnerships, corporations, labor unions, and unincor- porated organizations—may be a debtor in a liquida- tion proceeding. A husband and wife may file jointly for bankruptcy under a single petition. Railroads, insur- ance companies, banks, savings and loan associations, investment companies licensed by the Small Business Administration, and credit unions cannot be debtors in a cannot be debtors in a cannot liquidation bankruptcy, however. Other chapters of the Bankruptcy Code or other federal or state statutes apply to them.

A straight bankruptcy can be commenced by the fil- ing of either a voluntary or an involuntary petition in bankruptcy—the document that is filed with a bankbankruptcy—the document that is filed with a bankbankruptcy - ruptcy court to initiate bankruptcy proceedings. If a debtor files the petition, the bankruptcy is voluntary. If one or more creditors file a petition to force the debtor into bankruptcy, the bankruptcy is involuntary.

15–5a Voluntary Bankruptcy To bring a voluntary petition in bankruptcy, the debtor files official forms designated for that purpose in the bankruptcy court. The law now requires that before debtbefore debtbefore - ors can file a petition, they must receive credit counseling from an approved nonprofit agency within the 180- day period preceding the date of filing. Debtors filing a Chapter 7 petition must include a certificate proving that they have received individual or group counseling from an approved agency within the last 180 days.

A consumer-debtor who is filing for liquidation bank- ruptcy must confirm the accuracy of the petition’s con- tents. The debtor must also state in the petition, at the time of filing, that he or she understands the relief avail- able under other chapters of the Code and has chosen to proceed under Chapter 7.

Attorneys representing the consumer-debtors must file an affidavit stating that they have informed the debt- ors of the relief available under each chapter of the Bank- ruptcy Code. In addition, the attorneys must reasonably attempt to verify the accuracy of the consumer-debtors’ petitions and schedules (described next). Failure to do so is considered perjury.

Chapter 7 Schedules The voluntary petition must contain the following schedules: 1. A list of both secured and unsecured creditors, their

addresses, and the amount of debt owed to each. 2. A statement of the financial affairs of the debtor. 3. A list of all property owned by the debtor, including

property that the debtor claims is exempt. 4. A list of current income and expenses. 5. A certificate of credit counseling (as mentioned

previously). 6. Proof of payments received from employers within

sixty days prior to the filing of the petition. 7. A statement of the amount of monthly income, item-

ized to show how the amount is calculated. 8. A copy of the debtor’s federal income tax return for

the most recent year ending immediately before the filing of the petition.

The official forms must be completed accurately, sworn to under oath, and signed by the debtor. To con- ceal assets or knowingly supply false information on these schedules is a crime under the bankruptcy laws.

With the exception of tax returns, failure to file the required schedules within forty-five days after the filing of the petition will result in an automatic dismissal of the petition. (An extension may be granted, however.) The debtor has up to seven days before the date of the first creditors’ meeting to provide a copy of the most recent tax returns to the trustee. In addition, a debtor may be required to file a tax return at the end of each tax year while the case is pending and to provide a copy to the court. This may be done at the request of the court or the U.S. trustee—a government official who performs administrative tasks that a bankruptcy judge would oth- erwise have to perform. (Debtors may also be required to file tax returns during Chapter 11 and 13 bankruptcies.)

Substantial Abuse—Means Test In the past, a bankruptcy court could dismiss a Chapter 7 petition if the use of Chapter 7 would constitute a “substantial abuse” of bankruptcy law. Today, the law provides a means test to means test to means test determine a debtor’s eligibility for Chapter 7.

The purpose of the test is to keep upper-income people from abusing the bankruptcy process by filing for Chapter 7, as was thought to have happened in the past. The test forces more people to file for Chapter 13 bank- ruptcy rather than have their debts discharged under Chapter 7.

The Basic Formula. A debtor wishing to �le for bank- ruptcy must complete the means test to determine whether she or he quali�es for Chapter 7. �e debtor’s

328 U N I T T H R E E The Commercial Environment

average monthly income in recent months is compared with the median income in the geographic area in which the person lives. (�e U.S. Trustee Program provides these data at its Web site.) If the debtor’s income is below the median income, the debtor usually is allowed to �le for Chapter 7 bankruptcy, as there is no presumption of bankruptcy abuse.

Applying the Means Test to Future Disposable Income. If the debtor’s income is above the median income, then further calculations must be made. �e calculations are meant to determine whether the person will have suf-meant to determine whether the person will have suf-meant to determine whether the person will have suf �cient disposable income in the future to repay at least some of his or her unsecured debts.

As a basis for the calculations, it is presumed that the debtor’s recent monthly income will continue for the next sixty months. Disposable income is then calculated by Disposable income is then calculated by Disposable income subtracting living expenses and secured debt payments, such as mortgage payments, from monthly income.

Living expenses are amounts allowed under formu- las used by the Internal Revenue Service (IRS). The IRS allowances include modest allocations for food, cloth- ing, housing, utilities, transportation (including a car payment), health care, and other necessities. (The U.S. Trustee Program’s Web site also provides these amounts.) The allowances do not include expenditures for items such as cell phones and cable television service.

Can the Debtor Afford to Pay Unsecured Debts? Once future disposable income has been estimated, that amount is used to determine whether the debtor will have income that could be applied to unsecured debts. �e courts may also consider the debtor’s bad faith or other circumstances indicating abuse.indicating abuse.indicating abuse.indicating abuse.

■ CASE IN POINT 15.7 Christopher Dean Ng and his wife filed for Chapter 7 bankruptcy, hoping primarily to discharge their mortgage debt of $464,830. At the time the petition was filed, Ng was forty-three years old and worked as an electronic technician. He earned a monthly salary of $7,439.47, as well as a military pension of $1,439.88 a month. His wife was not employed. From Ng’s monthly salary, he made a voluntary contribution of $520 to an employer 401(k) plan and a $343 payment on a pension loan. In calculating his disposable income, Ng excluded these amounts.

The U.S. trustee filed a motion to dismiss Ng’s peti- tion due to substantial abuse. The trustee claimed that the retirement contributions should be disallowed. The court agreed and dismissed the Chapter 7 petition. The Ngs appealed, and the appellate court affirmed. Ng’s retire- ment contributions were not reasonably necessary based on his age, his financial circumstances, and his testimony

that he was not planning to retire for at least twenty years. The Ngs could afford to repay some of their debts before they made monthly contributions toward retirement.11 ■

Additional Grounds for Dismissal As already noted, a court can dismiss a debtor’s voluntary petition for Chapter 7 relief for substantial abuse or for failure to pro- vide the necessary documents within the specified time.

In addition, a court might dismiss a Chapter 7 in two other situations. First, if the debtor has been convicted of a violent crime or a drug-trafficking offense, the vic- tim can file a motion to dismiss the voluntary petition.12 Second, if the debtor fails to pay postpetition domestic- support obligations (which include child and spousal support), the court may dismiss the debtor’s petition.

Order for Relief If the voluntary petition for bank-If the voluntary petition for bank-If the voluntary petition for bank ruptcy is found to be proper, the filing of the petition will itself constitute an order for relief. (An order for relief is a court’s grant of assistance to a petitioner.) Once a consumer-debtor’s voluntary petition has been filed, the trustee and creditors must be given notice of the order for relief by mail not more than twenty days after entry of the order.

15–5b Involuntary Bankruptcy An involuntary bankruptcy occurs when the debtor’s creditors force the debtor into bankruptcy proceedings. An involuntary case cannot be filed against a charitable institution or a farmer (an individual or business that receives more than 50 percent of gross income from farming operations).

An involuntary petition should not be used as an everyday debt-collection device, and the Code provides penalties for the filing of frivolous petitions against debt- ors. If the court dismisses an involuntary petition, the petitioning creditors may be required to pay the costs and attorneys’ fees incurred by the debtor in defending against the petition. If the petition was filed in bad faith, damages can be awarded for injury to the debtor’s reputa- tion. Punitive damages may also be awarded.

Requirements For an involuntary action to be filed, the following requirements must be met: 1. If the debtor has twelve or more creditors, three or

more of these creditors having unsecured claims totaling at least $15,325 must join in the petition.

11. In re Ng, 422 Bankr. 118 (9th Cir. 2012).In re Ng, 422 Bankr. 118 (9th Cir. 2012).In re Ng 12. Note that the court may not dismiss a case on this ground if the debtor’s

bankruptcy is necessary to satisfy a claim for a domestic-support obligation.

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 329

2. If a debtor has fewer than twelve creditors, one or more creditors having a claim totaling $15,325 or more may file.13

Order for Relief If the debtor challenges the involun- tary petition, a hearing will be held, and the bankruptcy court will enter an order for relief if it finds either of the following: 1. The debtor is not paying debts as they come due. 2. A general receiver, assignee, or custodian took pos-

session of, or was appointed to take charge of, sub- stantially all of the debtor’s property within 120 days before the filing of the petition.

If the court grants an order for relief, the debtor will be required to supply the same information in the bank- ruptcy schedules as in a voluntary bankruptcy.

15–5c Automatic Stay The moment a petition, either voluntary or involuntary, is filed, an automatic stay, or suspension, of all actions by creditors against the debtor or the debtor’s property normally goes into effect. The automatic stay prohibits creditors from taking any act to collect, assess, or recover a claim against the debtor that arose before the filing of the petition. The stay normally continues until the bank- ruptcy proceeding is closed or dismissed. (In some circum- stances, it is possible to petition the bankruptcy court for relief from the automatic stay, as will be discussed shortly.)

If a creditor knowingly violates the automatic stay (a knowingly violates the automatic stay (a knowingly willful violation), any injured party, including the debtor, is entitled to recover actual damages, costs, and attorneys’ fees. Punitive damages may be awarded as well.fees. Punitive damages may be awarded as well.fees. Punitive damages may be awarded as well.fees. Punitive damages may be awarded as well.

■ CASE IN CASE IN POINT 15.8 Stefanie Kuehn filed for bank Stefanie Kuehn filed for bank- ruptcy. When she requested a transcript from the univer- sity at which she had obtained her master’s degree, the university refused because she owed more than $6,000 in tuition. Kuehn complained to the court. The court ruled that the university had violated the automatic stay by refusing to provide a transcript because it was attempting to collect an unpaid tuition debt.14 ■

The Adequate Protection Doctrine Underlying the Code’s automatic-stay provision for a secured credi- tor is a concept known as adequate protection. The ade- quate protection doctrine, among other things, protects secured creditors from losing their security as a result of the automatic stay.

13. 11 U.S.C. Section 303. The amounts stated in this chapter are in accor- dance with those computed on April 1, 2016.

14. In re Kuehn, 563 F.3d 289 (7th Cir. 2009).

The bankruptcy court can provide adequate protec- tion by requiring the debtor or trustee to make periodic cash payments or a one-time cash payment. The court can also require the debtor or trustee to provide additional collateral or replacement liens to the extent that the stay may actually cause the value of the property to decrease.

Exceptions to the Automatic Stay The Code provides the following exceptions to the automatic stay: 1. Collection efforts can continue for domestic-support

obligations. These obligations include any debt owed to or recoverable by a spouse, a former spouse, a child of the debtor, that child’s parent or guardian, or a governmental unit.

2. Proceedings against the debtor related to divorce, child custody or visitation, domestic violence, and support enforcement are not stayed.

3. Investigations by a securities regulatory agency (such as an investigation into insider trading) can continue.

4. Certain statutory liens for property taxes are not stayed.

Requests for Relief from the Automatic Stay A secured creditor or other party in interest can petition the bankruptcy court for relief from the automatic stay. If a creditor or other party requests relief from the stay, the stay will automatically terminate sixty days after the request, unless the court grants an extension or the parties agree otherwise.

Secured Property The automatic stay on secured property terminates forty-five days after the creditors’ meeting unless the debtor redeems or reaffirms certain debts. (Creditors’ meetings and reaffirmation will be dis- cussed later in this chapter.) In other words, the debtor cannot keep the secured property (such as a financed automobile), even if she or he continues to make pay- ments on it, without reinstating the rights of the secured party to collect on the debt.

Bad Faith If the debtor had two or more bankruptcy petitions dismissed during the prior year, the Code pre- sumes bad faith. In such a situation, the automatic stay does not go into effect until the court determines that the not go into effect until the court determines that the not petition was filed in good faith.

In addition, the automatic stay on secured debts will terminate thirty days after the petition is filed if the debtor filed a bankruptcy petition that was dismissed within the prior year. Any party in interest can request that the court extend the stay by showing that the filing is in good faith.

330 U N I T T H R E E The Commercial Environment

15–5d Estate in Bankruptcy On the commencement of a liquidation proceeding under Chapter 7, an estate in bankruptcy (sometimes estate in bankruptcy (sometimes estate in bankruptcy called an estate in property) is created. The estate consists estate in property) is created. The estate consists estate in property of all the debtor’s interests in property currently held, wherever located. The estate in bankruptcy includes all of the following:

1. Community property (property jointly owned by mar- ried persons in certain states).

2. Property transferred in a transaction voidable by the trustee.

3. Proceeds and profits from the property of the estate.

Certain after-acquired property to which the debtor becomes entitled within 180 days after filing may also within 180 days after filing may also within 180 days after filing become part of the estate. Such after-acquired property includes gifts, inheritances, property settlements (from divorce), and life insurance death proceeds.

Generally, though, the filing of a bankruptcy petition fixes a dividing line. Property acquired prior to the filing of the petition becomes property of the estate, and prop- erty acquired after the filing of the petition, except as just noted, remains the debtor’s.

15–5e The Bankruptcy Trustee Promptly after the order for relief in the liquidation pro- ceeding has been entered, a trustee is appointed. The basic duty of the trustee is to collect the debtor’s available estate and reduce it to cash for distribution, preserving the interests of both the debtor and the unsecured credi- tors. The trustee is held accountable for administering the debtor’s estate.

To enable the trustee to accomplish this duty, the Code gives the trustee certain powers, stated in both gen- eral and specific terms. These powers must be exercised within two years of the order for relief.

Duties for Means Testing The trustee is required to promptly review all materials filed by the debtor to deter- mine if there is substantial abuse. Within ten days after the first meeting of the creditors (discussed shortly), the trustee must file a statement indicating whether the case is presumed to be an abuse under the means test. The trustee must provide a copy of this statement to all credi- tors within five days.

When there is a presumption of abuse, the trustee must either file a motion to dismiss the petition (or convert it to a Chapter 13 petition) or file a statement explaining why a motion would not be appropriate. If the debtor owes a domestic-support obligation (such as

child support), the trustee must provide written notice of the bankruptcy to the claim holder (a former spouse, for instance).

The Trustee’s Powers The trustee has the power to require persons holding the debtor’s property at the time the petition is filed to deliver the property to the trustee.15 To enable the trustee to implement this power, the Code provides that the trustee has rights equivalent to those of equivalent to those of equivalent certain other parties, such as a creditor who has a judicial lien. This power of a trustee, which is equivalent to that of a lien creditor, is known as strong-arm power.

In addition, the trustee has specific powers of avoid-powers of avoid-powers of avoid ance. They enable the trustee to set aside (avoid) a sale or other transfer of the debtor’s property and take the property back for the debtor’s estate. These powers apply to voidable rights available to the debtor, preferences, and fraudulent transfers by the debtor. Each power is discussed in more detail next. In addition, a trustee can avoid certain statutory liens (creditors’ claims against the debtor’s property).

The debtor shares most of the trustee’s avoidance pow- ers. Thus, if the trustee does not take action to enforce one of the rights just mentioned, the debtor in a liquida- tion bankruptcy can enforce that right.16

Voidable Rights A trustee steps into the shoes of the debtor. Thus, any reason that a debtor can use to obtain the return of her or his property can be used by the trustee as well. These grounds include fraud, duress, incapacity, and mutual mistake.

■ EXAMPLE 15.9 Ben sells his boat to Tara. Tara gives Ben a check, knowing that she has insufficient funds in her bank account to cover the check. Tara has commit- ted fraud. Ben has the right to avoid that transfer and recover the boat from Tara. If Ben files for bankruptcy relief under Chapter 7, the trustee can exercise the same right to recover the boat from Tara, and the boat becomes a part of the debtor’s estate. ■

Preferences A debtor is not permitted to transfer property or to make a payment that favors—or gives a preference to—one creditor over others. The trustee is allowed to recover payments made both voluntarily and involuntarily to one creditor in preference over another.

15. Usually, though, the trustee takes constructive, rather than actual, possession of the debtor’s property. For instance, to obtain control of a debtor’s business inventory, a trustee might change the locks on the doors to the business and hire a security guard.

16. Under a Chapter 11 bankruptcy, for which no trustee other than the debtor generally exists, the debtor has the same avoidance powers as a trustee under Chapter 7. Under Chapters 12 and 13, a trustee must be appointed.

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 331

To have made a recoverable preferential payment, an insolvent debtor must have transferred property, for a insolvent debtor must have transferred property, for a insolvent pre- existing debt, within existing debt, within existing ninety days before the filing of the ninety days before the filing of the ninety days bankruptcy petition. The transfer must have given the creditor more than the creditor would have received as a result of the bankruptcy proceedings. The Code pre- sumes that a debtor is insolvent during the ninety-day period before filing a petition.

If a preferred creditor (one who has received a preferpreferred creditor (one who has received a preferpreferred creditor - ential transfer) has sold the property to an innocent third party, the trustee cannot recover the property from the innocent party. The preferred creditor, however, gener- ally can be held liable for the value of the property.

Preferences to Insiders. Sometimes, the creditor receiv- ing the preference is an insider. An insider is an indiinsider is an indiinsider - vidual, partner, partnership, corporation, or o�cer or director of a corporation (or a relative of one of these) who has a close relationship with the debtor. In this situa- tion, the avoidance power of the trustee extends to trans- fers made within one year before �ling. (If the transfer was one year before �ling. (If the transfer was one year fraudulent, as will be discussed shortly, the trustee can avoid transfers made within two years before �ling.) �e two years before �ling.) �e two years trustee must, however, prove that the debtor was insolvent when the transfer occurred and that it was made to or for the bene�t of an insider.

Transfers That Do Not Constitute Preferences. Not all transfers are preferences. Most courts generally assume that payment for services rendered within �fteen days before the payment is not a preference. If a creditor receives payment in the ordinary course of business from a debtor, such as payment of last month’s cell phone bill, the bankruptcy trustee cannot recover the payment.

To be recoverable, a preference must be a transfer for an antecedent (preexisting) debt, such as a year-old land- scaping bill. In addition, the Code permits a consumer- debtor to transfer any property to a creditor up to a total value of $6,225 without the transfer’s constituting a preference. Payment of domestic-support debts does not constitute a preference.

Fraudulent Transfers The trustee may avoid fraudu- lent transfers or obligations if they (1) were made within two years prior to the filing of the petition or (2) were made with actual intent to hinder, delay, or defraud a creditor. ■ EXAMPLE 15.10 Amy is planning to peti- tion for bankruptcy, so she sells her gold jewelry, worth $10,000, to a friend for $500. The friend agrees that in the future he will “sell” the jewelry back to Amy for the same amount. This is a fraudulent transfer that the trustee can undo. ■

Transfers made for less than reasonably equivalent consideration are also vulnerable if the debtor thereby became insolvent or was left engaged in business with an unreasonably small amount of capital. When a fraudu- lent transfer is made outside the Code’s two-year limit, creditors may seek alternative relief under state laws. Some state laws may allow creditors to recover transfers made up to three years before the filing of a petition.

15–5f Exemptions As just described, the trustee takes control of the debtor’s property in a Chapter 7 bankruptcy, but an individual debtor is entitled to exempt (exclude) certain property from the bankruptcy.

Federal Exemptions The Bankruptcy Code exempts the following property, up to a specified dollar amount that changes every three years:17

1. A portion of equity in the debtor’s home (the home- stead exemption).

2. Motor vehicles, up to a certain value (usually just one vehicle).

3. Reasonably necessary clothing, household goods and furnishings, and household appliances (the aggregate value not to exceed a certain amount).

4. Jewelry, up to a certain value. 5. Tools of the debtor’s trade or profession, up to a cer-

tain value. 6. A portion of unpaid but earned wages. 7. Pensions. 8. Public benefits, including public assistance (welfare),

Social Security, and unemployment compensation, accumulated in a bank account.

9. Damages awarded for personal injury up to a certain amount.

Property that is not exempt under federal law includes not exempt under federal law includes not bank accounts, cash, family heirlooms, collections of stamps and coins, second cars, and vacation homes.

State Exemptions Individual states have the power to pass legislation precluding debtors from using the fed- eral exemptions within the state. A majority of the states have done this. In those states, debtors may use only state, not federal, exemptions. In the rest of the states, debtors may choose either the exemptions provided under state law or the federal exemptions.

17. The dollar amounts stated in the Bankruptcy Code are adjusted auto- matically every three years on April 1 based on changes in the Consumer Price Index. The adjusted amounts are rounded to the nearest $25.

332 U N I T T H R E E The Commercial Environment

Limitations on the Homestead Exemption The Bankruptcy Code limits the amount of equity that can be claimed under the homestead exemption. In general, if the debtor acquired the homestead within three and a half years preceding the date of filing, the maximum equity exempted is $155,675, even if state law would permit a higher amount.

In addition, the state homestead exemption is available only if the debtor has lived in a state for two years before filing the bankruptcy petition. Furthermore, a debtor who has violated securities laws, been convicted of a fel- ony, or engaged in certain other intentional misconduct may not be permitted to claim the homestead exemption.

15–5g Creditors’ Meeting Within a reasonable time after the order for relief has been granted (not more than forty days), the trustee must call a meeting of the creditors listed in the schedules filed by the debtor. The bankruptcy judge does not attend this meeting. The debtor is required to attend (unless excused by the court) and to submit to examination under oath by the creditors and the trustee. At the meeting, the trustee ensures that the debtor is aware of the potential consequences of bankruptcy and of the possibility of fil- ing under a different chapter of the Code.

15–5h Creditors’ Claims To be entitled to receive a portion of the debtor’s estate, each creditor normally files a proof of claim with the bank- ruptcy court within ninety days of the creditors’ meeting. A proof of claim is necessary if there is any dispute con- cerning the claim. The proof of claim lists the creditor’s name and address, as well as the amount that the creditor asserts is owed to the creditor by the debtor.

When the debtor has no assets—called a “no-asset case”—creditors are notified of the debtor’s petition

for bankruptcy but are instructed not to file a claim. In no-asset cases, the unsecured creditors will receive no payment, and most, if not all, of these debts will be discharged.

15–5i Distribution of Property The Code provides specific rules for the distribution of the debtor’s property to secured and unsecured creditors. If any amount remains after the priority classes of credi- tors have been satisfied, it is turned over to the debtor.

Distribution to Secured Creditors The Code requires that consumer-debtors file a statement of inten- tion with respect to secured collateral. They can choose to pay off the debt and redeem the collateral, claim it is exempt, reaffirm the debt and continue making pay- ments, or surrender the property to the secured party.

If the collateral is surrendered to the secured party, the secured creditor can enforce the security interest. The secured party can either (1) accept the property in full satisfaction of the debt or (2) sell the collateral and use the proceeds to pay off the debt. Thus, the secured party has priority over unsecured parties as to the proceeds from the disposition of the collateral. Should the collat- eral be insufficient to cover the secured debt owed, the secured creditor becomes an unsecured creditor for the difference (deficiency).

There are limited exceptions to these rules. For instance, certain unsecured creditors can sometimes step into the shoes of secured tax creditors in Chapter 7 liquidation proceedings. In such situations, when the collateral securing the tax claims is sold, the unsecured creditors are paid first. This exception does not include holders of unsecured claims for administrative expenses incurred in Chapter 11 cases that are converted to Chap- ter 7 liquidations. In the following case, the plaintiff argued that it should.

Background and Facts Henry Anderson filed a voluntary petition in a federal bankruptcy court for relief under Chapter 11 of the Bankruptcy Code. The U.S. Department of the Treasury, through the Internal Revenue Service (IRS), filed a proof of claim against the bankruptcy estate for $997,551.80, of which $987,082.88 was secured by the debtor’s property. Stubbs & Perdue, P.A., served as Anderson’s

In re Anderson United States Court of Appeals, Fourth Circuit, 811 F.3d 166 (2016).

Case 15.2

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 333

counsel. During the proceedings, the court approved compensation of $200,000 to Stubbs for its ser- vices. These fees constituted an unsecured claim against the estate for administrative expenses. Later, Anderson’s case was converted to a Chapter 7 liquidation. The trustee accumulated $702,630.25 for distribution to the estate’s creditors—not enough to pay the claims of both the IRS and Stubbs. The trustee excluded Stubbs’s claim. Stubbs objected. The court dismissed Stubbs’s objection. A federal district court upheld the dismissal. Stubbs appealed, arguing that the IRS’s claim should be subordi- nated to Stubbs’s claim for fees.

In the Language of the Court Pamela HARRIS, Circuit Judge:

* * * * * * * Before any of the events at issue here, Section 724(b)(2) * * * provided all holders of admin-

istrative expense claims, like Stubbs, with the right to subordinate secured tax creditors in Chapter 7 liquidations. But that statutory scheme was criticized on the ground that it created perverse incentives, encouraging Chapter 11 debtors and their representatives to incur administrative expenses even where there was no real hope for a successful reorganization, to the detriment of secured tax creditors when Chapter 7 liquidation ultimately proved necessary.

* * * Congress responded with a fix * * * to limit the class of administrative expenses covered by Sec- tion 724(b)(2) * * *. In order to provide greater protection for holders of tax liens * * * , unsecured Chapter 11 administrative expense claims would no longer take priority over secured tax claims in Chapter 7 liquida- tions. [Emphasis added.]

* * * * * * * The Bankruptcy Technical Corrections Act [BTCA] * * * clarified that Chapter 11 administra-

tive expense claimants do not hold subordination rights under Section 724(b)(2). * * * Eleven months later, the Debtor’s bankruptcy case converted from Chapter 11 to Chapter 7,

implicating Section 724(b)(2) for the first time. * * * * * * * As a general rule, a court is to apply the law in effect at the time it renders its decision. [Emphasis

added.] * * * * Stubbs argues, however, that it would be unjust to apply the BTCA version of Section 724(b)(2) * * *

to disallow payment on its unsecured claim for Chapter 11 fees. Prior to the BTCA, Stubbs contends, it was entitled to subordinate the IRS’s secured claim.

The problem with Stubbs’s argument is its premise: that Stubbs held subordination rights under Sec- tion 724(b)(2) before the BTCA was enacted * * * . Before the BTCA was enacted, Section 724(b)(2) had no application to the Debtor’s case at all. It afforded Stubbs no entitlement to subordinate the IRS’s secured tax claim for the threshold reason that it simply did not apply in the Chapter 11 proceedings that began in this case * * * and did not end until * * * eleven months after the BTCA’s passage. The pre-after the BTCA’s passage. The pre-after BTCA version of Section 724(b)(2) that Stubbs invokes, in other words, never controlled this case.

Decision and Remedy The U.S. Court of Appeals for the Fourth Circuit affirmed the dismissal of Stubbs’s claim. Under Section 724(b)(2), “it is clear that Stubbs is not entitled to subordinate the IRS’s secured tax claim in favor of its unsecured claim to Chapter 11 administrative expenses.”

Critical Thinking • Legal Environment Why, as a general rule, should a court apply the law that is in effect at the time

the court renders its decision? • What If the Facts Were Different? Suppose that Anderson had filed his initial bankruptcy petition

under Chapter 7, not under Chapter 11. Would the result have been different? Discuss.

Case 15.2 Continued

334 U N I T T H R E E The Commercial Environment

Distribution to Unsecured Creditors Bank- ruptcy law establishes an order of priority for debts owed to unsecured creditors, and they are paid in the order of unsecured creditors, and they are paid in the order of unsecured their priority. Claims for domestic-support obligations, such as child support and alimony, have the highest pri- ority among unsecured creditors, so these claims must be paid first. Each class, or group, must be fully paid before the next class is entitled to any of the remaining proceeds.

If there are insufficient proceeds to fully pay all the creditors in a class, the proceeds are distributed propor- tionately to the creditors in that class. Classes lower in tionately to the creditors in that class. Classes lower in tionately priority receive nothing. In almost all Chapter 7 bank- ruptcies, the funds will be insufficient to pay all creditors.

Exhibit 15–2 illustrates the collection and distribution of property in most voluntary bankruptcies. The exhibit includes a listing of the classes of unsecured creditors.

15–5j Discharge From the debtor’s point of view, the primary purpose of liquidation is to obtain a fresh start through a discharge of debts. A discharge voids, or sets aside, any judgment on a discharged debt and prevents any action to collect it. Certain debts, however, are not dischargeable in bank- ruptcy. Also, certain debtors may not qualify to have all debts discharged in bankruptcy. These situations are dis- cussed next.

Exceptions to Discharge Claims that are not dis- chargeable in bankruptcy include the following: 1. Claims for back taxes accruing within two years prior

to bankruptcy. 2. Claims for amounts borrowed by the debtor to pay

federal taxes or any nondischargeable taxes.18 3. Claims against property or funds obtained by the

debtor under false pretenses or by false representations. 4. Claims by creditors who were not notified of the

bankruptcy. These claims did not appear on the schedules the debtor was required to file.

5. Claims based on fraud or misuse of funds by the debtor while acting in a fiduciary capacity or claims involving the debtor’s embezzlement or larceny.

6. Domestic-support obligations and property settle- ments as provided for in a separation agreement or divorce decree.

7. Claims for amounts due on a retirement account loan. 8. Claims based on willful or malicious conduct

by the debtor toward another or the property of another. ■ CASE IN POINT 15.11 Anthony Mick- letz owned a pizza restaurant that employed John

18. Taxes accruing within three years prior to bankruptcy are nondischarge- able, including federal and state income taxes, employment taxes, taxes on gross receipts, property taxes, excise taxes, customs duties, and any other taxes for which the government claims the debtor is liable in some capacity. See 11 U.S.C. Sections 507(a)(8) and 523(a)(1).

• Domestic-Support Obligations • Administrative Expenses • Ordinary Business Expenses • Wages and Salaries • Employee Benefit Plans • Certain Farmers and Fishermen • Consumer Deposits • Taxes and FTaxes and FT ines • Claims Resulting from Driving while

Intoxicated • General Creditors

Property TProperty TProperty r Tr T ansferred in Transactions Voidable Voidable V

by the Trustee Trustee T

Debtor’s Nonexempt Property

Debtor

Certain After-AcquiredAfter-AcquiredAfter Property

Proceeds and Profits from All of the Above

Property of the Estate Collected and

Distributed by the TrusteeTrusteeT

Secured Creditors

Unsecured Creditors

E X H I B I T 1 5 – 2 Collection and Distribution of Property in Most Voluntary Bankruptcies

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 335

Carmello. One night after Carmello had finished his shift, Mickletz called him back into the restaurant and accused him of stealing. An argument ensued, and Mickletz shoved Carmello, causing him to fall and injure his back. Because Mickletz did not pro- vide workers’ compensation coverage as required by law, the state prosecuted him criminally. He was ordered to pay more than $45,000 in restitution to Carmello for his injuries. Carmello also filed a civil suit against Mickletz, which the parties agreed to settle for $175,000. Later, Mickletz filed a petition for bankruptcy. Carmello argued that these debts were nondischargeable, and the court agreed. The exception from discharge includes any debts for will- ful (deliberate or intentional) injury, and Mickletz’s actions were deliberate.19 ■

9. Certain government fines and penalties. 10. Student loans, unless payment of the loans imposes an

undue hardship on the debtor and the debtor’s depen- dents. (For an example of what constitutes undue hard- ship, see Case in Point 15.12, which follows this list.)

11. Consumer debts of more than $650 for luxury goods or services owed to a single creditor incurred within ninety days of the order for relief.

12. Cash advances totaling more than $925 that are extensions of open-end consumer credit obtained by the debtor within seventy days of the order for relief.

13. Judgments against a debtor as a result of the debtor’s operation of a motor vehicle while intoxicated.

14. Fees or assessments arising from property in a home- owners’ association, as long as the debtor retained an interest in the property.

15. Taxes with respect to which the debtor failed to pro- vide required or requested tax documents.

■ CASE IN POINT 15.12 At the time he filed for Chapter 7 bankruptcy, Terence Wolfe had not been con- sistently employed for twenty years. He had been fired from numerous positions for behavioral issues and had difficulty finding and holding a job. Wolfe had been diagnosed with personality disorders and ultimately was granted disability status by the U.S. government. He was living on disability payments of $1,126 per month at the time he filed for Chapter 7 bankruptcy.

Among Wolfe’s debts were more than $131,000 in student loan debts. Wolfe sought to have these debts dis- charged because repaying them would constitute undue hardship. The court agreed and granted a discharge. According to the court, although Wolfe is intelligent, “he has been unable, for more than two decades, to maintain

19. In re Mickletz, 544 Bankr. 804 (E.D. Pa. 2016).

full-time employment for any meaningful length of time. He is living at a minimal standard of living and it is unlikely that he will ever be able to repay these loans.”20 ■

Today, the federal government guarantees many stu- dent loans (similar to the way the government backs certain mortgages). When student loans are guaranteed, the lenders are not affected by default in the same way and have no reason to refuse to finance education. This bolsters the argument that student loan debts should be dischargeable in the same way as other types of debts. See this chapter’s Ethics Today feature for a discussion of Ethics Today feature for a discussion of Ethics Today whether the law should make it easier to obtain a dis- charge of student loan debts.

Objections to Discharge In addition to the excep- tions to discharge previously discussed, a bankruptcy court may also deny discharge based on the debtor’s conduct. Grounds for denial of discharge of the debtor include the following: 1. The debtor’s concealment or destruction of property

with the intent to hinder, delay, or defraud a creditor. 2. The debtor’s fraudulent concealment or destruction

of financial records. 3. The grant of a discharge to the debtor within eight

years before the petition was filed. 4. The debtor’s failure to complete the required con-

sumer education course. 5. The debtor’s involvement in proceedings in which

the debtor could be found guilty of a felony. (Basi- cally, a court may not discharge any debt until the completion of felony proceedings against the debtor.)

When a discharge is denied under any of these cir- cumstances, the debtor’s assets are still distributed to the creditors. After the bankruptcy proceeding, however, the debtor remains liable for the unpaid portion of all claims.

In addition, a discharge may be revoked (taken back) within one year if it is discovered that the debtor acted fraudulently or dishonestly during the bank- ruptcy proceeding. If that occurs, a creditor whose claim was not satisfied in the distribution of the debt- or’s property can proceed with his or her claim against the debtor.

Whether a bankruptcy court properly denied a dis- charge based on the debtors’ conduct was the issue in the following case.

20. In re Wolfe, 501 Bankr. 426, 24 Fla.L.WeeklyFed. B235 (M.D.Fla. 2011).

336 U N I T T H R E E The Commercial Environment

Background and Facts Clarence and Pamela Cummings filed a petition for a Chapter 7 bankruptcy in a federal bankruptcy court. After the debtors filed two amended versions of the required schedules, the trustee asked for additional time to investigate. The court granted the request. The debtors then filed a third amended schedule. In it, they disclosed for the first time the existence of First Beacon Man- agement Company, a corporation that they planned to use as part of their postbankruptcy “fresh start.”

The trustee claimed that the Cummingses’ failure to disclose their interest in First Beacon was a “false oath relating to a material fact made knowingly and fraudulently” in violation of the Bankruptcy Code. The court agreed and denied the debtors a discharge. The Bankruptcy Appellate Panel (BAP) affirmed the court’s decision. The Cummingses appealed.

In the Language of the Court MEMORANDUM.

* * * * Chapter 7 debtors Clarence Thomas Cummings and Pamela K. Cummings appeal the judgment of

the Bankruptcy Appellate Panel (“BAP”) affirming * * * the bankruptcy court’s order denying discharge on the ground that the debtors made false oaths * * * . The bankruptcy court rejected the explanatory testimony of Mr. Cummings as “not credible” and “beyond not credible” and the BAP found that “there is ample evidence to support the bankruptcy court’s findings.

* * * * * * * Debtors claim that the bankruptcy court failed to consider other “voluminous independent and

undisputed documentary evidence” introduced at trial that, they assert, “completely obliterated any sug- gestion of fraudulent intent.”

* * * These materials do not advance debtors’ claim of inadvertence [lack of intent] or otherwise sug- gest bankruptcy court error. To the contrary, the documents corroborate the obviousness of debtors’ fraud and the objective it advanced, [namely], to insulate First Beacon Management Co., * * * the new corporate anchor of their post-petition fresh start, from the stigma of bankruptcy. [Emphasis added.]

Debtors’ eventual disclosure of their interest in First Beacon on their third amended Schedule * * * does not negate their initial fraud. To the contrary, the sequence of debtors’ filings substantiates the pres- ence of fraud: they elected, twice, to amend their Schedule * * * without adding First Beacon, and dis- closed First Beacon only after the issuance of an order granting the Trustee additional time to investigate.

* * * * The Trustee fully carried its burden of proving by a preponderance of the evidence * * * that under

the circumstances, debtors’ failure to disclose their interest in First Beacon as debtor property was a “false oath” relating to a material fact made knowingly and fraudulently.

Decision and Remedy The U.S. Court of Appeals for the Ninth Circuit affirmed the ruling of the Bankruptcy Appellate Panel. The Cummingses’ bankruptcy filings revealed the presence of fraud. Thus, their Chapter 7 petition for discharge of their debts was denied.

Critical Thinking • Economic Why would a debtor risk the denial of a discharge to conceal assets? Discuss.

In re Cummings United States Court of Appeals, Ninth Circuit, 595 Fed.Appx. 707 (2015).

Case 15.3

15–5k Reaffirmation of Debt An agreement to pay a debt dischargeable in bankruptcy is called a reaffirmation agreement. A debtor may wish to pay a debt—such as a debt owed to a family member, physician, bank, or some other creditor—even though the debt could be discharged in bankruptcy. Also, as

noted previously, a debtor cannot retain secured property while continuing to pay without entering into a reaffir- mation agreement.

Procedures To be enforceable, reaffirmation agreements must be made before the debtor is granted a discharge. The agreement must be signed and filed with the court.

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 337

Should There Be More Relief for Student Loan Defaults?

According to many observers, student loan debt has reached crisis levels in the United States. Outstanding student loan balances total $1.2 trillion nationally and are growing by around $3,000 per second. About 20 per- cent are ninety or more days’ delinquent or are in default. That is the highest delinquency rate among all forms of debt, including credit cards, automobile loans, and mortgages. The average student loan debt is more than $30,000.

Consequences of Default Any student borrower who has not made regular pay- ments for nine months is in default. If you are in default on a student loan, the U.S. Department of Education can do any of the following to collect:

1. Keep your tax refund if you were supposed to receive one.

2. Garnish your paycheck without obtaining a court judgment.

3. Take your federal benefits, such as Social Security retirement payments or disability payments.

In addition, in some states any professional license that you have can be revoked. The Department of Edu- cation can also bring a lawsuit against you. If it wins, it can collect the judgment from your bank accounts or place a lien on any real property that you own.

Caps on Interest Rates, Forgiveness, and Income-Based Plans Recently, Congress attempted to ease the burden on student loan debtors by reducing the interest rates they can be charged. In addition, President Barack Obama signed an executive order putting into place an income-based repayment plan. This plan caps

payments at no more than 10 percent of dis- posable income. Any balance not paid off after twenty years will be forgiven.

Should the federal government go further? Yes, at least according to President Obama. In 2015, Obama signed a presidential memo- randum titled “Student Aid Bill of Rights.” The memorandum directs the Department of

Education to implement actions to ensure that the debt collection process for defaulted student loans “is fair, transparent, [and] charges reasonable fees to defaulted borrowers.”

Critics point out that such student loan debt forgive- ness could have a cost. They claim that colleges and universities might “hint” to potential students that they need not worry about taking on higher student loans because some portion will be forgiven by the federal government.

Political Impetus Politicians are increasingly discussing student loan debt and the costs of higher education. Some are asking Congress to allow federal student loans to be discharged in most bankruptcy proceedings. Others advocate making college education free or at least reducing the costs charged to certain students. One plan calls for allowing students to refinance their loans at very low interest rates. Another proposal is to pro- hibit the federal government from profiting from stu- dent loan debt (the government brings in more than $41 billion a year from student loans).

Critical Thinking Why does the Bankruptcy Code pro- vide that student loans should not be dischargeable unless there is undue hardship? What argument can be made in favor of allowing student loans to be dischargeable?

ETHICS TODAY

Court approval is required unless the debtor is represented by an attorney during the negotiation of the reaffirma- tion and submits the proper documents and certifications. Even when the debtor is represented by an attorney, court approval may be required if it appears that the reaffirma- tion will result in undue hardship to the debtor.

When court approval is required, a separate hearing will take place. The court will approve the reaffirmation only if it finds that the agreement will not result in undue hardship to the debtor and that the reaffirmation is con- sistent with the debtor’s best interests.

Required Disclosures To discourage creditors from engaging in abusive reaffirmation practices, the law pro- vides specific language for disclosures that must be given to debtors entering into reaffirmation agreements. Among other things, these disclosures explain that the debtor is not required to reaffirm any debt. They also inform the debtor that liens on secured property, such as mortgages and cars, will remain in effect even if the debt is not reaffirmed.

The reaffirmation agreement must disclose the amount of the debt reaffirmed, the rate of interest, the date pay- ments begin, and the right to rescind. The disclosures

338 U N I T T H R E E The Commercial Environment

also caution the debtor: “Only agree to reaffirm a debt if it is in your best interest. Be sure you can afford the pay- ments you agree to make.”

The original disclosure documents must be signed by the debtor, certified by the debtor’s attorney, and filed with the court at the same time as the reaffirma- tion agreement. A reaffirmation agreement that is not accompanied by the original signed disclosures will not be effective.

■ CASE IN POINT 15.13 Howard Lapides, who owned a seafood import business, signed a secured promissory note for $400,000 with Venture Bank for a revolving line-of-credit loan. Part of the collateral for that loan was a third mortgage on the Lapideses’ home (two other banks held prior mortgages). Eventually, Howard and his wife filed for Chapter 7 bankruptcy protection, and their personal debts were discharged. Afterward, Venture Bank convinced the Lapideses to sign a reaffirmation agree- ment by telling them that it would refinance all three mortgages so that they could keep their house.

The Lapideses made twelve $3,500 payments to Ven- ture Bank, but when the bank did not refinance the other mortgages, they stopped making payments. Venture Bank filed suit, but a court refused to enforce the reaf-Bank filed suit, but a court refused to enforce the reaf-Bank filed suit, but a court refused to enforce the reaf firmation agreement because it violated the Bankruptcy Code. The agreement had never been signed by Lapide- ses’ attorney or filed with the bankruptcy court.21 ■

15–6 Reorganizations The type of bankruptcy proceeding most commonly used by corporate debtors is the Chapter 11 reorganization. In a reorganization, the creditors and the debtor formulate a plan under which the debtor pays a portion of the debts and is discharged of the remainder. The debtor is allowed to continue in business.

As noted, this type of bankruptcy generally involves a corporate reorganization. Nevertheless, any debtor (except a stockbroker or a commodities broker) who is eligible for Chapter 7 relief is eligible for relief under Chapter 11. Railroads are also eligible.

Congress has established a “fast-track” Chapter 11 procedure for small-business debtors whose liabilities do not exceed $2.49 million and who do not own or manage real estate. The fast track enables a debtor to avoid the appointment of a creditors’ committee and also shortens the filing periods and relaxes certain other requirements. Because the process is shorter and simpler, it is less costly.

21. Venture Bank v. Lapides, 800 F.3d 442 (8th Cir. 2015).

The same principles that govern the filing of a liquida- tion (Chapter 7) petition apply to reorganization (Chapter 11) proceedings. The case may be brought either volun- tarily or involuntarily. The automatic-stay provision and its exceptions (such as substantial abuse), as well as the adequate protection doctrine, apply in reorganizations.

15–6a Workouts In some instances, to avoid bankruptcy proceedings, creditors may prefer private, negotiated adjustments of creditor-debtor relations, also known as workouts. Often, these out-of-court workouts are much more flex- ible and thus more conducive to a speedy settlement. Speed is critical because delay is one of the most costly elements in any bankruptcy proceeding. Another advan- tage of workouts is that they avoid the various adminis- trative costs of bankruptcy proceedings.

15–6b Best Interests of the Creditors Once a Chapter 11 petition has been filed, a bankruptcy court can dismiss or suspend proceedings at any time if dismissal or suspension would better serve the interests of the creditors. Before taking such an action, the court must give notice and conduct a hearing. The Code also allows a court, after notice and a hearing, to dismiss a case under reorganization “for cause” when there is no reasonable likelihood of rehabilitation. Similarly, a court can dismiss when there is an inability to effect a plan or an unreasonable delay by the debtor that may harm the interests of creditors. A debtor whose petition is dis- missed for these reasons can file a subsequent Chapter 11 petition in the future.

15–6c Debtor in Possession On entry of the order for relief, the debtor generally con- tinues to operate the business as a debtor in possession (DIP). The court, however, may appoint a trustee (often referred to as a receiver) to operate the debtor’s business. receiver) to operate the debtor’s business. receiver The court will choose this action if gross mismanage- ment of the business is shown or if appointing a trustee is in the best interests of the estate.

The DIP’s role is similar to that of a trustee in a liq- uidation bankruptcy. The DIP is entitled to avoid pref-uidation bankruptcy. The DIP is entitled to avoid pref-uidation bankruptcy. The DIP is entitled to avoid pref erential payments and fraudulent transfers. The DIP can also exercise a trustee’s strong-arm powers. The DIP has the power to decide whether to cancel or assume pre- petition executory contracts (contracts that are not yet performed) or unexpired leases.

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 339

15–6d Creditors’ Committees As soon as practicable after the entry of the order for relief, a creditors’ committee of unsecured creditors is appointed.22 The business’s suppliers may serve on the committee. The committee can consult with the trustee or the DIP concerning the administration of the case or the formulation of the plan. Additional creditors’ committees may be appointed to represent special interest creditors.

Generally, no orders affecting the estate will be entered without the consent of the committee or after a hearing in which the judge is informed of the committee’s position. As mentioned earlier, businesses with debts of less than $2.49 million that do not own or manage real estate can avoid creditors’ committees. In these fast-track proceed- ings, orders can be entered without a committee’s consent.

15–6e The Reorganization Plan A reorganization plan to rehabilitate the debtor is a plan to conserve and administer the debtor’s assets in the hope of an eventual return to successful operation and sol- vency. The plan must be fair and equitable and must do the following: 1. Designate classes of claims and interests. 2. Specify the treatment to be afforded to the classes of

creditors. (The plan must provide the same treatment for all claims in a particular class.)

3. Provide an adequate means for the plan’s execution. (Individual debtors are required to utilize postpeti- tion assets as necessary to execute the plan.)

4. Provide for payment of tax claims over a five-year period.

The plan need not provide for full repayment to unse- cured creditors. Instead, creditors receive a percentage of each dollar owed to them by the debtor.

Filing the Plan Only the debtor may file a plan within the first 120 days after the date of the order for relief. This period may be extended, but not beyond eighteen months from the date of the order for relief. If the debtor does not meet the 120-day deadline or obtain an extension, any party may propose a plan. If a small-business debtor chooses to avoid a creditors’ committee, the time for the debtor’s filing is 180 days.

Acceptance of the Plan Once the plan has been developed, it is submitted to each class of creditors for

22. If the debtor has filed a reorganization plan accepted by the creditors, the trustee may decide not to call a meeting of the creditors.

acceptance. For the plan to be adopted, each class must accept it. A class has accepted the plan when a majority of the creditors in the class, representing two-thirds of the amount of the total claim, vote to approve it. If the debtor fails to procure creditor consent of the plan within 180 days, any party may propose a plan.

Confirmation of the Plan Confirmation is con- ditioned on the debtor’s certifying that all postpetition domestic-support obligations have been paid in full. In addition, even when all classes of creditors accept the plan, the court may refuse to confirm it if it is not “in the best interests of the creditors.” For small-business debtors, if the plan meets the listed requirements, the court must confirm the plan within forty-five days (unless this period is extended).

The plan can be modified on the request of the debtor, the DIP, the trustee, the U.S. trustee, or a holder of an unsecured claim. If an unsecured creditor objects to the plan, specific rules apply to the value of property to be distributed under the plan. Tax claims must be paid over a five-year period.

Even if only one class of creditors has accepted the plan, the court may still confirm the plan under the Code’s so-called cram-down provision. In other words, the court may confirm the plan over the objections of a class of creditors. Before the court can exercise the right of cram-down confirmation, it must be demonstrated that the plan does not discriminate unfairly against any creditors and is fair and equitable.

Discharge The plan is binding on confirmation. Nev- ertheless, the law provides that confirmation of a plan does not discharge an individual debtor. For individual debtors, the plan must be completed before discharge will be granted, unless the court orders otherwise. For all other debtors, the court may order discharge at any time after the plan is confirmed.

On discharge, the debtor is given a reorganization discharge from all claims not protected under the plan. This discharge does not apply to any claims that would be denied discharge under liquidation.

15–7 Bankruptcy Relief under Chapter 12 and Chapter 13

In addition to bankruptcy relief through liquidation and reorganization, the Code also provides for family-farmer and family-fisherman debt adjustments (Chapter 12) and

340 U N I T T H R E E The Commercial Environment

individuals’ repayment plans (Chapter 13). The proce- dures for filing Chapter 12 and Chapter 13 plans are very similar. Because Chapter 13 plans are the more commonly used of the two types, we discuss Chapter 13 first.

15–7a Individuals’ Repayment Plans—Chapter 13

Chapter 13 of the Bankruptcy Code provides for “Adjust- ment of Debts of an Individual with Regular Income.” Individuals with regular income who owe fixed (liqui- dated) unsecured debts of less than $383,175 or fixed secured debts of less than $1,149,525 may take advan- tage of bankruptcy repayment plans. Partnerships and corporations are excluded.

Among those eligible are salaried employees and sole proprietors, as well as individuals who live on welfare, Social Security, fixed pensions, or investment income. Many small-business debtors have a choice of filing under either Chapter 11 or Chapter 13. Repayment plans offer some advantages because they are less expen- sive and less complicated than reorganization or liquida- tion proceedings.

Filing the Petition A Chapter 13 repayment plan case can be initiated only by the debtor’s filing of a volun- tary petition or by court conversion of a Chapter 7 peti- tion. Recall that a court may convert a Chapter 7 petition because of a finding of substantial abuse under the means test. In addition, certain liquidation and reorganization cases may be converted to repayment plan cases with the consent of the debtor.23

A trustee, who will make payments under the plan, must be appointed. On the filing of a repayment plan petition, the automatic stay previously discussed takes effect. Although the stay applies to all or part of the debtor’s consumer debt, it does not apply to any business debt incurred by the debtor or to any domestic-support obligations.

Good Faith Requirement The Bankruptcy Code imposes the requirement of good faith on a debtor at both the time of the filing of the petition and the time of the filing of the plan. The Code does not define good faith, but if the circumstances on the whole indicate bad faith, a court can dismiss a debtor’s Chapter 13 petition.

23. A Chapter 13 repayment plan may be converted to a Chapter 7 liquida- tion at the request of the debtor or, under certain circumstances, by a creditor “for cause.” A Chapter 13 case may be converted to a Chapter 11 case after a hearing.

The Repayment Plan A plan of rehabilitation by repayment must provide for the following: 1. The turning over to the trustee of such future earn-

ings or income of the debtor as is necessary for execu- tion of the plan.

2. Full payment through deferred cash payments of all claims entitled to priority, such as taxes.24

3. Identical treatment of all claims within a particular class. (The Code permits the debtor to list co-debtors, such as guarantors or sureties, as a separate class.)

The repayment plan may provide either for pay- ment of all obligations in full or for payment of a lesser amount. The debtor must begin making payments under the proposed plan within thirty days after the plan has been filed and must continue to make “timely” pay- ments.25 If the debtor fails to make timely payments or to commence payments within the thirty-day period, the court can convert the case to a Chapter 7 bankruptcy or dismiss the petition.

Allowable Expenses. In putting together a repayment plan, a debtor must apply the means test to identify the amount of disposable income that will be available to repay creditors. �e debtor is allowed to deduct certain expenses from monthly income to arrive at this amount, but only if they are appropriate.

■ CASE IN POINT 15.14 Jason Ransom filed a Chap- ter 13 bankruptcy petition. Among his assets, he listed a Toyota Camry that he owned free of any debt. In his monthly expenses, he claimed a car-ownership deduction of $471 and a separate $388 deduction for costs to oper- ate the car. He proposed a five-year plan that would repay about 25 percent of his unsecured debt.

FIA Card Services, N.A., an unsecured creditor, objected to the plan. FIA argued that Ransom was not entitled to the car-ownership allowance because he did not owe money on the car. Ultimately, the United States Supreme Court ruled in FIA’s favor. A deduction is appropriate only if the debtor will incur that expense during the life of the Chapter 13 plan. A debtor who does not make loan or lease payments may not take a car-ownership deduction.26 ■

24. As with a Chapter 11 reorganization plan, full repayment of all claims is not always required.

25. The bankruptcy trustee holds on to these payments until the court either confirms or denies the debtor’s plan. If the court confirms the plan, the trustee distributes the funds to creditors as stated in the plan. If the court denies the debtor’s plan, the trustee returns the funds, minus administrative expenses, to the debtor.

26. Ransom v. FIA Card Services, N.A., 562 U.S. 61, 131 S.Ct. 716, 178 L.Ed.2d 603 (2011).

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 341

Length of the Plan. �e length of the payment plan can be three or �ve years, depending on the debtor’s family income. If the family income is greater than the median family income in the relevant geographic area under the means test, the term of the proposed plan must be three years.27 �e term may not exceed �ve years.

Confirmation of the Plan. After the plan is �led, the court holds a con�rmation hearing, at which interested parties (such as creditors) may object to the plan. �e hearing must be held at least twenty days, but no more than forty-�ve days, after the meeting of the creditors. �e debtor must have �led all prepetition tax returns and paid all postpetition domestic-support obligations before a court will con�rm any plan.

The court will confirm a plan with respect to each claim of a secured creditor under any of the following circumstances: 1. If the secured creditors have accepted the plan. 2. If the plan provides that secured creditors retain their

liens until there is payment in full or until the debtor receives a discharge.

3. If the debtor surrenders the property securing the claims to the creditors.

In addition, for a motor vehicle purchased within 910 days before the petition is filed, the plan must provide that a creditor with a purchase-money security interest (PMSI) retains its lien until the entire debt is paid. For PMSIs on other personal property, the payment plan must cover debts incurred within a one-year period pre- ceding the filing.

Discharge After the debtor has completed all pay- ments, the court grants a discharge of all debts provided for by the repayment plan. Generally, all debts are dis- chargeable except the following: 1. Allowed claims not provided for by the plan. 2. Certain long-term debts provided for by the plan. 3. Certain tax claims and payments on retirement

accounts. 4. Claims for domestic-support obligations. 5. Debts related to injury or property damage caused

while driving under the influence of alcohol or drugs. An order granting discharge is final as to the debts An order granting discharge is final as to the debts An order granting discharge is final as to the debts An order granting discharge is final as to the debts

listed in the repayment plan. ■ CASE IN POINT 15.15 Francisco Espinosa filed a petition for an individual repayment plan under Chapter 13 of the Bankruptcy Code. His plan proposed to pay only the principal on his

27. See 11 U.S.C. Section 1322(d) for details on when the court will find that the Chapter 13 plan should extend to a five-year period.

student loan and to discharge the interest. United Stu- dent Aid Funds, Inc. (the creditor), had notice of the plan and did not object. The court confirmed the plan without finding that payment of the student loan inter- est would cause undue hardship (as required under the Code).

Years later, United filed a motion asking the bank- ruptcy court to rule that its order confirming the plan was void because it was in violation of the rules gov- erning bankruptcy. The court denied United’s petition and ordered the creditor to cease its collection efforts. The case ultimately reached the United States Supreme Court, which affirmed the lower court’s holding that the student loan debt was discharged.28 ■

15–7b Family Farmers and Fishermen—Chapter 12

Congress created Chapter 12 of the Bankruptcy Code to help relieve economic pressure on small farmers. In 2005, Congress extended this protection to family fish- ermen, modified its provisions somewhat, and made it a permanent chapter in the Bankruptcy Code. (Previously, the statutes authorizing Chapter 12 had to be periodi- cally renewed by Congress.)

Concept Summary 15.1 compares bankruptcy proce- dures under Chapters 7, 11, 12, and 13.

Definitions For purposes of Chapter 12, a family farmer is one whose gross income is at least 50 percent farmer is one whose gross income is at least 50 percent farmer farm dependent and whose debts are at least 50 percent farm related. The total debt for a family farmer must not exceed $4,031,575. A partnership or close corporation that is at least 50 percent owned by the farm family can also qualify as a family farmer.29

A family fisherman is one whose gross income is at least 50 percent dependent on commercial fishing opera- tions and whose debts are at least 80 percent related to commercial fishing. The total debt for a family fisherman must not exceed $1,868,200. As with family farmers, a partnership or close corporation can also qualify.

Filing the Petition The procedure for filing a family- farmer or family-fisherman bankruptcy plan is similar to the procedure for filing a repayment plan under Chapter 13. The debtor must file a plan not later than ninety days

28. United Student Aid Funds, Inc. v. Espinosa, 559 U.S. 260, 130 S.Ct. 1367, 176 L.Ed.2d 158 (2010).

29. Note that for a corporation or partnership to qualify under Chapter 12, at least 80 percent of the value of the firm’s assets must consist of assets related to the farming operation.

342 U N I T T H R E E The Commercial Environment

Concept Summary 15.1

FORM CHAPTER 7 CHAPTER 11 CHAPTERS 12 AND 13

Purpose Liquidation. Reorganization. Adjustment.

Who Can Petition

Debtor (voluntary) or creditors (involuntary).

Debtor (voluntary) only.

Procedure Leading to Discharge

Nonexempt property is sold, and the proceeds are distributed (in order) to priority groups. Dischargeable debts are terminated.

Plan is submitted. If the plan is approved and followed, debts are discharged.

Plan is submitted and must be approved if the value of the property to be distributed equals the amount of the claims or if the debtor turns over disposable income for a three-year or five-year period. If the plan is followed, debts are discharged.

Advantages On liquidation and distribution, most or all debts are discharged, and the debtor has an opportunity for a fresh start.

Debtor continues in business. Creditors can either accept the plan, or it can be “crammed down” on them. The plan allows for the reorganization and liquidation of debts over the plan period.

Who Can Be a Debtor

Any “person” (including partnerships, corporations, and municipalities) except railroads, insurance companies, banks, savings and loan institutions, investment companies licensed by the Small Business Administration, and credit unions. Farmers and charitable institutions cannot be involuntarily petitioned. If the court finds the petition to be a substantial abuse of the use of Chapter 7, the debtor may be required to convert to a Chapter 13 repayment plan.

Any debtor eligible for Chapter 7 relief. Railroads are also eligible. Individuals have specific rules and limitations.

Chapter 12—Any family farmer (one whose gross income is at least 50 percent farm dependent and whose debts are at least 50 percent farm related) or family fisherman (one whose gross income is at least 50 percent dependent on commercial fishing operations and whose debts are at least 80 percent related to commercial fishing) or any partnership or close corporation at least 50 percent owned by a family farmer or fisherman, when total debt does not exceed a specified amount ($4,031,575 for farmers and $1,868,200 for fishermen).

Chapter 13—Any individual (not partnerships or corporations) with regular income who owes fixed (liquidated) unsecured debts of less than $383,175 or fixed secured debts of less than $1,149,525.

Debtor continues in business or possession of assets. If the plan is approved, most debts are discharged after the plan period.

Forms of Bankruptcy Relief Compared

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 343

after the order for relief has been entered. The filing of the petition acts as an automatic stay against creditors’ and co-obligors’ actions against the estate.

A farmer or fisherman who has already filed a reorga- nization or repayment plan may convert it to a Chapter 12 plan. The debtor may also convert a Chapter 12 plan to a liquidation plan.

Content and Confirmation of the Plan The con- tent of a plan under Chapter 12 is basically the same as that of a Chapter 13 repayment plan. Generally, the plan must be confirmed or denied within forty-five days of filing.

The plan must provide for payment of secured debts at the value of the collateral. If the secured debt

exceeds the value of the collateral, the remaining debt is unsecured.

For unsecured debtors, the plan must be confirmed in either of the following circumstances: (1) the value of the property to be distributed under the plan equals the amount of the claim, or (2) the plan provides that all of the debtor’s disposable income to be received in a three- year period (or longer, by court approval) will be applied to making payments. Disposable income is all income received less amounts needed to support the farmer or fisherman and his or her family and to continue the farming or commercial fishing operation. Completion of payments under the plan discharges all debts provided for by the plan.

Reviewing: Creditor-Debtor Relations and Bankruptcy

Three months ago, Janet Hart’s husband of twenty years died of cancer. Although he had medical insurance, he left Janet with outstanding medical bills of more than $50,000. Janet has two teenage daughters to support. She has worked at the local library for the past ten years, earning $1,500 per month. Since her husband’s death, she has also received $1,500 in Social Security benefits and $1,100 in life insurance proceeds every month, for a total monthly income of $4,100. After making the mortgage payment of $1,500 and paying the amounts due on other debts, Janet has barely enough left to buy groceries for her family. She decides to file for Chapter 7 bankruptcy, hoping for a fresh start. Using the information presented in the chapter, answer the following questions. 1. What must Janet do before filing a petition for relief under Chapter 7? 2. How much time does Janet have after filing the bankruptcy petition to submit the required schedules? What hap-

pens if Janet does not meet the deadline? 3. Assume that Janet files a petition under Chapter 7. Further assume that the median family income in the geo-

graphic area in which Janet lives is $49,300. What steps would a court take to determine whether Janet’s petition is presumed to be “substantial abuse” using the means test?

4. Suppose that the court determines that no presumption of substantial abuse applies in Janet’s case. Nevertheless, the court finds that Janet does have the ability to pay at least a portion of the medical bills out of her disposable income. What would the court likely order in that situation?

Debate This . . . Rather than being allowed to file Chapter 7 bankruptcy petitions, individuals and couples should always be forced to make an effort to pay off their debts through Chapter 13.

Terms and Concepts adequate protection doctrine 329 artisan’s lien 320 attachment 321 automatic stay 329 bankruptcy trustee 327 consumer-debtor 326 co-surety 324 cram-down provision 339 creditors’ composition

agreement 322

debtor in possession (DIP) 338 default 318 discharge 327 down payment 324 forbearance 325 foreclosure 325 garnishment 321 guarantor 323 homeowner’s insurance 324 homestead exemption 325

insider 331 lien 318 liquidation 326 mechanic’s lien 318 mortgage 324 mortgage insurance 325 order for relief 328 petition in bankruptcy 327 preference 330 preferred creditor 331Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

344 U N I T T H R E E The Commercial Environment

Issue Spotters 1. Jorge contracts with Larry of Midwest Roofing to

fix Jorge’s roof. Jorge pays half of the contract price in advance. Larry and Midwest complete the job, but Jorge refuses to pay the rest of the price. What can Larry and Midwest do? (See Laws Assisting Creditors.)

2. After graduating from college, Tina works briefly as a salesperson before filing for bankruptcy. Tina’s petition states that her only debts are student loans, taxes accruing

within the last year, and a claim against her based on her misuse of customers’ funds during her employment. Are these debts dischargeable in bankruptcy? Explain. (See Liquidation Proceedings.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 15–1. Liens. Nabil is the owner of a relatively old home val- ued at $105,000. The home’s electrical system is failing, and the wiring needs to be replaced. Nabil contracts with Kand- hari Electrical to replace the electrical system. Kandhari per- forms the repairs, and on June 1 submits a bill of $10,000 to Nabil. Because of financial difficulties, Nabil does not pay the bill. Nabil’s only asset is his home, but his state’s homestead exemption is $60,000. Discuss fully Kandhari’s remedies in this situation. (See Laws Assisting Creditors.)

15–2. Voluntary versus Involuntary Bankruptcy. Burke has been a rancher all her life, raising cattle and crops. Her ranch

is valued at $500,000, almost all of which is exempt under state law. Burke has eight creditors and a total indebtedness of $70,000. Two of her largest creditors are Oman ($30,000 owed) and Sneed ($25,000 owed). The other six creditors have claims of less than $5,000 each. A drought has ruined all of Burke’s crops and forced her to sell many of her cattle at a loss. She cannot pay off her creditors. (See Liquidation Proceedings.) (a) Under the Bankruptcy Code, can Burke, with a $500,000

ranch, voluntarily petition herself into bankruptcy? Explain. (b) Could either Oman or Sneed force Burke into involun-

tary bankruptcy? Explain.

Business Case Problems 15–3. Discharge in Bankruptcy. Like many students, Barbara Hann �nanced her education partially through loans. �ese loans included three federally insured Sta�ord Loans of $7,500 each ($22,500 in total). Hann believed that she had repaid the loans, but when she �led a Chapter 13 petition, Educational Credit Management Corp. (ECMC) �led an unsecured proof of claim based on the loans. Hann objected. At a hearing at which ECMC failed to appear, Hann submit- ted correspondence from the lender that indicated the loans had been paid. �e court entered an order sustaining Hann’s objection. Despite the order, can ECMC resume its e�ort to collect on Hann’s loans? Explain. [In re Hann, 711 F.3d 235 (1st Cir. 2013)] (See Liquidation Proceedings.) 15–4. Discharge. Michael and Dianne Shankle divorced. An Arkansas state court ordered Michael to pay Dianne ali- mony and child support, as well as half of the $184,000 in their investment accounts. Instead, Michael withdrew more than half of the investment funds and spent them. Over the next several years, the court repeatedly held Michael in contempt for

failing to pay Dianne. Six years later, Michael �led for Chap- ter 7 bankruptcy, including in the petition’s schedule the debt to Dianne of unpaid alimony, child support, and investment funds. Is Michael entitled to a discharge of this debt, or does it qualify as an exception? Explain. [In re Shankle, 554 Fed.Appx. 264 (5th Cir. 2014)] (See Liquidation Proceedings.) 15–5. Discharge under Chapter 13. James �omas and Jen- nifer Clark married and had two children. �ey bought a home in Ironton, Ohio, with a loan secured by a mortgage. Later, they took out a second mortgage. On their divorce, the court gave Clark custody of the children and required Clark to pay the �rst mortgage. �e divorce decree also required �omas and Clark to make equal payments on the second mortgage and provided that Clark would receive all proceeds on the sale of the home. �omas failed to make any payments, and Clark sold the home. At that point, she learned that Auto Now had a lien on the home because �omas had not made payments on his car. Clark used all the sale proceeds to pay o� the lien and the mortgages. When �omas �led a petition for a Chapter 13 bankruptcy in a federal

prepayment penalty clause 324 rea�rmation agreement 336 right of contribution 324 right of reimbursement 324 right of subrogation 323

short sale 325 surety 322 suretyship 322 U.S. trustee 327 workout 338

workout agreement 325 writ of attachment 321 writ of execution 321

C H A P T E R 1 5 Creditor-Debtor Relations and Bankruptcy 345

bankruptcy court, Clark �led a proof of claim for the mortgage and lien debts. Clark claimed that �omas should not be able to discharge these debts because they were part of his domestic- support obligations. Are these debts dischargeable? Explain. [In re �omas, 591 Fed.Appx. 443 (6th Cir. 2015)] (See Bankruptcy Relief under Chapter 12 and Chapter 13.) 15–6. Business Case Problem with Sample Answer— Liens. Daniel and Katherine Balk asked Jirak Construction,

LLC, to remodel their farmhouse in Lawler, Iowa. Jirak provided the Balks with an initial estimate of $45,975 for the cost. Over the course of the work, the Balks made signi�cant changes to the plan.

Jirak agreed to the changes and regularly advised the Balks about the increasing costs. In mid-project, Jirak provided an itemized breakdown at their request. �e Balks paid Jirak $67,000, but refused to pay more. Jirak claimed that they still owed $55,000 in labor and materials. Jirak �led a suit in an Iowa state court against the Balks to collect. Which of the liens discussed in this chapter would be most e�ective to Jirak in its attempt to collect? How does that type of lien work? Is the court likely to enforce it in this case? Explain. [Jirak Construction, LLC v. Balk,in this case? Explain. [Jirak Construction, LLC v. Balk,in this case? Explain. [ 863 N.W.2d 35 (Iowa App. 2015)] (See Laws Assisting Creditors.) • For a sample answer to Problem 15–6, go to Appendix E at

the end of this text.

15–7. Laws Assisting Creditors. Grand Harbour Condo- minium Owners Association, Inc., obtained a judgment in an Ohio state court against Gene and Nancy Grogg for $45,458.86. To satisfy the judgment, Grand Harbour �led a notice of gar- nishment with the court, seeking funds held by the Groggs in various banks. �e Groggs disputed Grand Harbour’s right to garnish the funds. �ey claimed that the funds were exempt Social Security and pension proceeds, but they o�ered no proof of this claim. �e banks responded by depositing $23,911.97 with the court. �ese funds were delivered to Grand Harbour. Later, the Groggs �led a petition for bankruptcy in a federal bankruptcy court. After they were granted a discharge, they �led a “motion to return funds to debtors” but provided no evidence that their debt to Grand Harbour had been included in the discharge. What is Grand Harbour’s best argument in response to the Groggs’ motion? [Grand Harbour Condominium Owners Association, Inc. v. Grogg, 2016 -Ohio-1386, __ Ohio App.3d __, __ N.E.2d __ (2016)] (See Laws Assisting Creditors.)

15–8. Liquidation Proceedings. Je�rey Krueger and Michael Torres, shareholders of Cru Energy, Inc., were embroiled in litigation in a Texas state court. Both claimed to act on Cru’s behalf, and each charged the other with attempt- ing to obtain control of Cru through fraud and other mis- conduct. Temporarily prohibited from participating in Cru’s business, Krueger formed Kru, a company with the same busi- ness plan and many of the same shareholders as Cru. Mean- while, to delay the state court proceedings, Krueger �led a petition for a Chapter 7 liquidation in a federal bankruptcy court. He did not reveal his interest in Kru to the bankruptcy court. Ownership of Krueger’s Cru shares passed to the bank- ruptcy trustee, but Krueger ignored this. He called a meeting of Cru’s shareholders—except Torres—and voted those shares to remove Torres from the board and elect himself chairman, president, chief executive o�cer, and treasurer. �e Cru board then dismissed all of Cru’s claims against Krueger in his suit with Torres. Are there su�cient grounds for the bankruptcy court to dismiss Krueger’s bankruptcy petition? Discuss. [In re Krueger, 812 F.3d 365 (5th Cir. 2016)] (See Liquidation Proceedings.)

15–9. A Question of Ethics—Discharge in Bank- ruptcy. Monica Sexton �led a petition for Chapter 13 reorgani-

zation. One of her creditors was Friedman’s Jewelers. Her petition misclassi�ed Friedman’s claim as $800 of unsecured debt. Within days, Friedman’s �led proof of a secured claim for $300 and an unsecured claim

for $462. Eventually, Friedman’s was sent payments of about $300 by check. None of the checks were cashed. By then, Friedman’s had �led its own petition under Chapter 11, Bankruptcy Receivables Management (BRM) had bought Friedman’s unpaid accounts, and the checks had not been forwarded. Sexton received a discharge on the completion of her plan. BRM was not noti�ed. BRM wrote to Sexton’s attorney to ask about the status of her case, but received no response. BRM demanded that Sexton surrender the collateral on its claim. Sexton asked the court to impose sanctions on BRM for violating the discharge order. [In re Sexton, for violating the discharge order. [In re Sexton, for violating the discharge order. [ 2011 WL 284180 (E.D.N.C. 2011)] (See Liquidation Proceedings.)

(a) Was Sexton’s debt to Friedman’s dischargeable? Discuss.

(b) Should BRM be sanctioned for willfully violating the dis- charge order? Why or why not?

Legal Reasoning Group Activity 15–10. Discharge in Bankruptcy. Cathy Coleman took out loans to complete her college education. After graduation, Coleman was irregularly employed as a teacher before �ling a petition in a federal bankruptcy court under Chapter 13. �e court con�rmed a �ve-year plan under which Coleman was required to commit all of her disposable income to paying the student loans. Less than a year later, when Coleman was laid o�, she still owed more than $100,000 to Educational Credit Management Corp. Coleman asked the court to discharge the debt on the ground that it would be an undue hardship for her to pay it. (See Liquidation Proceedings.)

(a) The first group will determine when a debtor normally is entitled to a discharge under Chapter 13.

(b) The second group will discuss whether student loans are dischargeable and when “undue hardship” is a legitimate ground for an exception to the general rule.

(c) The third group will outline the goals of bankruptcy law and make an argument, based on these facts and prin- ciples, in support of Coleman’s request.

346

U N I T T H R E E Application and Ethics

Fantasy Sports—Legal Gambling?

A fantasy sport involves games in which the participants compile imaginary teams made up of real players in a professional sport. As in real sports, fantasy sports team owners draft, trade, and drop players. The teams are grouped into leagues and compete based on the statistical perfor- mance of the players in actual games.

Fantasy sports is a multibillion-dollar industry that includes more than three hundred com- panies, ranging from small start-ups to large corporations. For example, CBSSports.com, which offers fantasy sports games on its Web site, is a brand operated by CBS Interactive, a division of CBS Corporation. More than 50 million U.S. adults play fantasy sports.

One of the most important issues confronting the industry is whether participation in fan- tasy sports constitutes illegal gambling.

Do Fantasy Sports Constitute Gambling under State Law? To gamble is to play a game of chance or bet on the outcome of an uncertain event in the hope gamble is to play a game of chance or bet on the outcome of an uncertain event in the hope gamble of winning. State laws concerning the legality of gambling vary. Even in states where most forms of gambling are illegal, however, some activities that would otherwise fall within the definition of gambling are allowed.

Consideration, Reward, and Chance In most states, an activity constitutes gambling if it involves consideration, reward, and chance. Most courts construe consideration narrowly in this context, limiting it to money or valuable property exchanged for a chance to win a prize. Some courts apply the term more broadly to any form of legal detriment exchanged for a chance to win.

A reward is the prize for winning. Courts generally hold that the reward, or prize, must be reward is the prize for winning. Courts generally hold that the reward, or prize, must be reward something tangible, regardless of its value.1

Chance requires that an activity’s outcome be determined unpredictably by factors outside a Chance requires that an activity’s outcome be determined unpredictably by factors outside a Chance participant’s control, not by judgment, practice, or skill. Most states deem an activity to involve chance if greater than 50 percent of the outcome is determined by outside factors.

Entry Fees, Prizes, and Skill In states that apply these three elements to determine whether an activity constitutes gambling, the lack of any one of them argues in favor of an activity’s law- fulness. For example, fantasy sports leagues that offer free entry for participants lack the element of consideration. Games that do not include prizes lack the element of reward.

Other fantasy sports games are not so clearly legal. For example, a game that extends for less than a full professional sports season involves a greater degree of chance and is thus less likely to qualify as legal.2 The shorter the time, the less opportunity a participant’s skill has to offset such factors as a player’s health, the decisions of a team manager or coach, and weather. There is also less time for participants to negotiate trades and manage their fantasy teams.

1. See, for example, State of Arkansas v. 26 Gaming Machines, 356 Ark. 47, 145 S.W.3d 368 (2004). 2. See Three Kings Holdings, L.L.C. v. Six, 45 Kan.App.2d 1043, 255 P.3d 1218 (2011).

U N I T T H R E E Application and Ethics

Stricter Standards The standards are stricter in some states. For example, states that apply the contract definition of consideration—something of legally sufficient value—to fantasy sports games will not exempt a game simply because there is no entry fee.

Some states interpret the element of chance to involve any chance. In those states, all fantasy any chance. In those states, all fantasy any sports games violate gambling laws. Other states have indicated or expressly stated that the games are illegal.3

Does Federal Law Define Fantasy Sports as Gambling? Most federal laws related to gambling were enacted to help states enforce their gambling laws. There are, however, at least two federal acts that may apply to fantasy sports.

“Wagering Schemes” The professional sports industry lobbied Congress to enact the Profes- sional and Amateur Sports Protection Act (PAPSA)4 in 1992. This act prohibits, with certain exceptions, the operation of a “wagering scheme” based on a game in which “professional or amateur athletes participate.”

It is not likely that PAPSA would apply to fantasy sports generally—most professional sports leagues operate their own fantasy sports Web sites and endorse seasonal play. But the act could apply to daily fantasy sports games—games played over a brief period, such as a week or a single daily fantasy sports games—games played over a brief period, such as a week or a single daily day, rather than an entire sports season. Their sponsors emphasize payouts and prizes, giving daily games the appearance of “wagering schemes.”

Skill of the Participants The Unlawful Internet Gambling Enforcement Act (UIGEA) of 20065 prohibits persons “engaged in the business of betting” to “knowingly accept” funds “in connection with the participation of another person in unlawful Internet gambling.” Under the act, “unlawful Internet gambling” is knowingly transmitting a bet, via the Internet, if the bet is otherwise illegal where it is “initiated, received, or . . . made.” In other words, if a person places a bet in a state in which gambling is illegal, a business that accepts the bet violates the UIGEA, regardless of the business’s location.6

The UIGEA exempts fantasy sports games in which, among other requirements, the “out- comes reflect the relative knowledge and skill of the participants and are determined predomi- nantly by the performance of individuals . . . in multiple real-world sporting events.” It is likely that daily fantasy sports games do not meet this requirement. Their short duration decreases the daily fantasy sports games do not meet this requirement. Their short duration decreases the daily effect of a participant’s skill and increases the effect of luck on the result.

Daily Fantasy Sports—Skill or Gamble? DraftKings and FanDuel operate daily fantasy sports (DFS) Web sites. In the fall of 2015, the two companies saturated the media with advertising, emphasizing million-dollar payouts. Then, in early October, DraftKings employee Brian Haskell allegedly used inside information to beat more than 200,000 other participants and win $350,000 in a game on FanDuel’s site. Draft- Kings denied the allegation. Both companies announced, “Nothing is more important . . . than the integrity of the games we offer to our customers.”

3. These states include Arizona, Iowa, Louisiana, Montana, and Washington. 4. 28 U.S.C. Sections 3701–3704. 5. 31 U.S.C. Sections 5361–5367. 6. See Interactive Media Entertainment and Gaming Association Inc. v. Attorney General of United States, 580 F.3d 113

(3d Cir. 2009).

U N I T T H R E E Application and EthicsU N I T T H R E E Application and Ethics

U N I T T H R E E

Before the end of the month, the Federal Bureau of Investigation and U.S. Department of Justice opened an investigation. ESPN announced that it would stop running segments spon- sored by DraftKings. The National Collegiate Athletic Association (NCAA) barred DraftKings and FanDuel from advertising at NCAA championship events and prohibited student athletes from participating in DFS. The National Football League limited the amount of money its players could win from DFS.

Meanwhile, a dozen states began considering new fantasy sports legislation. The Nevada Gaming Control Board ruled that DFS should be considered gambling and banned DFS sites from operating in the state. New York Attorney General Eric Schneiderman, characterizing DFS as games of chance rather than skill, ordered DraftKings and FanDuel to stop accepting “wagers” from New York residents.

Daily fantasy sports companies are engaged in illegal gambling . . . , causing the same kinds of social and economic harms as other forms of illegal gambling. . . . Daily fantasy sports is neither victimless nor harmless, and it is clear that DraftKings and FanDuel are the leaders of a massive, multi-billion-dollar scheme intended to evade the law and fleece sports fans across the country.7

Ethical Connection DraftKings and FanDuel contend that they are not taking bets—that the games on their sites involve more skill than luck. They have a legal right to argue this point in a New York state court on a challenge to the order of the state’s attorney general. And, in the best interest of their owners and customers, they may have an ethical duty to challenge the order.

In the meantime, do the two sites have an ethical duty to comply with the order? Or do they comply with the order? Or do they comply have an ethical obligation to defy the order to play to completion the games that New York defy the order to play to completion the games that New York defy residents started? The sites might thereby gain additional support for their argument to chal- lenge the attorney general. Or their open defiance might undercut any sympathy a court might have for their situation. It is a judgment call—an ethical gamble—and the question for the sites might be, “Do you feel lucky?”

Ethics Question Is gambling less ethical than trading in securities or funding a start-up? Why?

Critical Thinking What is the most significant factor in determining whether fantasy sports games constitute gambling? Explain.

7. Press Release, New York State Office of the Attorney General, A.G. Schneiderman Issues Cease-and-Desist Letters to FanDuel and DraftKings, Demanding That Companies Stop Accepting Illegal Wagers in New York State (Nov. 11, 2015) (http://www and DraftKings, Demanding That Companies Stop Accepting Illegal Wagers in New York State (Nov. 11, 2015) (http://www and DraftKings, Demanding That Companies Stop Accepting Illegal Wagers in New York State .ag.ny.gov/press-release/ag-schneiderman-issues-cease-and-desist-letters-fanduel-and-draftkings-demanding).

U N I T T H R E E Application and EthicsU N I T T H R E E Application and Ethics

Unit Four

�e Business and Employment Environment

16. Small Businesses and Franchises

17. Limited Liability Business Forms

18. Corporations

19. Agency Relationships

20. Employment Law

21. Employment Discrimination

22. Immigration and Labor Law

350

3. State tax registration (for instance, to obtain permits for collecting and remitting sales taxes).

4. Health and environmental permits. 5. Zoning and building codes. 6. Import/export regulations.

If the business has employees, the owner must also comply with a host of laws governing the workplace.

16–1b Protecting Intellectual Property Protecting rights in intellectual property is a central con- cern for many small businesses. For instance, software companies and app developers depend on their copy- rights and patents to protect their investments in the research and development required to create new pro- grams. Without copyright or patent protection, a com- petitor or a customer could simply copy the software or app.

Trademarks Choosing a trademark or service mark and making sure that it is protected under trademark law can be crucial to the success of a new business venture. Indeed, a factor to consider in choosing a name for a

16–1 General Considerations for Small Businesses

Most small businesses begin as sole proprietorships. Once the business is under way, the sole proprietorship form may become too limited. The owner and any additional investors may then want to establish a more formal orga- nization, such as a limited partnership (LP), a limited liability partnership (LLP), a limited liability company (LLC), or a corporation. These forms of business limit the owner’s personal liability, or legal responsibility, for business debts and obligations. Each business form has its own advantages and disadvantages, but legal limited liability generally is necessary for those who wish to raise outside capital.

16–1a Requirements for All Business Forms Any business, whatever its form, has to meet a vari- ety of legal requirements, which typically relate to the following: 1. Business name registration. 2. Occupational licensing.

A goal of many business students is to become an entrepreneur, one who initiates and assumes

the financial risk of a new business enterprise and undertakes to provide or control its management. One of the first decisions an entrepreneur must make is which form of business orga- nization will be most appropriate for the new endeavor.

In selecting an organizational form, the entrepreneur will consider a num-

ber of factors. These include (1) ease of creation, (2) the liability of the own- ers, (3) tax considerations, and (4) the ability to raise capital. Keep these fac- tors in mind as you read this unit and learn about the various forms of busi- ness organization. Remember, too, in considering these business forms that the primary motive of an entrepreneur is to make profits.

Traditionally, entrepreneurs have used three major business forms—the

sole proprietorship, the partnership, and the corporation. In this chapter, we examine sole proprietorships and partnerships. We also look at fran- chises. Although the franchise is not strictly speaking a business organiza- tional form, it is widely used today by entrepreneurs.

Small Businesses and Franchises

C H A P T E R 16

C H A P T E R 1 6 Small Businesses and Franchises 351

business entity is whether the business name will be used as a trademark. The general rule is that a trademark can- not be the same as another’s mark or so similar that confu- sion might result.

For the most protection, trademarks should be regis- tered with the U.S. Patent and Trademark Office (PTO). If the mark is federally registered, the owner may use the symbol ® with the mark. This well-known symbol puts others on notice of the registration and helps to prevent trademark infringement. An owner who has not regis- tered can use the symbol TM. Registration with the PTO should be renewed five years after the initial registration and at ten-year intervals thereafter.

Trade Secrets Much of the value of a small business may lie in its trade secrets, such as information about product development, production processes and tech- niques, and customer lists. Preserving the secrecy of the information is necessary for legal protection.

As a practical matter, trade secrets must be divulged to key employees. Thus, any business runs the risk that those employees might disclose the secrets to competitors—or even set up competing businesses themselves.

To protect their trade secrets, companies may require employees who have access to trade secrets to agree in their employment contracts never to divulge those secrets. A small business may also choose to include a covenant not to compete in an employment contract. A noncompete clause will help to protect against the pos- sibility that a key employee will go to work for a competi- tor or set up a competing business.

16–1c Obtaining Loans Raising capital is critical to the growth of most small businesses. In the early days of a business, the sole pro- prietor may be able to contribute sufficient capital, but as the business becomes successful, more funds may be needed. The owner may want to raise capital from exter- nal sources to expand the business. One way to do this is to borrow funds.

Obtaining a bank loan is beneficial for small businesses because it allows the owner to retain full ownership and control of the business. Note, though, that the bank may place some restrictions on future business decisions as a condition of granting the loan. In addition, bank loans may not be available for some businesses. Banks are usu- ally reluctant to lend significant sums to businesses that are not yet established. Even if a bank is willing to make

such a loan, the bank may require personal guaranty con- tracts from the owner, putting the owner’s personal assets at risk.

Loans with desirable terms may be available from the U.S. Small Business Administration (SBA). One SBA program provides loans of up to $25,000 to businessper- sons who are women, low-income individuals, or mem- bers of minority groups. Be aware that the SBA requires business owners to put some of their own funds at risk in the business. In addition, many states offer small- business grants to individuals starting a business.

16–2 Sole Proprietorships In the earliest stages, as mentioned, a small business may operate as a sole proprietorship, which is the simplest form of business. In this form, the owner is the business. Thus, anyone who does business without creating a sepa- rate business organization has a sole proprietorship. The law considers all new, single-owner businesses to be sole proprietorships unless the owner affirmatively adopts some other form.

More than two-thirds of all U.S. businesses are sole proprietorships. Sole proprietors can own and manage any type of business from an informal, home-office or Web-based undertaking to a large restaurant or construc- tion firm. About 99 percent of the sole proprietorships in the United States have revenues of less than $1 million per year.

16–2a Advantages of the Sole Proprietorship

A major advantage of the sole proprietorship is that the proprietor owns the entire business and receives all of the profits (because she or he assumes all of the risk). In addition, starting a sole proprietorship is easier and less costly than starting any other kind of business because few legal formalities are required. Generally, no docu- ments need to be filed with the government to start a sole proprietorship.1

1. Although starting a sole proprietorship involves fewer legal formalities than other business organizational forms, even a small sole proprietorship may need to comply with zoning requirements, obtain a state business license, and the like.

352 U N I T F O U R The Business and Employment Environment

Taxes A sole proprietor pays only personal income taxes (including Social Security and Medicare taxes) on the busi- ness’s profits. The profits are reported as personal income on the proprietor’s personal income tax return. In other words, the business itself need not file an income tax return. Sole proprietors are allowed to establish retirement accounts that are tax-exempt until the funds are withdrawn.

Like any form of business enterprise, a sole pro- prietorship can be liable for other taxes, such as those collected and applied to the disbursement of unemploy- ment compensation. Whether liability for the unpaid unemployment compensation taxes of a sole proprietor- ship remains with the seller or must be assumed by the buyer was at issue in the following case.

In the Language of the Court SIMPSON, Judge.SIMPSON, Judge.SIMPSON

* * * * [Julianne Gresh (Predecessor)] oper-

ated [Romper Room Day Care (Romper Room)], a childcare center, as a sole proprietorship for 12 years. Predecessor owed the [Pennsylvania Department of Labor and Industry Office of Unem- ployment Compensation Tax Services (Department)] substantial unpaid UC [unemployment compensation] contributions, interest and penalties. She admitted liability and entered pay- ment plans with the Department * * * . Pursuant to these payment plans, she made monthly payments in the minimal amount of $50. Predecessor was on the verge of losing her license to operate, and sought another entity to operate the location as a childcare facility.

[A. Gadley Enterprises, Inc. (Pur- chaser)] operated a childcare center, Young Environment Learning Center, in Erie, Pennsylvania. Purchaser decided to purchase assets from Predecessor in order to open a satellite location of Young Environmental Learning Center at the prior location of Romper Room. Pur- chaser and Predecessor executed an asset purchase agreement (Agreement).

Through the Agreement, Purchaser paid a total of $37,000 for Predecessor’s tangible and intangible assets. This total was comprised of $10,000 for the use of the name “Romper Room,” $10,790 for a covenant not to compete, and $17,210 for tangible assets listed on [an attached] Inventory List.

* * * The Inventory List did not include any of Predecessor’s personal

assets other than those used in the opera- tion of Romper Room.

* * * Four days after executing the after executing the after Agreement, * * * Predecessor notified the Department of the sale.

* * * The Department issued Pur- chaser a Notice of Assessment (Notice) in the amount of $43,370.49 for UC contributions, interest and penalties owed by Predecessor. The Notice stated Purchaser was liable because it purchased 51% or more of Predecessor’s assets.

In response, Purchaser filed a petition [with the Department] for reassessment.

* * * * Based on the evidence presented at

the hearing [held on the petition], the Department issued its decision and order denying the petition for reassessment.

* * * * Purchaser then filed a petition to

review to this Court. * * * * [43 Pennsylvania Statutes Section

788.3(a), part of the state’s Unemploy- ment Compensation Law] provides:

(a) Every employer * * * , who shall sell in bulk fifty-one percent or more of his assets, including but not lim- ited to, any stock of goods, wares or merchandise of any kind, fixtures, machinery, equipment, building or real estate, shall give the department ten (10) days’ notice of the sale prior to completion of the transfer * * * . The employer shall present to the purchaser of such property, a certifi- cate * * * showing that all reports have been filed and contributions, interest and penalties paid to the date of the proposed transfer. The failure of the

purchaser to require such certificate shall render such purchaser liable to the department for the unpaid contributions, interest and penalties.

* * * * There is no dispute that Purchaser

did not obtain a clearance certificate reflecting Predecessor’s payment of UC liability. There is also no dispute that Predecessor owed the Department for outstanding UC contributions, inter- est and penalties in the amount of $43,370.49 at the time of the sale.

* * * * Purchaser argues substantial evidence

does not support the Department’s find- ing that it purchased more than 51% of the [Predecessor’s] assets.

* * * * The Agreement establishes that the

Inventory List sets forth all business assets of Predecessor. Gresh confirmed the Inventory List was a complete list of assets used in the operation of her business.

The Inventory List reflects a total value of assets equaling $19,210. * * * The parties reduced the purchase price by $2,000 to account for the reduced value of the assets when Purchaser removed certain assets from the complete Inventory List. Purchaser acquired all the assets included in the Inventory List, other than those removed, for $17,210. The amount constitutes approximately 90% of the value of the complete list of assets ($19,210 × .9 = $17,289).

The Agreement, supplemented by corroborating [supporting] testimony,

Case Analysis 16.1 A. Gadley Enterprises, Inc. v. Department of Labor and Industry

. Gadley ndustry . Gadley

O . Gadley

ffice of Unemployment Compensation nterprises,

ffice of Unemployment Compensation nterprises, nc. v. Department of Labor and

ffice of Unemployment Compensation nc. v. Department of Labor and

Tax Services nc. v. Department of Labor and

ax Services nc. v. Department of Labor and

Commonwealth Court of Pennsylvania, __ A.3d __, 2016 WL 55591 (2016).

C H A P T E R 1 6 Small Businesses and Franchises 353

constitutes substantial evidence to sup- port the Department’s finding that the sale qualified as a bulk sale of more than 51% of Predecessor’s assets.

* * * * Purchaser also argues the Department

erred in construing the term “assets” in the bulk sales provision to include only business assets when determining whether a sale met the 51% threshold. Purchaser asserts the provision does not differentiate between business and per- sonal assets of an employer and there is no legal distinction when the employer is a sole proprietor.

* * * * * * * The definition of “employer” [in

the UC Law] includes a sole proprietor like Predecessor.

The word “assets” is not defined in the [UC] Law.

[In Section 788.3(a)] the term “assets” precedes a list of examples, fol- lowed by the phrase “including but not limited to.”

* * * * * * * The examples * * * indicate

that the term “assets” refers to business

assets. This conclusion is buttressed [reinforced] by the context of the statute as a whole, which pertains to employers operating businesses and paying employ- ees as part of their business operations.

The factual circumstances surround-The factual circumstances surround-The factual circumstances surround ing the sale also indicate the term “assets” means “business assets.” Here, the context is the sale of a business, in the childcare industry, to another business engaged in the same industry that intends to operate a childcare facility at the location of the former business. The Agreement reflects the intention of the parties that Purchaser would operate the childcare facility as a satellite location. [Emphasis added.]

* * * * * * * The provision does not treat

sole proprietors differently than other employers. The provision contains no exemption of liability for a purchaser when an employer operates as a sole proprietorship. Nor does it contain an exemption from liability when the for- mer employer entered a repayment plan with the Department.

Moreover, Purchaser’s interpretation does not consider the purpose of the bulk

sales provision. That purpose is to ensure an employer does not divest itself of assets without satisfying outstanding liabilities, either itself or by the purchaser. This Court agrees with the Department that Gresh’s repayment agreement in the minimal amount of $50 per month does not sat- isfy the UC liability. [Emphasis added.]

* * * * In sum, the Department’s construc-

tion of assets as business assets is reason- able and consistent with the context and purpose of [the] bulk sales provision. Purchaser’s failure to obtain a clearance certificate rendered it liable for Predeces- sor’s unpaid UC contributions, interest and penalties, regardless of Predecessor’s repayment agreement. Therefore, this Court upholds the Department’s inter- pretation of the bulk sales provision.

* * * * * * * For the foregoing reasons, we

affirm the Department.

Case 16.1 Continued

Legal Reasoning Questions

1. As is clear from the law applied in this case, and the result, the liability of a business for unpaid taxes “follows the assets.” Why? 2. What action can Gadley take now to avoid suffering the loss of the funds required to cover Gresh’s unpaid taxes? 3. What action should a buyer take before purchasing the assets of a business to avoid liability for the seller’s unpaid taxes?before purchasing the assets of a business to avoid liability for the seller’s unpaid taxes?before

Flexibility A sole proprietorship offers more flexibil- ity than does a partnership or a corporation. The sole proprietor is free to make any decision she or he wishes concerning the business—including what kind of busi- ness to pursue, whom to hire, and when to take a vaca- tion. The sole proprietor can sell or transfer all or part of the business to another party at any time without seeking approval from anyone else. In contrast, approval is typi- cally required from partners in a partnership and from shareholders in a corporation.

16–2b Disadvantages of the Sole Proprietorship

The major disadvantage of the sole proprietorship is that the proprietor alone bears the burden of any losses

or liabilities incurred by the business enterprise. In other words, the sole proprietor has unlimited liabil- ity for all obligations that arise in doing business. Any lawsuit against the business or its employees can lead to unlimited personal liability for the owner of a sole proprietorship.

■ EXAMPLE 16.1 Aaron and Melissa Klein, owners Aaron and Melissa Klein, owners of the Sweet Cakes by Melissa bakery, refused to bake a wedding cake for a same-sex couple’s wedding. They claimed that their religious beliefs did not allow them to provide services for same-sex ceremonies. The Oregon State Bureau of Labor and Industries argued that their decision violated the law. In 2015, an administrative law judge ruled against the Kleins’ motion to dismiss and ordered them to pay $135,000 in damages. As sole pro- prietors, the Kleins were personally responsible for pay- ing the damages. ■Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

354 U N I T F O U R The Business and Employment Environment

Personal Assets at Risk Creditors can pursue the owner’s personal assets to satisfy any business debts. Although sole proprietors may obtain insurance to pro- tect the business, liability can easily exceed policy limits. This unlimited liability is a major factor to be considered in choosing a business form.in choosing a business form.in choosing a business form.in choosing a business form.

■ EXAMPLE 16.2 Sheila Fowler operates a golf shop near a world-class golf course as a sole proprietorship. One of Fowler’s employees fails to secure a display of golf clubs. They fall on Dean Maheesh, a professional golfer, and seriously injure him. If Maheesh sues Fowler’s shop and wins, Fowler’s personal liability could easily exceed the limits of her insurance policy. Fowler could lose not only her business, but also her house, car, and any other per- sonal assets that can be attached to pay the judgment. ■

Lack of Continuity and Limited Ability to Raise Capital The sole proprietorship also has the disadvantage of lacking continuity after the death of the proprietor. When the owner dies, so does the business—it is automatically dissolved.

Another disadvantage is that in raising capital, the proprietor is limited to his or her personal funds and any loans that he or she can obtain for the business. Lenders may be unwilling to make loans to sole propri- etorships, particularly start-ups, because the sole pro- prietor risks unlimited personal liability and may not be able to pay. (See this chapter’s Digital Update feaDigital Update feaDigital Update - ture for a discussion of one court’s refusal to discharge a loan made to a sole proprietor who had declared bankruptcy.)

A Sole Proprietorship, Facebook Poker, and Bankruptcy

One major downside of a sole proprietorship is that it is more difficult for a sole proprietor to obtain funding for start-up and expansion. Moreover, if funding is obtained through loans, the sole proprietor is exposed to per- sonal liability.

Personal Liability Exposure for an Online Start-up

A case in point went before the United States bank- ruptcy court in Massachusetts in 2015.a Michael Dewhurst, living in Raynham, Massachusetts, some- times did computer work for Gerald Knappik. Dewhurst decided to start a new business venture—the commer- cial development of a Facebook poker–playing applica- tion. Dewhurst envisioned an application that would enable multiple individuals to play poker together over the Internet through Facebook. Dewhurst informed Knappik of his business plan and predicted that his Facebook poker application “was going to be some- thing very big.”

Knappik initially loaned $50,000 to Dewhurst for the project. The loan agreement stated, “The sole purpose of this loan agreement is to provide funds on a personal level for the startup of said business project, in con- junction with borrower’s personal funds, not limited to startup costs, operating expenses, advertising costs.”

That was the first of a series of personal loans that totaled $220,000.

Dewhurst had repaid only $9,000 on the total outstanding debt when he filed for bankruptcy. Ultimately, the bankruptcy court ascertained that at least $120,000 of the loans that were supposed to be used exclusively for the Facebook poker project had been used for

other activities. Furthermore, Dewhurst kept “no con- temporaneous records of his disbursements and uses of this cash, no cash journal, ledger, or disbursement slips of any kind.”

The Lender Objects to a Bankruptcy Discharge of Monies Owed

During bankruptcy proceedings, Knappik requested that the bankruptcy court deny discharge of Dewhurst’s debts to him. Upon review, the court stated that “Dewhurst’s failure to keep and preserve adequate records makes it impossible to reconstruct an accurate and complete account of financial affairs and business transactions.” The bankruptcy judge ultimately denied discharge of $120,000 of the debt owed to Knappik. Thus, a sole proprietor’s failed attempt to create an online poker-playing application led to personal liability even after he had filed for bankruptcy.

Critical Thinking Sole proprietorships, as well as other businesses, routinely seek funding for online projects. How can the individuals involved avoid personal liability?

DIGITAL UPDATE

a. In re Dewhurst, 528 Bankr. 211 (D.Mass. 2015).In re Dewhurst, 528 Bankr. 211 (D.Mass. 2015).In re Dewhurst

C H A P T E R 1 6 Small Businesses and Franchises 355

16–3 Partnerships A partnership arises from an agreement, express or implied, between two or more persons to carry on a busi- ness for a profit. Partners are co-owners of the business and have joint control over its operation and the right to share in its profits. The traditional form of partnership discussed in this chapter is commonly referred to as a general partnership now that limited liability forms of partnership exist.

16–3a Basic Partnership Concepts Partnerships are governed both by common law con- cepts—in particular, those relating to agency—and by statutory law. As in so many other areas of business law, the National Conference of Commissioners on Uniform State Laws has drafted uniform laws for partnerships, and these have been widely adopted by the states.

Agency Concepts and Partnership Law When two or more persons agree to do business as partners, they enter into a special relationship with one another. Each partner is deemed to be the agent of the other partners and of the partnership, similar to an agency relationship (to be discussed in another chapter). Thus, agency con- cepts apply. For instance, a partner is presumed to know about and is responsible for acts carried out by another partner within the scope of the partnership relationship. In their relationships with one another, partners, like agents, are bound by fiduciary ties.

In one important way, however, partnership law dif-In one important way, however, partnership law dif-In one important way, however, partnership law dif fers from agency law. The partners in a partnership agree to commit funds or other assets, labor, and skills to the business with the understanding that profits and losses will be shared. Thus, each partner has an ownership inter- est in the firm. In a nonpartnership agency relationship, est in the firm. In a nonpartnership agency relationship, est the agent usually does not have an ownership interest in the business and is not obligated to bear a portion of ordinary business losses.

The Uniform Partnership Act The Uniform Part- nership Act (UPA) governs the operation of partnerships in the absence of express agreement and has done much to reduce the absence of express agreement and has done much to reduce the absence of express agreement controversies in the law relating to partnerships. A major- ity of the states have enacted the most recent version of the UPA (introduced in 1997 and last amended in 2013).

Definition of a Partnership The UPA defines a partnership as “an association of two or more persons to carry on as co-owners a business for profit” [UPA 102(11)].

Note that the UPA’s definition of person includes corpora- tions, so a corporation can be a partner in a partnership [UPA 102(11)]. The intent to associate is a key element of intent to associate is a key element of intent a partnership, and one cannot join a partnership unless all other partners consent [UPA 401(i)].

Essential Elements of a Partnership Conflicts sometimes arise over whether a business enterprise is a legal partnership, especially when there is no formal, written partnership agreement. To determine whether a partnership exists, courts usually look for the following three essential elements, which are implicit in the UPA’s definition: 1. A sharing of profits and losses. 2. A joint ownership of the business. 3. An equal right to be involved in the management of

the business. If the evidence in a particular case is insufficient to estab- lish all three factors, the UPA provides a set of guidelines to be used.

The Sharing of Profits and Losses. �e sharing of both pro�ts and losses from a business creates a presumption that a partnership exists. ■ EXAMPLE 16.3 Syd and Drake start a business that sells fruit smoothies near a college campus. �ey open a joint bank account, from which they pay for supplies and expenses, and they share the proceeds (and losses) that the smoothie stand gener- ates. If a con�ict arises as to their business relationship, a court will assume that a partnership exists unless the par- ties prove otherwise. ■

A court will not presume that a partnership exists, however, if shared profits were received as payment of any of the following [UPA 202(c)(3)]: 1. A debt by installments or interest on a loan. 2. Wages of an employee or for the services of an inde-

pendent contractor. 3. Rent to a landlord. 4. An annuity to a surviving spouse or representative of

a deceased partner. 5. A sale of the goodwill (the valuable reputation of a

business viewed as an intangible asset) of a business or property.

■ EXAMPLE 16.4 A debtor, Mason Snopel, owes a creditor, Alice Burns, $5,000 on an unsecured debt. They agree that Mason will pay 10 percent of his monthly business profits to Alice until the loan with interest has been repaid. Although Mason and Alice are sharing profits from the business, they are not presumed to be partners. ■

356 U N I T F O U R The Business and Employment Environment

Joint Property Ownership. Joint ownership of property does not in and of itself create a partnership [UPA 202(c) (1) and (2)]. �e parties’ intentions are key. ■ EXAMPLE 16.5 Chiang and Burke jointly own farmland and lease it to a farmer for a share of the pro�ts from the farming operation in lieu of �xed rental payments. �is arrange- ment normally would not make Chiang, Burke, and the farmer partners. ■

Entity versus Aggregate At common law, a part- nership was treated only as an aggregate of individuals and never as a separate legal entity. Thus, at common law a lawsuit could never be brought by or against the firm in its own name. Each individual partner had to sue or be sued.

Today, in contrast, a majority of the states follow the UPA and treat a partnership as an entity for most purposes. For instance, a partnership usually can sue or be sued, col- lect judgments, and have all accounting performed in the name of the partnership entity [UPA 201, 307(a)].

As an entity, a partnership may hold the title to real or personal property in its name rather than in the names of the individual partners. Additionally, federal procedural laws permit the partnership to be treated as an entity in suits in federal courts and bankruptcy proceedings.

Tax Treatment of Partnerships Modern law does treat a partnership as an aggregate of the individual partners rather than a separate legal entity in one situa- tion—for federal income tax purposes. The partnership is a pass-through entity and not a taxpaying entity. A pass- through entity is a business entity that has no tax liabilthrough entity is a business entity that has no tax liabilthrough entity - ity. The entity’s income is passed through to the owners, who pay income taxes on it.

Thus, the income or losses the partnership incurs are “passed through” the entity framework and attributed to the partners on their individual tax returns. The part- nership itself pays no taxes and is responsible only for filing an information return with the Internal Revenue Service.

A partner’s profit from the partnership (whether dis- tributed or not) is taxed as individual income to the indi- vidual partner. Similarly, partners can deduct a share of the partnership’s losses on their individual tax returns (in proportion to their partnership interests).

16–3b Formation and Operation A partnership is a voluntary association of individuals. As such, it is formed by the agreement of the partners. As a general rule, agreements to form a partnership can

be oral, written, or implied by conduct. Some partnership agreements, however, such as one authorizing partners to transfer interests in real property, must be in writing to be legally enforceable.

A partnership agreement, also known as articles of partnership, can include almost any terms that the parties wish, unless they are illegal or contrary to public policy or statute [UPA 103]. The provisions commonly specify the amount of capital that each partner is contributing, and the percentage of the profits and losses of the business that each partner will receive.

The rights and duties of partners are governed largely by the specific terms of their partnership agreement. In the absence of provisions to the contrary in the partner- ship agreement, the law imposes certain rights and duties, as discussed in the following subsections. The character and nature of the partnership business generally influ- ence the application of these rights and duties.

Duration of the Partnership The partnership agreement can specify the duration of the partnership by stating that it will continue until a designated date or until the completion of a particular project. This is called a part-part-part nership for a term. Generally, withdrawing from a partner- ship for a term prematurely (before the expiration date) constitutes a breach of the agreement, and the responsible partner can be held liable for any resulting losses [UPA 602(b)(2)]. If no fixed duration is specified, the partner- ship is a partnership at will. A partnership at will can be dissolved at any time without liability.

Partnership by Estoppel When a third person has reasonably and detrimentally relied on the representation that a nonpartner was part of a partnership, a court may conclude that a partnership by estoppel exists.

Liability Imposed. A partnership by estoppel may arise when a person who is not a partner holds himself or herself out as a partner and makes representations that third parties rely on. In this situation, a court may impose liability—but not partnership rights—on the alleged partner.

Nonpartner as Agent. A partnership by estoppel may also be imposed when a partner represents, expressly or impliedly, that a nonpartner is a member of the �rm. In this situation, the nonpartner may be regarded as an agent whose acts are binding on the partnership [UPA 308].whose acts are binding on the partnership [UPA 308].whose acts are binding on the partnership [UPA 308].whose acts are binding on the partnership [UPA 308].

■ CASE IN POINT 16.6 Jackson Paper Manufactur- ing Company made paper used by Stonewall Packaging, LLC. Jackson and Stonewall had officers and directors

C H A P T E R 1 6 Small Businesses and Franchises 357

in common, and they shared employees, property, and equipment. In reliance on Jackson’s business reputa- tion, Best Cartage, Inc., agreed to provide transportation services for Stonewall and bought thirty-seven tractor- trailers to use in fulfilling the contract. Best provided the services until Stonewall terminated the agreement.

Best filed a suit for breach of contract against Stone- wall and Jackson, seeking $500,678 in unpaid invoices and consequential damages of $1,315,336 for the tractor- trailers it had purchased. Best argued that Stonewall and Jackson had a partnership by estoppel. The court agreed, finding that “defendants combined labor, skills, and property to advance their alleged business partnership.” Jackson had negotiated the agreement on Stonewall’s behalf. Jackson also had bought real estate, equipment, and general supplies for Stonewall with no expectation that Stonewall would repay these expenditures. This was sufficient to prove a partnership by estoppel.2 ■

Rights of Partners The rights of partners in a part- nership relate to the following areas: management, inter- est in the partnership, compensation, inspection of books, accounting, and property.

Management Rights. In a general partnership, all part- ners have equal rights in managing the partnership [UPA 401(f )]. Unless the partners agree otherwise, each part- ner has one vote in management matters regardless of the proportional size of his or her interest in the �rm. In a large partnership, partners often agree to delegate daily man- agement responsibilities to a management committee made up of one or more of the partners.

The majority rule controls decisions on ordinary matters connected with partnership business, unless otherwise specified in the agreement. Decisions that sig- nificantly change the nature of the partnership or that are outside the ordinary course of the partnership business, however, require the unanimous consent of the partners unanimous consent of the partners unanimous [UPA 301(2), 401(i), 401(j)]. For instance, unanimous consent is likely required for a partnership to admit new partners, to amend the partnership agreement, or to enter a new line of business.

Interest in the Partnership. Each partner is entitled to the proportion of business pro�ts and losses that is speci�ed in the partnership agreement. If the agreement does not apportion pro�ts (indicate how the pro�ts will be shared), the UPA provides that pro�ts will be shared

2. Best Cartage, Inc. v. Stonewall Packaging, LLC, 219 N.C.App. 429, 727 Best Cartage, Inc. v. Stonewall Packaging, LLC, 219 N.C.App. 429, 727 Best Cartage, Inc. v. Stonewall Packaging, LLC S.E.2d 291 (2012).

equally. If the agreement does not apportion losses, losses will be shared in the same ratio as pro�ts [UPA 401(b)].

■ EXAMPLE 16.7 The partnership agreement between Rick and Brett provides for capital contributions of $60,000 from Rick and $40,000 from Brett. If the agree- ment is silent as to how Rick and Brett will share profits or losses, they will share both profits and losses equally.

In contrast, if the agreement provides for profits to be shared in the same ratio as capital contributions, 60 per- cent of the profits will go to Rick, and 40 percent will go to Brett. Unless the agreement provides otherwise, losses will be shared in the same ratio as profits. ■

Compensation. Devoting time, skill, and energy to part- nership business is a partner’s duty and generally is not a compensable service. Rather, as mentioned, a partner’s income from the partnership takes the form of a distribu- tion of pro�ts according to the partner’s share in the busi- ness. Partners can, of course, agree otherwise.

Inspection of the Books. Partnership books and records must be kept accessible to all partners. Each partner has the right to receive full and complete information con- cerning the conduct of all aspects of partnership busi- ness [UPA 403]. The partnership books must be kept at the firm’s principal business office (unless the partners agree otherwise). Every partner is entitled to inspect all books and records on demand and can make copies of the materials.

Accounting of Partnership Assets or Profits. An accounting of partnership assets or pro�ts is required to determine the value of each partner’s share in the partner- ship. An accounting can be performed voluntarily, or it can be compelled by court order. Under UPA 405(b), a partner has the right to bring an action for an accounting during the term of the partnership, as well as on the part- nership’s dissolution.

Property Rights. Property acquired by a partnership is by a partnership is by the property of the partnership and not of the partners individually [UPA 203]. Partnership property includes all property that was originally contributed to the partner- ship and anything later purchased by the partnership or in the partnership’s name (except in rare circumstances) [UPA 204].

A partner may use or possess partnership property only on behalf of the partnership [UPA 401(g)]. A part- ner is not a co-owner of partnership property and has no not a co-owner of partnership property and has no not right to sell, mortgage, or transfer partnership property to another [UPA 501].

358 U N I T F O U R The Business and Employment Environment

Background and Facts Walter Salmon negotiated a twenty-year lease for the Hotel Bristol in New York City. To pay for the conversion of the building into shops and offices, Salmon entered into an agreement with Morton Meinhard to assume half of the cost. They agreed to share the profits and losses from the joint venture. (A joint venture is similar to a partnership but typically is created for a joint venture is similar to a partnership but typically is created for a joint venture single project.) Salmon was to have the sole power to manage the building, however.

Less than four months before the end of the lease term, the building’s owner, Elbridge Gerry, approached Salmon about a project to raze the converted structure, clear five adjacent lots, and con- struct a single building across the whole property. Salmon agreed and signed a new lease in the name of his own business, Midpoint Realty Company, without telling Meinhard. When Meinhard learned of the deal, he filed a suit in a New York state court against Salmon. The court ruled in Meinhard’s favor, and Salmon appealed.

In the Language of the Court CARDOZO, C.J. [Chief Justice]

* * * * Joint adventurers, like copartners, owe to one another, while the enterprise continues, the duty of the

finest loyalty. Many forms of conduct permissible in a work-a-day world for those acting at arm’s length are forbidden to those bound by fiduciary ties. * * * Not honesty alone, but the punctilio [strictness in observance of details] of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate [entrenched]. Uncompromising rigidity has been the attitude of courts * * * when petitioned to undermine the rule of undivided loyalty.

* * * The trouble about [Salmon’s] conduct is that he excluded his coadventurer from any chance to compete, from any chance to enjoy the opportunity for benefit.

* * * The very fact that Salmon was in control with exclusive powers of direction charged him the more obviously with the duty of disclosure, [because] only through disclosure could opportunity be equalized.

Classic Case 16.2 Meinhard v. Salmon Court of Appeals of New York, 249 N.Y. 458, 164 N.E. 545 (1928).

16–3c Duties and Liabilities of Partners The duties and liabilities of partners are derived from agency law. Each partner is an agent of every other part- ner and acts as both a principal and an agent in any business transaction within the scope of the partnership agreement.

Each partner is also a general agent of the partnership in carrying out the usual business of the firm “or business of the kind carried on by the partnership” [UPA 301(1)]. Thus, every act of a partner concerning partnership busi- ness and “business of the kind” and every contract signed in the partnership’s name bind the firm.

Fiduciary Duties The fiduciary duties that a partner owes to the partnership and to the other partners are the duty of care and the duty of loyalty [UPA 404(a)]. Under

the UPA, a partner’s duty of care is limited to refraining duty of care is limited to refraining duty of care from “grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law” [UPA 404(c)]. A partner is not liable to the partnership for simple neg- ligence or honest errors in judgment in conducting part- nership business.

The duty of loyalty requires a partner to account to the duty of loyalty requires a partner to account to the duty of loyalty partnership for “any property, profit, or benefit” derived by the partner in the conduct of the partnership’s busi- ness or from the use of its property. A partner must also refrain from competing with the partnership in busi- ness or dealing with the firm as an adverse party [UPA 404(b)].

The duty of loyalty can be breached by self-dealing, misusing partnership property, disclosing trade secrets, or usurping a partnership business opportunity. The fol- lowing case is a classic example.

C H A P T E R 1 6 Small Businesses and Franchises 359

* * * Authority is, of course, abundant that one partner may not appropriate to his own use a renewal of a lease, though its term is to begin at the expiration of the partnership. The lease at hand with its many changes is not strictly a renewal. Even so, the standard of loyalty for those in trust relations is without the fixed divisions of a graduated scale. * * * A man obtaining [an] * * * opportunity * * * by the position he occupies as a partner is bound by his obligation to his copartners in such dealings not to separate his interest from theirs, but, if he acquires any benefit, to communicate it to them. Certain it is also that there may be no abuse of special opportunities growing out of a special trust as manager or agent. [Emphasis added.]

* * * Very likely [Salmon] assumed in all good faith that with the approaching end of the venture he might ignore his coadventurer and take the extension for himself. He had given to the enterprise time and labor as well as money. He had made it a success. Meinhard, who had given money, but neither time nor labor, had already been richly paid. * * * [But] Salmon had put himself in a position in which thought of self was to be renounced, however hard the abnegation [self-denial]. He was much more than a coadventurer. He was a managing coadventurer. For him and for those like him the rule of undivided loyalty is relentless and supreme.

Decision and Remedy The Court of Appeals of New York held that Salmon had breached his fiduciary duty by failing to inform Meinhard of the business opportunity and secretly taking advantage of it himself. The court granted Meinhard an interest “measured by the value of half of the entire lease.”

Impact of This Case on Today’s Law This classic case involved a joint venture, not a partnership. At the time, a member of a joint venture had only the duty to refrain from actively subverting the rights of the other members. The decision in this case imposed the highest standard of loyalty on joint-venture members. The duty is now the same in both joint ventures and partnerships. Courts today frequently quote the elo- quent language used in this opinion when describing the standard of loyalty that applies to partnerships.

Critical Thinking • What If the Facts Were Different? Suppose that Salmon had disclosed Gerry’s proposal to Meinhard,

who had said that he was not interested. Would the result in this case have been different? Explain.

Case 16.2 Continued

Waiver of Fiduciary Duties A partner’s fiduciary duties may not be waived or eliminated in the partnership agreement. In fulfilling them, each partner must act con- sistently with the obligation of good faith and fair dealing [UPA 103(b), 404(d)]. The agreement can specify acts that the partners agree will violate a fiduciary duty.

Note that a partner may pursue his or her own inter- ests without automatically violating these duties [UPA 404(e)]. The key is whether the partner has disclosed the interest to the other partners. ■ EXAMPLE 16.8 Jayne Trell, a partner at Jacoby & Meyers, owns a shopping mall. Trell may vote against a partnership proposal to open a competing mall, provided that she has fully dis- closed her interest in the existing shopping mall to the other partners at the firm. ■ A partner cannot make secret profits or put self-interest before his or her duty to the interest of the partnership, however.

Authority of Partners The UPA follows general principles of agency law that pertain to a partner’s author- ity to bind a partnership in contract. If a partner acts within the scope of her or his authority, the partnership

is legally bound to honor the partner’s commitments to third parties. A partner may also subject the partnership to tort liability under agency principles.

A partnership may limit a partner’s capacity to act as the firm’s agent or transfer property on its behalf by fil- ing a “statement of partnership authority” in a designated state office [UPA 105, 303]. Such limits on a partner’s authority normally are effective only with respect to third parties who are notified of the limitation.

�e extent of implied authority generally is broader for partners than for ordinary agents. In an ordinary partner- ship, the partners can exercise all implied powers reason- ably necessary and customary to carry on that particular business. Some customarily implied powers include the authority to make warranties on goods in the sales business and the power to enter into contracts consistent with the firm’s regular course of business.

Liability of Partners One significant disadvan- tage associated with a traditional partnership is that the partners are personally liable for the debts of the partnerpersonally liable for the debts of the partnerpersonally - ship. In most states, the liability is essentially unlimited,

360 U N I T F O U R The Business and Employment Environment

because the acts of one partner in the ordinary course of business subject the other partners to personal liability [UPA 305]. Note that normally the partnership’s assets must be exhausted before creditors can reach the partners’ individual assets, however.

Joint Liability. Each partner in a partnership generally is jointly liable for the partnership’s obligations. Joint lia- bility means that a third party must sue all of the partners bility means that a third party must sue all of the partners bility as a group, but each partner can be held liable for the full amount.3 If, for instance, a third party sues one partner on a partnership contract, that partner has the right to demand that the other partners be sued with her or him. In fact, if the third party does not name all of the partners in the lawsuit, the assets of the partnership cannot be used to satisfy the judgment.

Joint and Several Liability. In the majority of the states, under UPA 306(a), partners are both jointly and sever- ally (separately, or individually) liable for all partnership obligations. Joint and several liability means that a third Joint and several liability means that a third Joint and several liability party has the option of suing all of the partners together (jointly) or one or more of the partners separately (sever- ally). All partners in a partnership can be held liable even if a particular partner did not participate in, know about, or ratify the conduct that gave rise to the lawsuit.

A judgment against one partner severally (separately) does not extinguish the others’ liability. (Similarly, a release of one partner does not discharge the partners’ several liability.) Those not sued in the first action nor- mally may be sued subsequently, unless the court in the first action held that the partnership was in no way liable. If a plaintiff is successful in a suit against a partner or partners, he or she may collect on the judgment only against the assets of those partners named as defendants.

Indemnification. With joint and several liability, a partner who commits a tort can be required to indem- nify (reimburse) the partnership for any damages it pays. Indemni�cation will typically be granted unless the tort unless the tort unless was committed in the ordinary course of the partnership’s business.

■ EXAMPLE 16.9 Nicole Martin, a partner at Patti’s Café, is working in the café’s kitchen one day when her young son suffers serious injuries to his hands from a dough press. Her son, through his father, files a negli- gence lawsuit against the partnership. Even if the suit is successful and the partnership pays damages to Martin’s

3. Under the prior version of the UPA, partners were subject to joint liabil- ity on partnership debts and contracts, but not on partnership debts arising from torts.

son, the firm is not entitled to indemnification. Mar- tin would not be required to indemnify the partnership because her negligence occurred in the ordinary course of the partnership’s business (making food for customers). ■

Liability of Incoming Partners. A partner newly admit- ted to an existing partnership is not personally liable for any partnership obligations incurred before the person before the person before became a partner [UPA 306(b)]. In other words, the new partner’s liability to existing creditors of the partnership is limited to her or his capital contribution to the �rm.

■ EXAMPLE 16.10 Smartclub, an existing partnership with four members, admits a new partner, Alex Jaff. He contributes $100,000 to the partnership. Smartclub has debts amounting to $600,000 at the time Jaff joins the firm. Although Jaff ’s capital contribution of $100,000 can be used to satisfy Smartclub’s obligations, Jaff is not personally liable for partnership debts incurred before he became a partner. If, however, the partnership incurs additional debts after Jaff becomes a partner, he will be personally liable for those amounts, along with all the other partners. ■

16–3d Dissociation and Termination Dissociation occurs when a partner ceases to be associ- ated in the carrying on of the partnership business. Dis- sociation normally entitles the partner to have his or her interest purchased by the partnership. It also terminates the partner’s actual authority to act for the partnership and to participate in running its business.

Once dissociation occurs, the partnership may con- tinue to do business without the dissociated partner.4 If the partners no longer wish to (or are unable to) con- tinue the business, the partnership may be terminated (dissolved).

Events That Cause Dissociation Under UPA 601, a partner can be dissociated from a partnership in any of the following ways: 1. By the partner’s voluntarily giving notice of an

“express will to withdraw.” (When a partner gives notice of intent to withdraw, the remaining part- ners must decide whether to continue the partner- ship business. If they decide not to continue, the

4. Under the previous version of the UPA, when a partner withdrew from a partnership, the partnership was considered dissolved, and the busi- ness had to end. The new UPA dramatically changed the law governing partnership breakups by no longer requiring that a partnership end if one partner dissociates.

C H A P T E R 1 6 Small Businesses and Franchises 361

voluntary dissociation of a partner will dissolve the firm [UPA 801(1)].)

2. By the occurrence of an event specified in the part- nership agreement.

3. By a unanimous vote of the other partners under cer- tain circumstances, such as when a partner transfers substantially all of her or his interest in the partnership.

4. By order of a court or arbitrator if the partner has engaged in wrongful conduct that affects the part- nership business. The court can order dissociation if a partner breached the partnership agreement or violated a duty owed to the partnership or to the other partners. Dissociation may also be ordered if the partner engaged in conduct that makes it “not reasonably practicable to carry on the business in partnership with the partner” [UPA 601(5)].

5. By the partner’s declaring bankruptcy, assigning his or her interest in the partnership for the benefit of creditors, or becoming physically or mentally inca- pacitated, or by the partner’s death.

Wrongful Dissociation A partner has the power to dissociate from a partnership at any time, but she or he may not have the right to do so. If the partner lacks the right to dissociate, then the dissociation is considered wrongful under the law [UPA 602]. When a partner’s dis- sociation breaches the terms of a partnership agreement, for instance, it is wrongful.

A partner who wrongfully dissociates is liable to the partnership and to the other partners for damages caused by the dissociation. This liability is in addition to any other obligation of the partner to the partnership or to the other partners.

Effects of Dissociation Dissociation (rightful or wrongful) terminates some of the rights of the dissociated partner and requires that the partnership purchase his or her interest. It also alters the liability of the parties to third parties.

On a partner’s dissociation, his or her right to partici- pate in the management and conduct of the partnership business terminates [UPA 603]. The partner’s duty of loyalty also ends. A partner’s duty of care continues only with respect to events that occurred before dissociation, unless the partner participates in winding up the partner- ship’s business (discussed shortly).

Buyouts. After a partner’s dissociation, his or her inter- est in the partnership must be purchased according to the rules in UPA 701. �e buyout price is based on the amount that would have been distributed to the partner if the partnership had been wound up on the date of

dissociation. O�set against the price are amounts owed by the partner to the partnership, including damages for wrongful dissociation.

Liability to Third Parties. For two years after a partner dissociates from a continuing partnership, the partnership may be bound by the acts of the dissociated partner based on apparent authority [UPA 702]. In other words, if a third party reasonably believed at the time of a transaction that the dissociated partner was still a partner, the partner- ship may be liable. Similarly, a dissociated partner may be liable for partnership obligations entered into during the two-year period following dissociation [UPA 703].

To avoid this possible liability, a partnership should notify its creditors, customers, and clients of a partner’s dissociation. In addition, either the partnership or the dissociated partner can file a statement of dissociation in the appropriate state office to limit the dissociated part- ner’s authority to ninety days after the filing [UPA 704]. Filing this statement helps to minimize the firm’s poten- tial liability for the former partner and vice versa.

Partnership Termination The same events that cause dissociation can result in the end of the partnership if the remaining partners no longer wish to (or are unable to) continue the partnership business. A partner’s depar- ture will not necessarily end the partnership, though. Generally, the partnership can continue if the remaining partners consent [UPA 801].

The termination of a partnership is referred to as dis- solution, which essentially means the commencement of the winding up process. Winding up is the actual pro- cess of collecting, liquidating, and distributing the part- nership assets.

Dissolution. Dissolution of a partnership generally can be brought about by acts of the partners, by operation of law, or by judicial decree [UPA 801]. Any partnership (including one for a �xed term) can be dissolved by the partners’ agreement.

If the partnership agreement states that it will dis- solve on a certain event, such as a partner’s death or bankruptcy, then the occurrence of that event will dis- solve the partnership.5 A partnership for a fixed term or a particular undertaking is dissolved by operation of law at the expiration of the term or on the completion of the undertaking.

Any event that makes it unlawful for the partner- ship to continue its business will result in dissolution

5. See, for instance, Estate of Webster v. Thomas, 2013 IL App (5th) 120121-U, 2013 WL 164041 (2013).

362 U N I T F O U R The Business and Employment Environment

[UPA 801(4)]. Under the UPA, a court may order dis- solution when it becomes obviously impractical for the firm to continue—for instance, if the business can only be operated at a loss [UPA 801(5)]

■ CASE IN POINT 16.11 Members of the Russell fam- ily began operating Russell Realty Associates (RRA) as a partnership. Eddie Russell had decision-making author- ity over the partnership’s business, which involved buy- ing, holding, leasing, and selling investment properties. After several years, Eddie and his sister, Nina Russell, started having disputes, and Nina began to routinely question Eddie’s business decisions. Because of their dis- agreements, RRA experienced two years of delays before it could sell one piece of property. Although the firm continued to profit, Eddie filed a complaint seeking a judicial dissolution of the partnership, which the court granted. Nina appealed.

The Virginia Supreme Court affirmed the lower court’s decision that Russell Realty must be judicially dissolved. The partners’ relationship had deteriorated to the point where the partnership was unable to function effectively. As a result, the firm had incurred substantial and unnec- essary added costs, which frustrated the partnership’s eco- nomic purpose and made it impracticable to continue.6 ■

Winding Up and Distribution of Assets. After dissolu- tion, the partnership continues for the limited purpose of winding up the business. �e partners cannot create new obligations on behalf of the partnership and have author- ity only to complete un�nished transactions and wind up the business [UPA 803, 804(1)].

Winding up includes collecting and preserving part- nership assets, discharging liabilities (paying debts), and accounting to each partner for the value of his or her interest in the partnership. Partners continue to have fiduciary duties to one another and to the firm during this process.

Both creditors of the partnership and creditors of the individual partners can make claims on the partner- ship’s assets. In general, partnership creditors share pro- portionately with the partners’ individual creditors in the partners’ assets, which include their interests in the partnership.

A partnership’s assets are distributed according to the following priorities [UPA 807]: 1. Payment of debts, including those owed to partner

and nonpartner creditors. 2. Return of capital contributions and distribution of

profits to partners.

6. Russell Realty Associates v. Russell, 724 S.E.2d 690 (Va.Sup.Ct. 2012).

If the partnership’s liabilities are greater than its assets, the partners bear the losses in the same proportion in which they shared the profits unless they have agreed otherwise.

Partnership Buy-Sell Agreements. Before entering into a partnership, partners may agree on how the assets will be valued and divided in the event that the partnership dissolves. Such an agreement may eliminate costly nego- tiations or litigation later.

This agreement, called a buy-sell agreement or buy-sell agreement or buy-sell agreement buy- out agreement, may provide for one or more partners to buy out the other or others should the situation war- rant. Alternatively, the agreement may specify that one or more partners will determine the value of the inter- est being sold and that the other or others will decide whether to buy or sell.

Under UPA 701(a), if a partner’s dissociation does not result in a dissolution of the partnership, a buyout of the partner’s interest is mandatory. The UPA contains an extensive set of buyout rules that apply when the partners do not have a buyout agreement. Basically, a withdraw- ing partner receives the same amount through a buyout that he or she would receive if the business were winding up [UPA 701(b)].

16–4 Franchises Instead of setting up a sole proprietorship to market their own products or services, many entrepreneurs opt to pur- chase a franchise. A franchise is an arrangement in which the owner of intellectual property—such as a trademark, a trade name, or a copyright—licenses others to use it in the selling of goods or services.

A franchisee (a purchaser of a franchise) is gener- ally legally independent of the franchisor (the seller of franchisor (the seller of franchisor the franchise). At the same time, the franchisee is eco- nomically dependent on the franchisor’s integrated busi- ness system and obtains the advantages of a regional or national organization.

Today, franchising companies and their franchisees account for a significant portion of all retail sales in this country. Well-known franchises include McDonald’s, 7-Eleven, and Holiday Inn. Franchising has also become a popular way for businesses to expand their operations internationally without violating the legal restrictions that many nations impose on foreign ownership of businesses.

16–4a Types of Franchises Many different kinds of businesses sell franchises, and numerous types of franchises are available. Generally,

C H A P T E R 1 6 Small Businesses and Franchises 363

though, franchises fall into one of three classifications: distributorships, chain-style business operations, and manufacturing arrangements.

Distributorship In a distributorship, a manufacturer (the franchisor) licenses a dealer (the franchisee) to sell its product. Often, a distributorship covers an exclusive ter- ritory. Automobile dealerships and beer distributorships are common examples.

■ EXAMPLE 16.12 Black Bear Beer Company distrib- utes its brands of beer through a network of authorized wholesale distributors, each with an assigned territory. Marik signs a distributorship contract for the area from Gainesville to Ocala, Florida. If the contract states that Marik is the exclusive distributor in that area, then no other franchisee may distribute Black Bear beer in that region. ■

Chain-Style Business Operation In a chain-style business operation, a franchise operates under a franchisor’s trade name and is identified as a member of a select group of dealers that engage in the franchisor’s business. The franchisee is generally required to follow standardized or prescribed methods of operation. Often, the franchisor insists that the franchisee maintain certain standards of performance.

In addition, the franchisee may be required to obtain materials and supplies exclusively from the franchisor. Chipotle Mexican Grill and most other fast-food chains are examples of this type of franchise. Chain-style fran- chises are also common in service-related businesses, including real estate brokerage firms, such as Century 21, and tax-preparing services, such as H&R Block, Inc.

Manufacturing Arrangement In a manufacturing, or processing-plant, arrangement, the franchisor transmits to the franchisee the essential ingredients or formula to make a particular product. The franchisee then markets the product either at wholesale or at retail in accordance with the franchisor’s standards. Examples of this type of franchise include Pepsi-Cola and other soft-drink bottling companies.

16–4b Laws Governing Franchising Because a franchise relationship is primarily a contractual relationship, it is governed by contract law. If the fran- chise exists primarily for the sale of products manufac- tured by the franchisor, the law governing sales contracts as expressed in Article 2 of the Uniform Commercial Code applies.

Additionally, the federal government and most states have enacted laws governing certain aspects of franchis- ing. Generally, these laws are designed to protect pro- spective franchisees from dishonest franchisors and to prevent franchisors from terminating franchises without good cause.

Federal Regulation of Franchises The federal government regulates franchising through laws that apply to specific industries and through the Franchise Rule, cre- ated by the Federal Trade Commission (FTC).

Industry-Specific Standards. Congress has enacted laws that protect franchisees in certain industries, such as auto- mobile dealerships and service stations. �ese laws protect the franchisee from unreasonable demands and bad faith terminations of the franchise by the franchisor.

An automobile manufacturer–franchisor cannot make unreasonable demands of dealer-franchisees or set unrealistically high sales quotas. If an automobile manu- facturer–franchisor terminates a franchise because of a dealer-franchisee’s failure to comply with unreasonable demands, the manufacturer may be liable for damages.7

Similarly, federal law prescribes the conditions under which a franchisor of service stations can terminate the franchise.8 In addition, federal antitrust laws sometimes apply in specified circumstances to prohibit certain types of anticompetitive agreements.

The Franchise Rule. �e FTC’s Franchise Rule requires franchisors to disclose certain material facts that a pro- spective franchisee needs in order to make an informed decision concerning the purchase of a franchise.9 �ose who violate the Franchise Rule are subject to substantial civil penalties, and the FTC can sue on behalf of injured parties to recover damages.

The rule requires the franchisor to make numerous writ- ten disclosures to prospective franchisees (see Exhibit 16–1). All representations made to a prospective franchisee must have a reasonable basis. For instance, if a franchisor provides projected earnings figures, the franchisor must indicate whether the figures are based on actual data or hypothetical examples. If a franchisor makes sales or earnings projections based on actual data for a specific franchise location, the franchisor must disclose the number and percentage of its existing franchises that have achieved this result.

7. Automobile Dealers’ Franchise Act, also known as the Automobile Deal- ers’ Day in Court Act, 15 U.S.C. Sections 1221 et seq.

8. Petroleum Marketing Practices Act (PMPA), 15 U.S.C. Sections 2801 et seq.

364 U N I T F O U R The Business and Employment Environment

State Regulation of Franchising State legislation varies but often is aimed at protecting franchisees from unfair practices and bad faith terminations by franchisors.

State Disclosures. A number of states have laws similar to the federal rules that require franchisors to provide pre- sale disclosures to prospective franchisees.10 Many state laws also require that a disclosure document (known as the Franchise Disclosure Document, or FDD) be reg- istered or �led with a state o�cial. State laws may also require that a franchisor submit advertising aimed at pro- spective franchisees to the state for approval.

To protect franchisees, a state law might require the disclosure of information such as the actual costs of oper- ation, recurring expenses, and profits earned, along with facts substantiating these figures. State deceptive trade practices acts may also apply and prohibit certain types of actions by franchisors.

May Require Good Cause to Terminate the Franchise. To prevent arbitrary or bad faith terminations, a state law

10. These states include California, Florida, Hawaii, Illinois, Indiana, Maryland, Michigan, Minnesota, New York, North Dakota, Oregon, Rhode Island, South Dakota, Texas, Utah, Virginia, Washington, and Wisconsin.

may prohibit termination without “good cause” or require that certain procedures be followed in terminating a franthat certain procedures be followed in terminating a franthat certain procedures be followed in terminating a franthat certain procedures be followed in terminating a fran- chise. ■ CASE IN POINT 16.13 FMS, Inc., entered into a franchise agreement with Samsung Construction Equip- ment North America to become an authorized dealer- ship selling Samsung construction equipment. Samsung then sold its equipment business to Volvo Construction Equipment North America, Inc., which was to continue selling Samsung brand equipment.

Later, Volvo rebranded the construction equipment under its own name and canceled FMS’s franchise. FMS sued, claiming that Volvo had terminated the franchise without “good cause” in violation of state law. Because Volvo was no longer manufacturing the Samsung brand equipment, the court found that Volvo had good cause to terminate FMS’s franchise. If Volvo had continued mak- ing the Samsung equipment, though, it could not have terminated the franchise.11 ■

16–4c The Franchise Contract The franchise relationship is defined by the contract between the franchisor and the franchisee. The franchise

11. FMS, Inc. v. Volvo Construction Equipment North America, Inc., 557 F.3d 758 (7th Cir. 2009).

The franchisor must make numerous disclosures, such as the range of goods and services included and the value and estimated profitability of the franchise. Disclosures can be delivered on paper or electronically. Prospective franchisees must be able to download or save any electronic disclosure documents.

To prevent deception, all representations made to a prospective franchisee must have a reasonable basis at the time they are made.

If a franchisor provides projected earnings figures, the franchisor must indicate whether the figures are based on actual data or hypothetical examples. The Franchise Rule does not require franchisors to provide potential earnings figures, however.

If a franchisor makes sales or earnings projections based on actual data for a specific franchise location, the franchisor must disclose the number and percentage of its existing franchises that have achieved this result.

Franchisors are required to explain termination, cancellation, and renewal provisions of the franchise contract to potential franchisees before the agreement is signed.

Projected Earnings Figures

Written (or Electronic) Disclosures

Reasonable Basis for Any Representations

REQUIREMENT EXPLANATION

Actual Data

Explanation of Terms

E X H I B I T 1 6 – 1 The FTC’s Franchise Rule Requirements

C H A P T E R 1 6 Small Businesses and Franchises 365

contract specifies the terms and conditions of the fran- chise and spells out the rights and duties of the franchisor and the franchisee.

If either party fails to perform its contractual duties, that party may be subject to a lawsuit for breach of con- tract. If a franchisee is induced to enter into a franchise contract by the franchisor’s fraudulent misrepresenta- tion, the franchisor may be liable for damages. Generally, statutes and the case law governing franchising tend to emphasize the importance of good faith and fair dealing in franchise relationships.

Payment for the Franchise The franchisee ordinar- ily pays an initial fee or lump-sum price for the franchise license (the privilege of being granted a franchise). This fee is separate from the various products that the franchi- see purchases from or through the franchisor. The fran- chise agreement may also require the franchisee to pay a percentage of the franchisor’s advertising costs and certain administrative expenses.

In some industries, the franchisor relies heavily on the initial sale of the franchise for realizing a profit. In other industries, the continued dealing between the parties brings profit to both. Generally, the franchisor receives a stated percentage of the annual (or monthly) sales or volume of business done by the franchisee.

Business Premises The franchise agreement may specify whether the premises for the business must be leased or purchased outright. Sometimes, a building must be constructed to meet the terms of the agreement. The agreement will specify whether the franchisor or the fran- chisee is responsible for supplying equipment and fur- nishings for the premises.

Location of the Franchise Typically, the franchi- sor determines the territory to be served. Some franchise contracts give the franchisee exclusive rights, or “terri- torial rights,” to a certain geographic area. Other fran- chise contracts, while defining the territory allotted to a particular franchise, either specifically state that the franchise is nonexclusive or are silent on the issue of ter- ritorial rights.

Many franchise disputes arise over territorial rights, and the implied covenant of good faith and fair dealing often comes into play in this area of franchising. If the contract does not grant exclusive territorial rights to the franchisee and the franchisor allows a competing fran- chise to be established nearby, the franchisee may suffer significant lost profits. In this situation, a court may hold that the franchisor breached an implied covenant of good faith and fair dealing.

Business Organization The franchisor may require that the business use a particular organizational form and capital structure. The franchise agreement may also set out standards such as sales quotas and record-keeping requirements. Additionally, a franchisor may retain strin- gent control over the training of personnel involved in the operation and over administrative aspects of the business.

Quality Control by the Franchisor The day-to- day operation of the franchise business normally is left up to the franchisee. Nonetheless, the franchise agreement may specify that the franchisor will provide some degree of supervision and control so that it can protect the fran- chise’s name and reputation.

Means of Control. When the franchise prepares a prod- uct, such as food, or provides a service, such as motel accommodations, the contract often states that the fran- chisor will establish certain standards for the facility. Typically, the contract will state that the franchisor is per- mitted to make periodic inspections to ensure that the standards are being maintained.

As a means of controlling quality, franchise agree- ments also typically limit the franchisee’s ability to sell the franchise to another party. ■ EXAMPLE 16.14 Mark Mark Keller, Inc., an authorized Jaguar franchise, contracts to sell its dealership to Henrique Autos West. A Jaguar franchise generally cannot be sold without Jaguar Cars’ permission. Prospective franchisees must meet Jaguar’s customer satisfaction standards. If Henrique Autos fails to meet those standards, Jaguar can refuse to allow the sale and can terminate the franchise. ■

Degree of Control. As a general rule, the validity of a pro- vision permitting the franchisor to establish and enforce certain quality standards is unquestioned. �e franchisor has a legitimate interest in maintaining the quality of the product or service to protect its name and reputation.

If a franchisor exercises too much control over the operations of its franchisees, however, the franchisor risks potential liability. A franchisor may occasionally be held liable—under the doctrine of respondeat superior—for respondeat superior—for respondeat superior the tortious acts of the franchisees’ employees.the tortious acts of the franchisees’ employees.the tortious acts of the franchisees’ employees.the tortious acts of the franchisees’ employees.

■ EXAMPLE 16.15 The National Labor Relations Board (NLRB) received 180 employee complaints that certain McDonald’s restaurants had engaged in unfair labor practices. Employees alleged that the restaurants had fired or penalized workers for participating in protests over wages and working conditions. Investigators found that at least some of the complaints had merit. The NLRB ruled that McDonald’s USA, LLC, could be held jointly liable along with several of its franchisees for labor and Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

366 U N I T F O U R The Business and Employment Environment

wage violations. The NLRB reasoned that McDonald’s exerts sufficient control over its franchisees to be found liable for the franchisees’ employment law violations. ■

Pricing Arrangements Franchises provide the fran- chisor with an outlet for the firm’s goods and services. Depending on the nature of the business, the franchisor may require the franchisee to purchase certain supplies from the franchisor at an established price.12 A franchi- sor cannot, however, set the prices at which the franchisee will resell the goods. Such price setting may be a violation of state or federal antitrust laws, or both. A franchisor can suggest retail prices but cannot mandate them.

16–4d Franchise Termination The duration of the franchise is a matter to be deter- mined between the parties. Sometimes, a franchise rela- tionship starts with a short trial period, such as a year, so that the franchisee and the franchisor can determine whether they want to stay in business with one another. At other times, the duration of the franchise contract cor- relates with the term of the lease for the business prem- ises, and both are renewable at the end of that period.

Grounds for Termination Set by Franchise Contract Usually, the franchise agreement specifies that termination must be “for cause” and then defines the grounds for termination. Cause might include, for instance, the death or disability of the franchisee, insol- vency of the franchisee, breach of the franchise agree- ment, or failure to meet specified sales quotas.

■ CASE IN POINT 16.16 All Professional Realty, Inc., and All Professional Hawaii Realty, Inc., entered into four franchise agreements with Century 21 Real Estate, LLC. Century 21 (the franchisor) gave All Professional (the franchisee) the right to operate four separate offices in California and Hawaii under the name “Century 21 All Professional.” The agreements required All Profes- sional to pay royalty and advertising fees. They also per- mitted Century 21 to terminate the agreements for good cause, which included the franchisee’s failure to operate at an approved location.

All Professional signed a note for $75,000 payable to Century 21 and agreed to make annual payments on the note. Four years later, All Professional stopped remitting the fees and making payments on the note, and it closed one of the California offices. Century 21 terminated the

12. Although a franchisor can require franchisees to purchase supplies from it, requiring a franchisee to purchase exclusively from the franchisor may violate federal antitrust laws.

franchise agreements. All Professional sued, but a federal district court held in favor of Century 21, and that deci- sion was affirmed on appeal. Century 21 did not breach the franchise agreements. All Professional did. Nonpay- ment of the fees and the note, and the abandonment of one of the franchisee’s offices, constituted a material breach of the contract. These actions provided Century 21 with legitimate grounds for termination of the fran- chise agreement.13 ■

Notice Requirements. Most franchise contracts provide that notice of termination must be given. If no set time for termination is speci�ed, then a reasonable time, with notice, is implied. A franchisee must be given reasonable time to wind up the business—that is, to do the account- ing and return the copyright or trademark or any other property of the franchisor.

Opportunity to Cure a Breach. A franchise agreement may allow the franchisee to attempt to cure an ordinary, curable breach within a certain time after notice so as to postpone, or even avoid, termination. Even when a contract contains a notice-and-cure provision, however, a franchisee’s breach of the duty of honesty and �delity may be enough to allow the franchisor to terminate the franchise.

■ CASE IN POINT 16.17 Milind and Minaxi Upad- hyaya entered into a franchise contract with 7-Eleven, Inc., to operate a store in Pennsylvania. The contract included a notice-and-cure provision. Under 7-Eleven’s usual contract, franchisees lease the store and equipment, and receive a license to use 7-Eleven’s trademarks and other intellectual property. 7-Eleven receives a percent- age of the store’s gross profit (net sales less the cost of goods sold).

A 7-Eleven manager noticed a high rate of certain questionable transactions at the Upadhyayas’ store and began investigating. The investigation continued for nearly two years and revealed that the store had been misreporting its sales so as to conceal sales proceeds from 7-Eleven. Evidence indicated that nearly one-third of the store’s sales transactions had not been properly recorded. 7-Eleven sent a “non-curable” notice of material breach and termination of the franchise to the Upadhyayas. The franchisees argued that they had not been given an opportunity to cure the breach. The court found there was sufficient evidence of fraud to warrant immediate termination without an opportunity to cure.14 ■

13. Century 21 Real Estate, LLC v. All Professional Realty, Inc., 600 Fed.Appx. 502 (9th Cir. 2015).

14. 7-Eleven, Inc. v. Upadhyaya, 926 F.Supp.2d 614 (E.D.Penn. 2013). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 1 6 Small Businesses and Franchises 367

Wrongful Termination Because a franchisor’s termi- nation of a franchise often has adverse consequences for the franchisee, much franchise litigation involves claims of wrongful termination. Generally, the termination provisions of contracts are more favorable to the franchi- sor than to the franchisee. This means that the franchi- see, who normally invests substantial time and financial resources in making the franchise operation successful, may receive little or nothing for the business on termina- tion. The franchisor owns the trademark and hence the business.

It is in this area that statutory and case law become important. The federal and state laws discussed earlier attempt, among other things, to protect franchisees from the arbitrary or unfair termination of their fran- chises by the franchisors.

The Importance of Good Faith and Fair Deal- ing Generally, both statutory law and case law emphasize the importance of good faith and fair dealing in termi- nating a franchise relationship. In determining whether a franchisor has acted in good faith when terminating a franchise agreement, the courts usually try to balance the rights of both parties.

If a court perceives that a franchisor has arbitrarily or unfairly terminated a franchise, the franchisee will be provided with a remedy for wrongful termination. A court will be less likely to consider a termination wrong- ful if the franchisor’s decision was made in the normal course of business and reasonable notice was given.

The importance of good faith and fair dealing in a franchise relationship is underscored by the consequences of the franchisor’s acts in the following case.

Background and Facts Buddy House was in the construction business in Arkansas and Texas. For decades, he collaborated on projects with Holiday Inn Franchising, Inc. Their relationship was char- acterized by good faith—many projects were undertaken without written contracts. At Holiday Inn’s request, House inspected a hotel in Wichita Falls, Texas, to estimate the cost of getting it into shape. Holiday Inn wanted House to renovate the hotel and operate it as a Holiday Inn. House estimated that recovering the cost of renovation would take him more than ten years, so he asked for a franchise term longer than Holiday Inn’s usual ten years. Holiday Inn refused, but said that if the hotel was run “appropriately,” the term would be extended at the end of ten years. House bought the hotel, renovated it, and operated it as Hotel Associates, Inc. (HAI), generating substantial profits. He refused offers to sell it for as much as $15 million.

Before the ten years had passed, Greg Aden, a Holiday Inn executive, developed a plan to license a different local hotel as a Holiday Inn instead of renewing House’s franchise license. Aden stood to earn a commission from licensing the other hotel. No one informed House of Aden’s plan. When the time came, HAI applied for an extension of its franchise, and Holiday Inn asked for major renovations. HAI spent $3 million to comply with this request. Holiday Inn did not renew HAI’s license, however, but instead granted a franchise to the other hotel. HAI sold its hotel for $5 million and filed a suit in an Arkansas state court against Holiday Inn, asserting fraud. The court awarded HAI compensatory and punitive damages. Holiday Inn appealed.

In the Language of the Court Raymond R. ABRAMSON, Judge.

* * * * Generally, a mere failure to volunteer information does not constitute fraud. But silence can amount to

actionable fraud in some circumstances where the parties have a relation of trust or confidence, where there is inequality of condition and knowledge, or where there are other attendant circumstances. [Emphasis added.]

In this case, substantial evidence supports the existence of a duty on Holiday Inn’s part to disclose the Aden [plan] to HAI. Buddy House had a long-term relationship with Holiday Inn characterized by honesty, trust, and the free flow of pertinent information. He testified that [Holiday Inn’s] assurances at

Spotlight on Holiday Inns

Case 16.3 Case 16.3 Holiday Inn Franchising, Inc. v. HHotel otel Associates, Inc. Court of Appeals of Arkansas, 2011 Ark.App. 147, 382 S.W.3d 6 (2011).Court of Appeals of Arkansas, 2011 Ark.App. 147, 382 S.W.3d 6 (2011).

Case 16.3 Continues

368 U N I T F O U R The Business and Employment Environment

the onset of licensure [the granting of the license] led him to believe that he would be relicensed after ten years if the hotel was operated appropriately. Yet, despite Holiday Inn’s having provided such an assurance to House, it failed to apprise House of an internal business plan * * * that advocated licensure of another facility instead of the renewal of his license. A duty of disclosure may exist where information is peculiarly within the knowledge of one party and is of such a nature that the other party is justified in assuming its non- existence. Given House’s history with Holiday Inn and the assurance he received, we are convinced he was justified in assuming that no obstacles had arisen that jeopardized his relicensure. [Emphasis added.]

Holiday Inn asserts that it would have provided Buddy House with the Aden [plan] if he had asked for it. But, Holiday Inn cannot satisfactorily explain why House should have been charged with the responsibility of inquiring about a plan that he did not know existed. Moreover, several Holiday Inn per- sonnel testified that Buddy House in fact should have been provided with the Aden plan. Aden himself stated that * * * House should have been given the plan. * * * In light of these circumstances, we see no ground for reversal on this aspect of HAI’s cause of action for fraud.

Decision and Remedy The state intermediate appellate court affirmed the lower court’s judgment and its award of compensatory damages. The appellate court increased the amount of punitive damages, how- ever, citing Holiday Inn’s “degree of reprehensibility.”

Critical Thinking • Legal Environment Why should House and HAI have been advised of Holiday Inn’s plan to grant a

franchise to a different hotel in their territory? • Economic A jury awarded HAI $12 million in punitive damages. The court reduced this award to $1

million, but the appellate court reinstated the original award. What is the purpose of punitive damages? Did Holiday Inn’s conduct warrant this award? Explain.

Case 16.3 Continued

Reviewing: Small Businesses and Franchises

Carlos Del Rey decided to open a Mexican fast-food restaurant and signed a franchise contract with a national chain called La Grande Enchilada. The contract required the franchisee to strictly follow the franchisor’s operating manual and stated that failure to do so would be grounds for terminating the franchise contract. The manual set forth detailed operating procedures and safety standards, and provided that a La Grande Enchilada representative would inspect the restaurant monthly to ensure compliance.

Nine months after Del Rey began operating his restaurant, a spark from the grill ignited an oily towel in the kitchen. No one was injured, but by the time firefighters were able to put out the fire, the kitchen had sustained extensive dam- age. The cook told the fire department that the towel was “about two feet from the grill” when it caught fire. This was in compliance with the franchisor’s manual that required towels be placed at least one foot from the grills. Nevertheless, the next day La Grande Enchilada notified Del Rey that his franchise would terminate in thirty days for failure to fol- low the prescribed safety procedures. Using the information presented in the chapter, answer the following questions. 1. What type of franchise was Del Rey’s La Grande Enchilada restaurant? 2. If Del Rey operates the restaurant as a sole proprietorship, who bears the loss for the damaged kitchen? Explain. 3. Assume that Del Rey files a lawsuit against La Grande Enchilada, claiming that his franchise was wrongfully termi-

nated. What is the main factor that a court would consider in determining whether the franchise was wrongfully terminated?

4. Would a court be likely to rule that La Grande Enchilada had good cause to terminate Del Rey’s franchise in this situation? Why or why not?

Debate This . . . A partnership should automatically end when one partner dissociates from the firm. Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 1 6 Small Businesses and Franchises 369

Terms and Concepts articles of partnership 356 buyout price 361 buy-sell agreement 362 dissociation 360 dissolution 361 entrepreneur 350

franchise 362 franchisee 362 franchisor 362 goodwill 355 information return 356 joint and several liability 360

joint liability 360 partnership 355 partnership by estoppel 356 pass-through entity 356 sole proprietorship 351 winding up 361

Issue Spotters 1. Frank plans to open a sporting goods store and to hire

Gogi and Hap. Frank will invest only his own funds. He expects that he will not make a profit for at least eigh- teen months and will make only a small profit in the three years after that. He hopes to expand eventually. Would a sole proprietorship be an appropriate form for Frank’s business? Why or why not? (See Sole Proprietorships.)

2. Darnell and Eliana are partners in D&E Designs, an architectural firm. When Darnell dies, his widow claims that as Darnell’s heir, she is entitled to take his place as Eliana’s partner or to receive a share of the firm’s assets. Is she right? Why or why not? (See Partnerships.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 16–1. Partnership Formation. Daniel is the owner of a chain of shoe stores. He hires Rubya to be the manager of a new store, which is to open in Grand Rapids, Michigan. Dan- iel, by written contract, agrees to pay Rubya a monthly salary and 20 percent of the profits. Without Daniel’s knowledge, Rubya represents himself to Classen as Daniel’s partner and shows Classen the agreement to share profits. Classen extends credit to Rubya. Rubya defaults. Discuss whether Classen can hold Daniel liable as a partner. (See Partnerships.) 16–2. Franchising. Maria, Pablo, and Vicky are recent college graduates who would like to go into business for

themselves. They are considering purchasing a franchise. If they enter into a franchising arrangement, they would have the support of a large company that could answer any ques- tions they might have. Also, a firm that has been in business for many years would be experienced in dealing with some of the problems that novice businesspersons might encounter. These and other attributes of franchises can lessen some of the risks of the marketplace. What other aspects of franchis- ing—positive and negative—should Maria, Pablo, and Vicky consider before committing themselves to a particular fran- chise? (See Franchises.)

Business Case Problems 16–3. Partnership Formation. Patricia Garcia and Ber- nardo Lucero were in a romantic relationship. While they were seeing each other, Garcia and Lucero acquired an elec- tronics service center, paying $30,000 apiece. Two years later, they purchased an apartment complex. �e property was deeded to Lucero, but neither Garcia nor Lucero made a down payment. �e couple considered both properties to be owned “50/50,” and they agreed to share pro�ts, losses, and manage- ment rights. When the couple’s romantic relationship ended, Garcia asked a court to declare that she had a partnership with Lucero. In court, Lucero argued that the couple did not have a written partnership agreement. Did they have a partnership? Why or why not? [Garcia v. Lucero, 366 S.W.3d 275 (Tex. App.—El Paso 2012)] (See Partnerships.) 16–4. Business Case Problem with Sample Answer—

Partnerships. Karyl Paxton asked Christopher Sacco to work with her interior design business, Pierce Paxton Collections, in New Orleans. At the time, they were in a romantic relationship. Sacco

was involved in every aspect of the business—bookkeeping, marketing, and design—but was not paid a salary. He was reimbursed, however, for expenses charged to his personal credit card, which Paxton also used. Sacco took no pro�ts from the �rm, saying that he wanted to “grow the business” and “build sweat equity.” When Paxton and Sacco’s personal rela- tionship soured, she �red him. Sacco objected, claiming that they were partners. Is Sacco entitled to 50 percent of the pro�ts of Pierce Paxton Collections? Explain. [Sacco v. Paxton, 133 So.3d 213 (La.App. 2014)] (See Partnerships.) • For a sample answer to Problem 16–4, go to Appendix E at

the end of this text. 16–5. Formation. Leisa Reed and Randell �urman lived together in Spring City, Tennessee. Randell and his father, Leroy, formed a cattle-raising operation and opened a bank account in the name of L&R Farm. Within a few years, Leroy quit the operation. Leisa and Randell each wrote a personal check for $5,000 to buy his cattle. Leisa picked up supplies, fed and administered medicine to cattle, collected hay, and Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

370 U N I T F O U R The Business and Employment Environment

participated in the bookkeeping for L&R. Later, checks drawn on her personal account for $12,000 to buy equipment and $35,000 to buy cattle were deposited into the L&R account. After several years, Leisa decided that she no longer wanted to associate with Randell, but they could not agree on a �nan- cial settlement. Was Leisa a partner in L&R? Is she entitled to half of the value of L&R’s assets? Explain. [Reed v. �ur-Reed v. �ur-Reed v. �ur man, 2015 WL 1119449 (Tenn.App.—Knoxville 2015)] (See Partnerships.) 16–6. Quality Control. �e franchise agreement of Dom- ino’s Pizza, L.L.C., sets out operational standards, including safety requirements, for a franchisee to follow but provides that the franchisee is an independent contractor. Each fran- chisee is free to use its own means and methods. For exam- ple, Domino’s does not know whether a franchisee’s delivery drivers are complying with vehicle safety requirements. MAC Pizza Management, Inc., operates a Domino’s franchise. A vehicle driven by Joshua Balka, a MAC delivery driver, hydroplaned due to a bald tire and wet pavement. It struck the vehicle of Devavaram and Ruth Christopher, killing Ruth and injuring Devavaram. Is Domino’s liable for negligence? Explain. [Domino’s Pizza, L.L.C. v. Reddy, 2015 WL 1247349 (Tex.App.—Beaumont 2015)] (See Franchises.) 16–7. Formation and Operation. FS Partners is a general partnership whose partners are Jerry Stahlman, a professional engineer, and Fitz & Smith, Inc., a corporation in the business of excavating and paving. Timothy Smith signed the partner- ship agreement on Fitz & Smith’s behalf and deals with FS matters on Fitz & Smith’s behalf. Stahlman handles the pay- ment of FS’s bills, including its tax bills, and is the designated partner on FS’s federal tax return. FS was formed to buy and develop twenty acres of unoccupied, wooded land in York County, Pennsylvania. �e deed to the property lists the owner as “FS Partners, a general partnership.” When the taxes on the real estate were not paid, the York County Tax Claim Bureau published notice that the property would be sold at a tax sale. �e bureau also mailed a notice to FS’s address of record and posted a notice on the land. Is this su�cient notice of the tax sale? Discuss. [FS Partners v. York County Tax Claim Bureau, 132 A.3d 577 (Pa. 2016)] (See Partnerships.) 16–8. Franchise Termination. Executive Home Care Fran- chising, LLC, sells in-home health-care franchises. Clint, Massare,

and Greer Marshall entered into a franchise agreement with Executive Home Care. �e agreement provided that the fran- chisees’ failure to comply with the agreement’s terms would likely cause irreparable harm to the franchisor, entitling it to an injunction. About two years later, the Marshalls gave up their franchise. �ey returned thirteen boxes of documents, stationery, operating manuals, marketing materials, and other items—everything in their possession that featured Executive Home Care trademarks. �ey quit operating out of the fran- chised location. �ey transferred the phone number back to the franchisor and informed their clients that they were no longer associated with Executive Home Care. �ey continued to engage in the home health-care business, however, under the name “Well-Being Home Care Corp.” Is Executive Home Care entitled to an injunction against the Marshalls and their new company? Discuss. [Executive Home Care Franchising, LLC v. Marshall Health Corp., __ Fed.Appx. __, 2016 WL 703801 (3d Cir. 2016)] (See Franchises.)

16–9. A Question of Ethics—Wrongful Dissocia- tion. Elliot Willensky and Beverly Moran formed a partner-

ship to buy, renovate, and sell a house. Moran agreed to �nance the e�ort, which was to cost no more than $60,000. Willensky agreed to oversee the work, which was to be done in six months. Willen-

sky lived in the house during the renovation. As the project pro- gressed, Willensky incurred excessive and unnecessary expenses, misappropriated funds for his personal use, did not pay bills on time, and did not keep Moran informed of the costs. More than a year later, the renovation was still not completed, and Wil-a year later, the renovation was still not completed, and Wil-a year later, the renovation was still not completed, and Wil lensky walked o� the project. Moran completed the renovation, which ultimately cost $311,222, and sold the house. Moran then sued to dissolve the partnership and recover damages from Willensky for breach of contract and wrongful dissociation. [Moran v. Willensky, [Moran v. Willensky, [ 339 S.W.3d 651 (Tenn.App.—Nashville 2010)] (See 2010)] (See 2010)] Partnerships.)

(a) Moran alleged that Willensky had wrongfully dissociated from the partnership. When did this dissociation occur? Why was his dissociation wrongful?

(b) Which of Willensky’s actions simply represent unethi- cal behavior or bad management, and which constitute a breach of the agreement?

Legal Reasoning Group Activity 16–10. Franchise Termination. Walid Elkhatib, an Arab American, bought a Dunkin’ Donuts franchise in Illinois. Ten years later, Dunkin’ Donuts began o�ering breakfast sandwiches with bacon, ham, or sausage through its franchises. Elkhatib refused to sell these items at his store on the ground that his religion forbade the handling of pork. Elkhatib then opened a second franchise, at which he also refused to sell pork products.

�e next year, at both locations, Elkhatib began selling meatless sandwiches. He also opened a third franchise. When he proposed to relocate this franchise, Dunkin’ Donuts refused to approve the new location. �e company also informed him that it would not renew any of his franchise agreements

because he did not carry the full sandwich line. Elkhatib �led a lawsuit against Dunkin’ Donuts. (See Franchises.) (a) The first group will argue on behalf of Elkhatib that

Dunkin’ Donuts wrongfully terminated his franchises. (b) The second group will take the side of Dunkin’ Donuts

and justify its decision to terminate the franchises. (c) The third group will assess whether Dunkin’ Donuts acted

in good faith in its relationship with Elkhatib. Consider whether Dunkin’ Donuts should be required to accom- modate Elkhatib’s religious beliefs and allow him not to serve pork in these three locations.Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

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C H A P T E R 17

17–1 The Limited Liability Company

A limited liability company (LLC) is a hybrid that combines the limited liability aspects of a corporation and the tax advantages of a partnership. The LLC has been available for only a few decades, but it has become the preferred structure for many small businesses.

LLCs are governed by state statutes, which vary from state to state. In an attempt to create more uniformity, the National Conference of Commissioners on Uniform State Laws issued the Uniform Limited Liability Com- pany Act (ULLCA). Less than one-fifth of the states have adopted it, however. Thus, the law governing LLCs remains far from uniform.

Nevertheless, some provisions are common to most state statutes. We base our discussion of LLCs on these common elements.

17–1a The Nature of the LLC LLCs share many characteristics with corporations. Like corporations, LLCs must be formed and operated in compliance with state law. Like the shareholders of a corporation, the owners of an LLC, who are called mem- bers, enjoy limited liability [ULLCA 303].1

1. Members of an LLC can also bring derivative actions, which you will read about in regard to corporations, on behalf of the LLC [ULLCA 101]. As with a corporate shareholder’s derivative suit, any damages recovered go to the LLC, not to the members personally.

Limited Liability of Members Members of LLCs are shielded from personal liability in most situations. In other words, the liability of members is normally limited to the amount of their investments.

An exception arises when a member has significantly An exception arises when a member has significantly An exception arises when a member has significantly An exception arises when a member has significantly contributed to the LLC’s tortious conduct. ■ CASE IN CASE IN POINT 17.1 Randy Coley, the sole member and manager of East Coast Cablevision, LLC, installed cable television systems for many hotels and resorts. Coley established a DIRECTV Satellite Master Antenna Television (SMATV) account in the name of Massanutten Resort. The system provided programming to 168 timeshare units, as well as to the resort’s bar, golf shop, lobbies, and waterpark. The bill for the resort’s account was sent to (and paid by) East Coast Cablevision, which in turn billed the customers.

Over time, East Coast Cablevision began providing cable services to additional customers using the resort’s SMATV account but did not pay DIRECTV for these other customers. Ultimately, another cable dealer affiliated with DIRECTV sued Coley for not paying for all of the DIRECTV programming transmissions that East Coast’s customers had received. The court held that because Coley had played a direct role in the unauthorized transmissions, he could be held personally liable for them.2 ■

When Liability May Be Imposed The members of an LLC, like the shareholders in a corporation, can lose their limited personal liability in certain circumstances. For instance, when an individual guarantees payment of

2. Sky Cable, LLC v. Coley, ___ F.Supp.3d ___, 2013 WL 3517337 (W.D.Va. 2013).

O ur government allows entre- preneurs to choose from a vari- ety of business organizational

forms. In selecting among them, busi- nesspersons are motivated to choose organizational forms that limit their liability. Limited liability may allow

them to take more business risk, which is associated with the potential for higher profits.

A relatively new and increasingly common form of business organi- zation is the limited liability com- pany (LLC). LLCs have become the

organizational form of choice among many small businesses. Other limited liability business forms include the limited liability partnership (LLP), the limited partnership (LP), and the lim- ited liability limited partnership (LLLP).

Limited Liability Business Forms

372 U N I T F O U R The Business and Employment Environment

a business loan to the LLC, that individual is personally liable for the business’s obligation. In addition, if an LLC member fails to comply with certain formalities, such as by commingling personal and business funds, a court can impose personal liability.

Under various principles of corporate law, courts may hold the owners of a business liable for its debts. On rare occasions, for instance, courts ignore the corporate struc- ture (“pierce the corporate veil”) to expose the shareholders to personal liability when it is required to achieve justice.

Similarly, courts will sometimes pierce the veil of an LLC to hold its members personally liable. Note, how- ever, that courts have reserved piercing the veil of an LLC for circumstances that are clearly extraordinary. There must normally be some flagrant disregard of the LLC formalities, as well as fraud or malfeasance on the part of the LLC member.

■ CASE IN POINT 17.2 Tom and Shannon Brown purchased a new home in Hattiesburg, Mississippi, from Ray Richard and Nick Welch. Richard had hired Wal- dron Properties, LLC (WP), to build the home. Several years later, cracks began to develop in the walls of the Browns’ home as a result of defects in the construction of the foundation. The Browns sued Murray Waldron, the sole member of WP, for breach of warranty under the state’s New Home Warranty Act (NHWA). Because the required NHWA notice they had received when they bought the home was signed by Waldron personally, they claimed that Waldron was liable personally.

The trial court found that WP, not Waldron individu- ally, was the builder of the Browns’ home. The Browns appealed. They contended that even if WP was the builder, the court should pierce the veil of the LLC and hold Waldron personally liable. The state appellate court disagreed and affirmed the lower court’s ruling. The Browns had not entered into a contract with either Wal- dron or WP. There was not sufficient evidence that Wal- dron had disregarded LLC formalities or had engaged in fraud or other misconduct to justify piercing the LLC’s veil to hold him personally liable.3 ■

Other Similarities to Corporations Another sim- ilarity between corporations and LLCs is that LLCs are legal entities apart from their owners. As a legal person, the LLC can sue or be sued, enter into contracts, and hold title to property [ULLCA 201]. The terminology used to describe LLCs formed in other states or nations is also similar to that used in corporate law. For instance, an LLC formed in one state but doing business in another state is referred to in the second state as a foreign LLC.

3. Brown v. Waldron, 186 So.3d 955 (Miss.App. 2016).

17–1b The Formation of the LLC LLCs are creatures of statute and thus must follow state statutory requirements.

Articles of Organization To form an LLC, arti- cles of organization must be filed with a central state agency—usually the secretary of state’s office [ULLCA 202].4 Typically, the articles must include the name of the business, its principal address, the name and address of a registered agent, the members’ names, and how the LLC will be managed [ULLCA 203]. The business’s name must include the words Limited Liability Company or the initials LLC [ULLCA 105(a)]. Although a majority of the LLC [ULLCA 105(a)]. Although a majority of the LLC states permit one-member LLCs, some states require at least two members.

Preformation Contracts Businesspersons sometimes enter into contracts on behalf of a business organization that is not yet formed. Persons who are forming a corpora- tion, for instance, may enter into contracts during the pro- cess of incorporation but before the corporation becomes a legal entity. These contracts are referred to as preincor-preincor-preincor poration contracts. The individual promoters who sign the contracts are bound to their terms. Once the corporation is formed and adopts the preincorporation contracts (by means of a novation, which substitutes a new contract for the old contract), it can enforce the contract terms.

In dealing with the preorganization contracts of LLCs, courts may apply the well-established principles of cor- porate law relating to preincorporation contracts. That is to say, when the promoters of an LLC enter preformation contracts, the LLC, once formed, can adopt the contracts by a novation and then enforce them.

■ CASE IN POINT 17.3 607 South Park, LLC, entered 607 South Park, LLC, entered into an agreement to sell a hotel to 607 Park View Associ- ates, Ltd., which then assigned the rights to the purchase to another company, 02 Development, LLC. At the time, 02 Development did not yet exist—it was legally cre- ated several months later. 607 South Park subsequently refused to sell the hotel to 02 Development, and 02 Development sued for breach of the purchase agreement.

A California appellate court ruled that LLCs should be treated the same as corporations with respect to preor- ganization contracts. Although 02 Development did not exist when the agreement was executed, once it came into existence, it could enforce any preorganization contract made on its behalf.5 ■

4. In addition to requiring articles of organization to be filed, a few states require that a notice of the intention to form an LLC be published in a local newspaper.

5. 02 Development, LLC v. 607 South Park, LLC, 159 Cal.App.4th 609, 02 Development, LLC v. 607 South Park, LLC, 159 Cal.App.4th 609, 02 Development, LLC v. 607 South Park, LLC 71 Cal.Rptr.3d 608 (2008). See also, Davis Wine Co. v. Vina Y Bodega Estampa, S.A., 823 F.Supp.2d 1159 (D.Or. 2011).Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 1 7 Limited Liability Business Forms 373

17–1c Jurisdictional Requirements As we have seen, LLCs and corporations share several characteristics, but a significant difference between these organizational forms involves federal jurisdictional requirements. Under the federal jurisdiction statute, a corporation is deemed to be a citizen of the state where it is incorporated and maintains its principal place of busi- ness. The statute does not mention the state citizenship of partnerships, LLCs, and other unincorporated associa- tions. The courts, however, have tended to regard these entities as citizens of every state of which their members are citizens.

The state citizenship of an LLC may come into play when a party sues the LLC based on diversity of citizen- ship. Remember that when parties to a lawsuit are from different states and the amount in controversy exceeds $75,000, a federal court can exercise diversity jurisdic- tion. Total diversity of citizenship must exist, however.Total diversity of citizenship must exist, however.Total

■ EXAMPLE 17.4 Jen Fong, a citizen of New York, wishes to bring a suit against Skycel, an LLC formed under the laws of Connecticut. One of Skycel’s members also lives in New York. Fong will not be able to bring a

suit against Skycel in federal court on the basis of diver- sity jurisdiction because the defendant LLC is also a citi- zen of New York. The same would be true if Fong was bringing a suit against multiple defendants and one of the defendants lived in New York. ■

17–1d Advantages of the LLC The LLC offers many advantages to businesspersons, which is why this form of business organization has become increasingly popular.

Limited Liability A key advantage of the LLC is the limited liability of its members. The LLC as an entity can be held liable for any loss or injury caused by the wrongful acts or omissions of its members. As we have seen, however, members themselves generally are not personally liable.

In the following case, a consumer died as a result of using an allegedly defective product made and sold by an LLC. The consumer’s children sought to hold the LLC’s sole member and manager personally liable for the firm’s actions.

Background and Facts Donald Hodge was hunting in a deer stand when its straps—which held Hodge high up in a tree—failed. When the straps failed, Hodge and the deer stand fell to the ground, killing Hodge. Louisiana-based Strong Built International, LLC, was the maker and seller of the deer stand, and Ken Killen was Strong Built’s sole member and manager.

Hodge’s children, Donald and Rachel Hodge, filed a lawsuit in a Louisiana state court against Strong Built and Killen. They sought damages on a theory of product liability for the injury and death of their father caused by the allegedly defective deer stand. Killen filed a motion for summary judg- ment, asserting that he was not personally liable to the Hodges. The court granted the motion and issued a summary judgment in Killen’s favor, dismissing the claims against him. The Hodges appealed.

In the Language of the Court AMY, Judge.

* * * * * * * An LLC member or manager’s liability to third parties is delineated in [Louisiana Revised Stat-

ute (La.R.S.)] 12:1320, which states: * * * * * * * no member, manager, employee, or agent of a limited liability company is liable in such capacity

for a debt, obligation, or liability of the limited liability company. * * * * * * * That protection is not unlimited. Pursuant to La.R.S. 12:1320(D), a member or manager may

be subjected to personal liability for claims involving * * * breach of a professional duty or other negligent or wrongful act. [Emphasis added.]

* * * In an affidavit, Mr. Killen asserted that he is “not an engineer, nor a licensed professional in any profession in Louisiana or any other state.” Mr. Killen also asserts that he:

Hodge v. Strong Built International, LLC Court of Appeal of Louisiana, Third Circuit, 159 So.3d 1159 (2015).

Case 17.1

374 U N I T F O U R The Business and Employment Environment

Flexibility in Taxation Another advantage of the LLC is its flexibility in regard to taxation. An LLC that has two or more members can choose to be taxed as two or more members can choose to be taxed as two or more members either a partnership or a corporation. A corporate entity normally must pay income taxes on its profits, and the shareholders must then pay personal income taxes on any of those profits that are distributed as dividends. An LLC that wants to distribute profits to its members almost always prefers to be taxed as a partnership to avoid the “double taxation” that is characteristic of the corporate entity.

Unless an LLC indicates that it wishes to be taxed as a corporation, the Internal Revenue Service (IRS) auto- matically taxes it as a partnership. This means that the LLC, as an entity, pays no taxes. Rather, as in a partner- ship, profits are “passed through” the LLC to the mem- bers, who then personally pay taxes on the profits. If an LLC’s members want to reinvest profits in the business rather than distribute the profits to members, however, they may prefer to be taxed as a corporation. Corporate income tax rates may be lower than personal tax rates.

An LLC that has only one member cannot be taxed as a partnership. For federal income tax purposes, one- member LLCs are automatically taxed as sole proprietor- ships unless they indicate that they wish to be taxed as corporations. With respect to state taxes, most states fol- low the IRS rules.

Management and Foreign Investors Another advantage of the LLC for businesspersons is the flexibility it offers in terms of business operations and management, as will be discussed shortly. Foreign investors are allowed to become LLC members, so organizing as an LLC can enable a business to attract investors from other countries. (Many nations—including France, Germany, Japan, and places in Latin America—have particular business forms that provide for limited liability much like an LLC.)

17–1e Disadvantages of the LLC The main disadvantage of the LLC is that state LLC stat- utes are not uniform. Therefore, businesses that operate

was a participant in the creation of the deer stand which * * * Strong Built International, L.L.C. manufac- tured and sold, but he never personally dictated or participated in the design, selection of materials used in the manufacture, or the manufacture of, or the selection of any warnings to any deer stand for the use or con- sumption by any consumer beyond my input and work as a manager * * * and member of * * * Strong Built International, L.L.C.

The plaintiffs offered no evidence to contradict Mr. Killen’s affidavit in this regard. Accordingly, we find no basis for Mr. Killen’s personal liability under the “breach of professional duty” exception.

Neither do we find sufficient evidence in the record to create a genuine issue of material fact with regard to the “other negligent or wrongful act” exception.

* * * With regard to [this exception], the member (or manager) must have a duty of care to the plain- tiff. * * * That duty must be “something more” than the duties arising out of the LLC’s contract with the plaintiff.plaintiff.plaintiff

* * * * * * * Mr. Killen states in his affidavit that not only was he not personally responsible for the design

and manufacture of the deer stands while involved with Strong Built International * * * but that any involvement that he may have had was in his capacity as a member and manager. The plaintiffs have sub- mitted nothing to show that Mr. Killen’s actions are “something more” than his duties as a member/manager of the LLC. [Emphasis added.]

Decision and Remedy A state intermediate appellate court affirmed the judgment in Killen’s favor. Under the applicable Louisiana state LLC statute, no member or manager of an LLC is liable in that capacity for the liability of the company. There are exceptions, but the Hodges failed to show that Killen’s actions went beyond his duties as a member and manager of Strong Built.

Critical Thinking • Economic Why does the law allow—and even encourage—limits to the liability of a business organiza-

tion’s owners and managers for the firm’s actions? Discuss.

Case 17.1 Continued

C H A P T E R 1 7 Limited Liability Business Forms 375

in more than one state may not receive consistent treat- ment in these states.

Generally, most states apply to a foreign LLC (an LLC formed in another state) the law of the state where the LLC was formed. Difficulties can arise, though, when one state’s court must interpret and apply another state’s laws.

17–2 LLC Management and Operation

The members of an LLC have considerable flexibility in managing and operating the business. Here, we discuss management options, fiduciary duties owed, and the operating agreement and general operating procedures of LLCs.

17–2a Management of an LLC Basically, LLC members have two options for manag- ing the firm, as shown in Exhibit 17–1. The firm can be either a “member-managed” LLC or a “manager- managed” LLC. Most state LLC statutes and the ULLCA

provide that unless the articles of organization specify otherwise, an LLC is assumed to be member managed [ULLCA 203(a)(6)].

In a member-managed LLC, all of the members parmember-managed LLC, all of the members parmember-managed - ticipate in management, and decisions are made by majority vote [ULLCA 404(a)]. In a manager-managed LLC, the members designate a group of persons to man- age the firm. The management group may consist of only members, both members and nonmembers, or only nonmembers.

However an LLC is managed, its managers need to be aware of the firm’s potential liability under employment- discrimination laws. Those laws may sometimes extend to individuals who are not members of a protected class, as discussed in this chapter’s Managerial Strategy feature.Managerial Strategy feature.Managerial Strategy

17–2b Fiduciary Duties Under the ULLCA, managers in a manager-managed LLC owe fiduciary duties (the duty of loyalty and the duty of care) to the LLC and its members [ULLCA 409(a), 409(h)]. (This same rule applies in corporate law—corporate directors and officers owe fiduciary duties to the corporation and its shareholders.) Because not all states have adopted the ULLCA, though, some state statutes provide that managers owe fiduciary duties only to the LLC and not to the LLC’s members.

To whom the fiduciary duties are owed can affect the outcome of litigation. ■ CASE IN POINT 17.5 Leslie Polk and his children, Yurii and Dusty Polk and Lezanne Proc- tor, formed Polk Plumbing, LLC, in Alabama. Dusty and Lezanne were managers of the LLC. Eventually, Yurii quit the firm. A year and a half later, Leslie “fired” Dusty and Lezanne and denied them access to the LLC’s books and offices, but continued to operate the business.

Dusty and Lezanne filed a suit in an Alabama state court against Leslie, claiming breach of fiduciary duty. The trial court instructed the jury that it could not con- sider the plaintiffs’ “firing” as part of their claim. Thus, although the jury found in their favor, it awarded only one dollar to each in damages. The plaintiffs appealed, and a state intermediate appellate court reversed and remanded the case for a new trial. Leslie did not have the authority under the terms of the LLC’s operating agree- ment to fire two managers. The trial court had erred in not allowing the jury to consider the circumstances of Dusty and Lezanne’s “firing” as part of their breach-of- fiduciary-duty claim.6 ■

6. Polk v. Polk, 70 So.3d 363 (Ala.App. 2011).

Member Managed Manager Managed

All members vote on decisions; majority vote

controls.

Most LLC statutes assume the firm will

be member managed unless the articles state

otherwise.

Members designate a person or group of persons

to manage the LLC, which may

include nonmembers.

Members normally specify that the LLC is manager managed in the articles

of organization.

LLC MANAGEMENT OPTIONS

E X H I B I T 1 7 – 1 Management of an LLC

376 U N I T F O U R The Business and Employment Environment

17–2c The LLC Operating Agreement The members of an LLC can decide how to operate the various aspects of the business by forming an operating agreement [ULLCA 103(a)]. In many states, an operatagreement [ULLCA 103(a)]. In many states, an operatagreement - ing agreement is not required for an LLC to exist, and if there is one, it need not be in writing. Generally, though, LLC members should protect their interests by creating a written operating agreement.

Operating agreements typically contain provisions relating to the following areas:

1. Management and how future managers will be chosen or removed. (Although most LLC statutes are silent on this issue, the ULLCA provides that members

may choose and remove managers by majority vote [ULLCA 404(b)(3)].)

2. How profits will be divided. 3. How membership interests may be transferred. 4. Whether the dissociation of a member, such as by

death or departure, will trigger dissolution of the LLC. 5. Whether formal members’ meetings will be held. 6. How voting rights will be apportioned. (If the agree-

ment does not cover voting, LLC statutes in most states provide that voting rights are apportioned according to each member’s capital contributions.7

7. In contrast, partners in a partnership generally have equal rights in man- agement and equal voting rights unless they specify otherwise in their partnership agreement.

Can a Person Who Is Not a Member of a Protected Class Sue for Discrimination?

Under federal law and the laws of most states, discrimination in employment based on race, color, religion, national origin, gender, age, or disability is prohibited. Persons who are mem- bers of these protected classes can sue if they are subjected to discrimination. But can a per- son subjected to discrimination bring a lawsuit if he is not a member of a protected class, even though managers and other employees believe that he is? This somewhat unusual situation occurred in New Jersey.

Courts in New Jersey

Myron Cowher worked at Carson & Roberts Site Construction & Engineering, Inc. For more than a year, at least two of his supervisors directed almost daily barrages of anti-Semitic remarks at him. They believed that he was Jewish, although his actual background was German-Irish and Lutheran.

Cowher brought a suit against the supervisors and the construction company, claiming a hostile work environment. The trial court, however, ruled that he did not have standing to sue under New Jersey law because he was not Jewish and, thus, was not a mem- ber of a protected class. Cowher appealed.

The appellate court disagreed with the trial court. The court ruled that if Cowher could prove that the discrimination “would not have occurred but for the perception that he was Jewish,” his claim was covered by New Jersey’s antidiscrimination law.a Thus, in the

appellate court’s view, the nature of the dis- criminatory remarks—and not the actual char- acteristics of the plaintiff—determines whether the remarks are actionable.

Another New Jersey court followed the precedent set by the Cowher case to allow Cowher case to allow Cowher Shi-Juan Lin, a Chinese worker whose fiancé and child were black, to recover for racial

discrimination. The employer created a hostile work environment by allowing Lin’s supervisor to constantly use the “n” word at work. The employer knew that even though Lin was not black, she was hurt by the supervisor’s remarks. Therefore, the court affirmed an administrative law judge’s award of damages for pain and suffering, plus attorneys’ fees.b

Business Questions 1. Should a manager for an LLC respond to employee

complaints of discrimination any differently than a manager at a corporation, a partnership, or a sole proprietorship? Why or why not?

2. How can a company, whether an LLC or some other business form, reduce the chances of discrimination lawsuits?

MANAGERIAL STRATEGY

b. Lin v. Dane Construction Co., 2014 WL 8131876 (N.J.Super.A.D. 2015).

a. Cowher v. Carson & Roberts, 425 N.J.Super. 285, 40 A.3d 1171 (2012). See also, Sheridan v. Egg Harbor Township Board of Education, 2015 WL 9694404 (N.J.Sup.Ct. 2016), involving a plaintiff who alleged discrimination based on obesity.

C H A P T E R 1 7 Limited Liability Business Forms 377

Some states provide that, in the absence of an agree- ment to the contrary, each member has one vote.)

If a dispute arises and there is no agreement covering the topic under dispute, the state LLC statute will gov- ern the outcome. For instance, most LLC statutes pro- vide that if the members have not specified how profits will be divided, they will be divided equally among the members. When an issue is not covered by an operating agreement or by an LLC statute, the courts often apply principles of partnership law.

Of course, LLC members are bound by the operating Of course, LLC members are bound by the operating Of course, LLC members are bound by the operating Of course, LLC members are bound by the operating agreement that they make. ■ CASE IN POINT 17.6 Green Green Cab Taxi and Disabled Service Association, LLC (Green Cab), is a taxi service company in King County, Wash- ington. The operating agreement requires the members to pay weekly fees. Members who do not pay are in default and must return their taxi licenses to the com- pany. In addition, a member in default cannot hold a seat on the board or withdraw from the company without the consent of all of the members.

When a disagreement arose among the members con- cerning the company’s management, Shumet Mekonen and several others withdrew from the company without the other members’ consent. Both sides continued to drive under the Green Cab name.

Mekonen’s group filed a suit in a Washington state court against a group of members who had not with- drawn, including Dessie Zewdu. In part, the Mekonen group sought the right to operate as Green Cab. The court held that the plaintiffs could not represent them- selves as Green Cab and ordered them to return their taxi licenses to the company. A state intermediate appellate court upheld the lower court’s order to the plaintiffs to return their taxi licenses to Green Cab. Under the provi- sions of the company’s operating agreement, the plain- tiffs, as “defaulting members,” had no right to retain and use the licenses.8 ■

17–3 Dissociation and Dissolution of an LLC

Recall that in a partnership, dissociation occurs when a partner ceases to be associated in the carrying on of the partnership business. The same concept applies to LLCs. And like a partner in a partnership, a member of an LLC has the power to dissociate at any time but may not have power to dissociate at any time but may not have power the right to dissociate.right to dissociate.right

8. Mekonen v. Zewdu, 179 Wash.App. 1042 (2014).

Under the ULLCA, the events that trigger a member’s dissociation from an LLC are similar to the events caus- ing a partner to be dissociated under the Uniform Part- nership Act (UPA). These include voluntary withdrawal, expulsion by other members, court order, incompetence, bankruptcy, and death. Generally, if a member dies or otherwise dissociates from an LLC, the other members may continue to carry on the LLC business unless the operating agreement provides otherwise.

17–3a Effects of Dissociation When a member dissociates from an LLC, he or she loses the right to participate in management and the right to act as an agent for the LLC. The member’s duty of loyalty to the LLC also terminates, and the duty of care con- tinues only with respect to events that occurred before dissociation.

Generally, the dissociated member also has a right to have his or her interest in the LLC bought out by the other members. The LLC’s operating agreement may contain provisions establishing a buyout price. If it does not, the member’s interest is usually purchased at fair value. In states that have adopted the ULLCA, the LLC must purchase the interest at fair value within 120 days after the dissociation.

If the member’s dissociation violates the LLC’s oper- ating agreement, it is considered legally wrongful, and the dissociated member can be held liable for damages the dissociated member can be held liable for damages the dissociated member can be held liable for damages the dissociated member can be held liable for damages caused by the dissociation. ■ EXAMPLE 17.7 Chadwick and Barrow are members in an LLC. Chadwick manages the accounts, and Barrow, who has many connections in the community and is a skilled investor, brings in the business. If Barrow wrongfully dissociates from the LLC, the LLC’s business will suffer, and Chadwick can hold Barrow liable for the loss of business resulting from her withdrawal. ■

17–3b Dissolution Regardless of whether a member’s dissociation was wrong- ful or rightful, normally the dissociated member has no right to force the LLC to dissolve. The remaining mem- bers can opt either to continue or to dissolve the business.

Members can also stipulate in their operating agree- ment that certain events will cause dissolution, or they can agree that they have the power to dissolve the LLC by vote. As with partnerships, a court can order an LLC to be dissolved in certain circumstances. For instance, a court might order dissolution when the members have engaged in illegal or oppressive conduct, or when it is no longer feasible to carry on the business.

378 U N I T F O U R The Business and Employment Environment

■ CASE IN POINT 17.8 Three men—Walter Perkins, Gary Fordham, and David Thompson—formed Venture Sales, LLC, to develop a subdivision in Petal, Mississippi. Each of them contributed land and funds, resulting in total holdings of 466 acres of land and about $158,000 in cash.

Perkins, who was working as an assistant coach for the Cleveland Browns, trusted Fordham and Thompson to develop the property. More than ten years later, however, they still had not done so, although they had formed two other LLCs and developed two other subdivisions in the area.

Fordham and Thompson claimed that they did not know when they could develop Venture’s property and suggested selling it at a discounted price, but Perkins dis- agreed. Perkins then sought a judicial dissolution of Ven- ture Sales. The court ordered the dissolution. Because Venture Sales was not meeting the economic purpose for which it was established (developing a subdivision), con- tinuing the business was impracticable.9 ■

A judge’s exercise of discretion to order the dissolution of an LLC was disputed in the following case.

9. Venture Sales, LLC v. Perkins, 86 So.3d 910 (Miss.Sup. 2012).

Case Analysis 17.2 Reese v. Newman District of Columbia Court of Appeals, 131 A.3d 880 (2016).

Case 17.2 Continues

In the Language of the Court KING, Senior Judge:

* * * Allison Reese and * * * Nicole Newman were co-owners of ANR Construction Management, LLC * * * . Following disputes over management of the company, Newman notified Reese in writing that she intended to * * * dissolve and wind-up the LLC. Reese did not want to dissolve the LLC but preferred that Newman simply be dis- sociated so that Reese could continue the business herself. Newman filed an action for judicial dissolution in [a District of Columbia court against Reese]. Reese filed a counterclaim for Newman’s dis- sociation * * * . Following a jury trial, the jury * * * found grounds for both judicial dissolution and forced dissocia- tion of Newman; the court, thereafter, ordered judicial dissolution of the LLC. * * * Reese appeals.

* * * * Reese argues that the trial court

erred when it purported to use discre- tion in choosing between dissolution of the LLC, as proposed by Newman, and forcing dissociation of Newman from the LLC, as proposed by Reese. Reese argues that the [District of Columbia (D.C.)] statute [governing dissociation from an LLC] does not allow for any discretion by the court, and that, in fact, the statute mandates that the court order

dissociation of Newman based on the jury’s findings.

In matters of statutory interpreta- tion, we review the trial court’s decision de novo. Our analysis starts with the plain language of the statute, as the general rule of statutory interpretation is that the intent of the lawmaker is to be found in the language that he has used. To that end, the words of the statute should be con- strued according to their ordinary sense and with the meaning commonly attributed to them. [Emphasis added.]

Reese argues that the court was required to dissociate Newman from the LLC under [D.C. Code] Section 29–806.02(5) which reads:

A person shall be dissociated as a shall be dissociated as a shall member from a limited liability com- pany when: * * * * (5) On application by the company, the person is expelled as a member by judicial order because the person has: (A) Engaged, or is engaging, in wrongful conduct that has adversely and materially affected, or will adversely and materially affect, the company’s activities and affairs; (B) Willfully or persistently commit- ted, or is willfully and persistently committing, a material breach of the operating agreement or the person’s duties or obligations under Section

29–804.09; or (C) Engaged in, or is engaging, in con- duct relating to the company’s activi- ties which makes it not reasonably practicable to carry on the activities with the person as a member.

Reese’s interpretation of the statute is that, upon application to the court by a company, a judge shall dissociate a mem- ber of an LLC, when that member com- mits any one of the actions described in subsections (5)(A)-(C).

* * * While the introductory language of Section 29–806.02 does use the word “shall”—that command is in no way directed at the trial judge. It reads, “a person shall be dissociated * * * when,” and then goes on to recite fifteen separate circumstances describing different occa- sions when a person shall be dissociated from an LLC. That is to say, when one of the events described in subparagraphs (1) through (15) occurs, the member shall be dissociated. Subparagraph (5), however, is merely one instance for which a person shall be dissociated; that is, when and if a judge has ordered a member expelled because she finds that any conditions under (5)(A)-(C) have been established. In other words, the command in the introductory language is not directed at the trial judge, it is directed at all the circumstances set forth

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Legal Reasoning Questions

1. What dispute gave rise to the action filed in the court in this case? How did that dispute lead to the issue on appeal? 2. What is the role of an appellate court when reviewing the exercise of discretion by a trial court? 3. Newman alleged that after she delivered her notice to dissolve ANR, Reese locked her out of the LLC’s bank accounts, blocked

her access to the LLC’s files and e-mail, and ended her salary and health benefits. Did any of the jury’s findings support these allegations? Explain.

Case 17.2 Continued

in subparagraphs (1) through (15) * * * . There is nothing in the language of Sec- tion 29–806.02(5) that strips a judge of her discretion because it does not require the judge to expel the member if any of the enumerated conditions are estab- lished. In short, Section 29–806.02(5) means: when a judge has used her discre- tion to expel a member of an LLC by judicial order, under any of the enumerated circumstances in (5)(A)-(C), that member shall be dissociated.

* * * Although Reese argues that the language of the “dissociation” section of the District’s code should be read as forc- ing the hand of a trial judge who finds grounds for dissociation, Reese attempts to read the “dissolution” section differently.

Reese differentiates the sections by pointing to the dissolution section’s express authorization to order a rem- edy other than dissolution in Section 29–807.01(b) which provides: “in a pro- ceeding brought under subsection

(a)(5) of this section, the * * * Court may order a remedy other than dissolu- tion.” While we are satisfied that judicial dissolution of an LLC is discretionary under this statute, Reese’s attempt to buttress [reinforce] her argument that Section 29–806.02(5) is compulsory by pointing to this express provision in the dissolution section and the absence of a similar express provision in the dissocia- tion section is unavailing. First, * * * the only “shall” in the dissociation section is in the introductory language, and the same “shall” can be found in the same place, in the dissolution section: “a lim- ited liability company is dissolved, and its activities and affairs shall be wound up, upon the occurrence of any of the fol- lowing.” If that language does not make the rest of the section mandatory in the dissolution section, and we are persuaded that it does not, it cannot be said that the “shall” in the introduction of the dis- sociation section does the opposite.

* * * * In sum, we hold that Section

29–806.02(5) can only be interpreted to mean: when a judge finds that any of the events in (5)(A)-(C) have taken place, she may (i.e., has discretion to) expel by judicial order a member of an LLC, and when a judge has done so the member shall be dissociated. More- over, when both grounds for dissociation of a member and dissolution of the LLC exist, the trial judge has discretion to choose either alternative. [Emphasis added.]

Here, the jury * * * found that grounds were present for either outcome. The trial judge acknowledged that both options were on the table and then exer- cised her discretion in ordering that dis- solution take place. We find no reason to disturb that order.

* * * * Accordingly, the judgment in this

appeal is therefore affirmed.

17–3c Winding Up When an LLC is dissolved, any members who did not wrongfully dissociate may participate in the winding up process. To wind up the business, members must collect, liquidate, and distribute the LLC’s assets.

Members may preserve the assets for a reasonable time to optimize their return, and they continue to have the authority to perform reasonable acts in conjunction with winding up. In other words, the LLC will be bound by the reasonable acts of its members during the winding up process.

Once all of the LLC’s assets have been sold, the pro- ceeds are distributed. Debts to creditors are paid first (including debts owed to members who are creditors of the LLC). The members’ capital contributions are

returned next, and any remaining amounts are then dis- tributed to members in equal shares or according to their operating agreement.

17–4 Limited Liability Partnerships The limited liability partnership (LLP) is a hybrid form of business designed mostly for professionals who normally do business as partners in a partnership. Almost all of the states have enacted LLP statutes.

The major advantage of the LLP is that it allows a part- nership to continue as a pass-through entity for tax pur- poses but limits the personal liability of the partners. The LLP is especially attractive for professional service firms

380 U N I T F O U R The Business and Employment Environment

and family businesses. All of the “Big Four” account- ing firms—the four largest international accountancy and professional services firms—are organized as LLPs, including Ernst & Young, LLP, and Pricewaterhouse Coopers, LLP.

17–4a Formation of an LLP LLPs must be formed and operated in compliance with state statutes, which may include provisions of the Uni- form Partnership Act (UPA). The appropriate form must be filed with a central state agency, usually the secretary of state’s office, and the business’s name must include either “Limited Liability Partnership” or “LLP” [UPA 1001, 1002]. An LLP must file an annual report with the state to remain qualified as an LLP in that state [UPA 1003].

In most states, it is relatively easy to convert a tradi- tional partnership into an LLP because the firm’s basic organizational structure remains the same. Additionally, all of the statutory and common law rules governing partnerships still apply, apart from those modified by the LLP statute. Normally, LLP statutes are simply amend- ments to a state’s already existing partnership law.

17–4b Liability in an LLP An LLP allows professionals, such as attorneys and accountants, to avoid personal liability for the malprac- tice of other partners. Of course, a partner in an LLP is still liable for her or his own wrongful acts, such as negligence. Also liable is the partner who supervised the individual who committed a wrongful act. (This gener- ally is true for all types of partners and partnerships, not just LLPs.)just LLPs.)just LLPs.)

■ EXAMPLE 17.9 Five lawyers operate a law firm as an LLP. One of the attorneys, Dan Kolcher, is sued for mal- practice and loses. The firm’s malpractice insurance is insuf-practice and loses. The firm’s malpractice insurance is insuf-practice and loses. The firm’s malpractice insurance is insuf ficient to pay the judgment. If the firm had been organized as a traditional (general) partnership, the personal assets of the other attorneys could be used to satisfy the obligation. Because the firm is organized as an LLP, however, no other partner at the firm can be held personally liable for Kolcher’s personally liable for Kolcher’s personally malpractice, unless she or he acted as Kolcher’s supervisor. In the absence of a supervisor, only Kolcher’s personal assets can be used to satisfy the judgment. ■

Although LLP statutes vary from state to state, gener- ally each state statute limits the liability of partners in some way. For instance, Delaware law protects each innocent partner from the “debts and obligations of the partnership arising from negligence, wrongful acts, or misconduct.”

The UPA more broadly exempts partners in an LLP from personal liability for any partnership obligation, “whether arising in contract, tort, or otherwise” [UPA 306(c)].

Liability outside the State of Formation When an LLP formed in one state wants to do business in another state, it may be required to file a statement of foreign qualification in the second state [UPA 1102]. A question sometimes arises as to which law applies if the LLP statutes in the two states provide different liability protection. Most states apply the law of the state in which the LLP was formed, even when the firm does business in another state, which is also the rule under UPA 1101.

Sharing Liability among Partners When more than one partner in an LLP commits malpractice, there is a question as to how liability should be shared. Is each partner jointly and severally liable for the entire result, as a general partner would be in most states?

Some states provide instead for proportionate liability—that is, for separate determinations of the negliability—that is, for separate determinations of the negliability—that is, for separate determinations of the negliability—that is, for separate determinations of the neg- ligence of the partners. ■ EXAMPLE 17.10 Accountants Zach and Lyla are partners in an LLP, with Zach super- vising Lyla. Lyla negligently fails to file a tax return for a client, Centaur Tools. Centaur files a suit against Zach and Lyla. Under a proportionate liability statute, Zach will be liable for no more than his portion of the respon- sibility for the missed tax deadline. In a state that does not allow for proportionate liability, Zach can be held liable for the entire loss. ■

17–4c Family Limited Liability Partnerships

A family limited liability partnership (FLLP) is a lim- ited liability partnership in which the partners are related to each other—for instance, as spouses or siblings. A per- son acting in a fiduciary capacity for persons so related can also be a partner. All of the partners must be natural persons or be acting in a fiduciary capacity for the benefit of natural persons.

Probably the most significant use of the FLLP form of business organization is in agriculture by family-owned farms. The FLLP offers the same advantages as other LLPs with certain additional advantages. For instance, in Iowa, FLLPs are exempt from real estate transfer taxes when partnership real estate is transferred among partners.10

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17–5 Limited Partnerships We now look at a business organizational form that limits the liability of some of its owners—the some of its owners—the some limited partner- ship (LP). Limited partnerships originated in medieval Europe and have been in existence in the United States since the early 1800s. Today, most states and the District of Columbia have adopted laws based on the Revised Uniform Limited Partnership Act (RULPA).

Limited partnerships differ from traditional (general) partnerships in several ways. Exhibit 17–2 compares the characteristics of general and limited partnerships.11

11. Under the UPA, a general partnership can be converted into a limited partnership and vice versa [UPA 902, 903]. The UPA also provides for the merger of a general partnership with one or more general or limited partnerships [UPA 905].

A limited partnership consists of at least one general partner and one or more partner and one or more partner limited partners. A general partner assumes management responsibility for the part- nership and has full responsibility for the partnership and for all its debts. A limited partner contributes cash or other property and owns an interest in the firm but is not involved in management responsibilities. A limited part- ner is not personally liable for partnership debts beyond the amount of his or her investment. If a limited partner takes part in the management of the business, however, she or he may forfeit that limited liability.

In the following case, two firms—a corporation and a limited partnership—were involved in the construc- tion of a residential development. One individual served as the president of the corporation and the sole general partner of the partnership. In addition, he took charge of the activities at the construction site. How did this indi- vidual’s status affect his responsibility for those activities?

Background and Facts Valley View Enterprises, Inc., built Pine Lakes Golf Club and Estates in Trumbull County, Ohio, in two phases—Phase I and Phase II. Valley View Properties, Ltd., a limited partnership, cut out the roadways and constructed sewer, water, and storm-water lines with water inlets for the development. Joseph Ferrara was the owner and the president of Valley View Enterprises and the sole general partner of Valley View Properties. Ferrara failed to obtain the proper permits for the development work in a timely manner and failed to comply with their requirements once they had been obtained.

Michael DeWine, the state’s attorney general, filed a lawsuit in an Ohio court against the Valley View entities and Ferrara, alleging violations of the state’s water pollution control laws and seeking civil penalties. The court entered a judgment in the defendants’ favor, holding with respect to Ferrara that “a corporate officer cannot be held liable merely by virtue of his status as a corporate officer.” DeWine appealed.

In the Language of the Court Timothy J. CANNON, P.J. [Presiding Judge]

* * * * Here, the state sought civil penalties from three entities: the property owner and Phase II permit

holder, Valley View Properties, Ltd.; the Phase I permit holder, Valley View Enterprises, Inc.; and the sole general partner of the property owner, Mr. Ferrara.

* * * The state alleges the trial court erred in its finding that “Valley View Properties is the only party against whom civil penalties can be assessed.” The trial court also found Mr. Ferrara was not liable based on his “good faith” actions and Valley View Enterprises, Inc. was not liable because it had no relationship to Pine Lakes Estates; [and] the state failed to present evidence that Mr. Ferrara ordered activities that caused pollution.

* * * Although the trial court found that Valley View Enterprises, Inc. had no relationship to Pine Lake Estates, the evidence establishes that Valley View Enterprises, Inc. applied for and was granted the [Phase I] Permit and, as the permittee, was required to ensure compliance with the permit. The [Phase I]

DeWine v. Valley View Enterprises, Inc. Court of Appeals of Ohio, Eleventh District, Trumbull County, 2015 –Ohio– 1222, ___ Ohio App.3d ___, ___ N.E.2d ___ (2015).

Case 17.3

382 U N I T F O U R The Business and Employment Environment

17–5a Formation of an LP In contrast to the private and informal agreement that usually suffices to form a general partnership, the for- mation of a limited partnership is a public and formal proceeding. The partners must strictly follow statutory requirements. Not only must a limited partnership have at least one general partner and one limited partner, but the partners must also sign a certificate of limited partnership.

The certificate of limited partnership must include certain information, including the name, mailing address, and capital contribution of each general and limited partner. The certificate must be filed with the designated state official—under the RULPA, the secretary of state. The certificate is usually open to public inspection.

17–5b Liabilities of Partners in an LP General partners are personally liable to the partnership’s creditors. Thus, at least one general partner is necessary in a limited partnership so that someone has personal liability. This policy can be circumvented in states that allow a corporation to be the general partner in a partner- ship. Because the corporation has limited liability by vir- tue of corporation statutes, if a corporation is the general partner, no one in the limited partnership has personal liability.

The liability of a limited partner, as mentioned, is limited to the capital that she or he contributes or agrees to contribute to the partnership [RULPA 502]. Limited partners enjoy this limited liability only so long as they do not participate in management [RULPA 303].

A limited partner who participates in management will be just as liable as a general partner to any credi- tor who transacts business with the limited partnership. Liability arises when the creditor believes, based on the limited partner’s conduct, that the limited partner is a general partner [RULPA 303]. The extent to which a limited partner can engage in management before being exposed to liability is not always clear, however.

17–5c Rights and Duties in a Limited Partnership

With the exception of the right to participate in manage- ment, limited partners have essentially the same rights as general partners. Limited partners have a right of access to the partnership’s books and to information regarding partnership business.

On dissolution of the partnership, limited partners are entitled to a return of their contributions in accordance with the partnership certificate [RULPA 201(a)(10)]. They can also assign their interests subject to the cer- tificate [RULPA 702, 704]. In addition, they can sue an

Permit explicitly states, “the permittee must comply with all conditions of this permit, any permit non- compliance constitutes a violation of [state law].” Additionally, * * * the evidence demonstrates that Mr. Ferrara personally was in charge of the activities performed at the sites; authorized the construction activities at the sites; and failed to obtain necessary certifications and permits. [Emphasis added.]

Moreover, the trial court’s finding that “a corporate officer cannot be held liable merely by virtue of his status as a corporate officer” is erroneous and not supported by the evidence. Admittedly, Mr. Fer- rara is the sole general partner of Valley View Properties, Ltd., an Ohio limited partnership. He is not, in relation to Valley View Properties, Ltd., a “corporate officer.” Therefore, he is not, in the course of his conduct as the general partner of that limited partnership, entitled to the insulation from liability of a corporate officer.

Decision and Remedy A state intermediate appellate court reversed the lower court’s judgment in favor of the defendants. With respect to Ferrara’s status in relation to Valley View Properties, he was the general partner and therefore not “entitled to the insulation from liability of a corporate officer.” On remand, the trial court was to determine the number of violations established by the state and to issue and apportion penalties among the liable parties.

Critical Thinking • Legal Environment How are the penalties likely to be apportioned among the three defendants?

Explain.

Case 17.3 Continued

C H A P T E R 1 7 Limited Liability Business Forms 383

Unlimited personal liability of all general partners; limited partners liable only to the extent of their capital contributions.

GENERAL PARTNERSHIP (UPA)

Sharing of Profits and Losses

Creation

Liability

Capital Contribution

By agreement of two or more persons to carry on a business as co-owners for profit.

By agreement. In the absence of agreement, profits are shared equally by the partners, and losses are shared in the same ratio as profits.

No minimum or mandatory amount; set by agreement.

Management By agreement. In the absence of agreement, all partners have an equal voice.

Duration Terminated by agreement of the partners, but can continue to do business even when a partner dissociates from the partnership.

Distribution of Assets on Liquidation— Order of Priorities

1. Payment of debts, including those owed to partner and nonpartner creditors.

2. Return of capital contributions and distribution of profit to partners.

Unlimited personal liability of all partners.

LIMITED PARTNERSHIP (RULPA)

By agreement of two or more persons to carry on a business as co-owners for profit. Must include one or more general partners and one or more limited partners. Filing of a certificate with the secretary of state is required.

Profits are shared as required in the certificate agreement, and losses are shared likewise, up to the amount of the limited partners’ capital contributions. In the absence of a provision in the certificate agreement, profits and losses are shared on the basis of percentages of capital contributions.

Only the general partner (or the general partners). Limited partners have no voice or else are subject to liability as general partners (but only if a third party has reason to believe that the limited partner is a general partner). A limited partner may act as an agent or employee of the partnership and vote on amending the certificate or on the sale or dissolution of the partnership.

Terminated by agreement in the certificate or by retirement, death, or mental incompetence of a general partner in the absence of the right of the other general partners to continue the partnership. Death of a limited partner does not terminate the partnership, unless he or she is the only remaining limited partner.

1. Outside creditors and partner creditors. 2. Partners and former partners entitled to distributions of partnership assets. 3. Unless otherwise agreed, return of capital contributions and distribution of profit to partners.

Set by agreement.

E X H I B I T 1 7 – 2 A Comparison of General Partnerships and Limited Partnerships

384 U N I T F O U R The Business and Employment Environment

outside party on behalf of the firm if the general partners with authority to do so have refused to file suit [RULPA 1001].

17–5d Dissociation and Dissolution A general partner has the power to voluntarily dissoci- ate, or withdraw, from a limited partnership unless the partnership agreement specifies otherwise. Under the RULPA, a limited partner can withdraw from the part- nership by giving six months’ notice, unless the partner- ship agreement specifies a term. In reality, though, most limited partnership agreements do specify a term, which eliminates the limited partner’s right to withdraw. Also, some states have passed laws prohibiting the withdrawal of limited partners.

Events That Cause Dissociation In a limited part- nership, a general partner’s voluntary dissociation from the firm normally will lead to dissolution unless all partunless all partunless - ners agree to continue the business. Similarly, the bank- ruptcy, retirement, death, or mental incompetence of a general partner will cause the dissociation of that partner and the dissolution of the limited partnership unless the other members agree to continue the firm [RULPA 801].

Bankruptcy of a limited partner, however, does not dissolve the partnership unless it causes the bankruptcy of the firm. In addition, death or an assignment of the interest (right to receive distributions) of a limited part- ner does not dissolve a limited partnership [RULPA 702, 704, 705]. A limited partnership can be dissolved by court decree [RULPA 802].

Distribution of Assets On dissolution, creditors’ claims, including those of partners who are creditors, take first priority. After that, partners and former partners receive unpaid distributions of partnership assets. Unless otherwise agreed, they are also entitled to a return of their contributions in the proportions in which they share in distributions [RULPA 804].

Valuation of Assets Disputes commonly arise about how the partnership’s assets should be valued and distributed

and whether the business should be sold. ■ CASE IN POINT OINT 17.11 Actor Kevin Costner was a limited partner in Mid- night Star Enterprises, LP, which runs a casino, bar, and restaurant in South Dakota. There were two other limited partners, Carla and Francis Caneva, who owned a small percentage of the partnership (3.25 units each) and received salaries for managing its operations. Another company owned by Costner, Midnight Star Enterprises, Limited (MSEL), was the general partner. Costner thus controlled a majority of the partnership (93.5 units).

When communications broke down between the partners, MSEL asked a court to dissolve the partnership. MSEL’s accountant determined that the firm’s fair mar- ket value was $3.1 million. The Canevas presented evi- dence that a competitor would buy the business for $6.2 million. The Canevas wanted the court to force Costner to either buy the business for that price within ten days or sell it on the open market to the highest bidder. Ulti- mately, the state’s highest court held in favor of Costner. A partner cannot force the sale of a limited partnership when the other partners want to continue the business. The court also accepted the $3.1 million buyout price of MSEL’s accountant and ordered Costner to pay the Canevas the value of their 6.5 partnership units.12 ■

17–5e Limited Liability Limited Partnerships

A limited liability limited partnership (LLLP) differs from a limited partnership in that a general partner in an LLLP has the same liability as a limited partner in a limited partnership. In other words, the liability of all partners is limited to the amount of their investments in the firm.

A few states provide expressly for LLLPs.13 In states that do not provide for LLLPs but do allow for limited partnerships and limited liability partnerships, a limited partnership should probably still be able to register with the state as an LLLP.

12. In re Dissolution of Midnight Star Enterprises, LP, 2006 SD 98, 724 In re Dissolution of Midnight Star Enterprises, LP, 2006 SD 98, 724 In re Dissolution of Midnight Star Enterprises, LP N.W.2d 334 (S.D.Sup.Ct. 2006).

13. The states that provide for LLLPs include Colorado, Delaware, Florida, Georgia, Kentucky, Maryland, Nevada, Texas, and Virginia.

C H A P T E R 1 7 Limited Liability Business Forms 385

Reviewing: Limited Liability Business Forms

The city of Papagos, Arizona, had a deteriorating bridge in need of repair on a prominent public roadway. The city posted notices seeking proposals for an artistic bridge design and reconstruction. Davidson Masonry, LLC, which was owned and managed by Carl Davidson and his wife, Marilyn Rowe, decided to submit a bid to create a decorative con- crete structure that incorporated artistic metalwork. They contacted Shana Lafayette, a local sculptor who specialized in large-scale metal creations, to help them design the bridge. The city selected their bridge design and awarded them the contract for a commission of $184,000.

Davidson Masonry and Lafayette then entered into an agreement to work together on the bridge project. Davidson Masonry agreed to install and pay for concrete and structural work, and Lafayette agreed to install the metalwork at her expense. They agreed that overall profits would be split, with 25 percent going to Lafayette and 75 percent going to Davidson Masonry. Lafayette designed numerous metal sculptures of trout that were incorporated into colorful deco- rative concrete forms designed by Rowe. Davidson performed the structural engineering. The group worked together successfully until the completion of the project. Using the information presented in the chapter, answer the following questions. 1. Would Davidson Masonry automatically be taxed as a partnership or a corporation? 2. Is Davidson Masonry member managed or manager managed? 3. Suppose that during construction, Lafayette asked Carl Davidson to rent space in a warehouse that was close to

the bridge so that she could work on her sculptures near the site where they would eventually be installed. Carl Davidson signed the rental contract in his own name rather than the name of the LLC. The other members of Davidson Masonry were not aware of the rental agreement. In this situation, would a court likely hold that David- son Masonry was liable on the contract that Carl Davidson had entered? Why or why not?

4. Now suppose that Rowe has an argument with her husband and wants to withdraw from being a member of David- son Masonry. What is the term for such a withdrawal, and what effect would it have on the LLC?

Debate This . . . Because LLCs are essentially just partnerships with limited liability for members, all partnership laws should apply.

Terms and Concepts articles of organization 372 certi�cate of limited

partnership 382 family limited liability partnership

(FLLP) 380 general partner 381

limited liability company (LLC) 371

limited liability limited partnership (LLLP) 384

limited liability partnership (LLP) 379

limited partner 381 limited partnership (LP) 381 member 371 operating agreement 376

Issue Spotters 1. Gabriel, Harris, and Ida are members of Jeweled Watches,

LLC. What are their options with respect to the manage- ment of their firm? (See LLC Management and Operation.)

2. Dorinda, Luis, and Elizabeth form a limited partnership. Dorinda is a general partner, and Luis and Elizabeth are

limited partners. If Elizabeth is petitioned into involun- tary bankruptcy, does that constitute a dissolution of the limited partnership? (See Limited Partnerships.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

386 U N I T F O U R The Business and Employment Environment

Business Scenarios 17–1. Limited Liability Companies. John, Lesa, and Tabir form a limited liability company. John contributes 60 percent of the capital, and Lesa and Tabir each contribute 20 percent. Nothing is decided about how profits will be divided. John assumes that he will be entitled to 60 percent of the prof-John assumes that he will be entitled to 60 percent of the prof-John assumes that he will be entitled to 60 percent of the prof its, in accordance with his contribution. Lesa and Tabir, how- ever, assume that the profits will be divided equally. A dispute over the profits arises, and ultimately a court has to decide the issue. What law will the court apply? In most states, what will result? How could this dispute have been avoided in the first place? Discuss fully. (See The Limited Liability Company.) 17–2. Diversity Jurisdiction and Limited Liability Companies. Joe, a resident of New Jersey, wants to open

a restaurant. He asks Kay, his friend, an experienced attor- ney and a New Yorker, for her business and legal advice in exchange for a 20 percent ownership interest in the restaurant. Kay helps Joe negotiate a lease for the restaurant premises and advises Joe to organize the business as a limited liability com- pany (LLC).

Joe forms Café Olé, LLC, and with Kay’s help, obtains financing. Then, the night before the restaurant opens, Joe tells Kay that he is “cutting her out of the deal.” The restau- rant proves to be a success. Kay wants to file a suit in a federal district court against Joe and the LLC. Can a federal court exercise jurisdiction over the parties based on diversity of citi- zenship? Explain. (See The Limited Liability Company.)

Business Case Problems 17–3. Limited Liability Companies. Coco Investments, LLC, and other investors participated in a condominium con- version project to be managed by Zamir Manager River Terrace, LLC. �e participants entered into a new LLC agreement for the project. �e investors subsequently complained that Zamir had failed to disclose its plans for dramatic changes involving higher-than-expected construction costs and delays. �ey also claimed that Zamir had failed to provide �nancial information and had restructured loans in a manner that allowed Zamir representatives to avoid personal liability. �e investors sued Zamir on various grounds, including breach of contract and breach of �duciary duty. Zamir moved for summary judg- ment. How should the court rule? Explain. [Coco Investments, LLC v. Zamir Manager River Terrace, LLC, 26 Misc.3d 1231, 907 N.Y.S.2d 99 (2010)] (See �e Limited Liability Company.) 17–4. LLC Dissolution. Walter Van Houten and John King formed 1545 Ocean Avenue, LLC, with each managing 50 percent of the business. Its purpose was to renovate an exist- ing building and construct a new commercial building. Van Houten and King quarreled over many aspects of the work on the properties. King claimed that Van Houten paid the contractors too much for the work performed. As the proj- ects neared completion, King demanded that the LLC be dissolved and that Van Houten agree to a buyout. Because the parties could not agree on a buyout, King sued for dis- solution. �e trial court enjoined (prevented) further work on the projects until the dispute was settled. As the ground for dissolution, King cited the �ghts over management decisions. �ere was no claim of fraud or frustration of purpose. �e trial court ordered that the LLC be dissolved, and Van Houten appealed. Should either of the owners be forced to dissolve the LLC before the completion of its purpose—that is, before the building projects are �nished? Explain. [In re 1545 Ocean Avenue, LLC, 893 N.Y.S.2d 590 (N.Y.A.D. 2 Dept. 2010)] (See Dissociation and Dissolution of an LLC.)

17–5. Business Case Problem with Sample Answer— LLC Operation. After Hurricane Katrina struck the Gulf

Coast, James Williford, Patricia Mosser, Mar- quetta Smith, and Michael Floyd formed Blue- water Logistics, LLC, to bid on construction contracts. Under Mississippi law, every member of

a member-managed LLC is entitled to participate in managing the business. �e operating agreement provided for a “super majority” 75 percent vote to remove a member who “has either committed a felony or under any other circumstances that would jeopardize the company status” as a contractor. After Bluewater had completed more than $5 million in contracts, Smith told Williford that she, Mosser, and Floyd were exercis- ing their “super majority” vote to �re him. No reason was pro- vided. Williford sued Bluewater and the other members. Did Smith, Mosser, and Floyd breach the state LLC statute, their �duciary duties, or the Bluewater operating agreements? Dis- cuss. [Bluewater Logistics, LLC v. Williford, 55 So.3d 148 (Miss.Sup.Ct. 2011)] (See LLC Management and Operation.) • For a sample answer to Problem 17–5, go to Appendix E at

the end of this text.

17–6. Jurisdictional Requirements. Fadal Machining Centers, LLC, and MAG Industrial Automation Centers, LLC, sued a New Jersey–based corporation, Mid-Atlantic CNC, Inc., in federal district court. Ten percent of MAG was owned by SP MAG Holdings, a Delaware LLC. SP MAG had six members, including a Delaware limited partnership called Silver Point Capital Fund and a Delaware LLC called SPCP Group III. In turn, Silver Point and SPCP Group had a com- mon member, Robert O’Shea, who was a New Jersey citizen. Assuming that the amount in controversy exceeds $75,000, does the district court have diversity jurisdiction? Why or why not? [Fadal Machining Centers, LLC v. Mid-Atlantic CNC, Inc., 464 Fed.Appx. 672 (9th Cir. 2012)] (See �e Limited Liability Company.)

C H A P T E R 1 7 Limited Liability Business Forms 387

17–7. Jurisdictional Requirements. Siloam Springs Hotel, LLC, operates a Hampton Inn in Siloam Springs, Arkansas. Siloam bought insurance from Century Surety Co. to cover the hotel. When guests su�ered injuries due to a leak of car- bon monoxide from the heating element of an indoor swim- ming pool, Siloam �led a claim with Century. Century denied coverage, which Siloam disputed. Century asked a federal dis- trict court to resolve the dispute. In asserting that the federal court had jurisdiction, Century noted that the amount in con- troversy exceeded $75,000 and that the parties had complete diversity of citizenship. Century is “a corporation organized under the laws of Ohio, with its principal place of business in Michigan,” and Siloam is “a corporation organized under the laws of Oklahoma, with its principal place of business in Arkansas.” Can the court exercise diversity jurisdiction in this case? Discuss. [Siloam Springs Hotel, L.L.C. v. Century Surety Co., 781 F.3d 1233 (10th Cir. 2015)] (See �e Limited Liabil-Limited Liabil-Limited Liabil ity Company.) 17–8. A Question of Ethics—Limited Liability Compa- nies. Blushing Brides, LLC, a publisher of wedding planning

magazines in Columbus, Ohio, opened an account with Gray Printing Co. in July 2000. On behalf of Blushing Brides, Louis Zacks, the �rm’s member- manager, signed a credit agreement that identi�ed the

�rm as the “purchaser” and required payment within thirty days. Despite the agreement, Blushing Brides typically took up to six months to pay the full amount for its orders. Gray printed and shipped 10,000 copies of a fall/winter 2001 issue for Blushing Brides but had not been paid when the �rm ordered 15,000 copies of a spring/summer 2002 issue. Gray refused to print the new order without an assurance of payment. On May 22, Zacks signed a promissory note payable to Gray within thirty days for $14,778,

plus interest at 6 percent per year. Gray printed the new order but by October had been paid only $7,500. Gray �led a suit in an Ohio state court against Blushing Brides and Zacks to collect the balance. [Gray Printing Co. v. Blushing Brides, LLC, [Gray Printing Co. v. Blushing Brides, LLC, [ 2006 -Ohio- 1656 (Ohio App. 2006)] (See (Ohio App. 2006)] (See (Ohio App. 2006)] �e Limited Liability Company.) (a) Under what circumstances is a member of an LLC liable

for the firm’s debts? In this case, is Zacks personally liable under the credit agreement for the unpaid amount on Blushing Brides’ account? Did Zacks’s promissory note affect the parties’ liability on the account? Explain.

(b) Should a member of an LLC assume an ethical responsi- bility to meet the obligations of the firm? Discuss.

(c) Gray shipped only 10,000 copies of the spring/summer 2002 issue of Blushing Brides’ magazine, waiting for the publisher to identify a destination for the other 5,000 cop- ies. The magazine had a retail price of $4.50 per copy. Did Gray have a legal or ethical duty to “mitigate the damages” by attempting to sell or otherwise distribute these copies itself? Why or why not?

17–9. Special Case Analysis—LLC Dissolution. Go to Case Analysis 17.2, Reese v. Newman. Read the excerpt and answer the following questions. (a) Issue: Which party’s choice between two alternatives was

at the heart of the issue on the appeal of the Reese case? Reese case? Reese (b) Rule of Law: What rules of interpretation did the appel-

late court use to construe the language of the statutes that created those alternatives?

(d) Conclusion: How did the court’s construction of that lan- guage lead to the result?

Legal Reasoning Group Activity 17–10. Fiduciary Duties in LLCs. Newbury Properties Group owns, manages, and develops real property. Jerry Stoker and the Stoker Group, Inc. (the Stokers), also develop real property. Newbury entered into agreements with the Stokers concerning a large tract of property in Georgia. �e parties formed Bellemare, LLC, to develop various parcels of the tract for residential purposes. �e operating agreement of Bellemare indicated that “no Member shall be accountable to the LLC or to any other Member with respect to any other business or activity even if the business or activity competes with the LLC’s business.” Later, when the Newbury group

contracted with other parties to develop parcels within the tract in competition with Bellemare, LLC, the Stokers sued, alleging breach of �duciary duty. (See LLC Management and Operation.) (a) The first group will discuss and outline the fiduciary

duties that the members of an LLC owe to each other. (b) The second group will determine whether the terms of an

operating agreement can alter these fiduciary duties. (c) The last group will decide in whose favor the court should

rule in this situation.

388

C H A P T E R 18

18–1 Nature and Classification A corporation is a legal entity created and recognized by state law. This business entity can have one or more owners (called shareholders), and it operates under a name distinct from the names of its owners. Both indi- viduals and other businesses can be shareholders. The corporation substitutes itself for its shareholders when conducting corporate business and incurring liability. Its authority to act and the liability for its actions, however, are separate and apart from the shareholders who own it.

A corporation is recognized under U.S. law as a person—an artificial legal person, as opposed to a natural person. As a “person,” it enjoys many of the same rights and privileges under state and federal law that U.S. citi- zens enjoy. For instance, corporations possess the same right of access to the courts as citizens and can sue or be sued. The constitutional guarantees of due process, free speech, and freedom from unreasonable searches and sei- zures also apply to corporations.

18–1a Corporate Personnel In a corporation, the responsibility for the overall man- agement of the firm is entrusted to a board of directors, whose members are elected by the shareholders. The

board of directors makes the policy decisions and hires corporate officers and other employees to run the daily corporate officers and other employees to run the daily corporate officers business operations.

When an individual purchases a share of stock in a corporation, that person becomes a shareholder and an owner of the corporation. Unlike the partners in a part- nership, the body of shareholders can change constantly without affecting the continued existence of the corpo- ration. A shareholder can sue the corporation, and the corporation can sue a shareholder. Additionally, under certain circumstances, a shareholder can sue on behalf of a corporation.

18–1b The Limited Liability of Shareholders

One of the key advantages of the corporate form is the limited liability of its owners. Normally, corporate share- holders are not personally liable for the obligations of the corporation beyond the extent of their investments.

In certain limited situations, however, a court can pierce the corporate veil and impose liability on share- holders for the corporation’s obligations. Additionally, creditors often will not extend credit to small companies unless the shareholders assume personal liability, as guar- antors, for corporate obligations.

T he corporation is a creature of statute. A corporation is an arti- ficial being, existing only in law

and being neither tangible nor visible. Its existence generally depends on state law, although some corporations, especially public organizations, are cre- ated under federal law. Each state has its own body of corporate law, and these laws are not entirely uniform.

The Model Business Corporation Act (MBCA) is a codification of mod- ern corporation law that has been influential in shaping state corpora- tion statutes. Today, the majority of state statutes are guided by the most recent version of the MBCA, often referred to as the Revised Model Busi- ness Corporation Act (RMBCA).

Keep in mind, however, that there is considerable variation among the laws of states that have used the MBCA or the RMBCA as a basis for their statutes. In addition, several states do not follow either act. Con- sequently, individual state corporation laws should be relied on to determine corporate law rather than the MBCA or RMBCA.

Corporations

C H A P T E R 1 8 Corporations 389

18–1c Corporate Earnings and Taxation When a corporation earns profits, it can either pass them on to shareholders in the form of dividends or retain them as profits. These retained earnings, if invested properly, will yield higher corporate profits in the future. In theory, higher profits will cause the price of the company’s stock to rise. Individual shareholders can then reap the benefits in the capital gains they receive when they sell their stock.

Corporate Taxation Whether a corporation retains its profits or passes them on to the shareholders as divi- dends, those profits are subject to income taxation by various levels of government. Failure to pay taxes can lead to severe consequences. The state can suspend the organi- zation’s corporate status until the taxes are paid and can even dissolve the corporation for failing to pay taxes.

Another important aspect of corporate taxation is that corporate profits can be subject to double taxation. The company pays tax on its profits. Then, if the prof-The company pays tax on its profits. Then, if the prof-The company pays tax on its profits. Then, if the prof its are passed on to the shareholders as dividends, the shareholders must also pay income tax on them. (This is true unless the dividends represent distributions of capi- tal, which are returns of holders’ investments in the stock of the company.) The corporation normally does not receive a tax deduction for dividends it distributes. This double-taxation feature is one of the major disadvantages of the corporate form.

Holding Companies Some U.S. corporations use holding companies to reduce or defer their U.S. income taxes. At its simplest, a holding company (sometimes referred to as a parent company) is a company whose busiparent company) is a company whose busiparent company - ness activity consists of holding shares in another company. Typically, the holding company is established in a low-tax or no-tax offshore jurisdiction, such as the Cayman Islands, Dubai, Hong Kong, Luxembourg, Monaco, or Panama.

Sometimes, a U.S. corporation sets up a holding company in a low-tax offshore environment and then transfers its cash, bonds, stocks, and other investments to the holding company. In general, any profits received by the holding company on these investments are taxed at the rate of the offshore jurisdiction where the company is registered. Once the profits are brought “onshore,” though, they are taxed at the federal corporate income tax rate. Any payments received by the shareholders are also taxable at the full U.S. rates.

18–1d Criminal Acts Under modern criminal law, a corporation may be held liable for the criminal acts of its agents and employees.

Although corporations cannot be imprisoned, they can be fined. (Of course, corporate directors and officers can be imprisoned.) In addition, under sentencing guidelines for crimes committed by corporate employees, corpora- tions can face fines amounting to hundreds of millions of dollars.

18–1e Tort Liability A corporation is liable for the torts committed by its agents or officers within the course and scope of their employment under the doctrine of respondeat superior (to be discussed in the agency chapter). The doctrine of respondeat superior applies to corporations in the same respondeat superior applies to corporations in the same respondeat superior way as it does to other agency relationships. way as it does to other agency relationships. way as it does to other agency relationships. way as it does to other agency relationships.

■ CASE IN POINT 18.1 Mark Bloom was an officer and a director of MB Investment Partners, Inc. (MB), at the time that he formed North Hills, LP, a stock investment fund. Bloom and other MB employees used MB’s offices and equipment to administer investments in North Hills.

Later, investors in North Hills requested a full redemp- tion of their investments. By that time, however, most of the funds that had been invested were gone. North Hills had, in fact, been a Ponzi scheme that Bloom had used to finance his lavish personal lifestyle, taking at least $20 million from North Hills for his personal use.

Barry Belmont and other North Hills investors filed a suit in a federal district court against MB, alleging fraud. The court held that MB was liable for Bloom’s fraud. MB appealed, and the appellate court affirmed. Tort liability can be attributed to a corporation for the acts of its agent that were committed within the scope of the agent’s employment.1 ■

18–1f Classification of Corporations The classification of a corporation normally depends on its location, purpose, and ownership characteristics, as described in the following subsections.

Domestic, Foreign, and Alien Corporations A corporation is referred to as a domestic corporation by its home state (the state in which it incorporates). A corpora- tion formed in one state but doing business in another is referred to in the second state as a foreign corporation. A corporation formed in another country (say, Mexico) but doing business in the United States is referred to in the United States as an alien corporation.

A corporation does not have an automatic right to do business in a state other than its state of incorporation.

1. Belmont v. MB Investment Partners, Inc., 708 F.3d 470 (3d Cir. 2013). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

390 U N I T F O U R The Business and Employment Environment

In some instances, it must obtain a certificate of authority in any state in which it plans to do business. Once the certificate has been issued, the corporation generally can exercise in that state all of the powers conferred on it by its home state. If a foreign corporation does business in a state without obtaining a certificate of authority, the state can impose substantial fines and sanctions on that corporation.

Note that most state statutes specify certain activities, such as soliciting orders via the Internet, that are not con- sidered “doing business” within the state. For instance, a foreign corporation normally does not need a certificate of authority to sell goods or services via the Internet or by mail.

What constitutes doing business within a state? In the following case, the court answered that question.

Background and Facts Drake Manufacturing Company, a Delaware corporation, entered into a contract to sell certain products to Polyflow, Inc., headquartered in Pennsylvania. Drake promised to ship the goods from Drake’s plant in Sheffield, Pennsylvania, to Polyflow’s place of business in Oaks, Pennsylvania, as well as to addresses in California, Canada, and Holland.

When Polyflow withheld payment of about $300,000 for some of the goods, Drake filed a breach of contract suit in a Pennsylvania state court against Polyflow seeking to collect the unpaid amount. But Drake had failed to obtain a certificate of authority to do business in Pennsylvania as a foreign corporation. Polyflow asserted that this failure to register with the state deprived Drake of the capacity to bring an action against Polyflow in the state’s courts. The court issued a judgment in Drake’s favor. Polyflow appealed.

In the Language of the Court Opinion by JENKINS, J. [Judge]:

* * * * [15 Pennsylvania Consolidated Statutes (Pa.C.S.)] Section 4121 provides: “A foreign business cor-

poration, before doing business in this Commonwealth, shall procure a certificate of authority to do so from the Department of State.”

* * * Typical conduct requiring a certificate of authority includes maintaining an office to conduct local intrastate business [and] entering into contracts relating to local business or sales.

A corporation is not “doing business” solely because it resorts to the courts of this Commonwealth to recover an indebtedness. [Emphasis added.]

* * * * [15 Pa.C.S.] Section 4141(a) provides in relevant part that “a nonqualified foreign business cor-

poration doing business in this Commonwealth * * * shall not be permitted to maintain any action or proceeding in any court of this Commonwealth until the corporation has obtained a certificate of authority.”

* * * * * * * The evidence demonstrates that Drake failed to submit a certificate of authority into evidence

prior to the verdict in violation of 15 Pa.C.S. Section 4121. Therefore, the trial court should not have permitted Drake to prosecute its action.

The trial court contends that Drake is exempt from the certificate of authority requirement because it merely commenced suit in Pennsylvania to collect a debt * * * . Drake did much more, however, than file suit or attempt to collect a debt. Drake maintains an office in Pennsylvania to conduct local busi- ness, conduct which typically requires a certificate of authority. Drake also entered into a contract with Polyflow, and * * * shipped couplings and portable swaging machines to Polyflow’s place of business in Pennsylvania * * * . In short, Drake’s conduct was * * * regular, systematic, and extensive, * * * thus constitut-Drake’s conduct was * * * regular, systematic, and extensive, * * * thus constitut-Drake’s conduct was * * * regular, systematic, and extensive, * * * thus constitut ing the transaction of business and requiring Drake to obtain a certificate of authority. [Emphasis added.]

We also hold that Drake needed a certificate of authority to sue Polyflow in Pennsylvania for Polyflow’s We also hold that Drake needed a certificate of authority to sue Polyflow in Pennsylvania for Polyflow’s W failure to pay for out-of-state shipments in California, Canada and Holland. A foreign corporation that

Drake Manufacturing Co. v. Polyflow, Inc. Superior Court of Pennsylvania, 2015 PA Super 16, 109 A.3d 250 (2015).

Case 18.1

C H A P T E R 1 8 Corporations 391

“does business” in Pennsylvania * * * must obtain a certificate in order to prosecute a lawsuit in this Com- monwealth, regardless of whether the lawsuit itself concerns in-state conduct or out-of-state conduct.

Decision and Remedy A state intermediate appellate court reversed the judgment in Drake’s favor. Under Pennsylvania state statutes, Drake was required to obtain a certificate of authority to do business in that state. Drake failed to do so. The court should not have allowed Drake to prosecute its action against Polyflow.

Critical Thinking • Legal Environment Why would the appellate court permit Polyflow to get away with not paying for

delivered and presumably merchantable goods?

Case 18.1 Continued

Public and Private Corporations A public corpora-public corpora-public corpora tion is a corporation formed by the government to meet some tion is a corporation formed by the government to meet some tion political or governmental purpose. Cities and towns that incorporate are common examples. In addition, many federal government organizations, such as the U.S. Postal Service, the Tennessee Valley Authority, and AMTRAK, are public corporations.

Note that a public corporation is not the same as a publicly held corporation. A publicly held corporation (often called a public company) is any corporation whose public company) is any corporation whose public company shares are publicly traded in a securities market, such as the New York Stock Exchange or the NASDAQ.

Private corporations, in contrast, are created either wholly or in part for private benefit—that is, for profit. Most corporations are private. Although they may serve a public purpose, as a public electric or gas utility does, they are owned by private persons rather than by a government.2

2. The United States Supreme Court first recognized the property rights of private corporations and clarified the distinction between public and private corporations in the landmark case Trustees of Dartmouth College v. Woodward, 17 U.S. (4 Wheaton) 518, 4 L.Ed. 629 (1819).Woodward, 17 U.S. (4 Wheaton) 518, 4 L.Ed. 629 (1819).Woodward

Nonprofit Corporations Corporations formed for purposes other than making a profit are called nonprofit or nonprofit or nonprofit not-for-profit corporations. Private hospitals, educational not-for-profit corporations. Private hospitals, educational not-for-profit institutions, charities, and religious organizations, for instance, are frequently organized as nonprofit corpora- tions. The nonprofit corporation is a convenient form of organization that allows various groups to own property and to form contracts without exposing the individual members to personal liability.

In some circumstances, a nonprofit corporation and its members may also be immune from liability for a personal injury caused by its negligence. Whether those circumstances were present in the following case was the question before the court.

In the Language of the Court PER CURIAM.

* * * * * * * Plaintiff [Loredana Pantano]

slipped and fell on icy steps at an entrance to the [Newark] Museum, suf-entrance to the [Newark] Museum, suf-entrance to the [Newark] Museum, suf fering injuries to her back. At the time, plaintiff was employed as an immigra- tion attorney by La Casa de Don Pedro (La Casa), a nonprofit organization located in Newark [New Jersey]. Upon

arrival at her office that day, plaintiff was told by La Casa’s Director of Personal Development to go to the Museum for an educational panel discussion being held as part of La Casa’s fortieth anniver- sary celebration.

* * * The event was one of several organized to celebrate and commemo- rate the organization’s history and role in the development of Newark. Staff members were not directly engaged in

fundraising, but they were told to mingle with those attending the event, some of whom were contribu- tors to La Casa. The Museum charged La Casa a fee for the use of the facility, specifically an auditorium to be used by the panel and those in attendance.

The Museum is a nonprofit associa- tion organized exclusively for charitable, artistic, scientific, educational, historical

Case Analysis 18.2 Pantano v. Newark Museum Superior Court of New Jersey, Appellate Division, __ A.3d __, 2016 WL 528771 (2016).

392 U N I T F O U R The Business and Employment Environment

and cultural purposes * * * . It does, on occasion, rent its facilities to the public in order to generate income.

Plaintiff filed suit [in a New Jersey state court against the Museum] alleging the Museum was negligent in its maintenance of the premises. * * * The Museum moved for summary judgment, contending that plaintiff was a direct beneficiary of its charitable endeavors.

* * * * * * * The judge granted the Museum’s

motion, and this appeal followed. Plaintiff contends that she was not a

beneficiary of the Museum’s charitable purposes at the time of her fall because she was on the premises at the direction of her employer. We agree that pursuant to the [New Jersey Supreme] Court’s holding in Mayer v. Fairlawn Jewish Cen- ter, 38 N.J. 549, 186 A.2d 274 (1962), plaintiff was not a direct recipient of the Museum’s good works.

* * * * In pertinent part, the [state Chari-

table Immunity Act (CIA)] provides:

No nonprofit corporation * * * shall * * * be liable to respond in dam- ages to any person who shall suffer damage from the negligence * * * of such corporation * * * where such person is a beneficiary, to whatever degree, of the works of such non- profit corporation * * * ; provided, however, that such immunity from liability shall not extend to any

person * * * where such person is one unconcerned in and unrelated to and outside of the benefactions of such corporation.

The CIA serves two primary pur- poses. First, immunity preserves a charity’s assets. Second, immunity recognizes that a beneficiary of the services of a charitable organization has entered into a relation- ship that exempts the benefactor from liability. [Emphasis added.]

* * * The established test for deter- mining whether a party is a beneficiary of the works of a charity has two prongs. The first is that the institution pleading the immunity, at the time in question, was engaged in the performance of the charitable objectives it was organized to advance. The second is that the injured party must have been a direct recipient of those good works.

* * * * As to the first prong, * * * a qualify-

ing organization does not lose its statu- tory immunity merely because it charges money for its services, unless it makes a profit or collects fees for services totally unrelated to its organizational pursuits. * * * Hosting an educational panel dis- cussion in the auditorium was entirely consistent with the Museum’s charitable endeavors.

The second prong of the test * * * distinguishes between persons benefiting from the charity, and persons who con- tribute to the charity by virtue of their attendance or participation.

* * * * In Mayer, * * * an employee of the

Development Corporation for Israel was promoting the sale of bonds at a dinner on the premises of [Fairlawn Jewish Cen- ter, the defendant, when he sustained an injury].

* * * * * * * He was there in fulfillment

of his function and obligation as an employee to engage in the employer’s work at the direction of the employer, and not for the purpose of receiving per- sonally the philanthropy of the Center. Under the circumstances present he was a stranger to the charity and the [CIA did] not stand in the way of recovery.

* * * * * * * [Thus, under the CIA,] to be a

beneficiary under the second prong, the injured party must be a direct recipient of the Museum’s good works. Only those unconcerned in and unrelated to the bene- factions of the organization are not benefi- ciaries. [Emphasis added.]

* * * * As an intermediate appellate court,

we are bound to follow and enforce the decisions of the Supreme Court. Under [Mayer], plaintiff, as an employee of La Mayer], plaintiff, as an employee of La Mayer Casa who was ordered on the day of her fall to attend the panel discussion at the Museum, was not a direct beneficiary of the Museum’s charitable endeavors.

We therefore reverse the order grant- ing summary judgment to the Museum and remand the matter.

Legal Reasoning Questions

1. How do the purposes of the CIA support each other? 2. Can a person be a direct beneficiary of a nonprofit’s good works even though the person is on the nonprofit’s premises under

the direction of a third party? Explain. 3. Suppose that the museum had not been hosting an educational panel in its auditorium but instead had rented the facility to an

organization for a sales conference. Would the result have been different? Discuss.

Case 18.2 Continued

Close Corporations Most corporate enterprises in the United States fall into the category of close corpora- tions. A close corporation is one whose shares are held by relatively few persons, often members of a family. Close corporations are also referred to as closely held, family, or privately held corporations.privately held corporations.privately held

Usually, the members of the small group constitut- ing the shareholders of a close corporation are personally known to each other. Because the number of sharehold- ers is so small, there is no trading market for the shares. In practice, a close corporation is often operated like a partnership.

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The statutes in many states allow close corporations to depart significantly from certain formalities required by traditional corporation law.3 Under the RMBCA, close corporations have considerable flexibility in deter- mining their operating rules [RMBCA 7.32]. If all of a corporation’s shareholders agree in writing, the cor- poration can operate without directors and bylaws. In addition, the corporation can operate without annual or special shareholders’ or directors’ meetings, stock cer- tificates, or formal records of shareholders’ or directors’ decisions.4

Management of Close Corporations. Management of a close corporation resembles that of a sole proprietor- ship or a partnership, in that control is held by a single shareholder or a tightly knit group of shareholders. As a corporation, however, the �rm must meet all speci�c legal requirements set forth in state statutes.

To prevent a majority shareholder from dominat- ing the company, a close corporation may require that more than a simple majority of the directors approve any action taken by the board. In a larger corporation, such a requirement would typically apply only to extraordinary actions (such as selling all the corporate assets) and not to ordinary business decisions.

Transfer of Shares in Close Corporations. By de�nition, a close corporation has a small number of shareholders. �us, the transfer of one shareholder’s shares to someone else can cause serious management problems. �e other shareholders may �nd themselves required to share control with someone they do not know or like. ■ EXAMPLE 18.2 �ree siblings, Sherry, Karen, and Henry Johnson, are the only shareholders of Johnson’s Car Wash, Inc. Henry wants to sell his shares, but Sherry and Karen do not want him to sell the shares to a third person unknown to them. ■

To avoid this situation, a close corporation can restrict the transferability of shares to outside persons. Share- holders can be required to offer their shares to the cor- poration or to the other shareholders before selling them to an outside purchaser. In fact, in a few states close cor- porations must transfer shares in this manner under state statutes.

One way the close corporation can effect restrictions on transferability is by spelling them out in a share- holder agreement. A shareholder agreement can also provide for proportional control when one of the original

3. In some states, such as Maryland, a close corporation need not have a board of directors.

4. Shareholders cannot agree, however, to eliminate certain rights of share- holders, such as the right to inspect corporate records or the right to bring derivative actions (lawsuits on behalf of the corporation).derivative actions (lawsuits on behalf of the corporation).derivative actions

shareholders dies. The decedent’s shares of stock in the corporation can be divided in such a way that the pro- portionate holdings of the survivors, and thus their pro- portionate control, will be maintained.

Misappropriation of Close Corporation Funds. Some- times, a majority shareholder in a close corporation takes advantage of his or her position and misappropriates company funds. In such situations, the normal remedy for the injured minority shareholders is to have their shares appraised and to be paid the fair market value for them.

S Corporations A close corporation that meets the qualifying requirements specified in Subchapter S of the Internal Revenue Code can choose to operate as an S corporation. (A corporation will automatically be taxed under Subchapter C unless it elects S corporation status.) If a corporation has S corporation status, it can avoid the imposition of income taxes at the corporate level while retaining many of the advantages of a corporation, par- ticularly limited liability. Among the numerous require- ments for S corporation status, the following are the most important: 1. The corporation must be a domestic corporation. 2. The corporation must not be a member of an affili-

ated group of corporations. 3. The shareholders must be individuals, estates, or

certain trusts and tax-exempt organizations. Partner- ships and nonqualifying trusts cannot be sharehold- ers. Corporations can be shareholders under certain circumstances.

4. The corporation must have no more than one hun- dred shareholders.

5. The corporation must have only one class of stock, although it is not necessary that all shareholders have the same voting rights.

6. No shareholder of the corporation may be a nonresi- dent alien.

An S corporation is treated differently than a regular corporation for tax purposes. An S corporation is taxed like a partnership, so the corporate income passes through to the shareholders, who pay personal income tax on it. This treatment enables the S corporation to avoid the double taxation imposed on regular corporations. In addition, the shareholders’ tax brackets may be lower than the tax bracket that the corporation would have been in if the tax had been imposed at the corporate level.

In spite of these benefits, the S corporation has lost much of its appeal. The newer limited liability business forms (such as LLCs, LPs, and LLPs) offer similar tax advantages and greater flexibility.

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Professional Corporations Professionals such as physicians, lawyers, dentists, and accountants can incor- porate. A professional corporation is typically identified by the letters P.C. (professional corporation), S.C. (ser- vice corporation), or P.A. (professional association).

In general, the laws governing the formation and operation of professional corporations are similar to those governing ordinary business corporations. There are some differences in terms of liability, however, because the shareholder-owners are professionals who are held to a higher standard of conduct. For liability purposes, some courts treat professional corporations somewhat like partnerships and hold each professional liable for malpractice committed within the scope of the business by others in the firm.

Benefit Corporations A growing number of states have enacted legislation that creates a relatively new cor- porate form called a benefit corporation. A benefit cor- poration is a for-profit corporation that seeks to have a material positive impact on society and the environment. Benefit corporations differ from traditional corporations in the following ways:

1. Purpose. Although the corporation is designed to make a profit, its purpose is to benefit the public as a whole. (In contrast, the purpose of an ordinary business cor- poration is to provide long-term shareholder value.) The directors of a benefit corporation must, during the decision-making process, consider the impact of their decisions on society and the environment.

2. Accountability. Shareholders of a benefit corpora- tion determine whether the company has achieved a material positive impact. Shareholders also have a right of private action, called a benefit enforcement proceeding, enabling them to sue the corporation if it fails to pursue or create public benefit.

3. Transparency. A benefit corporation must issue an annual benefit report on its overall social and envi- ronmental performance that uses a recognized third- party standard to assess its performance. The report must be delivered to the shareholders and posted on a public Web site.

18–2 Formation and Powers Many of today’s largest companies started as sole propri- etorships or partnerships. They converted to corporate enti- ties as they grew because they needed to obtain additional capital by issuing shares of stock. Incorporating a business

is much simpler today than it was twenty years ago, and many states allow businesses to incorporate via the Internet.

18–2a Promotional Activities In the past, preliminary steps were taken to organize and promote a business prior to incorporating. Contracts were made with investors and others on behalf of the future cor- poration. Today, due to the relative ease of forming a corpo- ration in most states, persons incorporating their business rarely, if ever, engage in preliminary promotional activities.

Nevertheless, businesspersons should understand that they are personally liable for any preincorporation contracts made with investors, accountants, or others on behalf of the future corporation. Personal liability contin- ues until the newly formed corporation assumes liability for the preincorporation contracts through a novation.

18–2b Incorporation Procedures Each state has its own set of incorporation procedures. Most often, they are listed on the secretary of state’s Web site. Generally, however, all incorporators follow several basic steps, discussed next.

Select the State of Incorporation Because state corporate laws differ, individuals seeking to incorporate a business may look for the states that offer the most advan- tageous tax or other provisions. Many corporations, for instance, have chosen to incorporate in Delaware because it has historically had the least restrictive laws, along with provisions that favor corporate management. For reasons of convenience and cost, though, businesses often choose to incorporate in the state in which the corporation’s busi- ness will primarily be conducted.

Secure the Corporate Name The choice of a cor- porate name is subject to state approval to ensure against duplication or deception. Most state statutes require a search to confirm that the chosen corporate name is avail- able. A new corporation’s name cannot be the same as, or deceptively similar to, the name of an existing corporation doing business within the state. All states require the cor- poration’s name to include the word Corporation (Corp.), Incorporated (Inc.), Company (Co.), or Limited (Ltd.).5

Prepare the Articles of Incorporation The pri- mary document needed to incorporate a business is the articles of incorporation. The articles include basic

5. Failure to use one of these terms to disclose corporate status may be grounds for holding an individual incorporator liable for corporate contracts under agency law.

C H A P T E R 1 8 Corporations 395

information about the corporation and serve as a primary source of authority for its future organization and busi- ness functions. The person or persons who execute (sign) the articles are the incorporators.

Articles of incorporation vary widely depending on the jurisdiction and the size and type of the corporation. Generally, though, the articles must include the following must include the following must information [RMBCA 2.02]:

1. The name of the corporation. 2. The number of shares of stock the corporation is

authorized to issue [RMBCA 2.02(a)]. (Large corpo- rations often also state a par value for each share, such as $0.20 per share, and specify the various types or classes of stock authorized for issuance.)

3. The name and street address of the corporation’s initial registered agent and registered office. The reg- istered agent is the person who can receive legal doc- uments (such as orders to appear in court) on behalf of the corporation. The registered office is usually the main corporate office.

4. The name and address of each incorporator.

In addition, the articles may set forth other informay set forth other informay - mation, such as the names and addresses of the initial members of the board of directors and the duration and purpose of the corporation. A corporation has perpetual existence unless the articles state otherwise. A corpora- tion can be formed for any lawful purpose. The RMBCA does not require the articles to include a specific state- ment of purpose. Consequently, the articles often include only a general statement of purpose. By not mention- ing specifics, the corporation avoids the need for future amendments to the corporate articles [RMBCA 2.02(b) (2)(i), 3.01]. Similarly, the articles do not provide much detail about the firm’s operations, which are spelled out in the company’s bylaws (discussed shortly).bylaws (discussed shortly).bylaws

File the Articles with the State Once the articles of incorporation have been prepared and signed, they are sent to the appropriate state official, usually the secretary of state, along with the required filing fee. In most states, the secretary of state then stamps the articles “Filed” and returns a copy of the articles to the incorporators. Once this occurs, the corporation officially exists.

18–2c First Organizational Meeting to Adopt Bylaws

After incorporation, the first organizational meeting must be held. If the articles of incorporation named the initial board of directors, then the directors, by majority vote, call

the meeting. If the articles did not name the directors (as is typical), then the incorporators hold the meeting to elect the directors and complete any other business necessary.

Usually, the most important function of this meeting is the adoption of bylaws, which are the internal rules of man- agement for the corporation. The bylaws cannot conflict with the state corporation statute or the articles of incorpo- ration [RMBCA 2.06]. Under the RMBCA, the sharehold- ers may amend or repeal the bylaws. The board of directors may also amend or repeal the bylaws, unless the articles of incorporation or provisions of the state corporation statute reserve this power to the shareholders [RMBCA 10.20].

The bylaws typically describe such matters as voting requirements for shareholders, the election of the board of directors, and the methods of replacing directors. Bylaws also frequently outline the manner and time of holding shareholders’ and board meetings.

18–2d Improper Incorporation The procedures for incorporation are very specific. If they are not followed precisely, others may be able to challenge the existence of the corporation. Errors in incorporation procedures can become important when, for instance, a third party who is attempting to enforce a contract or bring a suit for a tort injury learns of them.

De Jure Corporations If a corporation has substan- tially complied with all conditions precedent to incor- poration, the corporation is said to have de jure (rightful and lawful) existence. In most states and under RMBCA 2.03(b), the secretary of state’s filing of the articles of incorporation is conclusive proof that all mandatory stat- utory provisions have been met [RMBCA 2.03(b)].

Sometimes, the incorporators fail to comply with all statutory mandates. If the defect is minor, such as an incorrect address listed on the articles of incorporation, most courts will overlook the defect and find that a de jure corporation exists.jure corporation exists.jure

De Facto Corporations If the defect in formation is substantial, such as a corporation’s failure to hold an organizational meeting to adopt bylaws, the outcome will vary depending on the jurisdiction. Some states, includ- ing Mississippi, New York, Ohio, and Oklahoma, recog- nize the common law doctrine of de facto corporation. In those states, the courts will treat a corporation as a legal corporation despite a defect in its formation if the follow- ing three requirements are met:

1. A state statute exists under which the corporation can be validly incorporated.

396 U N I T F O U R The Business and Employment Environment

2. The parties have made a good faith attempt to com- ply with the statute.

3. The parties have already undertaken to do business as a corporation.

Many state courts, however, have interpreted their states’ version of the RMBCA as abolishing the common law doctrine of de facto corporations. These states include Alaska, Arizona, Minnesota, New Mexico, Oregon, South Dakota, Tennessee, Utah, and Washington, as well as the District of Columbia. In those jurisdictions, if there is a substantial defect in complying with the incor- poration statute, the corporation does not legally exist, and the incorporators are personally liable.

Corporation by Estoppel Sometimes, a business association holds itself out to others as being a corpora- tion when it has made no attempt to incorporate. In those situations, the firm normally will be estopped (prevented) from denying corporate status in a lawsuit by a third party. The estoppel doctrine most commonly applies when a third party contracts with an entity that claims to be a corporation but has not filed articles of incorpora- tion. It may also apply when a third party contracts with a person claiming to be an agent of a corporation that does not in fact exist.

When justice requires, courts in some states will treat an alleged corporation as if it were an actual corporation for the purpose of determining rights and liabilities in particular circumstances. Recognition of corporate status does not extend beyond the resolution of the problem at hand.

■ CASE IN POINT 18.3 W.P. Media, Inc., and Alabama W.P. Media, Inc., and Alabama MBA, Inc., agreed to form a wireless Internet services company. W.P. Media was to create a wireless network, and Alabama MBA was to contribute the capital. Hugh Brown signed the parties’ contract on behalf of Alabama MBA as the chair of its board. At the time, however, Ala- bama MBA’s articles of incorporation had not yet been filed. Brown filed the articles of incorporation the fol- lowing year.

Later, Brown and Alabama MBA filed a suit alleging that W.P. Media had breached their contract by not build- ing the wireless network. W.P. Media contended that Ala- bama MBA had not existed as a corporation when the agreement was signed and thus the agreement was void. The Supreme Court of Alabama held that because W.P. Media had treated Alabama MBA as a corporation, W.P. Media was estopped from denying Alabama MBA’s cor- porate existence.6 ■

6. Brown v. W.P. Media, Inc., 17 So.3d 1167 (2009).

18–2e Corporate Financing Part of the process of corporate formation involves cor- porate financing. Corporations normally are financed by the issuance and sale of corporate securities, which include stocks and bonds. Stocks, or equity securities, rep- resent the purchase of ownership in the business firm. Bonds, or debt securities, represent the borrowing of funds by firms (and governments).

Bonds Bonds are issued by business firms and by gov- ernments at all levels as evidence of the funds they are borrowing from investors. Bonds normally have a des- ignated maturity date—the date when the principal, or maturity date—the date when the principal, or maturity date face amount, of the bond is returned to the investor. They are sometimes referred to as fixed-income securities because their owners (that is, the creditors) receive fixed- dollar interest payments, usually semiannually, during the period of time before maturity. Because debt financing represents a legal obligation on the part of the corpora- tion, various features and terms of a particular bond issue are specified in a lending agreement.

Of course, not all debt is in the form of debt securi- ties. For instance, some debt is in the form of accounts payable and notes payable, which typically are short- term debts. Bonds are simply a way for the corporation to split up its long-term debt so that it can be more easily marketed.

Stocks Issuing stocks is another way that corporations can obtain financing. Basically, stocks represent owner- ship in a business firm. The true ownership of a corpora- tion is represented by common stock, which provides a proportionate interest in the corporation with regard to (1) control (voting rights), (2) earnings, and (3) net assets. A shareholder’s interest is generally in proportion to the number of shares he or she owns out of the total number of shares issued.

The issuing firm is not obligated to return a princi- pal amount per share to each holder of common stock, because no firm can ensure that the market price per share of its common stock will not decline over time. The issuing firm also does not have to guarantee a dividend. Indeed, some corporations never pay dividends. Hold- ers of common stock are investors who assume a residual position in the overall financial structure of a business. In terms of receiving payment for their investments, they are last in line.

Preferred stock is stock with preferences. Holders of preferred stock usually have priority over holders of com- mon stock as to dividends and payment on dissolution of the corporation but frequently do not have the right to

C H A P T E R 1 8 Corporations 397

vote. Holders of preferred stock have a stronger position than common shareholders with respect to dividends and claims on assets, but they will not share in the full prosperity of the firm if it grows successfully over time. Preferred stockholders do receive fixed dividends periodi- cally, however, and they may benefit to some extent from changes in the market price of the shares.

Venture Capital Start-up businesses and high-risk enterprises often obtain venture capital financing. Ven- ture capital is capital provided by professional, outside investors (venture capitalists, usually groups of wealthy investors and securities firms) to new business ventures. Venture capital investments are high risk—the investors must be willing to lose all of their invested funds—but offer the potential for well-above-average returns at some point in the future.

To obtain venture capital financing, the start-up business typically gives up a share of its ownership to the venture capitalists. Venture capitalists also may pro- vide managerial and technical expertise, and they nearly always are given some control over the new company’s decisions. Many Internet-based companies, such as Google, were initially financed by venture capital.

Private Equity Capital Private equity firms obtain their capital from wealthy investors in private markets. The firms use their private equity capital to invest in existing—often, publicly traded—corporations. Usually, they buy an entire corporation and then reorganize it. Sometimes, divisions of the purchased company are sold off to pay down debt. Ultimately, the private equity firm may sell shares in the reorganized (and perhaps more prof-may sell shares in the reorganized (and perhaps more prof-may sell shares in the reorganized (and perhaps more prof itable) company to the public in an initial public offering (IPO). In this way, the private equity firm can make prof-(IPO). In this way, the private equity firm can make prof-(IPO). In this way, the private equity firm can make prof its by selling its shares in the company.

Crowdfunding Start-up businesses can also attempt to obtain financing through crowdfunding. crowdfunding. crowdfunding Crowdfund- ing is a cooperative activity in which people network and ing is a cooperative activity in which people network and ing pool funds and other resources via the Internet to assist a cause or invest in a venture. Sometimes, crowdfunding is used to raise funds for charitable purposes, such as disaster relief, but increasingly it is being used to finance budding entrepreneurs.

In 2016, new Securities and Exchange Commis- sion (SEC) rules went into effect to allow companies to offer and sell securities through crowdfunding. The rules removed a decades-old ban on public solicitation for private investments, which means that companies can advertise investment opportunities to the general public. According to the SEC, the new rules are intended to help

smaller companies raise capital while providing investors with additional protections. Companies are required to make specific disclosures and are limited to raising $1 million a year through crowdfunding.

18–2f Corporate Powers When a corporation is created, the express and implied powers necessary to achieve its purpose also come into existence.

Express Powers The express powers of a corporation are found in its articles of incorporation, in the law of the state of incorporation, and in the state and federal consti- tutions. Corporate bylaws and the resolutions of the cor- poration’s board of directors also establish express powers.

The following order of priority is used if a con- flict arises among the various documents involving a corporation: 1. The U.S. Constitution. 2. State constitutions. 3. State statutes. 4. The articles of incorporation. 5. Bylaws. 6. Resolutions of the board of directors.

It is important that the bylaws set forth the specific operating rules of the corporation. State corporation statutes frequently provide default rules that apply if the company’s bylaws are silent on an issue.

On occasion, the U.S. government steps in to chal- lenge what a corporation may consider one of its express powers. This chapter’s Global Insight discusses a dispute Global Insight discusses a dispute Global Insight between the government and Microsoft Corporation over a demand that the company provide the government with access to e-mail stored in servers on foreign soil.

Implied Powers When a corporation is created, it acquires certain implied powers. Barring express consti- tutional, statutory, or other prohibitions, the corporation has the implied power to perform all acts reasonably nec- essary to accomplish its corporate purposes. For this rea- son, a corporation has the implied power to borrow and lend funds within certain limits and to extend credit to parties with whom it has contracts.

Most often, the president or chief executive officer of the corporation signs the necessary documents on behalf of the corporation. Corporate officers such as these have the implied power to bind the corporation in matters directly connected with the ordinary business affairs of the enterprise.ordinary business affairs of the enterprise.ordinary

There is a limit to what a corporate officer can do, though. A corporate officer does not have the authority

398 U N I T F O U R The Business and Employment Environment

to bind the corporation to an action that will greatly affect the corporate purpose or undertaking, such as the sale of substantial corporate assets.

Ultra Vires Doctrine The term ultra vires means ultra vires means ultra vires “beyond the power.” In corporate law, acts of a corpora- tion that are beyond its express or implied powers are ultra vires acts. In the past, most cases dealing with vires acts. In the past, most cases dealing with vires ultra vires acts involved contracts made for unauthorized purposes. Now, because the articles of incorporation of most private corporations do not state a specific purpose, the ultra vires doctrine has declined in importance.

Today, cases that allege ultra vires acts usually involve ultra vires acts usually involve ultra vires nonprofit corporations or municipal (public) corporanonprofit corporations or municipal (public) corporanonprofit corporations or municipal (public) corporanonprofit corporations or municipal (public) corpora- tions. ■ CASE IN POINT 18.4 Four men formed a nonprofit corporation to create the Armenian Genocide Museum & Memorial (AGM&M). The bylaws appointed them

as trustees (similar to corporate directors) for life. One of the trustees, Gerard L. Cafesjian, became the chair and president of AGM&M. Eventually, the relationship among the trustees deteriorated, and Cafesjian resigned.

The corporation then brought a suit claiming that Cafesjian had engaged in numerous ultra vires acts, self-dealing, and mismanagement. Although the bylaws required an 80 percent affirmative vote of the trustees to take action, Cafesjian had taken many actions without the board’s approval. He had also entered into contracts for real estate transactions in which he had a personal interest. Because Cafesjian had taken actions that exceeded his authority and had failed to follow rules set forth in the bylaws, the court ruled that the corporation could go forward with its suit.7 ■

7. Armenian Assembly of America, Inc. v. Cafesjian, 692 F.Supp.2d 20 (D.C. Cir. 2010).

Does Cloud Computing Have a Nationality?

Everyone has heard of “the cloud,” and most people use it for the storage of their digital data—photos, e-mails, music, documents, and just about anything else. Not surprisingly, major global digital players like Apple, Ama- zon, Google, and Microsoft have spent bil- lions to create “clouds” of servers all over the world. In the clouds are stored confidential, organized, and secure data. The revenues generated by the U.S. cloud computing industry exceed $100 billion a year. But is the long-term picture for such revenues in doubt?

Microsoft Battles and the Global Cloud Industry Waits

The U.S. government issued a warrant to Microsoft to produce e-mails related to a narcotics case from a Hotmail account. That account was hosted in a Microsoft cloud location in Ireland. Microsoft refused, but a magistrate judge in the Southern District of New York confirmed the government’s right to the Ireland-located e-mails.a

On appeal to a U.S. district court, Microsoft again lost.b

Microsoft appealed to the U.S. Court of Appeals for the Second Circuit and won in 2016.c

Microsoft maintained that “the power to embark on unilateral law enforcement incur- sions into a foreign sovereign country—directly or indirectly—has profound policy conse- quences. Worse still, it threatens the privacy of U.S. citizens.” According to Microsoft’s deputy general counsel, David Howard, “The U.S. gov- ernment doesn’t have the power to search a

home in another country, nor should it have the power search the content of e-mails stored overseas.”

A number of organizations apparently agreed with Microsoft. The ACLU, Apple, eBay, the Electronic Fron- tier Foundation, Fox News, the Irish government, and National Public Radio all filed “friend of the court” briefs in support of Microsoft’s position. The federal appellate court was persuaded that the warrant could not be enforced extraterritorially.

Impact on the Industry

More was at stake in this case than the issues Microsoft identified. If Microsoft had ultimately lost, some industry experts predicted that U.S. technology companies would lose up to $35 billion a year from their cloud storage business. Foreign corporations and individuals would no longer trust U.S. companies to keep their data secret.

Critical Thinking The law underlying the case against Microsoft is the Electronic Communications Privacy Act, which was enacted three years before the invention of the World Wide Web. Should that law still apply today? Why or why not?

GLOBAL INSIGHT

a. In re Warrant to Search a Certain E-Mail Account Controlled and Maintained by Microsoft Corp., 15 F.Supp.3d 466 (S.D.N.Y. 2014).

b. In re Warrant to Search a Certain E-Mail Account Controlled and Maintained by Microsoft Corp., 2014 WL 4629624 (S.D.N.Y. 2014).

c. In Matter of Warrant to Search a Certain E-Mail Account Controlled and Maintained by Microsoft Corp., ___ F.3d ___, 2016 WL 3770056 (2d Cir. 2016).

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Remedies for Ultra Vires Acts Under Section 3.04 of the RMBCA, shareholders can seek an injunction from a court to prevent (or stop) the corporation from engag- ing in ultra vires acts. The attorney general in the state ultra vires acts. The attorney general in the state ultra vires of incorporation can also bring an action to obtain an injunction against the ultra vires transactions or to seek dissolution of the corporation. The corporation or its shareholders (on behalf of the corporation) can seek dam- ages from the officers and directors who were responsible for the ultra vires acts.ultra vires acts.ultra vires

18–3 Piercing the Corporate Veil Occasionally, the owners use a corporate entity to perpe- trate a fraud, circumvent the law, or in some other way accomplish an illegitimate objective. In these situations, the courts will ignore the corporate structure by pierc- ing the corporate veil and exposing the shareholders to personal liability [RMBCA 2.04].

Generally, courts pierce the veil when the corporate privilege is abused for personal benefit or when the cor- porate business is treated so carelessly that it is indistin- guishable from that of a controlling shareholder. When the facts show that great injustice would result from a shareholder’s use of a corporation to avoid individual responsibility, a court will look behind the corporate structure to the individual shareholders.

18–3a Factors That Lead Courts to Pierce the Corporate Veil

The following are some of the factors that frequently cause the courts to pierce the corporate veil:

1. A party is tricked or misled into dealing with the cor- poration rather than the individual.

2. The corporation is set up never to make a profit or always to be insolvent. Alternatively, it is too thinly capitalized—that is, it has insufficient capital at the time it is formed to meet its prospective debts or potential liabilities.

3. The corporation is formed to evade an existing legal obligation.

4. Statutory corporate formalities, such as holding required corporation meetings, are not followed.

5. Personal and corporate interests are mixed together, or commingled, to such an extent that the corpora- tion has no separate identity.

State corporation codes usually do not prohibit a shareholder from lending funds to her or his corporation.

Courts will scrutinize such a transaction closely if the loan comes from an officer, director, or majority shareholder, however. Loans from persons who control the corpora- tion must be made in good faith and for fair value.tion must be made in good faith and for fair value.tion must be made in good faith and for fair value.tion must be made in good faith and for fair value.

■ CASE IN POINT 18.5 Dog House Investments, LLC, Dog House Investments, LLC, operated a dog “camp” in Nashville, Tennessee. Dog House leased the property from Teal Properties, Inc., which was owned by Jerry Teal, its sole shareholder. Under the lease, Teal Properties promised to repair damage from fire or other causes that rendered the property “untenant- able” (unusable). Following a flood, Dog House notified Jerry that the property was untenantable. Jerry assured Dog House that the flood damage was covered by insur- ance but took no steps to restore the property. The par- ties then agreed that Dog House would undertake the repairs and be reimbursed by Teal Properties.

Dog House spent $39,000 to repair the damage and submitted invoices for reimbursement. Teal Prop- erties recovered $40,000 from its insurance company but did not pay Dog House. Close to bankruptcy, Dog House filed a suit in a Tennessee state court against Teal Properties and Jerry. The court pierced the corpo- rate veil and held Jerry personally liable for the repair costs. Jerry appealed, but a state intermediate appellate court affirmed. The reviewing court found that piercing the corporate veil was appropriate because Jerry did not maintain an arms-length relationship with the corpo- ration. Teal Properties owned no property and had no assets—it merely received rent that was immediately paid to Jerry Teal.8 ■

18–3b A Potential Problem for Close Corporations

The potential for corporate assets to be used for personal benefit is especially great in a close corporation. In such a corporation, the separate status of the corporate entity and the shareholders (often family members) must be carefully preserved. Practices that invite trouble for a close corporation include the commingling of corporate and personal funds and the shareholders’ continuous per- sonal use of corporate property (for instance, vehicles).

Typically, courts are reluctant to hold shareholders in close corporations personally liable for corporate obliga- tions unless there is some evidence of fraud or wrongdotions unless there is some evidence of fraud or wrongdotions unless there is some evidence of fraud or wrongdotions unless there is some evidence of fraud or wrongdo- ing. ■ CASE IN POINT 18.6 Pip, Jimmy, and Theodore Brennan are brothers and shareholders of Brennan’s, Inc., which owns and operates New Orleans’s famous Bren- nan’s Restaurant. As a close corporation, Brennan’s, Inc.,

8. Dog House Investments, LLC v. Teal Properties, Inc., 448 S.W.3d 905 (Tenn.App. 2014).

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did not hold formal corporate meetings with agendas and minutes, but it did maintain corporate books, hold corporate bank accounts, and file corporate tax returns.

The Brennan brothers retained attorney Edward Colbert to represent them in a family matter, and the attorney’s bills were sent to the restaurant and paid from the corporate account. Later, when Brennan’s, Inc., sued Colbert for malpractice, Colbert argued that the court should pierce the corporate veil because the Brennan brothers did not observe corporate formalities. The court refused to do so, however, because there was no evidence of fraud, malfeasance, or other wrongdoing by the Brennan brothers. There is no requirement for small, close corporations to operate with the formality usually expected of larger corporations.9 ■

18–3c The Alter-Ego Theory Sometimes, courts pierce the corporate veil under the theory that the corporation was not operated as a sepa- rate entity. Rather, it was just another side (the alter ego) of the individual or group that actually controlled the corporation. This is called the alter-ego theory.

The alter-ego theory is applied when a corporation is so dominated and controlled by an individual (or group) that the separate identities of the person (or group) and the corporation are no longer distinct. Courts use the alter-ego theory to avoid injustice or fraud that would result if wrongdoers were allowed to hide behind the pro- tection of limited liability.

■ CASE IN POINT 18.7 Steiner Electric Company Steiner Electric Company (Steiner) is an Illinois corporation that sells electrical prod- ucts. Steiner sold goods to Delta Equipment Company and Sackett Systems, Inc., on credit. Both Delta and Sack- ett were owned and controlled by a single shareholder— Leonard J. Maniscalco. Steiner was not fully paid for the products it sold on credit to Delta and Sackett. Eventually, Steiner sued Delta and won a default judgment, but by that time, Delta had been dissolved. Steiner then asked a state court to pierce the corporate veil and hold Manis- calco liable for the debts of the two companies, claiming the companies were merely Maniscalco’s alter egos.

The court agreed and held Maniscalco liable. Delta and Sackett were inadequately capitalized, transactions were not properly documented, funds were commingled, and corporate formalities were not observed. Maniscalco had consistently treated both companies in such a man- ner that they were, in practice, his alter egos.10 ■

9. Brennan’s, Inc. v. Colbert, 85 So.3d 787 (La.App.4th Cir. 2012). 10. Steiner Electric Co. v. Maniscalco, 51 N.E.3d 45, 2016 IL App (1st)

132023 (2016).

18–4 Directors and Officers Corporate directors, officers, and shareholders all play different roles within the corporate entity. Sometimes, actions that may benefit the corporation as a whole do not coincide with the separate interests of the individu- als making up the corporation. In such situations, it is important to know the rights and duties of all partici- pants in the corporate enterprise.

18–4a Directors The board of directors is the ultimate authority in every corporation. Directors have responsibility for all policy- making decisions necessary to the management of all cor- porate affairs. No individual director, however, can act to individual director, however, can act to individual bind the corporation. The directors must act as a body in carrying out routine corporate business. The board selects and removes the corporate officers, determines the capital structure of the corporation, and declares dividends. Each director has one vote, and customarily the majority rules.

Few qualifications are required for directors. Only a handful of states impose minimum age and residency requirements. A director may be a shareholder, but that is not necessary (unless the articles of incorporation or bylaws require ownership interest).

Election of Directors Subject to statutory limita- tions, the number of directors is set forth in the corpo- ration’s articles or bylaws. Historically, the minimum number of directors has been three, but today many states permit fewer. Normally, the incorporators appoint the first board of directors at the time the corporation is cre- ated, or the directors are named in the articles of incor- poration. The initial board serves until the first annual shareholders’ meeting. Subsequent directors are elected by a majority vote of the shareholders.

A director usually serves for a term of one year—from annual meeting to annual meeting. Most state statutes permit longer and staggered terms. A common practice is to elect one-third of the board members each year for a three-year term. In this way, there is greater management continuity.

A director can be removed for cause—that is, for failfor cause—that is, for failfor cause - ing to perform a required duty—either as specified in the articles or bylaws or by shareholder action. When a vacancy on the board occurs, such as if a director dies or resigns, either the shareholders or the board itself can fill the vacant position, depending on state law and the bylaws. Note that even when an election is authorized,

C H A P T E R 1 8 Corporations 401

a court can invalidate the results if the directors have attempted to manipulate the election in order to reduce the shareholders’ influence.

Compensation of Directors In the past, corporate directors were rarely compensated. Today, directors are often paid at least nominal sums. In large corporations, they may receive more substantial compensation because of the time, work, effort, and especially risk involved.

Most states permit the corporate articles or bylaws to authorize compensation for directors. In fact, the RMBCA states that unless the articles or bylaws provide otherwise, the board itself may set the directors’ com- pensation [RMBCA 8.11]. Directors also receive indirect benefits, such as business contacts and prestige, and other rewards, such as stock options.

In many corporations, directors are also chief corpo- rate officers (such as president or chief executive officer) and receive compensation in their managerial positions. A director who is also an officer of the corporation is referred to as an inside director, whereas a director who does not hold a management position is an outside director. Typically, a corporation’s board of directors includes both inside and outside directors.

Board of Directors’ Meetings The board of direc- tors conducts business by holding formal meetings with recorded minutes. The dates of regular meetings are usually established in the articles or bylaws or by board resolution, and ordinarily no further notice is required. Special meetings can be called as well, with notice sent to all directors.

Most states allow directors to participate in board of directors’ meetings from remote locations. Directors can participate via telephone, Web conferencing, or Skype, provided that all the directors can simultaneously hear one another during the meeting [RMBCA 8.20].

Quorum of Directors. Unless the articles of incorpora- tion or bylaws specify a greater number, a majority of the board of directors normally constitutes a quorum [RMBCA 8.24]. (A quorum is the minimum number of members of a body of o�cials or other group that must be present for business to be validly transacted.) Some state statutes speci�cally allow corporations to set a quorum at less than a majority but not less than one-third of the directors.11

11. See, for example, Delaware Code Annotated Title 8, Section 141(b); and New York Business Corporation Law Section 707.

Voting. Once a quorum is present, the directors trans- act business and vote on issues a�ecting the corporation. Each director present at the meeting has one vote.12 Ordi- nary matters generally require a simple majority vote, but certain extraordinary issues may require a greater-than- majority vote.

Committees of the Board of Directors When a board of directors has a large number of members and must deal with myriad complex business issues, meet- ings can become unwieldy. Therefore, the boards of large, publicly held corporations typically create committees of directors and delegate certain tasks to these committees. By focusing on specific subjects, committees can increase the efficiency of the board.

Two common types of committees are the executive committee and thecommittee and thecommittee audit committee. An executive com- mittee handles interim management decisions between board meetings. It is limited to dealing with ordinary business matters and does not have the power to declare dividends, amend the bylaws, or authorize the issuance of stock. The audit committee is responsible for the selec- tion, compensation, and oversight of the independent public accountants that audit the firm’s financial records. The Sarbanes-Oxley Act requires all publicly held corpora- tions to have an audit committee.

Rights of Directors A corporate director must have certain rights to function properly in that position, including the rights of participation, inspection, and indemnification.

Right to Participation. �e right to participation means that directors are entitled to participate in all board of directors’ meetings and have a right to be noti�ed of these meetings. Because the dates of regular board meetings are usually speci�ed in the bylaws, no notice of these meet- ings is required. If special meetings are called, however, notice is required unless waived by the director [RMBCA 8.23].

Right of Inspection. A director also has a right of inspec- tion, which means that each director can access the corporation’s books and records, facilities, and prem- ises. Inspection rights are essential for directors to make informed decisions and to exercise the necessary supervi- sion over corporate o�cers and employees. �is right of inspection is almost absolute and cannot be restricted (by the articles, bylaws, or any act of the board of directors).

12. Except in Louisiana, which allows a director to vote by proxy under certain circumstances.

402 U N I T F O U R The Business and Employment Environment

■ CASE IN POINT 18.8 NavLink, Inc., a Delaware corporation, provides high-end data management for customers and governments in Saudi Arabia, Qatar, Lebanon, and the United Arab Emirates. NavLink’s co- founders, George Chammas and Laurent Delifer, served on its board of directors.

Chammas and Delifer were concerned about the company’s 2015 annual budget and three-year operat- ing plan. Despite repeated requests, Chammas was never given the meeting minutes from several board meetings in 2015. Chammas and Delifer believed that the other directors were withholding information and holding secret “pre-board meetings” at which plans and decisions were being made without them. They filed suit in a Dela- ware state court seeking inspection rights.

The court ordered NavLink to provide the plaintiffs with board meeting minutes and with communications from NavLink’s secretary regarding the minutes. The plaintiffs were also entitled to inspect corporate docu- ments and communications concerning NavLink’s 2015 budget and three-year plan.13 ■

Right to Indemnification. When a director becomes involved in litigation by virtue of her or his position, the director may have a right to indemni�cation (reim- bursement) for the legal costs, fees, and damages incurred. Most states allow corporations to indemnify and purchase liability insurance for corporate directors [RMBCA 8.51].

18–4b Corporate Officers and Executives Corporate officers and other executive employees are hired by the board of directors. At a minimum, most cor- porations have a president, one or more vice presidents, a secretary, and a treasurer. In most states, an individual can hold more than one office, such as president and sec- retary, and can be both an officer and a director of the corporation.

In addition to carrying out the duties articulated in the bylaws, corporate and managerial officers act as agents of the corporation. Therefore, the ordinary rules of agency normally apply to their employment.

Corporate officers and other high-level managers are employees of the company, so their rights are defined by employment contracts. Nevertheless, the board of direc- tors normally can remove a corporate officer at any time with or without cause. If the directors remove an officer in violation of the terms of an employment contract, how- ever, the corporation may be liable for breach of contract.

13. Chammas v. NavLink, Inc., 2016 WL 767714 (Del.Ch.Ct. 2016).

18–4c Duties and Liabilities of Directors and Off icers

The duties of corporate directors and officers are similar because both groups are involved in decision making and are in positions of control. Directors and officers are con- sidered to be fiduciaries of the corporation because their relationship with the corporation and its shareholders is one of trust and confidence. As fiduciaries, directors and officers owe ethical—and legal—duties to the corpora- tion and to the shareholders as a group. These fiduciary duties include the duty of care and the duty of loyalty.

Duty of Care Directors and officers must exercise due care in performing their duties. The standard of due care has been variously described in judicial decisions and codified in many state corporation codes. Generally, it requires a director or officer to:

1. Act in good faith (honestly). 2. Exercise the care that an ordinarily prudent (careful)

person would exercise in similar circumstances. 3. Do what she or he believes is in the best interests of

the corporation [RMBCA 8.30(a), 8.42(a)].

If directors or officers fail to exercise due care and the corporation or its shareholders suffer harm as a result, the directors or officers can be held liable for negligence. (An exception is made if the business judgment rule applies, as business judgment rule applies, as business judgment rule will be discussed shortly.)

Duty to Make Informed Decisions. Directors and o�- cers are expected to be informed on corporate matters and to conduct a reasonable investigation of the situa- tion before making a decision. �ey must, for instance, attend meetings and presentations, ask for information from those who have it, read reports, and review other written materials. In other words, directors and o�cers must investigate, study, and discuss matters and evaluate alternatives before making a decision. �ey cannot decide on the spur of the moment without adequate research.

Although directors and officers are expected to act in accordance with their own knowledge and training, they are also normally entitled to rely on information given to them by certain other persons. Under the laws of most states and Section 8.30(b) of the RMBCA, such persons include competent officers or employees, profession- als such as attorneys and accountants, and committees of the board of directors. (The committee must be one on which the director does not serve, however.) The reli- ance must be in good faith to insulate a director from liability if the information later proves to be inaccurate or unreliable.

C H A P T E R 1 8 Corporations 403

Duty to Exercise Reasonable Supervision. Directors are also expected to exercise a reasonable amount of super- vision when they delegate work to corporate o�cers and vision when they delegate work to corporate o�cers and vision when they delegate work to corporate o�cers and vision when they delegate work to corporate o�cers and employees. ■ EXAMPLE 18.9 Dana, a corporate bank director, fails to attend any board of directors’ meetings for �ve years. In addition, Dana never inspects any of the corporate books or records and generally fails to super- vise the activities of the bank president and the loan com- mittee. Meanwhile, Brennan, the bank president, who is a corporate o�cer, makes various improper loans and permits large overdrafts. In this situation, Dana (the cor- porate director) can be held liable to the corporation for losses resulting from the unsupervised actions of the bank president and the loan committee. ■

Dissenting Directors. Directors’ votes at board of direc- tors’ meetings should be entered into the minutes. Some- times, an individual director disagrees with the majority’s vote (which becomes an act of the board of directors). Unless a dissent is entered in the minutes, the director is presumed to have assented. If the directors are later held liable for mismanagement as a result of a decision, dis- senting directors are rarely held individually liable to the corporation. For this reason, a director who is absent from a given meeting sometimes registers a dissent with the sec- retary of the board regarding actions taken at the meeting.

The Business Judgment Rule Directors and offi- cers are expected to exercise due care and to use their best judgment in guiding corporate management, but they are not insurers of business success. Under the business judgment rule, a corporate director or officer will not be liable to the corporation or to its shareholders for honest mistakes of judgment and bad business decisions.

Courts give significant deference to the decisions of corporate directors and officers, and consider the reason- ableness of a decision at the time it was made, without the benefit of hindsight. Thus, corporate decision makers are not subjected to second-guessing by shareholders or others in the corporation.

When the Rule Applies. �e business judgment rule will apply as long as the director or o�cer: 1. Took reasonable steps to become informed about the

matter. 2. Had a rational basis for her or his decision. 3. Did not have a conflict between her or his personal

interest and the interest of the corporation.

Provides Broad Protections. �e business judgment rule provides broad protections to corporate decision

makers. In fact, most courts will apply the rule unless there is evidence of bad faith, fraud, or a clear breach of �duciary duties.

■ CASE IN POINT 18.10 The board of directors of the Chugach Alaska Corporation (CAC) voted to remove Sheri Buretta as the chair and install Robert Hen- richs. During his term, Henrichs acted without board approval, made decisions with only his supporters pres- ent, retaliated against directors who challenged his deci- sions, and ignored board rules for conducting meetings. He refused to comply with bylaws that required a spe- cial shareholders’ meeting in response to a shareholder petition and personally mistreated directors, sharehold- ers, and employees. After six months, the board voted to reinstall Buretta.

CAC filed a suit in an Alaska state court against Hen- richs, alleging a breach of fiduciary duty. A jury found Henrichs liable, and the court barred him from serv- ing on CAC’s board for five years. The appellate court affirmed. Given the nature and seriousness of Henrichs’s misconduct, the business judgment rule did not protect him.14 ■

Duty of Loyalty Loyalty can be defined as faithfulLoyalty can be defined as faithfulLoyalty - ness to one’s obligations and duties. In the corporate con- text, the duty of loyalty requires directors and officers to subordinate their personal interests to the welfare of the corporation. For instance, a director should not oppose a transaction that is in the corporation’s best interest simply because pursuing it may cost the director his or her posi- tion. Directors cannot use corporate funds or confidential corporate information for personal advantage and must refrain from self-dealing.

Cases dealing with the duty of loyalty typically involve one or more of the following: 1. Competing with the corporation. 2. Usurping (taking personal advantage of ) a corporate

opportunity. 3. Pursuing an interest that conflicts with that of the

corporation. 4. Using information that is not available to the public

to make a profit trading securities (insider trading). 5. Authorizing a corporate transaction that is detrimen-

tal to minority shareholders. 6. Selling control over the corporation.

The following Classic Case illustrates the conflict that Classic Case illustrates the conflict that Classic Case can arise between a corporate officer’s personal interest and his or her duty of loyalty.

14. Henrichs v. Chugach Alaska Corp., 250 P.3d 531 (Alaska Sup.Ct. 2011). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

404 U N I T F O U R The Business and Employment Environment

Background and Facts In 1930, Charles Guth became the president of Loft, Inc., a candy-and- restaurant chain. Guth and his family also owned Grace Company, which made syrups for soft drinks. Coca-Cola Company supplied Loft with cola syrup. Unhappy with what he felt was Coca-Cola’s high price, Guth entered into an agreement with Roy Megargel to acquire the trademark and formula for Pepsi-Cola and form Pepsi-Cola Corporation. Neither Guth nor Megargel could finance the new ven- ture, however, and Grace Company was insolvent.

Without the knowledge of Loft’s board, Guth used Loft’s capital, credit, facilities, and employees to further the Pepsi enterprise. At Guth’s direction, a Loft employee made the concentrate for the syrup, which was sent to Grace to add sugar and water. Loft charged Grace for the concentrate but allowed forty months’ credit. Grace charged Pepsi for the syrup but also granted substantial credit. Grace sold the syrup to Pepsi’s customers, including Loft, which paid on delivery or within thirty days. Loft also paid for Pepsi’s advertising. Finally, with profits declining as a result of switching from Coca-Cola, Loft filed a suit in a Delaware state court against Guth, Grace, and Pepsi, seeking their Pepsi stock and an accounting. The court entered a judgment in the plaintiff’s favor. The defendants appealed to the Delaware Supreme Court.

In the Language of the Court LAYTON, Chief Justice, delivering the opinion of the court:

* * * * Corporate officers and directors are not permitted to use their position of trust and confidence to fur-

ther their private interests. * * * They stand in a fiduciary relation to the corporation and its stockholders. A public policy, existing through the years, and derived from a profound knowledge of human charac- teristics and motives, has established a rule that demands of a corporate officer or director, peremptorily [not open for debate] and inexorably [unavoidably], the most scrupulous observance of his duty, not only affirma- tively to protect the interests of the corporation committed to his charge, but also to refrain from doing anything that would work injury to the corporation * * * . The rule that requires an undivided and unselfish loyalty to the corporation demands that there shall be no conflict between duty and self-interest. [Emphasis added.]

* * * * * * * If there is presented to a corporate officer or director a business opportunity which the corporation is

financially able to undertake [that] is * * * in the line of the corporation’s business and is of practical advan- tage to it * * * and, by embracing the opportunity, the self-interest of the officer or director will be brought into conflict with that of his corporation, the law will not permit him to seize the opportunity for himself. * * * conflict with that of his corporation, the law will not permit him to seize the opportunity for himself. * * * conflict with that of his corporation, the law will not permit him to seize the opportunity for himself. In such circumstances, * * * the corporation may elect to claim all of the benefits of the transaction for itself, and the law will impress a trust in favor of the corporation upon the property, interests and profits so acquired. [Emphasis added.]

* * * * * * * The appellants contend that no conflict of interest between Guth and Loft resulted from his

acquirement and exploitation of the Pepsi-Cola opportunity [and] that the acquisition did not place Guth in competition with Loft * * * . [In this case, however,] Guth was Loft, and Guth was Pepsi. He absolutely controlled Loft. His authority over Pepsi was supreme. As Pepsi, he created and controlled the supply of Pepsi-Cola syrup, and he determined the price and the terms. What he offered, as Pepsi, he had the power, as Loft, to accept. Upon any consideration of human characteristics and motives, he cre- ated a conflict between self-interest and duty. He made himself the judge in his own cause. * * * More- over, a reasonable probability of injury to Loft resulted from the situation forced upon it. Guth was in the same position to impose his terms upon Loft as had been the Coca-Cola Company.

* * * The facts and circumstances demonstrate that Guth’s appropriation of the Pepsi-Cola opportu- nity to himself placed him in a competitive position with Loft with respect to a commodity essential to it, thereby rendering his personal interests incompatible with the superior interests of his corporation;

Classic Case 18.3 Guth v. Loft, Inc. Supreme Court of Delaware, 23 Del.Ch. 255, 5 A.2d 503 (1939).

C H A P T E R 1 8 Corporations 405

and this situation was accomplished, not openly and with his own resources, but secretly and with the money and facilities of the corporation which was committed to his protection.

Decision and Remedy The Delaware Supreme Court upheld the judgment of the lower court. The state supreme court was “convinced that the opportunity to acquire the Pepsi-Cola trademark and formula, goodwill and business belonged to [Loft], and that Guth, as its President, had no right to appropriate the opportunity to himself.”

Impact of This Case on Today’s Law This early Delaware decision was one of the first to set forth a test for determining when a corporate officer or director has breached the duty of loyalty. The test has two basic parts: Was the opportunity reasonably related to the corporation’s line of business, and was the cor-basic parts: Was the opportunity reasonably related to the corporation’s line of business, and was the cor-basic parts: Was the opportunity reasonably related to the corporation’s line of business, and was the cor poration financially able to undertake the opportunity? The court also considered whether the corporation had an interest or expectancy in the opportunity. It recognized that when the corporation had “no interest or expectancy, the officer or director is entitled to treat the opportunity as his own.”

Critical Thinking • What If the Facts Were Different? Suppose that Loft’s board of directors had approved Pepsi-Cola’s

use of its personnel and equipment. Would the court’s decision have been different? Discuss.

Case 18.3 Continued

Conflicts of Interest Corporate directors often have many business affiliations, and a director may sit on the board of more than one corporation. Of course, directors are precluded from entering into or supporting businesses that operate in direct competition with corporations on whose boards they serve. Their fiduciary duty requires them to make a full disclosure of any potential conflicts of interest that might arise in any corporate transaction [RMBCA 8.60].

Sometimes, a corporation enters into a contract or engages in a transaction in which an officer or director has a personal interest. The director or officer must make a full disclosure of the nature of the conflicting interest and full disclosure of the nature of the conflicting interest and full disclosure all facts pertinent to the transaction. He or she must also abstain from voting on the proposed transaction. When these rules are followed, the transaction can proceed. Otherwise, directors would be prevented from ever hav- ing financial dealings with the corporations they serve.ing financial dealings with the corporations they serve.ing financial dealings with the corporations they serve.ing financial dealings with the corporations they serve.

■ EXAMPLE 18.11 Ballo Corporation needs office space. Stephanie Colson, one of its five directors, owns the building adjoining the corporation’s headquarters. Colson can negotiate a lease for the space to Ballo if she fully discloses her conflicting interest and any facts known to her about the proposed transaction to Ballo and the other four directors. If the lease arrangement is fair and reasonable, Colson abstains from voting on it, and the other members of the corporation’s board of directors unanimously approve it, the contract is valid. ■

Liability of Directors and Officers Directors and officers are exposed to liability on many fronts. They can be held liable for negligence in certain circumstances, as previously discussed. They may also be held liable for the crimes and torts committed by themselves or by corporate employees under their supervision.

Additionally, if shareholders perceive that the corpo- rate directors are not acting in the best interests of the corporation, they may sue the directors on behalf of the corporation. (This is known as a shareholder’s derivative suit, which will be discussed later in this chapter.) Direc- tors and officers can also be held personally liable under a number of statutes, such as statutes enacted to protect consumers or the environment.

18–5 Shareholders The acquisition of a share of stock makes a person an owner and a shareholder in a corporation. Shareholders thus own the corporation. Although they have no legal title to corporate property, such as buildings and equip- ment, they do have an equitable (ownership) interest in the firm.

As a general rule, shareholders have no responsibility for the daily management of the corporation, although they are ultimately responsible for choosing the board of directors, which does have such control. Ordinarily,

406 U N I T F O U R The Business and Employment Environment

corporate officers and other employees owe no direct duty to individual shareholders (unless some contract or special relationship exists between them in addition to the corporate relationship).

The duty of officers and directors is to act in the best interests of the corporation and its shareholder-owners as a whole. In turn, as you will read later in this chapter, controlling shareholders owe a fiduciary duty to minority shareholders.

18–5a Shareholders’ Powers Shareholders must approve fundamental changes affect- ing the corporation before the changes can be imple- mented. Hence, shareholder approval normally is required to amend the articles of incorporation or bylaws, to conduct a merger or dissolve the corporation, and to sell all or substantially all of the corporation’s assets. Some of these powers are subject to prior board approval. Shareholder approval may also be requested (though it is not required) for certain other actions, such as to approve an independent auditor.

Shareholders also have the power to vote to elect or remove members of the board of directors. As described earlier, the first board of directors is either named in the articles of incorporation or chosen by the incorporators to serve until the first shareholders’ meeting. From that time on, selection and retention of directors are exclu- sively shareholder functions.

Directors usually serve their full terms. If the share- holders judge them unsatisfactory, they are simply not reelected. Shareholders have the inherent power, how- ever, to remove a director from office for cause (breach of duty or misconduct) by a majority vote. Some state stat- utes (and some articles of incorporation) permit removal of directors without cause by the vote of a majority of the shareholders entitled to vote.15

18–5b Shareholders’ Meetings Shareholders’ meetings must occur at least annually. In addition, special meetings can be called to deal with urgent matters. A corporation must notify its sharehold- ers of the date, time, and place of an annual or special shareholders’ meeting at least ten days, but not more than

15. Most states allow cumulative voting for directors (described later in cumulative voting for directors (described later in cumulative voting the chapter). If cumulative voting is authorized, a director may not be removed if the number of votes against removal would be sufficient to elect a director under cumulative voting. See, for instance, California Corporations Code Section 303A. See also Section 8.08(c) of the RMBCA.

sixty days, before the meeting date [RMBCA 7.05].16 (The date and time of the annual meeting can be specified in the bylaws.) Notice of a special meeting must include a statement of the purpose of the meeting, and business transacted at the meeting is limited to that purpose. Most corporations specify in their bylaws the acceptable meth- ods of notifying shareholders about meetings.

Proxies It usually is not practical for owners of only a few shares of stock of publicly traded corporations to attend a shareholders’ meeting. Therefore, the law allows stockholders to appoint another person as their agent to vote their shares at the meeting. The agent’s formal authorization to vote the shares is called a proxy (from proxy (from proxy the Latin procurare, meaning “to manage or take care of ”). Proxy materials are sent to all shareholders before share- holders’ meetings.

Management often solicits proxies, but any person can solicit proxies to concentrate voting power. Proxies have been used by groups of shareholders as a device for taking over a corporation. Proxies normally are revocable (can be withdrawn), unless they are specifically designated as irrevocable and coupled with an interest. A proxy is coupled with an interest when, for instance, the person receiving the proxies from shareholders has agreed to buy their shares. Under RMBCA 7.22(c), proxies are valid for eleven months, unless the proxy agreement mandates a longer period.

Shareholder Proposals When shareholders want to change a company policy, they can put their ideas up for a shareholder vote. They do this by submitting a share- holder proposal to the board of directors and asking the board to include the proposal in the proxy materials that are sent to all shareholders before meetings.

Rules for Proxies and Shareholder Proposals The Securities and Exchange Commission (SEC) regu- lates the purchase and sale of securities. The SEC has special provisions relating to proxies and shareholder proposals. SEC Rule 14a-8 provides that all sharehold- ers who own stock worth at least $1,000 are eligible to submit proposals for inclusion in corporate proxy materi- als. The corporation is required to include information on whatever proposals will be considered at the shareholders’ meeting along with proxy materials. Only those proposals that relate to significant policy considerations, not ordi- nary business operations, must be included.

16. The shareholder can waive the requirement of notice by signing a waiver form [RMBCA 7.06]. A shareholder who does not receive notice but who learns of the meeting and attends without protesting the lack of notice is said to have waived notice by such conduct.

C H A P T E R 1 8 Corporations 407

Under the SEC’s e-proxy rules,17 all public com- panies must post their proxy materials on the Internet and notify shareholders how to find that information. Although the law requires proxy materials to be posted online, public companies may also send the materials to shareholders by other means, including paper documents and DVDs sent by mail.

18–5c Shareholder Voting Shareholders exercise ownership control through the power of their votes. Corporate business matters are pre- sented in the form of resolutions, which shareholders vote to approve or disapprove. Each common shareholder normally is entitled to one vote per share.

The articles of incorporation can exclude or limit vot- ing rights, particularly for certain classes of shares. For instance, owners of preferred shares are usually denied the right to vote [RMBCA 7.21]. If a state statute requires specific voting procedures, the corporation’s articles or bylaws must be consistent with the statute.

Quorum Requirements For shareholders to act dur- ing a meeting, a quorum must be present. Generally, a quorum exists when shareholders holding more than 50 percent of the outstanding shares are present. State laws often permit the articles of incorporation to set higher or lower quorum requirements, however. In some states, obtaining the unanimous written consent of sharehold- ers is a permissible alternative to holding a shareholders’ meeting [RMBCA 7.25].

Once a quorum is present, voting can proceed. If a state statute requires specific voting procedures, the corpora- tion’s articles or bylaws must be consistent with the statute. A majority vote of the shares represented at the meeting usually is required to pass resolutions. At times, more than a simple majority vote is required, either by a state statute or by the corporate articles. Extraordinary corporate mat- ters, such as a merger, consolidation, or dissolution of the corporation, require approval by a higher percentage of all corporate shares entitled to vote [RMBCA 7.27].

Voting Lists The corporation prepares a voting list before each shareholders’ meeting. Ordinarily, only per- sons whose names appear on the corporation’s stockholder records as owners are entitled to vote.

The voting list contains the name and address of each shareholder as shown on the corporate records on a given cutoff date, or record date. (Under RMBCA 7.07, the bylaws or board of directors may fix a record date that

17. 17 C.F.R. Parts 240, 249, and 274.

is as much as seventy days before the meeting.) The vot- ing list also includes the number of voting shares held by each owner. The list is usually kept at the corporate headquarters and must be made available for shareholder inspection [RMBCA 7.20].

Cumulative Voting Most states permit, and many require, shareholders to elect directors by cumulative vot-cumulative vot-cumulative vot ing, a voting method designed to allow minority share- holders to be represented on the board of directors.

Formula. With cumulative voting, each shareholder is entitled to a total number of votes equal to the num- ber of board members to be elected multiplied by the number of voting shares that the shareholder owns. The shareholder can cast all of these votes for one can- didate or split them among several nominees for direc- tor. All candidates stand for election at the same time.

How Cumulative Voting Works. Cumulative voting can Cumulative voting can Cumulative voting can best be understood by example. ■ EXAMPLE 18.12 A cor- poration has 10,000 shares issued and outstanding. �e minority shareholders hold 3,000 shares, and the majority shareholders hold the other 7,000 shares. �ree members of the board are to be elected. �e majority shareholders’ nominees are Alvarez, Beasley, and Caravel. �e minority shareholders’ nominee is Dovrik. Can Dovrik be elected to the board by the minority shareholders?

If cumulative voting is allowed, the answer is yes. The minority shareholders have 9,000 votes among them (the number of directors to be elected times the number of shares, or 3 × 3,000 = 9,000 votes). All of these votes can be cast to elect Dovrik. The majority shareholders have 21,000 votes (3 × 7,000 = 21,000 votes), but these votes must be distributed among their three nominees.

The principle of cumulative voting is that no matter how the majority shareholders cast their 21,000 votes, they will not be able to elect all three directors if the minority shareholders cast all of their 9,000 votes for Dovrik, as illustrated in Exhibit 18–1. ■ In contrast, when cumulative voting is not required, the entire board can be elected by a majority of shares.

Other Voting Techniques Before a shareholders’ meeting, a group of shareholders can agree in writing to vote their shares together in a specified manner. Such agreements, called shareholder voting agreements, usually are held to be valid and enforceable. A shareholder can also vote by proxy, as noted earlier.

Another technique is for shareholders to enter into a voting trust. A voting trust is an agreement (a trust convoting trust is an agreement (a trust convoting trust - tract) under which a shareholder assigns the right to vote

408 U N I T F O U R The Business and Employment Environment

his or her shares to a trustee, usually for a specified period of time. The trustee is then responsible for voting the shares on behalf of all the shareholders in the trust. The shareholder retains all rights of ownership (for instance, the right to receive dividend payments) except the power to vote the shares [RMBCA 7.30].

18–5d Rights of Shareholders Shareholders possess numerous rights in addition to the right to vote their shares, and we examine several here.

Stock Certificates In the past, corporations com- monly issued stock certificates that evidenced ownership of a specified number of shares in the corporation. Only a few jurisdictions still require physical stock certificates, and shareholders there have the right to demand that the corporation issue certificates (or replace those that were lost or destroyed). Stock is intangible personal property, however, and the ownership right exists independently of the certificate itself.

In most states and under RMBCA 6.26, a board of directors may provide that shares of stock will be uncer- tificated, or “paperless”—that is, no actual, physical stock certificates will be issued. Notice of shareholders’ meet- ings, dividends, and operational and financial reports are distributed according to the ownership lists recorded in the corporation’s books.

Preemptive Rights Sometimes, the articles of incorporation grant preemptive rights to shareholders

[RMBCA 6.30]. With preemptive rights, a shareholder receives a preference over all other purchasers to subscribe to or purchase a prorated share of a new issue of stock. Generally, preemptive rights must be exercised within a specific time period (usually thirty days).

A shareholder who is given preemptive rights can pur- chase a percentage of the new shares being issued that is equal to the percentage of shares she or he already holds in the company. This allows each shareholder to main- tain her or his proportionate control, voting power, and tain her or his proportionate control, voting power, and tain her or his proportionate control, voting power, and tain her or his proportionate control, voting power, and financial interest in the corporation. ■ EXAMPLE 18.13 Katlin is a shareholder who owns 10 percent of a com- pany. Because she also has preemptive rights, she can buy 10 percent of any new issue (to maintain her 10 percent position). Thus, if the corporation issues 1,000 more shares, Katlin can buy 100 of the new shares. ■

Preemptive rights are most important in close corpo- rations because each shareholder owns a relatively small number of shares but controls a substantial interest in the corporation. Without preemptive rights, it would be possible for a shareholder to lose his or her propor- tionate control over the firm. Nevertheless, preemptive rights do not exist unless provided for in the articles of incorporation.

Stock Warrants Stock warrants are rights given by a company to buy stock at a stated price by a specified date. Usually, when preemptive rights exist and a corporation is issuing additional shares, it gives its shareholders stock warrants. Warrants are often publicly traded on securities exchanges.

Ballot

Minority Shareholder

Votes

Majority Shareholder

Votes Directors Elected

Alvarez

Alvarez, Beasley, Dovrik

Beasley, Caravel, Dovrik

Beasley Caravel Dovrik

10,000

9,001

6,000

10,000

9,000

7,000

1,000

2,999

8,000

9,000

E X H I B I T 1 8 – 1 Results of Cumulative Voting

C H A P T E R 1 8 Corporations 409

Dividends As mentioned, a dividend is a distribution of corporate profits or income ordered by the directors and ordered by the directors and ordered by the directors paid to the shareholders in proportion to their shares in the corporation. Dividends can be paid in cash, property, stock of the corporation that is paying the dividends, or stock of other corporations.18

State laws vary, but each state determines the gen- eral circumstances and legal requirements under which dividends are paid. State laws also control the sources of revenue to be used. All states allow dividends to be paid from the undistributed net profits earned by the corpora- tion, for instance. A number of states allow dividends to be paid out of any surplus.

Illegal Dividends. Dividends are illegal if they are improperly paid from an unauthorized account or if their payment causes the corporation to become insolvent. Generally, shareholders must return illegal dividends only if they knew that the dividends were illegal when the pay- ment was received (or if the dividends were paid when the corporation was insolvent). Whenever dividends are illegal or improper, the board of directors can be held per- sonally liable for the amount of the payment.

The Directors’ Failure to Declare a Dividend. When directors fail to declare a dividend, shareholders can ask a court to compel the directors to do so. To succeed, the shareholders must show that the directors have acted so unreasonably in withholding the dividend that their con- duct is an abuse of their discretion.

Often, a corporation accumulates large cash reserves for a legitimate corporate purpose, such as expansion or research. The mere fact that the firm has sufficient earn- ings or surplus available to pay a dividend normally is not enough to compel the directors to declare a dividend. The courts are reluctant to interfere with corporate oper- ations and will not compel directors to declare dividends unless abuse of discretion is clearly shown.

Inspection Rights Shareholders in a corporation enjoy both common law and statutory inspection rights. The RMBCA provides that every shareholder is entitled to examine specified corporate records, including voting lists [RMBCA 7.20, 16.02]. The shareholder may inspect in person, or an attorney, accountant, or other authorized assistant can do so as the shareholder’s agent.

18. On one occasion, a distillery declared and paid a dividend in bonded whiskey.

A shareholder has a right to inspect and copy corpo- rate books and records only for a proper purpose, and the request to inspect must be made in advance. A share- holder who is denied the right of inspection can seek a court order to compel the inspection.

■ CASE IN POINT 18.14 Trading Block Holdings, Inc., offers online brokerage services. On April 1, 2013, some shareholders of Trading Block, through an attor- ney, sent a letter asking to inspect specific items in the corporation’s books and records. The letter indicated that the purpose was to determine the financial condition of the company, how it was being managed, and whether the company’s financial practices were appropriate. It also stated that the shareholders wanted to know whether Trading Block’s management had engaged in any self- dealing that had negatively impacted the company as a whole.

On April 30, Trading Block responded with a let- ter stating that the plaintiffs were on a “fishing expedi- tion” and did not have a proper purpose for inspecting the corporate records. Eventually, the shareholders filed a motion to compel inspection in an Illinois state court. The trial court denied the plaintiffs’ motion. On appeal, the reviewing court held that the plaintiffs’ allegations of self-dealing by directors and officers constituted a proper purpose for their inspection request. The trial court’s decision was reversed.19 ■

Transfer of Shares Corporate stock represents an ownership right in intangible personal property. The law generally recognizes the owner’s right to transfer stock to another person unless there are valid restrictions on its transferability, such as frequently occur with close corpo- ration stock.

When shares are transferred, a new entry is made in the corporate stock book to indicate the new owner. Until the corporation is notified and the entry is complete, all rights—including voting rights, notice of shareholders’ meetings, and the right to dividend distributions— remain with the current record owner.

The Shareholder’s Derivative Suit When the corporation is harmed by the actions of a third party, the directors can bring a lawsuit in the name of the cor- poration against that party. If the corporate directors

19. Sunlitz Holding Co., W.L.L. v. Trading Block Holdings, Inc., 2014 IL App (1st) 133938, 17 N.E.3d 715, 384 Ill.Dec. 733 (4 Dist. 2014).

410 U N I T F O U R The Business and Employment Environment

fail to bring a lawsuit, shareholders can do so “deriva- tively” in what is known as a shareholder’s derivative suit.

The right of shareholders to bring a derivative action is especially important when the wrong suffered by the corporation results from the actions of the corporate directors and officers. For obvious reasons, the directors and officers would probably be unwilling to take any action against themselves.

Written Demand Required. Before shareholders can bring a derivative suit, they must submit a written demand to the corporation, asking the board of directors to take appropriate action [RMBCA 7.40]. �e directors then have ninety days in which to act. Only if they refuse to do so can the derivative suit go forward. In addition, a court will dismiss a derivative suit if a majority of the directors or an independent panel determines in good faith that the lawsuit is not in the best interests of the corporation [RMBCA 7.44].

Any Damages Awarded Go to the Corporation. When shareholders bring a derivative suit, they are not pursuing rights or bene�ts for themselves personally but are acting as guardians of the corporate entity. �erefore, if the suit is successful, any damages recovered normally go into the corporation’s treasury, not to the shareholders personally.

18–5e Duties and Liabilities of Shareholders

One of the hallmarks of the corporate form of organi- zation is that shareholders are not personally liable for the debts of the corporation. If the corporation fails, the shareholders can lose their investments, but that gener- ally is the limit of their liability. As discussed previously, in certain instances, a court will pierce the corporate veil (disregard the corporate entity) and hold the sharehold- ers individually liable. But these situations are the excep- tion, not the rule.

A shareholder can also be personally liable in certain other rare instances such as those related to illegal divi- dends or to watered stock. Finally, in certain instances, a majority shareholder who engages in oppressive conduct or attempts to exclude minority shareholders from receiving certain benefits can be held personally liable.

Watered Stock When a corporation issues shares for less than their fair market value, the shares are referred

to as watered stock.20 Usually, the shareholder who receives watered stock must pay the difference to the corporation (the shareholder is personally liable). In some states, the shareholder who receives watered stock may be liable to creditors of the corporation for unpaid corporate debts.

■ EXAMPLE 18.15 During the formation of a cor- poration, Gomez, one of the incorporators, transfers his property, Sunset Beach, to the corporation for 10,000 shares of stock at a par value of $100 per share for a total price of $1 million. After the property is transferred and the shares are issued, Sunset Beach is carried on the cor- porate books at a value of $1 million.

On appraisal, it is discovered that the market value of the property at the time of transfer was only $500,000. The shares issued to Gomez are therefore watered stock, and he is liable to the corporation for the difference between the value of the shares and the value of the property. ■

Duties of Majority Shareholders In some instances, a majority shareholder is regarded as having a fiduciary duty to the corporation and to the minor- ity shareholders. This duty arises when a single share- holder (or a few shareholders acting in concert) owns a sufficient number of shares to exercise de facto control over the corporation. In these situations, the major- ity shareholder owes a fiduciary duty to the minority shareholders.

When a majority shareholder breaches her or his fiduciary duty to a minority shareholder, the minority shareholder can sue for damages. A breach of fiduciary duties by those who control a close corporation nor- mally constitutes what is known as oppressive conduct. A common example of a breach of fiduciary duty occurs when the majority shareholders “freeze out” the minority shareholders and exclude them from certain benefits of participating in the firm.participating in the firm.participating in the firm.participating in the firm.

■ EXAMPLE 18.16 Brodie, Jordan, and Barbara form a Brodie, Jordan, and Barbara form a close corporation to operate a machine shop. Brodie and Jordan own 75 percent of the shares in the company, but all three are directors. After disagreements arise, Brodie asks the company to purchase his shares, but his requests are refused. A few years later, Brodie dies, and his wife, Ella, inherits his shares. Jordan and Barbara refuse to perform a valuation of the company, deny Ella access to corporate information, do not declare any dividends, and refuse to elect Ella as a director. In this situation, the majority share- holders have violated their fiduciary duty to Ella. ■

20. The phrase watered stock was originally used to describe cattle that were watered stock was originally used to describe cattle that were watered stock kept thirsty during a long drive and then were allowed to drink large quantities of water just before their sale. The increased weight of the watered stock allowed the seller to reap a higher profit.

C H A P T E R 1 8 Corporations 411

18–6 Major Business Forms Compared

When deciding which form of business organization to choose, businesspersons normally consider several factors, including ease of creation, the liability of the

owners, tax considerations, and the ability to raise capi- tal. Each major form of business organization offers dis- tinct advantages and disadvantages with respect to these and other factors.

Exhibit 18–2 summarizes the essential advantages and disadvantages of each of the forms of business organiza- tion discussed in this text.

CORPORATIONPARTNERSHIPSOLE PROPRIETORSHIP

Method of Creation

Created at will by owner. Created by agreement of the parties.

Authorized by the state under the state’s corporation law.

Legal Position Not a separate entity; owner is the business.

A general partnership is a separate legal entity in most states.

Always a legal entity separate and distinct from its owners—a legal fiction for the purposes of owning property and being a party to litigation.

Liability Unlimited liability. Unlimited liability. Limited liability of shareholders—shareholders are not liable for the debts of the corporation.

Duration Determined by owner; automatically dissolved on owner’s death.

Terminated by agreement of theTerminated by agreement of theT partners, but can continue to do business even when a partner dissociates from the partnership.

Can have perpetual existence.

Transferability of Interest

Interest can be transferred, but individual’s proprietorship then ends.

Although partnership interest can be assigned, assignee does not have full rights of a partner.not have full rights of a partner.not have full rights of a partner

Shares of stock can be transferred.

Management Completely at owner’s discretion.

Each partner has a direct and equal voice in management unless expressly agreed otherwise in the partnership agreement.

Shareholders elect directors, who set policy and appoint officers.

Taxation Owner pays personal taxes on business income.

Each partner pays pro rata share of income taxes on net profits, whether or not they are distributed.

Double taxation—corporation pays income tax on net profits, with no deduction for dividends, and shareholders pay income tax on disbursed dividends they receive.

Organizational Fees, Annual License Fees, and Annual Reports

None or minimal. None or minimal. All required.

Transaction of Business in Other States

Generally no limitation. Generally no limitation.a Normally must qualify to do business and obtain certificate of authority.

a. A few states have enacted statutes requiring that foreign partnerships qualify to do business there A few states have enacted statutes requiring that foreign partnerships qualify to do business there A few states have enacted statutes requiring that foreign partnerships qualify to do business there A few states have enacted statutes requiring that foreign partnerships qualify to do business there.

E X H I B I T 1 8 – 2 Major Forms of Business Compared

412 U N I T F O U R The Business and Employment Environment

LIMITED LIABILITY PARTNERSHIP

LIMITED LIABILITY COMPANY

LIMITED PARTNERSHIP

Method of Creation

Created by agreement to carry on a business for profit. At least one party must be a general partner and the other(s) limited partner(s). Certificate of limited partnership is filed.

Created by an agreement of the member-owners of the company. Articles of organization are filed. Charter must be issued by the state.

Created by agreement of the partners. A statement of qualification for the limited liability partnership is filed.

Duration By agreement in certificate, or by termination of the last general partner (retirement, death, and the like) or last limited partner.

Unless a single-member LLC, can have perpetual existence (same as a corporation).

Remains in existence until cancellation or revocation.

Transferability of Interest

Interest can be assigned, but if assignee becomes a member with consent of other partners, certificate must be amended.

Member interests are freely transferable.

Interest can be assigned same as in a general partnership.

Management General partners have equal voice or by agreement. Limited partners may not retain limited liability if they actively participate in management.

Member-owners can fully participate in management or can designate a group of persons to manage on behalf of the members.

Same as a general partnership.

Taxation Generally taxed as a partnership.

LLC is not taxed, and members are taxed personally on profits “passed through” the LLC.

Same as a general partnership.

Organizational Fees, Annual License Fees, and Annual Reports

Organizational fee required; usually not others.

Organizational fee required. Others vary with states.

Fees are set by each state for filing statements of qualification, statements of foreign qualification, and annual reports.

Transaction of Business in Other States

Generally no limitations. Generally no limitations, but may vary depending on state.

Must file a statement of foreign qualification before doing business in another state.

Legal Position Treated as a legal entity. T. T. Treated as a legal entity. G. G. Generally, treated same as a enerally, treated same as a enerally general partnership.

Liability Unlimited liability of all general partners. Limited partners are liable only to the extent of capital contributions.

Member-owners’ liability is limited to the amount of capital contributions or investments.

Varies, but under the Uniform Partnership Act, liability of a partner for acts committed by other partners is limited.

E X H I B I T 1 8 – 2 Major Forms of Business Compared (Continued)

C H A P T E R 1 8 Corporations 413

Reviewing: Corporations

David Brock was on the board of directors of Firm Body Fitness, Inc., which owned a string of fitness clubs in New Mexico. Brock owned 15 percent of the Firm Body stock and was also employed as a tanning technician at one of the fitness clubs. After the January financial report showed that Firm Body’s tanning division was operating at a substantial net loss, the board of directors, led by Marty Levinson, discussed terminating the tanning operations. Brock success- fully convinced a majority of the board that the tanning division was necessary to market the clubs’ overall fitness package. By April, the tanning division’s financial losses had risen. The board hired a business analyst, who conducted surveys and determined that the tanning operations did not significantly increase membership.

A shareholder, Diego Peñada, discovered that Brock owned stock in Sunglow, Inc., the company from which Firm Body purchased its tanning equipment. Peñada notified Levinson, who privately reprimanded Brock. Shortly there- after, Brock and Mandy Vail, who owned 37 percent of the Firm Body stock and also held shares of Sunglow, voted to replace Levinson on the board of directors. Using the information presented in the chapter, answer the following questions. 1. What duties did Brock, as a director, owe to Firm Body? 2. Does the fact that Brock owned shares in Sunglow establish a conflict of interest? Why or why not? 3. Suppose that Firm Body brought an action against Brock claiming that he had breached the duty of loyalty by not

disclosing his interest in Sunglow to the other directors. What theory might Brock use in his defense? 4. Now suppose that Firm Body did not bring an action against Brock. What type of lawsuit might Peñada be able to

bring based on these facts?

Debate This . . . The sole shareholder of an S corporation should not be able to avoid liability for the torts of her or his employees.

Terms and Concepts alien corporation 389 articles of incorporation 394 bene�t corporation 394 bond 396 business judgment rule 403 bylaws 395 close corporation 392 commingle 399 common stock 396 crowdfunding 397 dividends 389 domestic corporation 389 foreign corporation 389

holding company 389 inside director 401 outside director 401 pierce the corporate veil 399 preemptive rights 408 preferred stock 396 private equity capital 397 proxy 406 public corporation 391 publicly held corporation 391 quorum 401 retained earnings 389 S corporation 393

securities 396 shareholder agreement 393 shareholder’s derivative suit 410 stock 396 stock certi�cate 408 stock warrant 408 ultra vires 398ultra vires 398ultra vires venture capital 397 voting trust 407 watered stock 410

414 U N I T F O U R The Business and Employment Environment

Issue Spotters 1. Northwest Brands, Inc., is a small business incorpo-

rated in Minnesota. Its one class of stock is owned by twelve members of a single family. Ordinarily, corporate income is taxed at the corporate and shareholder lev- els. Is there a way for Northwest Brands to avoid this double taxation? Explain your answer. (See Nature and Classification.)

2. Nico is Omega Corporation’s majority shareholder. He owns enough stock in Omega that if he were to sell it, the sale would be a transfer of control of the firm. Dis- cuss whether Nico owes a duty to Omega or the minority shareholders in selling his shares. (See Shareholders.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 18–1. Preincorporation. Cummings, Okawa, and Taft are recent college graduates who want to form a corporation to manufacture and sell digital tablets. Peterson tells them he will set in motion the formation of their corporation. First, Peter- son makes a contract with Owens for the purchase of a piece of land for $20,000. Owens does not know of the prospective corporate formation at the time the contract is signed. Second, Peterson makes a contract with Babcock to build a small plant on the property being purchased. Babcock’s contract is con- ditional on the corporation’s formation. Peterson secures all necessary subscription agreements and capitalization, and he files the articles of incorporation. (See Formation and Powers.) (a) Discuss whether the newly formed corporation, Peterson, or

both are liable on the contracts with Owens and Babcock.

(b) Discuss whether the corporation is automatically liable to Babcock on formation.

18–2. Conflicts of Interest. Oxy Corp. is negotiating with Wick Construction Co. for the renovation of Oxy’s cor- porate headquarters. Wick, the owner of Wick Construction Co., is also one of the five members of Oxy’s board of direc- tors. The contract terms are standard for this type of contract. Wick has previously informed two of the other directors of his interest in the construction company. Oxy’s board approves the contract by a three-to-two vote, with Wick voting with the majority. Discuss whether this contract is binding on the corporation. (See Directors and Officers.)

Business Case Problems 18–3. Spotlight on Smart Inventions—Piercing the Corporate Veil. �omas Persson and Jon Nokes founded

Smart Inventions, Inc., to market household con- sumer products. �e success of their �rst product, the Smart Mop, continued with later products, which were sold through infomercials and other

means. Persson and Nokes were the �rm’s o�cers and equal shareholders. Persson was responsible for product develop- ment, and Nokes was in charge of day-to-day operations. In time, they became dissatis�ed with each other’s e�orts. Nokes represented the �rm as �nancially “dying,” “in a grim state, . . . worse than ever,” and o�ered to buy all of Persson’s shares for $1.6 million. Persson accepted.

On the day that they signed the agreement to transfer the shares, Smart Inventions began marketing a new product— the Tap Light. It was an instant success, generating millions of dollars in revenues. In negotiating with Persson, Nokes had intentionally kept the Tap Light a secret. Persson sued Smart Inventions, asserting fraud and other claims. Under what principle might Smart Inventions be liable for Nokes’s fraud? Is Smart Inventions liable in this case? Explain. [Pers- son v. Smart Inventions, Inc., 125 Cal.App.4th 1141, 23 Cal. Rptr.3d 335 (2 Dist. 2005)] (See Piercing the Corporate Veil.) 18–4. Duty of Loyalty. Kids International Corp. produced children’s wear for Walmart and other retailers. Gila Dweck

was a Kids director and its chief executive o�cer. Because she felt that she was not paid enough, she started Success Apparel to compete with Kids. Success operated out of Kids’ premises, used its employees, borrowed on its credit, took advantage of its business opportunities, and capitalized on its customer relationships. As an “administrative fee,” Dweck paid Kids 1 percent of Success’s total sales. Did Dweck breach any �du- ciary duties? Explain. [Dweck v. Nasser, 2012 WL 3194069 (Del.Ch. 2012)] (See Directors and Officers.Directors and Officers.Directors and Off ) 18–5. Business Case Problem with Sample Answer— Piercing the Corporate Veil. Scott Snapp contracted with

Castlebrook Builders, Inc., which was owned by Stephen Kappeler, to remodel a house. Kappeler estimated that the remodeling would cost around $500,000. Eventually, however, Snapp paid Kap-

peler more than $1.3 million. Snapp �led a suit in an Ohio state court against Castlebrook, alleging breach of contract and fraud, among other things. During the trial, it was revealed that Castlebrook had issued no shares of stock and that personal and corporate funds had been commingled. �e minutes of the corporate meetings all looked exactly the same. In addition, Kappeler could not provide an accounting for the Snapp project. In particular, he could not explain evidence of double and triple billing nor demonstrate that the amount Snapp paid had actually been spent on the remodeling project.

C H A P T E R 1 8 Corporations 415

Are these su�cient grounds to pierce the corporate veil? Explain. [Snapp v. Castlebrook Builders, Inc., 2014 -Ohio- 163, 7 N.E.3d 574 (2014)] (See Formation and Powers.) • For a sample answer to Problem 18–5, go to Appendix E at

the end of this text.

18–6. Business Judgment Rule. Country Contractors, Inc., contracted to provide excavation services for A West- side Storage of Indianapolis, Inc., but did not complete the job and later �led for bankruptcy. Stephen Songer and Jahn Songer were Country’s sole shareholders. �e Songers had not misused the corporate form to engage in fraud. �e �rm had not been undercapitalized, personal and corporate funds had not been commingled, and Country had kept account- ing records and minutes of its annual board meetings. Are the Songers personally liable for Country’s failure to complete its contract? Explain. [Country Contractors, Inc. v. A Westside Stor- age of Indianapolis, Inc., 4 N.E.3d 677 (Ind.App. 2014)] (See Directors and OfficersDirectors and OfficersDirectors and Off .) 18–7. Torts. Jennifer Ho�man took her cell phone to a store owned by R&K Trading, Inc., for repairs. Later, Ho�man �led a suit in a New York state court against R&K, Verizon Wire- less, Inc., and others. Ho�man sought to recover damages for a variety of torts, including in�iction of emotional distress and negligent hiring and supervision. She alleged that an R&K employee, Keith Press, had examined her phone in a back room, accessed private photos of her stored on her phone, and disseminated the photos to the public. Ho�man testi�ed that “after the incident, she learned from another R&K employee that personal information and pictures had been removed from the phones of other customers.” Can R&K be held liable for the torts of its employees? Explain. [Ho�man v. Verizon Wireless, Inc., 5 N.Y.S.3d 123, 125 A.D.3d 806 (2015)] (See Nature and Classi�cation.) 18–8. Rights of Shareholders. FCR Realty, LLC, and Cli�ord B. Green & Sons, Inc., were co-owned by three brothers—Frederick, Cli�ord Jr., and Richard Green. Each brother was a shareholder of the corporation. Frederick was

a controlling shareholder, as well as president. Each brother owned a one-third interest in the LLC. Cli�ord believed that Frederick had misused LLC and corporate funds to pay non- existent debts and liabilities and had diverted LLC assets to the corporation. He also contended that Frederick had dis- bursed about $1.8 million in corporate funds to Frederick’s own separate business. Cli�ord hired an attorney and �led an action on behalf of the two companies against Frederick for breach of �duciary duty. Frederick argued that Cli�ord lacked the knowledge necessary to adequately represent the companies’ interest because he did not understand �nancial statements. Can Cli�ord maintain the action against Freder- ick? If so, and if the suit is successful, who recovers the dam- ages? Explain. [FCR Realty, LLC v. Green, __ Conn.Supp. __, __ Conn.L.Rptr. __, 2016 WL 571449 (Super. 2016)] (See Shareholders.)

18–9. A Question of Ethics—Piercing the Corporate Veil. In New York City, 2406-12 Amsterdam Associates LLC

brought an action in a New York state court against Alianza Dominicana and Alianza LLC to recover unpaid rent. �e plainti� asserted cause to pierce the corporate veil, alleging that Alianza Domini-

cana had made promises to pay its rent while discreetly forming Alianza LLC to avoid liability for it. According to 2406-12, Alianza LLC was 90 percent owned by Alianza Dominicana, had no employees, and had no function but to hold Alianza Dominicana’s assets away from its creditors. �e defendants �led a motion to dismiss the plainti�’s claim. [2406-12 [2406-12 [ Amsterdam Associates, LLC v. Alianza, LLC, 136 A.D.3d 512, 25 N.Y.S.2d 167 (1 Dept. 2016)] (See 512, 25 N.Y.S.2d 167 (1 Dept. 2016)] (See 512, 25 N.Y.S.2d 167 (1 Dept. 2016)] Piercing the Cor- porate Veil.)porate Veil.)porate Veil

(a) Assuming that 2406-12’s allegations are true, are there sufficient grounds to pierce Alianza LLC’s corporate veil? Discuss.

(b) Suppose that the parties to this dispute were small, close corporations. How might that circumstance affect the result in this case?

Legal Reasoning Group Activity 18–10. Corporate versus LLC Form of Business. The limited liability company (LLC) may be the best organi- zational form for most businesses. For a significant num- ber of firms, however, the corporate form or some other form of organization may be better. (See Nature and Classification.)

(a) The first group will outline several reasons why a firm might be better off as a corporation than as an LLC.

(b) The second group will discuss the differences between corporations and LLCs in terms of their management structures.

416

also exist between employers and independent contrac- tors who are hired to perform special tasks or services.

19–1a Employer-Employee Relationships Normally, all employees who deal with third parties are deemed to be agents. A salesperson in a department store, for instance, is an agent of the store’s owner (the princi- pal) and acts on the owner’s behalf. Any sale of goods made by the salesperson to a customer is binding on the principal. Similarly, most representations of fact made by the salesperson with respect to the goods sold are binding on the principal.

Because employees who deal with third parties gener- ally are deemed to be agents of their employers, agency law and employment law overlap considerably. Agency relationships, however, can exist outside an employer- employee relationship, so agency law has a broader reach than employment law. Additionally, agency law is based on the common law, whereas much employment law is statutory law.

Employment laws (state and federal) apply only to the employer-employee relationship. Statutes governing

19–1 Agency Law Section 1(1) of the Restatement (Third) of Agency1 defines agency as “the fiduciary relation [that] results from the agency as “the fiduciary relation [that] results from the agency manifestation of consent by one person to another that the other shall act in his [or her] behalf and subject to his [or her] control, and consent by the other so to act.” In other words, in a principal-agent relationship, the parties have agreed that the agent will act on behalf and instead of the principal in negotiating and transacting business of the principal in negotiating and transacting business of with third parties.

The term fiduciary is at the heart of agency law. fiduciary is at the heart of agency law. fiduciary When this term is used as a noun, it refers to a person having a duty created by his or her undertaking to act primarily for another’s benefit in matters connected with the undertaking. When used as an adjective, as in the phrase fiduciary relationship, it means that the relation- ship involves trust and confidence.

Agency relationships commonly exist between employ- ers and employees. Agency relationships may sometimes

1. The Restatement (Third) of Agency is an authoritative summary of the Restatement (Third) of Agency is an authoritative summary of the Restatement (Third) of Agency law of agency and is often referred to by judges in their decisions and opinions.

O ne of the most common, impor- tant, and pervasive legal rela- tionships is that of agency. In

an agency relationship involving two parties, one of the parties, called the agent, agrees to represent or act for the other, called the principal. The principal has the right to control the agent’s conduct in matters entrusted to the agent.

Agency relationships are crucial in the business world. By using agents, a principal can conduct multiple

business operations at the same time in different locations. Indeed, the only way that certain business entities can function is through their agents. For instance, a corporate officer is an agent who serves in a representative capacity for the corporation. The offi- cer has the authority to bind the cor- poration to a contract. Only through its officers can corporations enter into contracts.

Most employees are also consid- ered to be agents of their employers.

Today, however, the United States is experiencing a trend toward a so- called gig economy, which centers on short-term, independent workers who are not employees. Companies like Uber and Lyft (discussed in this chapter’s feature) provide evidence of this trend. This type of on-demand employment raises questions related to agency, making agency an increas- ingly important topic for students of business law and the legal environ- ment to understand.

Agency Relationships

C H A P T E R 19

C H A P T E R 1 9 Agency Relationships 417

Social Security, withholding taxes, workers’ compensa- tion, unemployment compensation, workplace safety, and employment discrimination apply only if an employer-employee relationship exists. These laws do not apply to independent contractors.

19–1b Employer–Independent Contractor Relationships

Independent contractors are not employees because, by definition, those who hire them have no control over the details of their work performance. Section 2 of the Restatement (Third) of Agency defines an Restatement (Third) of Agency defines an Restatement (Third) of Agency independent contractor as follows:contractor as follows:contractor

[An independent contractor is] a person who contracts with another to do something for him [or her] but who is not controlled by the other nor subject to the other’s right to control with respect to his [or her] physical con- duct in the performance of the undertaking. He [or she] may or may not be an agent.

Building contractors and subcontractors are indepen- dent contractors. A property owner who hires a contrac- tor and subcontractors to complete a project does not control the details of the way they perform their work. Truck drivers who own their vehicles and hire out on a per-job basis are independent contractors, but truck driv- ers who drive company trucks on a regular basis usually are employees. See this chapter’s Ethics Today feature for a Ethics Today feature for a Ethics Today discussion of disputes involving the classification of driv- ers working for Uber and Lyft.

The relationship between a principal and an inde- pendent contractor may or may not involve an agency relationship. To illustrate: A homeowner who hires a real estate broker to sell her house has contracted with an independent contractor (the broker). The homeowner has also established an agency relationship with the broker for the specific purpose of selling the property. Another example is an insurance agent, who is both an indepen- dent contractor and an agent of the insurance company for which he sells policies. (Note that an insurance broker, in contrast, normally is an agent of the person obtaining insurance and not of the insurance company.)

19–1c Determination of Employee Status The courts are frequently asked to determine whether a particular worker is an employee or an independent contractor. How a court decides this issue can have a sig- nificant effect on the rights and liabilities of the parties.

Employers are required to pay certain taxes, such as Social Security and unemployment taxes, for employees but not for independent contractors. Therefore, workers may ben- efit from obtaining employee status in some situations.

Criteria Used by the Courts In deciding whether a worker is categorized as an employee or an independent contractor, courts often consider the following questions:

1. How much control does the employer exercise over the details of the work? If the employer exercises consid- erable control over the details of the work and the day-to-day activities of the worker, this indicates employee status. This is perhaps the most impor- tant factor weighed by the courts in determining employee status.

2. Is the worker engaged in an occupation or business dis- tinct from that of the employer? If so, this points to tinct from that of the employer? If so, this points to tinct from that of the employer? independent-contractor, not employee, status.

3. Is the work usually done under the employer’s direction or by a specialist without supervision? If the work is usually done under the employer’s direction, this indicates employee status.

4. Does the employer supply the tools at the place of work? If so, this indicates employee status.

5. For how long is the person employed? If the person is employed for a long period of time, this indicates employee status.

6. What is the method of payment—by time period or at the completion of the job? Payment by time period, such as once every two weeks or once a month, indi- cates employee status.

7. What degree of skill is required of the worker? If a great degree of skill is required, this may indicate that the person is an independent contractor hired for a spe- cialized job and not an employee.

Whether a worker is an employee or an indepen- dent contractor can affect the employer’s liability for the worker’s actions. An employer normally is not responsi- ble for the actions of an independent contractor. ■ CASE IN POINT 19.1 Terence Pershad was a tow truck driver for Five Star Auto Service. Five Star had contracted to perform towing and auto repair services for AAA North Jersey, Inc. After one of its customers was involved in a car accident, AAA called Five Star for assistance, and Five Star sent a truck driven by Pershad. Pershad got into a fight with Nicholas Coker, a passenger in the car, and assaulted Coker with a knife.

Coker filed a suit in a New Jersey state court against Pershad, Five Star, and AAA. The court determined that

418 U N I T F O U R The Business and Employment Environment

Is It Fair to Classify Uber and Lyft Drivers as Independent Contractors?

The transportation-for-hire world has changed dramatically since Uber, Lyft, and other transportation-sharing companies came onto the scene. Uber started in San Francisco in 2009. Today, its services are available in one form or another in about 60 countries and more than 300 cities worldwide. Its main competitor, Lyft, was launched in 2012 and operates in more than 200 U.S. cities. The growth in transportation sharing has not been without its set- backs, though. Most of them involve laws that have prohibited Uber and Lyft from operating in certain cities, as well as lawsuits by drivers claiming that they were misclassified.

Classification of Workers Workers in the United States generally fall into two categories: employees and independent contractors. Employment laws, including minimum wage and anti- discrimination statutes, cover employees. Such laws do not cover most independent contractors. Enter the digital age of on-demand workers who obtain job assignments via apps.

Workers for Lyft, Uber, and similar companies choose when and where they will perform their duties. They do not choose how much they will be paid, however. For them, employment is a take-it-or-leave-it proposition. They electronically accept the platform terms of the apps, or they obtain no work assignments.

Some critics of this contractual system argue that there should be a new category of workers with “dependent-contractor” status who receive some of the protections traditionally given only to employees. Cer- tain aspects of current labor law would be attached to the relationships between dependent contractors and their employers.

Worker Misclassification Lawsuits A number of former or current Uber and Lyft driv- ers have pursued legal remedies to change their job classification and to obtain better benefits. In California, for instance, two federal court judges allowed separate lawsuits to go before juries on the

question of whether on-demand drivers should be considered employees rather than independent contractors.a

In a similar case, rather than go to court, Lyft settled a worker misclassification lawsuit for $12.25 million. The suit, which was settled in 2016, had been brought in 2013. The settlement did not achieve a reclassification

of Lyft drivers as employees. Basically, Lyft agreed to change its terms of service to conform to California’s independent contractor status regulations. For instance, the company can no longer deactivate drivers’ accounts without reason and without warning the driv- ers. Drivers have to be given a fair hearing first. Even though the lawsuit and the agreement were California based, the new terms of service will apply to all Lyft’s drivers nationwide.

Competitors Sue Uber In many cities, competitors, especially taxi drivers, have sued Uber. These lawsuits have involved claims of unfair competition, lack of minimum wages, and unsafe vehicles. A taxi driver sued Uber in northern California, for instance, but a federal district court ruled in favor of Uber’s request for summary judgment.b

Another suit was brought in Pennsylvania. In this one, Checker Cab of Philadelphia claimed that Uber was violating Pennsylvania’s unfair competition law. Checker Cab sought a preliminary injunction to pre- vent Uber from taking away its customers. The federal district court refused to grant an injunction, however, because Checker Cab failed to show irreparable harm. That decision was upheld on appeal.c

Critical Thinking What choices do disgruntled Uber and Lyft drivers have?

ETHICS TODAY

a. Cotter v. Lyft, Inc., 60 F.Supp.3d 1067 (N.D.Cal. 2015); O’Connor v. Uber Technologies, Inc., et al., Case No. C-13-3826 EMC (N.D.Cal. 2015).

b. Rosen v. Uber Technologies, Inc., __ F.Supp.3d __, 2016 WL 704078 (N.D.Cal. 2016).

c. Checker Cab of Philadelphia v. Uber Technologies, Inc., __ Fed.Appx. __, 2016 WL 929310 (3d Cir. 2016).

Pershad was Five Star’s employee and that Five Star was an independent contractor, not AAA’s employee. Therefore, AAA was not liable (and Five Star was, so it entered into a settlement agreement with Coker). Coker appealed, but a state intermediate appellate court affirmed. AAA could not be held liable for the actions of Five Star, its

independent contractor, because “AAA did not control the manner and means of Five Star’s work.”2 ■

Criteria Used by the IRS The Internal Revenue Ser- vice (IRS) has established its own criteria for determining

2. Coker v. Pershad, 2013 WL 1296271 (N.J.Sup.Ct. 2013).Coker v. Pershad, 2013 WL 1296271 (N.J.Sup.Ct. 2013).Coker v. Pershad Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 1 9 Agency Relationships 419

whether a worker is an independent contractor or an employee. The most important factor is the degree of control the business exercises over the worker.

The IRS tends to closely scrutinize a firm’s classifica- tion of its workers because, as mentioned, employers can avoid certain tax liabilities by hiring independent contrac- tors instead of employees. Even when a firm has classified a worker as an independent contractor, the IRS may decide that the worker is actually an employee. If the IRS decides that an employee is misclassified, the employer will be responsible for paying any applicable Social Security, with- holding, and unemployment taxes due for that employee.

Employee Status and “Works for Hire” Ordinar- ily, a person who creates a copyrighted work is the owner of it—unless it is a “work for hire.” Under the Copyright Act, any copyrighted work created by an employee within the scope of her or his employment at the request of the employer is a “work for hire.” The employer owns the copyright to the work.

In contrast, when an employer hires an independent contractor—such as a freelance artist, writer, or com- puter programmer—the independent contractor nor- mally owns the copyright. An exception is made if the parties agree in writing that the work is a “work for hire” and the work falls into one of nine specific categories. The nine categories include audiovisual works, collective works (such as magazines), motion pictures, textbooks, tests, and translations.

■ CASE IN POINT 19.2 As a freelance contractor, Brian As a freelance contractor, Brian Cooley created two sculptures of dinosaur eggs for the National Geographic Society for use in connection with an article in its magazine, National Geographic. Cooley spent hundreds of hours researching, designing, and constructing the sculptures. National Geographic hired Louis Psihoyos to photograph Cooley’s sculptures for the article. Cooley and Psihoyos had separate contracts with National Geographic in which each transferred the copyrights in their works to National Geographic for a limited time.

The rights to the works were returned to the artists at different times after publication. Psihoyos then began licensing his photographs of Cooley’s sculptures to third parties in return for royalties. He digitized the photo- graphs and licensed them to various online stock pho- tography companies, and they appeared in several books published by Penguin Group. Cooley sued Psihoyos for copyright infringement.

Psihoyos argued that he owned the photos and could license them however he saw fit, but a federal district court disagreed. The court found that Psihoyos did not have an unrestricted right to use and license the photos.

When Psihoyos reproduced an image of a Cooley sculp- ture, he reproduced the sculpture, which infringed on Cooley’s copyright. Therefore, the court granted a sum- mary judgment to Cooley.3 ■

19–2 Formation of the Agency Relationship

Agency relationships normally are consensual. They come about by voluntary consent and agreement between the parties. Normally, the agreement need not be in writing, and consideration is not required.

A person must have contractual capacity to be a prin- cipal.4 The idea is that those who cannot legally enter into contracts directly should not be allowed to do so indirectly through an agent. Any person can be an agent, however, regardless of whether he or she has the capacity to contract (including minors).

An agency relationship can be created for any legal purpose. An agency relationship created for a purpose that is illegal or contrary to public policy is unenforcethat is illegal or contrary to public policy is unenforcethat is illegal or contrary to public policy is unenforcethat is illegal or contrary to public policy is unenforce- able. ■ EXAMPLE 19.3 Archer (as principal) contracts with Burke (as agent) to sell illegal narcotics. The agency relationship is unenforceable because selling illegal nar- cotics is a felony and is contrary to public policy. If Burke sells the narcotics and keeps the profits, Archer cannot sue to enforce the agency agreement. ■

An agency relationship can arise in four ways: by agreement of the parties, by ratification, by estoppel, and by operation of law.

19–2a Agency by Agreement Most agency relationships are based on an express or implied agreement that the agent will act for the principal and that the principal agrees to have the agent so act. An agency agreement can take the form of an express written agency agreement can take the form of an express written agency agreement can take the form of an express written contract or be created by an oral agreement. contract or be created by an oral agreement. contract or be created by an oral agreement. ■ EXAMPLE 19.4 Reese asks Grace, a gardener, to contract with others for the care of his lawn on a regular basis. If Grace agrees, an agency relationship exists between Reese and Grace for the lawn care. ■

An agency agreement can also be implied by conAn agency agreement can also be implied by conAn agency agreement can also be implied by conAn agency agreement can also be implied by con- duct. ■ CASE IN POINT 19.5 Gilbert Bishop was admit- ted to a nursing home, Laurel Creek Health Care Center, suffering from various physical ailments. He was not able to use his hands well enough to write but was otherwise

3. Cooley v. Penguin Group (USA), Inc., 31 F.Supp.3d 599 (S.D.N.Y. 2014). 4. Note that some states allow a minor to be a principal. When a minor is

permitted to be a principal, any resulting contracts will be voidable by the minor principal but not by the adult third party.not by the adult third party.not

420 U N I T F O U R The Business and Employment Environment

mentally competent. Bishop’s sister offered to sign the admission papers for him, but it was Laurel Creek’s policy to have the patient’s spouse sign the forms if the patient could not.

Bishop’s sister then brought his wife, Anna, to the hos- pital to sign the paperwork, which included a mandatory arbitration clause. Later, when the family filed a lawsuit against Laurel Creek, the nursing home sought to enforce the arbitration clause. Ultimately, a Kentucky appellate court held that Bishop was bound by the contract and the arbitration clause his wife had signed. Bishop’s con- duct had indicated that he was giving his wife authority to act as his agent in signing the admission papers.5 ■

19–2b Agency by Ratification On occasion, a person who is in fact not an agent (or who is an agent acting outside the scope of her or his authority) makes a contract on behalf of another (a prin- cipal). If the principal approves or affirms that contract by word or by action, an agency relationship is created by ratification. Ratification involves a question of intent, and intent can be expressed by either words or conduct.

19–2c Agency by Estoppel Sometimes, a principal causes a third person to believe that another person is the principal’s agent, and the third person acts to his or her detriment in reasonable reli- ance on that belief. When this occurs, the principal is “estopped to deny” (prevented from denying) the agency relationship. The principal’s actions have created the appearance of an agency that does not in fact exist, creatappearance of an agency that does not in fact exist, creatappearance - ing an agency by estoppel.

The Third Party’s Reliance Must Be Reasonable The third person must prove that he or she reasonably believed that an agency relationship existed.6 Facts and circumstances must show that an ordinary, prudent per- son familiar with business practice and custom would have been justified in concluding that the agent had authority.

Created by the Principal’s Conduct Note that the acts or declarations of a purported agent in and of agent in and of agent themselves do not create an agency by estoppel. Rather,

5. Laurel Creek Health Care Center v. Bishop, 2010 WL 985299 (Ky.App. 2010).

6. These concepts also apply when a person who is, in fact, an agent under- takes an action that is beyond the scope of her or his authority.

it is the deeds or statements of the principalprincipal that create an principal that create an principal agency by estoppel. ■ CASE IN POINT 19.6 Francis Azur was president and chief executive officer of ATM Corpo- ration of America. Michelle Vanek was Azur’s personal assistant. Among other duties, she reviewed his credit- card statements. For seven years, Vanek took unauthor- ized cash advances from Azur’s credit-card account with Chase Bank. The charges appeared on at least sixty-five monthly statements.

When Azur discovered Vanek’s fraud, he fired her and closed the account. He filed a suit against Chase, argu- ing that the bank should not have allowed Vanek to take cash advances. The court concluded that Azur (the prin- cipal) had given the bank reason to believe that Vanek (the agent) had authority. Therefore, Azur was estopped (prevented) from denying Vanek’s authority.7 ■

19–2d Agency by Operation of Law The courts may find an agency relationship in the absence of a formal agreement in other situations as well. This may occur in family relationships, such as when one spouse purchases certain basic necessaries and charges them to the other spouse’s account. The courts often rule that a spouse is liable for payment for the necessaries because of either a social policy or a legal duty to supply necessaries to family members.

Agency by operation of law may also occur in emer- gency situations. If an agent cannot contact the principal and failure to act would cause the principal substantial loss, the agent may take steps beyond the scope of her or his authority. For instance, a railroad engineer may con- tract on behalf of his or her employer for medical care for an injured motorist hit by the train.

19–3 Duties of Agents and Principals

Once the principal-agent relationship has been created, both parties have duties that govern their conduct. As discussed previously, the principal-agent relationship is fiduciary—based on trust. In a fiduciary relationship, each fiduciary—based on trust. In a fiduciary relationship, each fiduciary party owes the other the duty to act with the utmost good faith.

7. Azur v. Chase Bank, USA, N.A., 601 F.3d 212 (3d Cir. 2010).

C H A P T E R 1 9 Agency Relationships 421

19–3a Agent’s Duties to the Principal Generally, the agent owes the principal five duties—per- formance, notification, loyalty, obedience, and account- ing (see Exhibit 19–1).

Performance An implied condition in every agency contract is the agent’s agreement to use reasonable dili- gence and skill in performing the work. When an agent fails to perform his or her duties, liability for breach of contract may result.

Standard of Care. �e degree of skill or care required of an agent is usually that expected of a reasonable person under similar circumstances. Generally, this is interpreted to mean ordinary care. If an agent has represented herself or himself as possessing special skills, however, the agent is expected to exercise the degree of skill claimed. Failure to do so constitutes a breach of the agent’s duty.

Gratuitous Agents. Not all agency relationships are based on contract. In some situations, an agent acts gra- tuitously—that is, without payment. A gratuitous agent cannot be liable for breach of contract because there is no contract. He or she is subject only to tort liability. Once a gratuitous agent has begun to act in an agency capac- ity, he or she has the duty to continue to perform in that capacity. A gratuitous agent must perform in an accept- able manner and is subject to the same standards of care and duty to perform as other agents.and duty to perform as other agents.and duty to perform as other agents.and duty to perform as other agents.

■ EXAMPLE 19.7 Bower’s friend Alcott is a real estate broker. Alcott offers to sell Bower’s vacation home at no

charge. If Alcott never attempts to sell the home, Bower has no legal cause of action to force her to do so. If Alcott does attempt to sell the home to Friedman, but then per- forms so negligently that the sale falls through, Bower can sue Alcott for negligence. ■

Notification An agent is required to notify the princi- pal of all matters that come to her or his attention con- cerning the subject matter of the agency. This is the duty of notification, of notification, of notification, or the duty to inform.

■ EXAMPLE 19.8 Perez, an artist, is about to negoti- ate a contract to sell a series of paintings to Barber’s Art Gallery for $25,000. Perez’s agent learns that Barber is insolvent and will be unable to pay for the paintings. The agent has a duty to inform Perez of Barber’s insolvency because it is relevant to the subject matter of the agency, which is the sale of Perez’s paintings. ■

Generally, the law assumes that the principal is aware of any information acquired by the agent that is relevant to the agency—regardless of whether the agent actually passes on this information to the principal. It is a basic tenet of agency law that notice to the agent is notice to the principal.

Loyalty Loyalty is one of the most fundamental duties in a fiduciary relationship. Basically, the agent has the duty to act solely for the benefit of his or her principal and not in the interest of the agent or a third party. For instance, an agent cannot represent two principals in the same transaction unless both know of the dual capacity and consent to it.

DUTIES OF THE AGENT

Performance Notification Loyalty Obedience Accounting

Agent must use reasonable diligence

and skill when performing duties.

Agent is required to notify the principal of all matters that

concern the subject of the agency.

Agent has a duty to act solely for the

principal’s benefit.

Agent must follow all lawful and stated

instructions from the principal.

Agent must provide records of all property

and funds received or paid out on the principal’s behalf.

E X H I B I T 1 9 – 1 Duties of the Agent

422 U N I T F O U R The Business and Employment Environment

The duty of loyalty also means that any information or knowledge acquired through the agency relationship is confidential. It is a breach of loyalty to disclose such information either during the agency relationship or after its termination. Typical examples of confidential infor- mation are trade secrets and customer lists compiled by the principal.

The agent’s loyalty must be undivided. The agent’s actions must be strictly for the benefit of the principal and must not result in any secret profit for the agent.

In the following case, an employer alleged that a for- mer employee had breached his duty of loyalty by plan- ning a competing business while still working for the employer.

Background and Facts Taser International, Inc., develops and makes electronic control devices, commonly called stun guns, as well as accessories for electronic control devices, including a personal video and audio recording device called the TASER CAM.

Steve Ward was Taser’s vice president of marketing when he began to explore the possibility of Steve Ward was Taser’s vice president of marketing when he began to explore the possibility of Steve W developing and marketing devices of his own design, including a clip-on camera. Ward talked to patent attorneys and a product development company and completed most of a business plan. After he resigned from Taser, he formed Vievu, LLC, to market his clip-on camera.

Ten months after Ward resigned, Taser announced the AXON, a product that provides an audio-Ten months after Ward resigned, Taser announced the AXON, a product that provides an audio-T video record of an incident from the visual perspective of the person involved. Taser then filed a suit in an Arizona state court against Ward, alleging that he had breached his duty of loyalty to Taser. The court granted Taser’s motion for a summary judgment in the employer’s favor. Ward appealed.

In the Language of the Court PORTLEY, Judge.

* * * * * * * An agent is under the duty to act with entire good faith and loyalty for the furtherance of the

interests of his principal in all matters concerning or affecting the subject of his agency. One aspect of this broad principle is that an employee is precluded from actively competing with

his or her employer during the period of employment. Although an employee may not compete prior to termination, the employee may take action during

employment, not otherwise wrongful, to prepare for competition following termination of the agency relation- ship. Preparation cannot take the form of acts in direct competition with the employer’s business. [Emphasis added.]

* * * * It is undisputed that, prior to his resignation, Ward did not solicit or recruit any Taser employ-

ees, distributors, customers, or vendors; he did not buy, sell, or incorporate any business; he did not acquire office space or other general business services; he did not contact or enter into any agreements with suppliers or manufacturers for his proposed clip-on camera; and he did not sell any products. However, Ward did begin developing a business plan, counseled with several attorneys, explored and abandoned the concept of an eyeglass-mounted camera device, and engaged, to some extent, in the exploration and development of a clip-on camera device.

Ward argues that his pre-termination activities did not constitute active competition but were merely lawful preparation for a future business venture. Taser contends, however, that “this case is * * * about developing a rival design during employment, knowing full well TASER has sold such a device and continues to develop a second-generation product.”

* * * * * * * Assuming Taser was engaged in the research and development of a recording device during

Ward’s employment, assuming Ward knew or should have known of those efforts, and assuming Taser’s device would compete with Ward’s concept, substantial design and development efforts by Ward during his employment would constitute direct competition with the business activities of Taser and

Spotlight on Taser International

Case 19.1 Case 19.1 Taser International, Inc. v. Wardnc. v. Ward Court of Appeals of Arizona, Division 1, 224 Ariz. 389, 231 P.3d 921 (2010).Court of Appeals of Arizona, Division 1, 224 Ariz. 389, 231 P.3d 921 (2010).

C H A P T E R 1 9 Agency Relationships 423

would violate his duty of loyalty. In the context of a business which engages in research, design, develop- ment, manufacture, and marketing of products, we cannot limit “competition” to just actual sales of com- peting products.

Decision and Remedy A state intermediate appellate court agreed with Taser that an employee may not actively compete with his employer before his employment is terminated. But the parties disputed the extent of Ward’s pre-termination efforts, creating a genuine issue of material fact that could not be resolved on a motion for summary judgment. The appellate court thus reversed the lower court’s decision in Taser’s favor and remanded the case for further proceedings.

Critical Thinking • Legal Environment Did Ward breach any duties owed to his employer in addition to his alleged breach

of the duty of loyalty? Discuss. • What If the Facts Were Different? Suppose that Ward’s pre-termination activities focused on a prod-Suppose that Ward’s pre-termination activities focused on a prod-Suppose that Ward’s pre-termination activities focused on a prod

uct that was not designed to compete with Taser’s products. Would these efforts have breached the duty of loyalty? Why or why not?

Case 19.1 Continued

Obedience When acting on behalf of the principal, an agent has a duty to follow all lawful and clearly stated instructions of the principal. Any deviation from such instructions is a violation of this duty.

During emergency situations, however, when the principal cannot be consulted, the agent may deviate from the instructions without violating this duty. When- ever instructions are not clearly stated, the agent can ful- fill the duty of obedience by acting in good faith and in a manner reasonable under the circumstances.

Accounting Unless the agent and principal agree oth- erwise, the agent must keep and make available to the principal an account of all property and funds received

and paid out on the principal’s behalf. This includes gifts from third parties in connection with the agency.

The agent has a duty to maintain a separate account for the principal’s funds and must not intermingle these funds with the agent’s personal funds. If a licensed pro- fessional (such as an attorney) violates this duty, he or she may be subject to disciplinary action by the licensing authority (such as the state bar association). Of course, the professional will also be liable to his or her client (the principal) for failure to account.

19–3b Principal’s Duties to the Agent The principal also has certain duties to the agent (as shown in Exhibit 19–2). These duties relate to compensation,

DUTIES OF THE PRINCIPAL

Compensation

Principal must pay the agreed-on (or reasonable)

value for the agent’s services.

Reimbursement and Indemnification

Principal must reimburse the agent for any funds

paid out at the principal’s request, as well as for

necessary expenses.

Cooperation Safe Working Conditions

Principal must cooperate with and assist an agent

in performing his or her duties.

Principal must provide a safe working environment for agents and employees.

E X H I B I T 1 9 – 2 Duties of the Principal

424 U N I T F O U R The Business and Employment Environment

reimbursement and indemnification, cooperation, and safe working conditions.

Compensation In general, when a principal requests certain services from an agent, the agent reasonably expects payment. For instance, when an accountant or an attorney is asked to act as an agent, an agreement to compensate the agent for this service is implied. The principal therefore has a duty to pay the agent for ser- vices rendered.

Unless the agency relationship is gratuitous and the agent does not act in exchange for payment, the principal must pay the agreed-on value for the agent’s services. If no amount has been expressly agreed on, then the princi- pal owes the agent the customary compensation for such services. The principal also has a duty to pay that com- pensation in a timely manner.

■ CASE IN POINT 19.9 Keith Miller worked as a sales representative for Paul M. Wolff Company, a subcontrac- tor specializing in concrete-finishing services. Sales rep- resentatives at Wolff are paid a 15 percent commission on projects that meet a 35 percent gross profit thresh- old. The commission is paid after the projects are com- pleted. When Miller resigned, he asked for commissions on fourteen projects for which he had secured contracts but which had not yet been completed. Wolff refused, so Miller sued.

The court found that “an agent is entitled to receive commissions on sales that result from the agent’s efforts,” even after the employment or agency relationship ends. Miller had met the gross profit threshold on ten of the unfinished projects, and therefore, he was entitled to more than $21,000 in commissions.8 ■

Reimbursement and Indemnification When- ever an agent disburses funds at the request of the prin- cipal, the principal has a duty to reimburse the agent. The principal must also reimburse the agent (even a gratuitous agent) for any necessary expenses incurred in the course of the reasonable performance of her or his agency duties. Agents cannot recover for expenses incurred as a result of their own misconduct or negli- gence, though.

8. Miller v. Paul M. Wolff Co., 178 Wash.App. 957, 316 P.3d 1113 (2014).

Subject to the terms of the agency agreement, the principal has the duty to indemnify (compensate) an indemnify (compensate) an indemnify agent for liabilities incurred because of authorized and lawful acts and transactions. For instance, if the agent, on the principal’s behalf, forms a contract with a third party, and the principal fails to perform the contract, the third party may sue the agent for damages. In this situation, the principal is obligated to compensate the agent for any costs incurred by the agent as a result of the principal’s failure to perform the contract.

Additionally, the principal must indemnify the agent for the value of benefits that the agent confers on the principal. The amount of indemnification usually is specified in the agency contract. If it is not, the courts will look to the nature of the business and the type of loss to determine the amount. Note that this rule applies to acts by gratuitous agents as well.

Cooperation A principal has a duty to cooperate with the agent and to assist the agent in performing his or her duties. The principal must do nothing to prevent that performance.

For instance, when a principal grants an agent an exclusive territory, the principal creates an exclusive agency, in which the principal cannot compete with the agent or appoint or allow another agent to compete. If the principal does so, he or she violates the exclusive agency and is exposed to liability for the agent’s lost profits.profits.profits.

■ EXAMPLE 19.10 Penny (the principal) creates Penny (the principal) creates an exclusive agency by granting Andrew (the agent) a territory within which only Andrew may sell Penny’s organic skin care products. If Penny starts to sell the products herself within Andrew’s territory—or permits another agent to do so—Penny has failed to cooperate with the agent. Because she has violated the exclusive agency, Penny can be held liable for Andrew’s lost sales or profits. ■

In the following case, a pair of potential homebuyers entered into an agreement with a realtor to act as the buyers’ exclusive agent in locating and purchasing prop- erty. Later, the buyers executed an exclusive agency agree- ment with a different realtor. Neither agent knew about the other until the buyers found a home that they liked and bought it.

C H A P T E R 1 9 Agency Relationships 425

In the Language of the Court HARPER, J. [Judge]

* * * * The defendant [Christopher Jones]

met Andrea Woolston, a licensed realtor working as an independent contractor [for NRT New England, LLC, doing business as Coldwell Banker Residen- tial Brokerage], in October 2010. The defendant expressed to Woolston a desire to purchase a home for himself and his then fiancée, Katherine Wilt- shire. One of the first things Woolston asked the defendant was whether he was represented by another agent. The defendant responded that he was not. After a number of conversations about the defendant’s needs and wishes, the parties executed an exclusive right to represent buyer agreement (agreement), which established, among other things, that Woolston was the defendant’s exclusive agent for finding, negotiat- ing, and purchasing property. Over the next several months, Woolston devoted a substantial amount of time searching for properties for the defendant to pur- chase. Specifically, Woolston researched available properties at six town halls in the communities in which the defen- dant was interested. She showcased a number of properties personally to the defendant and Wiltshire and introduced many more to them through e-mail. Woolston and the defendant had at least twenty appointments where they viewed multiple properties. Additionally, Woolston visited many properties alone to determine if they were suitable for the defendant. Altogether, Woolston spent hundreds of hours seeking a suitable home for the defendant.

The agreement was in effect from January 11, 2011 until July 11, 2011, and set forth the geographical area that the defendant was interested in and the rate of compensation for the plaintiff ’s services. With respect to geographical area, the parties agreed that Woolston would seek properties in Killingworth, Guilford, Essex, Old Saybrook, Deep River, Lyme, and Old Lyme [Connecti- cut]. With respect to compensation, the defendant agreed to pay the plaintiff a commission equal to 2.5 percent of the purchase price of the property “if the [buyer] or any person or entity acting on the [buyer’s] behalf purchases, options, exchanges, leases or trades any property, through the efforts of anyone, including the [buyer].” The agreement imposed the following duties on the defendant: “The [buyer] will not deal directly with any other broker, agent or licensee during the term of this agreement. The [buyer] will notify other brokers, agents or licensees at first contact that the [buyer] is being exclusively represented by [NRT]. The [buyer] will disclose to [NRT] any past and/or current contacts for any real prop- erty or with any other real estate broker or agent.”

On May 10, 2011, the defendant informed Woolston via e-mail that he and Wiltshire purchased property at 300 Vineyard Point Road in Guilford for $1,375,000. The defendant learned of this property on May 4, 2011, from Mary Jane Burt, a realtor with H. Pearce Real Estate (H. Pearce), who previously had represented Wiltshire with the sale of her house in Hamden [Connecticut]. Woolston subsequently confronted the defendant and eventually learned that he

and Wiltshire previ- ously had executed an exclusive right to represent buyer agreement with Burt and H. Pearce. This agreement was in effect from August 1, 2010, until August 1, 2011, and contained a provision desig- nating Burt as the exclusive agent for the defendant and Wiltshire. Thus, at the time the defendant purchased the prop- erty in Guilford, he was under contract for exclusive agency with both Woolston and Burt. The defendant never told Woolston or Burt that he had two agreements in effect at the same time. Woolston notified her superiors of what had transpired.

* * * [NRT] filed a * * * complaint [in a Connecticut state court] against the defendant [for] breach of contract * * * . After a trial * * * , the court * * * found that the plaintiff had proven * * * breach of contract * * * and damages. * * * The court awarded the plaintiff $34,375 in damages [which represented 2.5 percent of the purchase price for the Vineyard Point property] plus attorney’s fees and costs. This appeal followed.

* * * * The defendant * * * claims that the

agreement was unenforceable. Specifi- cally, he argues that the court improperly * * * found that it was inequitable to deny the plaintiff recovery.

* * * * There is ample evidence in the record

to support the court’s conclusion that denying the plaintiff relief would be inequitable. Woolston testified, and the defendant himself conceded, that she rendered a significant amount of services to the defendant over several months.

Case Analysis 19.2 NRT New England, LLC v. Jones Appellate Court of Connecticut, 162 Conn.App. 840, 134 A.3d 632 (2016).

Case 19.2 Continues

426 U N I T F O U R The Business and Employment Environment

Safe Working Conditions The common law requires the principal to provide safe working prem- ises, equipment, and conditions for all agents and employees. The principal has a duty to inspect work- ing areas and to warn agents and employees about any unsafe situations. When the agent is an employee, the employer’s liability is frequently covered by state work- ers’ compensation insurance. In addition, federal and state statutes often require the employer to meet certain safety standards.

19–3c Rights and Remedies of Agents and Principals

In general, for every duty of the principal, the agent has a corresponding right, and vice versa. When one party to the agency relationship violates his or her duty to the other party, the remedies available to the nonbreaching party arise out of contract and tort law. These remedies include monetary damages, termination of the agency relationship, an injunction, and required accountings.

The agent has the right to be compensated, to be reimbursed and indemnified, and to have a safe working

environment. An agent also has the right to perform agency duties without interference by the principal. In addition, an agent can withhold further performance and demand that the principal give an accounting.

A principal has contract remedies for an agent’s breach of fiduciary duties. The principal has tort remedies if the agent engages in misrepresentation, negligence, deceit, libel, slander, or trespass. In addition, any breach of a fiduciary duty by an agent may justify the principal’s ter- mination of the agency.

19–4 Agent’s Authority The liability of a principal to third parties with whom an agent contracts depends on whether the agent had the authority to enter into legally binding contracts on the principal’s behalf. An agent’s authority can be either actual (express or implied) or actual (express or implied) or actual apparent. If an agent con- tracts outside the scope of his or her authority, the prin- cipal may still become liable by ratifying the contract.

Specifically, Woolston researched prop- erties at town halls for availability and encumbrances, contacted property own- ers, arranged personal visits, prepared and presented literature to the defendant on available properties, and attended appointments with the defendant and Wiltshire. Woolston spent hundreds of hours working for the defendant in total.

The defendant, on the other hand, accepted Woolston’s services while under contract with another agent in violation of the agreement. Indeed, the defendant acknowledged that he was untruthful with Woolston at the beginning of their relationship when he told her that he was not represented by another agent.

In fact, he was scheduling appoint- ments and viewing properties with both Woolston and Burt at approximately the same time in May 2011. For example, the defendant e-mailed Woolston on May 2, 2011, thanking her for show- ing him a property. Approximately one week later, the defendant e-mailed Woolston to inform her that he viewed 300 Vineyard Point Road with Burt and had “put in an all cash bid that has been accepted.”

The defendant nevertheless argues that it would not be inequitable to deny recovery to the plaintiff because Woolston performed no services in connection with his purchase of 300

Vineyard Point Road. We are not per- suaded. The defendant agreed to pay a commission “equal to 2.5% of the purchase price if the [buyer] or any person or entity acting on the [buyer’s] behalf purchases * * * any property, through the efforts of anyone, including the [buyer], where an agreement to purchase the property was entered into during the term of this agreement.” How- ever unjust this result may seem to the defendant in hindsight, we cannot say it is inequitable because it is precisely what he agreed to. [Emphasis added.]

* * * * The judgment is affirmed.

Legal Reasoning Questions

1. What is the advantage to a principal of an exclusive agency agreement? What was the advantage to Jones of his agreement with Woolston? Discuss.

2. Why, in addition to damages, was the plaintiff awarded attorneys’ fees and costs? 3. Jones’s agreement with Woolston provided that on the purchase of the property, NRT “will, whenever feasible, seek compensa-

tion from the seller or the seller’s agent.” The court determined that it was not feasible. Why would it not be reasonable in this situation to ask the seller of the property to pay part of Woolston’s commission?

Case 19.2 Continued

C H A P T E R 1 9 Agency Relationships 427

19–4a Express Authority Express authority is authority declared in clear, direct, Express authority is authority declared in clear, direct, Express authority and definite terms. Express authority can be given orally or in writing.

The Equal Dignity Rule In most states, the equal dignity rule requires that if the contract being executed is or must be in writing, then the agent’s authority must also be in writing. (Recall that a writing includes an electronic record.) Failure to comply with the equal dignity rule can make a contract voidable at the option of the principal. The law regards the contract at that point as a mere offer. If the principal decides to accept the offer, the acceptance must be ratified, or affirmed, in writing.be ratified, or affirmed, in writing.be ratified, or affirmed, in writing.be ratified, or affirmed, in writing.

■ EXAMPLE 19.11 Paloma (the principal) orally asks Austin (the agent) to sell a ranch that Paloma owns. Aus- tin finds a buyer and signs a sales contract on behalf of Paloma to sell the ranch. Because a contract for an inter- est in realty must be in writing, the equal dignity rule applies. The buyer cannot enforce the contract unless Paloma subsequently ratifies Austin’s agency status in a writing. Once the sales contract is ratified, either party can enforce rights under the contract. ■

Modern business practice allows several exceptions to the equal dignity rule: 1. An executive officer of a corporation normally can

conduct ordinary business transactions without ordinary business transactions without ordinary obtaining written authority from the corporation.

2. When the agent acts in the presence of the principal, the rule does not apply.

3. When the agent’s act of signing is merely a formal- ity, then the agent does not need written authority to ity, then the agent does not need written authority to ity, then the agent does not need written authority to ity, then the agent does not need written authority to sign. ■ EXAMPLE 19.12 Sandra Healy (the principal) negotiates a contract but is called out of town the day it is to be signed. If Healy orally authorizes Derek Santini to sign, the oral authorization is sufficient. ■

Power of Attorney Giving an agent a power of attorney confers express authority.attorney confers express authority.attorney 9 The power of attor- ney is a written document and is usually notarized. (A document is notarized when a notary public—a person notary public—a person notary public authorized to attest to the authenticity of signatures— signs, dates, and imprints the document with her or his seal of authority.) Most states have statutory provisions for creating a power of attorney.

A power of attorney can be special (permitting the special (permitting the special agent to perform specified acts only), or it can be gen- eral (permitting the agent to transact all business for the eral (permitting the agent to transact all business for the eral

9. An agent who holds a power of attorney is called an attorney-in-fact for the principal. The holder does not have to be an attorney-at-law (and often is not).

principal). Because a general power of attorney grants extensive authority to the agent, it should be used with great caution and usually only in exceptional circum- stances. Ordinarily, a power of attorney terminates on the incapacity or death of the person giving the power.10

19–4b Implied Authority An agent has the implied authority to do what is reaimplied authority to do what is reaimplied authority - sonably necessary to carry out express authority and accomplish the objectives of the agency. Authority can also be implied by custom or inferred from the position the agent occupies.the agent occupies.the agent occupies.

■ EXAMPLE 19.13 Archer is employed by Packard Grocery to manage one of its stores. Packard has not expressly stated that Archer has authority to contract with third persons. Nevertheless, authority to man- age a business implies authority to do what is reason- ably required (as is customary or can be inferred from a manager’s position) to operate the business. This includes forming contracts to hire employees, buying merchan- dise and equipment, and advertising the products sold in the store. ■

Note, however, that an agent’s implied authority can- not contradict his or her express authority. Thus, if a principal has limited an agent’s express authority, then the fact that the agent customarily would have such authority is irrelevant.

19–4c Apparent Authority Actual authority (express or implied) arises from what the principal makes clear to the agent. Apparent authority, in contrast, arises from what the principal causes a third party to believe. An agent has apparent authority when apparent authority when apparent authority the principal, by either word or action, causes a third party reasonably to believe that the agent has authority to act, even though the agent has no express or implied authority.

Apparent authority usually comes into existence Apparent authority usually comes into existence Apparent authority usually comes into existence Apparent authority usually comes into existence through a principal’s pattern of conduct over time. through a principal’s pattern of conduct over time. ■ CASE CASE IN POINT 19.14 Gilbert Church owned Church Farm, Gilbert Church owned Church Farm, Inc., a horse-breeding farm in Illinois, which was man- aged by Herb Bagley. Church Farm’s advertisements for the breeding rights to one of its stallions, Imperial Guard, directed all inquiries to “Herb Bagley, Manager.” Vern and Gail Lundberg contacted Bagley and executed a pre- printed contract giving them breeding rights to Imperial

10. A durable power of attorney, however, continues to be effective despite durable power of attorney, however, continues to be effective despite durable the principal’s incapacity or death. An elderly person, for instance, might grant a durable power of attorney to provide for the handling of property and investments or specific health-care needs should he or she become incompetent.

428 U N I T F O U R The Business and Employment Environment

Guard “at Imperial Guard’s location.” Bagley handwrote a statement on the contract that guaranteed the Lund- bergs “six live foals in the first two years.” He then signed it “Gilbert G. Church by H. Bagley.”

The Lundbergs bred four mares, which resulted in one live foal. Church then moved Imperial Guard from Illinois to Oklahoma. The Lundbergs sued Church for breaching the contract by moving the horse. Church claimed that Bagley was not authorized to sign contracts for Church or to change or add terms but only to present preprinted contracts to potential buyers. The jury found in favor of the Lundbergs and awarded $147,000 in damages. Church appealed, but the state appellate court affirmed the judgment. The court found that “an agent may bind his principal by acts which the principal has not given him actual authority to perform, but which he appears authorized to perform.” Because Church allowed circumstances to lead the Lundbergs to believe Bagley had the authority, Church was bound by Bagley’s actions.11 ■

19–4d Emergency Powers When an unforeseen emergency demands action by the agent to protect or preserve the property and rights of the principal, but the agent is unable to communicate with the principal, but the agent is unable to communicate with the principal, but the agent is unable to communicate with the principal, the agent has emergency power. principal, the agent has emergency power. principal, the agent has emergency power. ■ EXAMPLE 19.15 Rob Fulsom is an engineer for Pacific Drilling Company. While Fulsom is acting within the scope of his employment, he is severely injured in an accident on an oil rig many miles from home. Acosta, the rig supervi- sor, directs Thompson, a physician, to give medical aid to Fulsom and to charge Pacific for the medical services.

Acosta, an agent, has no express or implied authority to bind the principal, Pacific Drilling, for Thompson’s medical services. Because of the emergency situation, however, the law recognizes Acosta as having authority to act appropriately under the circumstances. ■

19–4e Ratification Ratification occurs when the principal affirms, or accepts responsibility for, an agent’s unauthorized act. When ratiunauthorized act. When ratiunauthorized - fication occurs, the principal is bound to the agent’s act, and the act is treated as if it had been authorized by the principal from the outset. Ratification can be either express or implied.

If the principal does not ratify the contract, the princi- pal is not bound, and the third party’s agreement with the agent is viewed as merely an unaccepted offer. Because

11. Lundberg v. Church Farm, Inc., 502 N.E.2d 806, 151 Ill.App.3d (1986).

the third party’s agreement is an unaccepted offer, the third party can revoke it at any time, without liability, before the principal ratifies the contract. The agent, how- ever, may be liable to the third party for misrepresenting her or his authority.

The requirements for ratification can be summarized as follows: 1. The agent must have acted on behalf of an identified

principal who subsequently ratifies the action. 2. The principal must know all of the material facts

involved in the transaction. If a principal ratifies a contract without knowing all of the facts, the princi- pal can rescind (cancel) the contract.

3. The principal must affirm the agent’s act in its entirety.

4. The principal must have the legal capacity to autho- rize the transaction at the time the agent engages in the act and at the time the principal ratifies. The third party must also have the legal capacity to engage in the transaction.

5. The principal’s affirmation (ratification) must occur before the third party withdraws from the transaction.

6. The principal must observe the same formalities when ratifying the act as would have been required to authorize it initially.

19–5 Liability in Agency Relationships

Frequently, a question arises as to which party, the prin- cipal or the agent, should be held liable for contracts formed by the agent or for torts and crimes committed by the agent.

19–5a Liability for Contracts Liability for contracts formed by an agent depends on how the principal is classified and on whether the actions of the agent were authorized or unauthorized. Princi- pals are classified as disclosed, partially disclosed, or undisclosed.12

1. A disclosed principal is a principal whose identity is known by the third party at the time the contract is made by the agent.

2. A partially disclosed principal is a principal whose identity is not known by the third party. Neverthe- less, the third party knows that the agent is or may

C H A P T E R 1 9 Agency Relationships 429

be acting for a principal at the time the contract is acting for a principal at the time the contract is acting for a principal at the time the contract is acting for a principal at the time the contract is be acting for a principal at the time the contract is be made. ■ EXAMPLE 19.16 Eileen has contracted with Eileen has contracted with a real estate agent to sell certain property. She wishes to keep her identity a secret, but the agent makes it clear to potential buyers of the property that he is acting in an agency capacity. In this situation, Eileen is a partially disclosed principal. ■

3. An undisclosed principal is a principal whose iden- tity is totally unknown by the third party. In addi- tion, the third party has no knowledge that the agent is acting in an agency capacity at the time the con- tract is made.

Authorized Acts If an agent acts within the scope of her or his authority, normally the principal is obligated to perform the contract regardless of whether the prin- cipal was disclosed, partially disclosed, or undisclosed. Whether the agent may also be held liable under the conagent may also be held liable under the conagent may also be held liable - tract, however, depends on the disclosed, partially dis- closed, or undisclosed status of the principal.

Disclosed or Partially Disclosed Principal. A disclosed or partially disclosed principal is liable to a third party for a contract made by the agent. If the principal is disclosed, the agent has no contractual liability for the nonperfor- mance of the principal or the third party. If the princi- pal is partially disclosed, in most states the agent is also treated as a party to the contract. �us, the third party can hold the agent liable for contractual nonperformance.hold the agent liable for contractual nonperformance.hold the agent liable for contractual nonperformance.hold the agent liable for contractual nonperformance.13

■ CASE IN POINT 19.17 Stonhard, Inc., makes epoxy and urethane flooring and installs it in industrial and commercial buildings. Marvin Sussman contracted with Stonhard to install flooring at a Blue Ridge Farms food- manufacturing facility in Brooklyn, New York. Sussman did not disclose that he was acting as an agent for the facility’s owner, Blue Ridge Foods, LLC, at the time of the contract.

When Stonhard was not paid for the flooring it installed, it filed a suit against the facility, its owner, and Sussman to recover damages for breach of contract. The lower court dismissed the complaint against Sussman personally, but on appeal a reviewing court reversed that decision. The contract had been signed by Sussman “of Blue Ridge Farms.” That evidence indicated that Suss- man was acting as an agent for a partially disclosed prin- cipal, in that the agency relationship was known, but not the principal’s identity. “As an agent for an undisclosed

13. Restatement (Third) of Agency, Section 6.02.

[or partially disclosed] principal, Sussman became per- sonally liable under the contract.”14 ■

Undisclosed Principal. When neither the fact of an agency relationship nor the identity of the principal is dis- closed, the undisclosed principal is bound to perform just as if the principal had been fully disclosed at the time the contract was made.

When a principal’s identity is undisclosed and the agent is forced to pay the third party, the agent is entitled to be indemnified (compensated) by the principal. The principal had a duty to perform, even though his or her identity was undisclosed, and failure to do so will make the principal ultimately liable.

Once the undisclosed principal’s identity is revealed, the third party generally can elect to hold either the prin- cipal or the agent liable on the contract. Conversely, the undisclosed principal can require the third party to fulfill the contract, unless one of the following is true:unless one of the following is true:unless 1. The undisclosed principal was expressly excluded as a

party in the written contract. 2. The contract is a negotiable instrument signed by the

agent with no indication of signing in a representa- tive capacity.15

3. The performance of the agent is personal to the con- tract, thus allowing the third party to refuse the prin- cipal’s performance.

Unauthorized Acts If an agent has no authority but nevertheless contracts with a third party, the principal cannot be held liable on the contract. It does not matter whether the principal was disclosed, partially disclosed, or undisclosed. The agentagentagent is liable.agent is liable.agent

■ EXAMPLE 19.18 Chu signs a contract for the pur Chu signs a contract for the pur- chase of a truck, purportedly acting as an agent under authority granted by Navarro. In fact, Navarro has not given Chu any such authority. Navarro refuses to pay for the truck, claiming that Chu had no authority to pur- chase it. The seller of the truck is entitled to hold Chu liable for payment. ■

If the principal is disclosed or partially disclosed, and the agent contracts with a third party without authoriza- tion, the agent is liable to the third party. The agent’s liability here is based on his or her breach of the implied warranty of authority, not on the breach of the contract

14. Stonhard, Inc. v. Blue Ridge Farms, LLC, 114 A.D.3d 757, 980 N.Y.S.2d 507 (2 Dept. 2014).

15. Under the Uniform Commercial Code (UCC), only the agent is liable if the instrument neither names the principal nor shows that the agent signed in a representative capacity [UCC 3–402(b)(2)].

430 U N I T F O U R The Business and Employment Environment

itself.16 An agent impliedly warrants that he or she has the authority to enter a contract on behalf of the principal. If the third party knows at the time the contract is made that the agent does not have authority—or if the agent expresses to the third party uncertainty as to the extent of uncertainty as to the extent of uncertainty her or his authority—the agent is not personally liable.

Actions by E-Agents Although in the past standard agency principles applied only to human agents, today these same agency principles also apply to e-agents. An electronic agent, or e-agent, is a semiautonomous soft- ware program that is capable of executing specific tasks, such as searching through many databases and retrieving relevant information for the user.

E-agents can enter into binding agreements on behalf of their principals. Thus, if consumers place an order over the Internet, and the company (principal) takes the order via an e-agent, the company cannot later claim that it did not receive the order.

19–5b Liability for Torts and Crimes Obviously, any person, including an agent, is liable for his or her own torts and crimes. Whether a principal can also be held liable for an agent’s torts and crimes depends on several factors, which we examine here. In some situations, a prin- cipal may be held liable not only for the torts of an agent but also for torts committed by an independent contractor.

Principal’s Tortious Conduct A principal who acts through an agent may be liable for harm resulting from the principal’s own negligence or recklessness. Thus, a principal may be liable if he or she gives improper instructions, authorizes the use of improper materials or tools, or establishes improper rules that result in the agent’s committing a tort.agent’s committing a tort.agent’s committing a tort.agent’s committing a tort.

■ EXAMPLE 19.19 Parker knows that Audrey’s driv- er’s license has been suspended but nevertheless tells her to use the company truck to deliver some equipment to a customer. If someone is injured as a result, Parker will be liable for his own negligence in instructing Audrey to drive without a valid license. ■

Principal’s Authorization of Agent’s Tortious Conduct Similarly, a principal who authorizes an agent to commit a tort may be liable to persons or property injured thereby, because the act is considered to be the injured thereby, because the act is considered to be the injured thereby, because the act is considered to be the injured thereby, because the act is considered to be the principal’s. ■ EXAMPLE 19.20 Pedro directs his agent, Andy, to cut the corn on specific acreage, which neither of them has the right to do. The harvest is therefore a

16. The agent is not liable on the contract because the agent was never intended personally to be a party to the contract.

trespass (a tort), and Pedro is liable to the owner of the corn (Andy is also liable even if he did not know that Pedro lacked the right to harvest the corn). ■

Liability for Agent’s Misrepresentation A prin- cipal is exposed to tort liability whenever a third person sustains a loss due to the agent’s misrepresentation. The principal’s liability depends on whether the agent was actually or apparently authorized to make representations and whether the representations were made within the scope of the agency.

The principal is always directly responsible for an agent’s misrepresentation made within the scope of the agent’s misrepresentation made within the scope of the agent’s misrepresentation made within the scope of the agent’s misrepresentation made within the scope of the agent’s authority. ■ EXAMPLE 19.21 Ainsley is a dem- onstrator for Pavlovich’s products. Pavlovich sends Ains- ley to a home show to demonstrate the products and to answer questions from consumers. Pavlovich has given Ainsley authority to make statements about the products. If Ainsley makes only true representations, all is fine. But if he makes false claims, Pavlovich will be liable for any injuries or damages sustained by third parties in reliance on Ainsley’s false representations. ■

When a principal has placed an agent in a position of apparent authority, the principal may also be liable for the agent’s fraudulent acts. For instance, partners in a partnership generally have the apparent implied authority to act as agents of the firm. Thus, if one of the partners commits a tort or a crime, the partnership itself—and often the other partners personally—can be held liable for the loss.

Liability for Agent’s Negligence An agent is liable for his or her own torts. A principal may also be liable for harm an agent causes to a third party under the doctrine of respondeat superior,17 a Latin term meaning “let the master respond.” Under the doctrine of respondeat supe- rior, the principal-employer is liable for any harm caused to a third party by an agent-employee in the course or scope of employment. The doctrine imposes vicarious liability, or indirect liability, because the principal- employer is being held liable for torts committed by an agent-employee.

When an agent commits a negligent act in such a situation, both the agent and the principal are lia the agent and the principal are lia the agent and the principal are liaboth the agent and the principal are liaboth - ble. ■ EXAMPLE 19.22 Aegis hires SDI to provide land- scaping services for its property. An herbicide sprayed by SDI employee David Hoggatt enters the Aegis build- ing through the air-conditioning system and causes

17. Pronounced ree-spahn-dee-uht soo-peer-dee-uht soo-peer-dee-uht soo- -ee-your. The doctrine of peer-ee-your. The doctrine of peer respon- deat superior applies not only to employer-employee relationships but deat superior applies not only to employer-employee relationships but deat superior also to other principal-agent relationships in which the principal has the right of control over the agent.

C H A P T E R 1 9 Agency Relationships 431

Catherine Warner, an Aegis employee, to suffer a heart attack. If Warner sues, both SDI (principal) and Hoggatt (agent) can be held liable for negligence. ■

The doctrine of respondeat superior is similar to the respondeat superior is similar to the respondeat superior theory of strict liability in that liability is imposed regard- less of fault for reasons of public policy. Every person has a duty to manage his or her a�airs so as not to injure another. �is duty applies even when a person acts through an agent (controls the conduct of another).

Determining the Scope of Employment. �e key to determining whether a principal may be liable for the torts of an agent under the doctrine of respondeat superior is whether the torts are committed within the scope of the agency. Courts may consider the following factors in determining whether a particular act occurred within the course and scope of employment:

1. Whether the employee’s act was authorized by the employer.

2. The time, place, and purpose of the act. 3. Whether the act was one commonly performed by

employees on behalf of their employers. 4. The extent to which the employer’s interest was

advanced by the act. 5. The extent to which the private interests of the

employee were involved. 6. Whether the employer furnished the means or instru-

mentality (such as a truck or a machine) by which an injury was inflicted.

7. Whether the employer had reason to know that the employee would perform the act in question and whether the employee had done it before.

8. Whether the act involved the commission of a seri- ous crime.

In the following case, the court had to determine whether or not a dump truck operator was the employee of a concrete services contractor.

Background and Facts Asphalt & Concrete Services, Inc. (ACS), was working on a play pad at St. John Regional Catholic School in Frederick, Maryland. ACS project manager Blake Wood contacted William Johnson at Higher Power Trucking, LLC, to arrange for a dump truck to haul material from a quarry to the job site. One day, while Johnson was driving the dump truck between the job site and the quarry, the truck struck and injured Moran Perry, who was crossing an intersection.

To recover for his injuries, Perry filed a lawsuit in a Maryland state court against ACS. Perry alleged that Johnson’s negligence in operating the dump truck was the proximate cause of his injuries and that Johnson was ACS’s employee. ACS, however, claimed that Johnson was an independent contrac- tor. A jury agreed with Perry and awarded him $529,500 in damages. The court issued a judgment in Perry’s favor, and ACS appealed.

In the Language of the Court GRAEFF, J. [Judge]

* * * * * * * Pursuant to the doctrine of respondeat superior, an employer may be found liable for torts

committed by its employee while acting in the scope of employment. ACS does not dispute this well- established rule, but it argues that the evidence showed that Mr. Johnson was not its employee.

* * * Maryland courts have traditionally considered five criteria in determining whether or not an employer/employee relationship exists between two parties. These criteria, developed from the common law standard for determining the master/servant relationship, include (1) the power to select and hire the employee, (2) the payment of wages, (3) the power to discharge, (4) the power to control the employee’s conduct, and (5) whether the work is part of the regular business of the employer. [Emphasis added.]

Of the five factors, the factor of control stands out as the most important. * * * Whether the employer has the right to control and direct the employee in the performance of the work and in the manner in which the work is to be done is the decisive, or controlling, test.

* * * *

Asphalt & Concrete Services, Inc. v. Perry Court of Special Appeals of Maryland, 221 Md.App. 235, 108 A.3d 558 (2015).

Case 19.3

Case 19.3 Continues

432 U N I T F O U R The Business and Employment Environment

The Distinction between a “Detour” and a “Frolic.” A useful insight into the concept of “scope of employ- ment” can be gained from Judge Baron Parke’s classic distinction between a “detour” and a “frolic” in the case of Joel v. Morison (1834).18 In this case, the English court held that if a servant merely took a detour from his master’s business, the master will be responsible. If, however, the servant was on a “frolic of his own” and not in any way “on his master’s business,” the master will not be liable.

■ EXAMPLE 19.23 While driving his employer’s vehi- cle to call on a customer, Mandel decides to stop at a store—which is three blocks off his route—to take care of a personal matter. As Mandel approaches the store, he negligently runs into a parked vehicle owned by Chan. In this situation, because Mandel’s detour from the employ- er’s business is not substantial, he is still acting within the scope of employment, and the employer is liable.

But suppose instead that Mandel decides to pick up a few friends in another city for cocktails and in the process negligently runs his vehicle into Chan’s. In this situation, the departure from the employer’s business is substantial— Mandel is on a “frolic” of his own. Thus, the employer normally will not be liable to Chan for damages. ■

18. 6 Car. & P. 501, 172 Eng.Rep. 1338 (1834).

An employee going to and from work or to and from meals usually is considered to be outside the scope of employment. If travel is part of a person’s position, how- ever, as it is for a traveling salesperson, then travel time is normally considered within the scope of employment.

Liability for Agent’s Intentional Torts Most intentional torts that individuals commit have no rela- tion to their employment, and their employers will not be held liable. Nevertheless, under the doctrine of respondeat superior, the employer can be liable for inten- tional torts that an employee commits within the course and scope of employment. For instance, a department store owner is liable when a security guard who is a store employee commits the tort of false imprisonment while acting within the scope of employment.

In addition, an employer who knows or should know that an employee has a propensity for committing tor- tious acts is liable for the employee’s acts even if they would not ordinarily be considered within the scope of employment. ■ EXAMPLE 19.24 Chaz, the owner of the Comedy Club, hires Alec as a bouncer for the club even though he knows that Alec has a history of arrests for criminal assault and battery. In this situation, Chaz may be liable if Alec viciously attacks a customer in the park- ing lot after hours. ■ An employer can also be liable for

Here, * * * the evidence indicated as follows: (1) ACS called Mr. Johnson directly to reserve his truck- ing services; (2) Mr. Wood spoke only to Mr. Johnson when calling Higher Power; (3) ACS directed Mr. Johnson to go to the * * * quarry to pick up materials for the play pad project and gave him the time to be there for the pick-up; (4) Mr. Johnson was required to bring the materials directly to the job site after his truck was loaded, and if Mr. Johnson did not deliver the materials promptly, ACS had the right to dock his pay or to no longer employ him; (5) ACS paid Mr. Johnson on an hourly basis from the time he picked up his first load until ACS dismissed him from the job site; (6) after Mr. Johnson delivered his first load of materials, ACS directed him to return to the quarry to pick up and bring back additional materials; and (7) at the job site, Mr. Johnson was obligated to follow ACS’s directions in terms of where to drop the materials, how much material to drop, and how many times he would need to return to the quarry. Based on that evidence, a jury could find that Mr. Johnson was subject to ACS’s control, and ACS was liable for Mr. Johnson’s negligence pursuant to the doctrine of respondeat superior.

Decision and Remedy The state intermediate appellate court affirmed the jury’s finding with respect to Johnson’s status as ACS’s employee. The court disagreed, however, with the lower court’s admission of cer-Johnson’s status as ACS’s employee. The court disagreed, however, with the lower court’s admission of cer-Johnson’s status as ACS’s employee. The court disagreed, however, with the lower court’s admission of cer tain evidence that may have influenced the jury’s finding of proximate cause for Perry’s injuries. As a result, the court reversed the judgment on this ground and remanded the case for a new trial.

Critical Thinking • Economic Why did ACS contend that Johnson was not its employee? Discuss.

Case 19.3 Continued

C H A P T E R 1 9 Agency Relationships 433

permitting an employee to engage in reckless actions that can injure others.

Liability for Independent Contractor’s Torts Generally, an employer is not liable for physical harm caused to a third person by the negligent act of an inde- pendent contractor in the performance of the contract. This is because the employer does not have the right to control the details of an independent contractor’s to control the details of an independent contractor’s to control performance.

Courts make an exception to this rule when the con- tract involves unusually hazardous activities, such as blasting operations, the transportation of highly volatile chemicals, or the use of poisonous gases. In these situa- tions, strict liability is imposed, and an employer cannot be shielded from liability merely by using an indepen- dent contractor.

Liability for Agent’s Crimes An agent is liable for his or her own crimes. A principal or employer normally is not liable for an agent’s crime even if the crime was not liable for an agent’s crime even if the crime was not committed within the scope of authority or employment. An exception to this rule is made when the principal or employer participated in the crime by conspiracy or other action.

In addition, in some jurisdictions, a principal may be liable under specific statutes if an agent, in the course and scope of employment, violates certain regulations. For instance, a principal might be liable for an agent’s viola- tion of sanitation rules or regulations governing prices, weights, or the sale of liquor.

19–6 Termination of an Agency Agency law is similar to contract law in that both an agency and a contract may be terminated by an act of the parties or by operation of law. Once the relationship between the principal and the agent has ended, the agent no longer has the right (actual authority) to bind the actual authority) to bind the actual principal. For an agent’s apparent authority to be termiapparent authority to be termiapparent - nated, though, third persons may also need to be notified that the agency has been terminated.

19–6a Termination by Act of the Parties An agency may be terminated by certain acts of the par- ties, which are listed and described in Exhibit 19–3. When an agency agreement specifies the time period

METHOD RULES ILLUSTRATION

1. Lapse of Time.

2. Purpose Achieved.

3. Occurrence of a Specific Event.

4. Mutual Agreement.

5. At the Option of One Party (revocation, if by principal;

renunciation, if by agent).

Agency terminates automatically at the end of the stated time.

Agency normally terminates automatically on the event's occurrence.

Agency terminates when both parties consent to end the agency relationship.

Agency terminates automatically on the completion of the purpose for which it was formed.

Either party normally has a right to terminate the agency relationship. Wrongful termination can lead to liability for breach of contract.

Page lists her property for sale with Alex, a real estate agent, for six months. The agency ends in six months.

Calvin, a cattle rancher, hires Abe asCalvin, a cattle rancher, hires Abe asCalvin, a cattle rancher his agent in the purchase of fifty head of breeding stock. The agency ends when the cattle have been purchased.

Meredith appoints Allen to handle her business affairs while she is away. The agency terminates when Meredith returns.

Linda and Greg agree that Greg will no longer be her agent in procuring business equipment.

When Patrick becomes ill, he informs Alice that he is revoking her authority to be his agent.

E X H I B I T 1 9 – 3 Termination by Act of the Parties

434 U N I T F O U R The Business and Employment Environment

during which the agency relationship will exist, the agency ends when that time period expires. If no definite time is stated, then the agency continues for a reasonable time and can be terminated at will by either party. What constitutes a reasonable time depends on the circum- stances and the nature of the agency relationship.

The parties can, of course, mutually agree to end their agency relationship. In addition, as a general rule, either party can terminate the agency relationship with- out the agreement of the other. The act of termination is called revocation if done by the principal and renun- ciation if done by the agent. Note, however, that the terminating party may face liability if the termination is wrongful.

Wrongful Termination Although both parties have the power to terminate the agency, they may not always power to terminate the agency, they may not always power possess the right to do so. Wrongful termination can right to do so. Wrongful termination can right subject the canceling party to a lawsuit for breach of subject the canceling party to a lawsuit for breach of subject the canceling party to a lawsuit for breach of subject the canceling party to a lawsuit for breach of contract. ■ EXAMPLE 19.25 Rawlins has a one-year employment contract with Munro to act as agent in return for $65,000. Munro has the power to discharge power to discharge power Rawlins before the contract period expires. But if he does so, he can be sued for breaching the contract, because he had no right to terminate the agency. right to terminate the agency. right ■

Even in an agency at will—in which either party may terminate at any time—the principal who wishes to ter- minate must give the agent reasonable notice. The notice reasonable notice. The notice reasonable must be at least sufficient to allow the agent to recoup his or her expenses and, in some situations, to make a normal profit.

Notice of Termination When the parties terminate an agency, it is the principal’s duty to inform any third parties who know of the existence of the agency that it has been terminated. No particular form is required for notice of termination to be effective. The principal can person- ally notify the third party, or the party can learn of the ter- mination through some other means. Although an agent’s actual authority ends when the agency is terminated, an agent’s apparent authority continues until the third party apparent authority continues until the third party apparent authority receives notice (from any source) that such authority has been terminated.

19–6b Termination by Operation of Law Certain events terminate agency authority automati- cally because their occurrence makes it impossible for the agent to perform or improbable that the principal would continue to want performance. Note that when an agency terminates by operation of law, there is no duty to notify third persons.

1. Death or insanity. The general rule is that the death or insanity of either the principal or the agent automati- cally and immediately terminates an ordinary agency relationship.19 Knowledge of the death or insanity is not required.

2. Impossibility. When the specific subject matter of an agency is destroyed or lost, the agency terminates. Similarly, when it is impossible for the agent to per- form the agency lawfully because of a change in the law, the agency terminates.

3. Changed circumstances. Sometimes, an event occurs that has such an unusual effect on the subject matter of the agency that the agent can reasonably infer that the principal will not want the agency to continue. In the principal will not want the agency to continue. In the principal will not want the agency to continue. In such situations, the agency terminates. such situations, the agency terminates. such situations, the agency terminates. ■ EXAMPLE 19.26 Baird hires Joslen to sell a tract of land for $40,000. Subsequently, Joslen learns that there is oil under the land and that the land is therefore worth $1 million. The agency and Joslen’s authority to sell the land for $40,000 are terminated. ■

4. Bankruptcy. If either the principal or the agent peti- tions for bankruptcy, the agency is usually termiusually termiusually - nated. In certain circumstances, such as when the agent’s financial status is irrelevant to the purpose of the agency, the agency relationship may continue.

5. War. When the principal’s country and the agent’s country are at war with each other, the agency is terminated.

19. An exception to this rule exists in the bank-customer relationship. A bank, as agent, can continue to exercise specific types of authority after the customer’s death or insanity and can continue to pay checks drawn by the customer for ten days after death.

C H A P T E R 1 9 Agency Relationships 435

Reviewing: Agency Relationships

James Blatt hired Marilyn Scott to sell insurance for the Massachusetts Mutual Life Insurance Company. Their contract stated, “Nothing in this contract shall be construed as creating the relationship of employer and employee.” The con- tract was terminable at will by either party. Scott financed her own office and staff, was paid according to performance, had no taxes withheld from her checks, and could legally sell products of Massachusetts Mutual’s competitors. Blatt learned that Scott was simultaneously selling insurance for Perpetual Life Insurance Corporation, one of Massachusetts Mutual’s fiercest competitors. Blatt therefore withheld client contact information from Scott. Scott complained to Blatt that he was inhibiting her ability to sell insurance for Massachusetts Mutual. Blatt subsequently terminated their contract. Scott filed a suit in a New York state court against Blatt and Massachusetts Mutual. Scott claimed that she had lost sales for Massachusetts Mutual—and commissions—as a result of Blatt’s withholding contact information from her. Using the information presented in the chapter, answer the following questions. 1. Who is the principal and who is the agent in this scenario? By which method was an agency relationship formed

between Scott and Blatt? 2. What facts would the court consider most important in determining whether Scott was an employee or an inde-

pendent contractor? 3. How would the court most likely rule on Scott’s employee status? Why? 4. Which of the four duties that Blatt owed Scott in their agency relationship has probably been breached?

Debate This . . . The doctrine of respondeat superior should be modified to make agents solely liable for their tortious (wrongful) acts committed within the scope of employment.

Terms and Concepts agency 416 apparent authority 427 disclosed principal 428 e-agent 430 equal dignity rule 427 exclusive agency 424

express authority 427 �duciary 416 implied authority 427 independent contractor 417 notary public 427 partially disclosed principal 428

power of attorney 427 rati�cation 428 respondeat superior 430respondeat superior 430respondeat superior undisclosed principal 429 vicarious liability 430

Issue Spotters 1. Winona contracted with XtremeCast, a broadcast media

firm, to cohost an Internet-streaming sports program. Winona and XtremeCast signed a new contract for each episode. In each contract, Winona agreed to work a cer- tain number of days for a certain salary. During each broadcast, Winona was free to improvise her performance. She had no other obligation to work for XtremeCast. Was Winona an independent contractor? (See Agency Law.)

2. Davis contracts with Estee to buy a certain horse on her behalf. Estee asks Davis not to reveal her identity. Davis

makes a deal with Farmland Stables, the owner of the horse, and makes a down payment. Estee does not pay the rest of the price. Farmland Stables sues Davis for breach of contract. Can Davis hold Estee liable for whatever damages he has to pay? Why or why not? (See Liability in Agency Relationships.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

436 U N I T F O U R The Business and Employment Environment

Business Scenarios 19–1. Employee versus Independent Contractor. Ste- phen Hemmerling was a driver for the Happy Cab Co. Hem- merling paid certain fixed expenses and followed various rules relating to the use of the cab, the hours that could be worked, and the solicitation of fares, among other things. Rates were set by the state. Happy Cab did not withhold taxes from Hemmer- ling’s pay. While driving the cab, Hemmerling was injured in an accident and filed a claim for workers’ compensation benefits in a state court. Such benefits are not available to independent contractors. On what basis might the court hold that Hemmer- ling was an employee? Explain. (See Agency Law.) 19–2. Respondeat Superior. ABC Tire Corp. hires Arnez as a traveling salesperson and assigns him a geographic area and time schedule in which to solicit orders and service cus- tomers. Arnez is given a company car to use in covering the

territory. One day, Arnez decides to take his personal car to cover part of his territory. It is 11:00 a.m., and Arnez has just finished calling on all customers in the city of Tarrytown. His next appointment is at 2:00 p.m. in the city of Austex, twenty miles down the road. Arnez starts out for Austex, but halfway there he decides to visit a former college roommate who runs a farm ten miles off the main highway. Arnez is enjoying his visit with his former roommate when he realizes that it is 1:45 p.m. and that he will be late for the appointment in Austex. Driving at a high speed down the country road to reach the main highway, Arnez crashes his car into a tractor, severely injuring Thomas, the driver of the tractor. Thomas claims that he can hold ABC Tire Corp. liable for his injuries. Discuss fully ABC’s liability in this situation. (See Liability in Agency Relationships.)

Business Case Problems 19–3. Liability for Contracts. �omas Huskin and his wife entered into a contract to have their home remodeled by House Medic Handyman Service. Todd Hall signed the contract as an authorized representative of House Medic. It turned out that House Medic was a �ctitious name for Hall Hauling, Ltd. �e contract did not indicate this, however, and Hall did not inform the Huskins about Hall Hauling. When a contract dispute later arose, the Huskins sued Todd Hall per- sonally for breach of contract. Can Hall be held personally liable? Why or why not? [Huskin v. Hall, 2012 WL 553136 (Ohio Ct.App. 2012)] (See Liability in Agency Relationships.) 19–4. Agent’s Duties to Principal. William and Max- ine Miller were shareholders of Claimsco International, Inc. �ey �led a suit against the other shareholders, Michael Har- ris and Kenneth Hoxie, and the accountant who worked for all of them—John Verchota. Among other things, the Mill- ers alleged that Verchota had breached a duty that he owed them. �ey claimed that at Harris’s instruction, Verchota had taken various actions that placed them at a disadvantage to the other shareholders. Verchota had allegedly adjusted Claims- co’s books to maximize the Millers’ �nancial liabilities, for instance, and had falsely reported distributions of income to them without actually transferring that income. Which duty are the Millers referring to? If the allegations can be proved, did Verchota breach this duty? Explain. [Miller v. Harris, 2013 IL App (2d) 120512, 985 N.E.2d 671 (2 Dist. 2013)] (See Duties of Agents and Principals.)

19–5. Business Case Problem with Sample Answer— Determining Employee Status. Nelson Ovalles worked

as a cable installer for Cox Rhode Island Telecom, LLC, under an agreement with a third party, M&M Communications, Inc. �e agreement stated that no employer-employee relationship

existed between Cox and M&M’s technicians, including

Ovalles. Ovalles was required to designate his a�liation with Cox on his work van, clothing, and identi�cation badge. Cox had minimal contact with him, however, and had limited power to control how he performed his duties. Cox supplied cable wire and similar items, but the equipment was deliv- ered to M&M, not to Ovalles. On a workday, while Ovalles was ful�lling a work order, his van rear-ended a car driven by Barbara Cayer. Is Cox liable to Cayer? Explain. [Cayer v. Cox Rhode Island Telecom, LLC, 85 A.3d 1140 (R.I. 2014)] (See Agency Law.) • For a sample answer to Problem 19–5, go to Appendix E at

the end of this text.

19–6. Agent’s Authority. Terry Holden’s stepmother, Rosie, was diagnosed with amyotrophic lateral sclerosis (ALS), and Terry’s wife, Susan, became Rosie’s primary caregiver. Rosie executed a durable power of attorney appointing Susan as her agent. Susan opened a joint bank account with Rosie at Bank of America, depositing $9,643.62 of Rosie’s funds. Susan used some of the money to pay for “household expenses to keep us going while we were taking care of her.” Rosie died three months later. Terry’s father, Charles, as executor of Rosie’s estate, �led a petition in a Texas state court against Susan for an accounting. What general duty did Susan owe Rosie as her agent? What does an agent’s duty of account- ing require? Did Susan breach either of these duties? Explain. [Holden v. Holden, 456 S.W.3d 642 (Tex.App.—Tyler 2015)] (See Agent’s Authority.) 19–7. Scope of Agent’s Authority. Kindred Nursing Centers East, LLC, owns and operates Whitesburg Gardens, a long-term care and rehabilitation facility, in Huntsville, Alabama. Lorene Jones was admitted to the facility follow- ing knee-replacement surgery. Jones’s daughter, Yvonne Bar- bour, signed the admission forms required by Whitesburg Gardens as her mother’s representative in her presence. Jones

C H A P T E R 1 9 Agency Relationships 437

did not object. �e forms included an “Alternative Dispute Resolution Agreement,” which provided for binding arbitra- tion in the event of a dispute between “the Resident” (Jones) and “the Facility” (Whitesburg Gardens). Six days later, Jones was transferred to a di�erent facility. After recovering from the surgery, she �led a suit in an Alabama state court against Kindred, alleging substandard care on a claim of negligence. Can Jones be compelled to submit her claim to arbitration? Explain. [Kindred Nursing Centers East, LLC v. Jones, __ So.3d __, 2016 WL 762450 (Ala. 2016)] (See Agent’s Authority.) 19–8. Agency Relationships. Standard Oil of Connecti- cut, Inc., sells home heating, cooling, and security systems. Standard schedules installation and service appointments with its customers and then contracts with installers and technicians to do the work. �e company requires an installer or techni- cian to complete a project by a certain time but to otherwise “exercise independent judgment and control in the execution of any work.” �e installers and technicians are licensed and certi�ed by the state. Standard does not train them, provide instruction manuals, supervise them at customers’ homes, or inspect their work. �e installers and technicians use their own equipment and tools, and they can choose which days they work. Standard pays a set rate per project. According to criteria used by the courts, are these installers and technicians independent contractors or employees? Why? [Standard Oil of

Connecticut, Inc. v. Administrator, Unemployment Compensa- tion Act, 320 Conn. 611, 134 A.3d 581 (2016)] (See Agency Law.) 19–9. A Question of Ethics—Vicarious Liability. Jamie

Paliath worked as a real estate agent for Home Town Realty of Vandalia, LLC (the principal, a real estate broker). Torri Auer, a California resi- dent, relied on Paliath’s advice and assistance to buy

three rental properties in Ohio. Before the sales, Paliath had rep- resented that each property was worth approximately twice as much as what Auer would pay and that there was a waiting list of prospective tenants. Paliath also stated that all of the property needed work and agreed to do the work for a speci�ed price. Nearly a year later, substantial work was still needed, and only a few of the units had been rented. Auer sued Paliath and Home Town Realty for fraudulent misrepresentation. [Auer v. Paliath, Town Realty for fraudulent misrepresentation. [Auer v. Paliath, Town Realty for fraudulent misrepresentation. [ 140 Ohio St.3d 276, 17 N.E.3d 561, 2014-Ohio-3632 (2014)] (See Liability for Torts and Crimes.) (a) Were Paliath’s representations to Auer within the scope of

her employment? Explain. Will the court hold the princi- pal (Home Town Realty) liable for the misrepresentations of the agent (Paliath)?

(b) What is the ethical basis for imposing vicarious liability on a principal for an agent’s tort?

Legal Reasoning Group Activity 19–10. Agent’s Duties to Principal. John Warren wanted to buy a condominium in California. Hildegard Merrill was the agent for the seller. Because Warren’s credit rating was poor, Merrill told him he needed a co-borrower to obtain a mortgage at a reasonable rate. Merrill said that her daugh- ter Charmaine would “go on title” until the loan and sale were complete if Warren would pay her $10,000. Merrill also o�ered to defer her commission on the sale as a loan to War- ren so that he could make a 20 percent down payment on the property. He agreed to both plans.

Merrill secured the mortgage in Charmaine’s name alone by misrepresenting her daughter’s address, business, and income.

To close the sale, Merrill had Warren remove his name from the title to the property. In October, Warren moved into the condo- minium, repaid Merrill the amount of her deferred commission, and began paying the mortgage. Within a few months, Merrill had Warren evicted. Warren subsequently �led a suit against Merrill and Charmaine. (See Duties of Agents and Principals.)

(a) The first group will determine who among these parties was in an agency relationship.

(b) The second group will discuss the basic duty that an agent owes a principal and decide whether that duty was breached here.

438

C H A P T E R 2 0

Exceptions Based on Contract Theory Some courts have held that an implied employment contract implied employment contract implied exists between the employer and the employee. If the employee is fired outside the terms of the implied con- tract, he or she may succeed in an action for breach of con- tract even though no written employment contract exists.tract even though no written employment contract exists.tract even though no written employment contract exists.tract even though no written employment contract exists.

■ EXAMPLE 20.1 BDI Enterprises’ employment manual and personnel bulletin both state that, as a mat- ter of policy, workers will be dismissed only for good cause. Jing Chin is an employee at BDI. If Chin rea- sonably expects BDI to follow this policy, a court may find that there is an implied contract based on the terms stated in the manual and bulletin. ■ Generally, the key consideration in determining whether an employment manual creates an implied contractual obligation is the employee’s reasonable expectations.

An employer’s oral promises to employees regard- ing discharge policy may also be considered part of an implied contract. If the employer fires a worker in a man- ner contrary to what was promised, a court may hold that the employer has violated the implied contract and is liable for damages.

Exceptions Based on Tort Theory In some situ- ations, the discharge of an employee may give rise to an action for wrongful discharge (discussed shortly) under tort theories. Abusive discharge procedures may result in a lawsuit for intentional infliction of emotional distress or defamation. In addition, some courts have permitted workers to sue their employers under the tort theory of

20–1 Employment at Will Employment relationships have traditionally been governed by the common law doctrine of employment at will. Under this doctrine, either party may terminate the employment relationship at any time and for any reason, unless doing so violates an employee’s statutory or contractual rights.

Today, the majority of U.S. workers continue to have the legal status of “employees at will.” In other words, this common law doctrine is still in widespread use, and only one state (Montana) does not apply it.

Nonetheless, federal and state statutes governing employment relationships prevent the doctrine from being applied in a number of circumstances. An employer may not fire an employee if doing so would violate a fed- eral or state statute, such as a law prohibiting employ- ment discrimination.

Note that the distinction made under agency law between employee status and independent-contractor status is important here. The employment laws that will be discussed apply only to the employer-employee rela- tionship. They do not apply to independent contractors.

20–1a Common Law Exceptions to the Employment-at-Will Doctrine

As noted, statutory law has affected the application of the employment-at-will doctrine. In addition, the courts have carved out various exceptions to the doctrine based on contract theory, tort theory, and public policy.

U ntil the early 1900s, most employer-employee relationships were governed by the common

law. Even today, under the common law employment-at-will doctrine, private employers have considerable freedom to hire and fire workers at will, regard- less of the employees’ performance.

Numerous statutes and adminis- trative agency regulations now also govern the workplace. Thus, to a large extent, statutory law has dis- placed common law doctrines. In this chapter and the next two, we look at the most significant laws regulating employment relationships.

This chapter discusses federal stat- utes that regulate various aspects of the workplace, including employee wages, hours, medical leave, safety, and pension and health plans.

Employment Law

C H A P T E R 2 0 Employment Law 439

fraud. Fraud might be alleged when an employer made false promises to a prospective employee.

■ EXAMPLE 20.2 Goldfinch Consulting, Inc., induces Brianna to leave a lucrative job and move to another state by offering her “a long-term job with a thriving business.” In fact, Goldfinch is not only having significant financial problems but is also planning a merger that will result in the elimination of the position offered to Brianna. If she takes the job in reliance on Goldfinch’s representations and is fired shortly thereafter, Brianna may be able to bring an action against the employer for fraud. ■

Exceptions Based on Public Policy The most common exception to the employment-at-will doctrine is made on the basis that the employer’s reason for firing the employee violates a fundamental public policy of the jurisdiction. Generally, the courts require that the public policy involved be expressed clearly in the statutory law governing the jurisdiction.

The public-policy exception may apply to an employee discharged for whistleblowing—that is, telling governwhistleblowing—that is, telling governwhistleblowing - ment authorities, upper-level managers, or the media that the employer is engaged in some unsafe or illegal activity. Normally, however, whistleblowers seek protection from retaliatory discharge under federal and state statutes, such as the Whistleblower Protection Act.1

1. 5 U.S.C. Section 1201.

■ CASE IN POINT 20.3 Donald Waddell worked for Donald Waddell worked for the Boyce Thompson Institute for Plant Research. Wad- dell did not have an employment contract for a fixed term, and the institute’s employee manual said that his job was “terminable at will.” Soon after he was hired, the institute implemented a whistleblower policy designed to encourage “the highest standards of financial reporting and lawful and ethical behavior.”

Waddell repeatedly told his supervisor, Sophia Dar- ling, that she needed to file certain financial documents more promptly. Darling fired Waddell, telling him that he was disrespectful and insubordinate. Waddell then sued the institute, contending that he should not have been fired because he was acting under the company’s whistleblowing policy.

A New York appellate court, however, found that Waddell could be fired. Waddell was employed at will. In addition, he was not protected under the whistle- blower policy, which had been implemented after his employment. Thus, he could not have detrimentally relied on the policy in accepting the job.2 ■

The issue in the following case was whether the at- will employment doctrine could be applied to support the discharge of an employee who brought a handgun to work and left it locked in his vehicle in plain sight.

2. Waddell v. Boyce Thompson Institute for Plant Research, Inc., 92 A.D.3d 1172, 940 N.Y.S.2d 331 (2012).

In the Language of the Court BAKER, Judge.

* * * *

Facts * * * Caterpillar [Inc.,] had a Facil-

ity Firearms policy (the Firearms Policy) that read as follows:

In accordance with Indiana State Statute 34–28–7–2, employees or suppliers legally permitted to pos- sess and transport a firearm are authorized to store the firearm in the licensee’s private means of transporta- tion in line with state law. Any per- son who chooses to transport his or her firearm under this law must abide by the regulations within the law while on Caterpillar property.

Any person found to be in violation of this policy may be subject to disci- plinary action up to and including ter- mination and/or criminal prosecution.

Indiana Code Section 34–28–7–2(a) (“the Firearms Statute”) reads as follows:

* * * A person may not adopt or enforce an ordinance, a resolution, a policy, or a rule that: (1) prohibits; or (2) has the effect of prohibiting; an employee of the person, including a contract employee, from possessing a firearm or ammunition that is locked in the trunk of the employee’s vehicle, kept in the glove compartment of the employee’s locked vehicle, or stored out of plain sight in the employee’s locked vehicle.

[One day, Cat- erpillar employee William] Sudlow drove to work [with] a loaded Ruger .357 Magnum handgun—for which he had a permit—stuffed down between the center console and the driver’s seat. Sud- low left the gun there when he parked and exited his vehicle and entered the building to begin his workday. Another Caterpillar employee was walking through the parking lot and walked past Sudlow’s vehicle. The employee noticed what appeared to be a handgun inside the vehicle. He could see the weapon’s handle, the guard over the trigger, and the holster. He then reported the issue to Caterpillar’s head of security. Eventu- ally, the head of security confirmed the

Case Analysis 20.1 Caterpillar, Inc. v. Sudlow Court of Appeals of Indiana, 52 N.E.3d 19 (2016).

440 U N I T F O U R The Business and Employment Environment

Case 20.1 Continued

presence of the weapon in the vehicle and told Sudlow that he was suspended indefinitely.

[Two days later,] Sudlow was fired for violating the Firearms Policy. The same day, Caterpillar posted a new firearms policy throughout the building; the new policy explicitly states that firearms in employees’ vehicles must be kept “secured and out of sight.”

* * * Sudlow filed a complaint [in an Indiana state court] against Caterpillar, alleging that Caterpillar had violated the Firearms Statute when it terminated his employment for violating the Firearms Policy. * * * The trial court entered an * * * order granting summary judgment in Sudlow’s favor * * * . The trial court found as follows:

1. The Plaintiff stored a firearm in his vehicle while in the employee parking lot and said firearm was in plain sight. 2. The Defendant’s posted policy, in effect at the time of said incident, allowed employees to store a weapon in his or her vehicle, and did not require that said firearm be kept out of sight. 3. The Plaintiff ’s actions complied with the Defendant’s policy. * * * * 5. The Firearms Statute allows an employer to be more restrictive in its firearms policy, but the Defendant did not make its policy so restrictive as to prevent the Plaintiff ’s action in this case.

* * * A jury * * * awarded damages to Sudlow in the amount of $85,000. Cat- erpillar now appeals.

Discussion and Decision * * * This appeal * * * calls for us

to interpret statutory language, which is a pure question of law to which we apply a de novo standard of review [as if the reviewing court was deciding the issue for the first time].

I. The Firearms Statute * * * * Here, Caterpillar’s Firearms Policy

did not prohibit conduct that is pro- tected by the Firearms Statute. * * * Indeed, * * * Caterpillar could have enacted a more restrictive policy * * * but it chose not to do so. It is read- ily apparent that neither the Firearms Policy nor Caterpillar’s interpretation thereof violated the Firearms Statute. As a cause of action under the Firearms Stat-a cause of action under the Firearms Stat-a cause of action under the Firearms Stat ute is authorized only when an employer violates the statute, Sudlow has no right to recover on this basis. [Emphasis added.]

Sudlow argues that the Firearms Stat- ute “protects a lawful possessor of fire- arms from adverse employment action for reasonable and responsible possession of firearms, and Caterpillar’s actions had the effect of prohibiting Sudlow from lawfully keeping his firearm in his car.” He similarly contends that the intent of the statute “is to protect the rights of lawful firearm possession.” Sudlow essentially argues that the Firearms Statute does the following: (1) sets a default position of permitting every gun owner to be allowed to take any gun into any workplace; and (2) if the employer wants to curtail that conduct, the stat- ute would require employers to enact a firearms policy to do so. In other words, Sudlow believes that if an employer does not have a firearms policy in place, an employee could walk into the workplace with a loaded assault rifle and face no employment consequences as a result.

It is clear that the Firearms Statute is not nearly so broad—in fact, it is written quite narrowly and specifically. According to the plain and unambiguous language of the statute, the reasonable and responsible possession of firearms— the protected activity—is defined as a firearm that is locked in the trunk, kept in the glove compartment, or stored out

of plain sight in the employee’s locked vehicle. Here, Sudlow’s conduct did not fall into that category; as a result, it was not protected by the Firearms Statute.

Caterpillar’s Firearms Policy did not prohibit statutorily protected conduct. Fur- thermore, its interpretation of its Firearms Policy also did not prohibit protected con- duct. Consequently, Sudlow is not entitled to relief under the Firearms Statute.

II. Common Law If Sudlow does not have a cause of

action under the Firearms Statute, his only recourse would be something akin to a wrongful termination claim. It is undis- puted that he was an at-will employee, meaning that his employment could have been terminated by either party at will, with or without a reason. There are three exceptions to the employment-at-will doctrine, but the parties discuss only the public policy exception: we have recog- nized a public policy exception to the employment-at-will doctrine if a clear statutory expression of a right or duty is contravened [violated].

The Firearms Statute is the best expression of Indiana’s public policy regarding the right to transport and store firearms at work. And while this statute does confer a right to store a weapon in a trunk, glove compartment, or out of sight in a locked vehicle, it simply does not confer a right to store a weapon in a vehicle in plain sight. It is apparent, therefore, that in this case, there was no contravention [violation] of a clear statutory expression of a right. As a result, the public expression of a right. As a result, the public expression of a right policy exception to the employment- at-will doctrine does not apply, and Sudlow is not entitled to relief under the common law. [Emphasis added.]

The judgment of the trial court is reversed and remanded with instructions to enter summary judgment in favor of Caterpillar.

Legal Reasoning Questions

1. Did Caterpillar’s Firearms Policy violate Indiana’s public policy regarding the right to transport and store firearms at work? Explain.

2. On what point did the trial and appellate courts disagree? How did that difference affect the result at each level? 3. Is the at-will employment doctrine fair to employees? Why or why not?

C H A P T E R 2 0 Employment Law 441

20–1b Wrongful Discharge Whenever an employer discharges an employee in viola- tion of an employment contract or a statutory law pro- tecting employees, the employee may bring an action for wrongful discharge. For instance, an employee who is terminated in retaliation for some protected activity, such as whistleblowing or participating in an employment-discrimination investigation, can sue for wrongful discharge.

Even if an employer’s actions do not violate any provi- sions in an employment contract or statute, the employer may still be subject to liability. An employee can sue for wrongful discharge under a common law doctrine, such as a tort theory or agency. For instance, if while firing a female employee, an employer publicly discloses pri- vate facts about her sex life, that employee could sue for wrongful discharge based on an invasion of privacy.

20–2 Wages, Hours, and Layoffs In the 1930s, Congress enacted several laws to regulate the wages and working hours of employees, including the following: 1. The Davis-Bacon Act3 requires contractors and subcon-

tractors working on federal government construction projects to pay “prevailing wages” to their employees.

2. The Walsh-Healey Act4 applies to U.S. government contracts. It requires that a minimum wage, as well as overtime pay at 1.5 times regular pay rates, be paid to employees of manufacturers or suppliers entering into contracts with agencies of the federal government.

3. The Fair Labor Standards Act (FLSA)5 extended wage- hour requirements to cover all employers engaged in interstate commerce or in producing goods for inter- state commerce. Certain other types of businesses were included as well. The FLSA, as amended, pro- vides the most comprehensive federal regulation of wages and hours today.wages and hours today.wages and hours today

20–2a Child Labor The FLSA prohibits oppressive child labor. Restrictions on child labor differ by age group.

Children under fourteen years of age are allowed to do only certain types of work. They can deliver newspapers, work for their parents, and be employed in entertain- ment and (with some exceptions) agriculture. Children

3. 40 U.S.C. Sections 276a–276a-5. 4. 41 U.S.C. Sections 35–45. 5. 29 U.S.C. Sections 201–260.

aged fourteen and fifteen are allowed to work, but not in hazardous occupations. There are also restrictions on how many hours per day and per week children in these age groups can work.

Working times and hours are not restricted for persons between the ages of sixteen and eighteen, but this age group cannot be employed in hazardous jobs. None of these restrictions apply to those over the age of eighteen.

20–2b Minimum Wages The FLSA provides that a minimum wage of $7.25 per hour must be paid to covered nonexempt employees. Most states also have minimum wages. More than half of the states have set their minimum wages above the federal minimum wage. When the state minimum wage is greater than the federal minimum wage, the employee is entitled to the higher wage.is entitled to the higher wage.is entitled to the higher wage.is entitled to the higher wage.

■ EXAMPLE 20.4 The Oakland Raiders paid $1.25 million in 2014 to settle wage claims made by the team’s cheerleading squad (the Raiderettes) as a class action. The cheerleaders had complained that they were not being paid for hours that they spent attending other events and performing other tasks required of them by contract. After the time spent performing these other tasks was factored in, the cheerleaders were receiving wages that were well below California’s minimum wage, persuading the Raiders to settle the dispute. ■

Are employees entitled to receive wages for all the time they spend at work, including times when they are taking a personal break? See this chapter’s Ethics Today feature for a discussion of this issue.

20–2c Tipped Workers When an employee receives tips while on the job, the FLSA gives employers a tip credit toward the minimum wage amount. The employer is required to pay only $2.13 an hour in direct wages—if that amount, plus the tips received, equals at least the federal minimum wage. If an employee’s tips and direct wages do not equal the federal minimum wage, the employer must make up the difference. Note that some states have enacted laws to prevent employers from including tips in the minimum wage. In these states, tipped workers receive the regular minimum wage.

If employers pay at least the federal minimum wage, the FLSA allows them to take employee tips and make the FLSA allows them to take employee tips and make the FLSA allows them to take employee tips and make the FLSA allows them to take employee tips and make other arrangements for their distribution. other arrangements for their distribution. ■ CASE IN CASE IN POINT 20.5 Misty Cumbie worked as a waitress at a café in Portland, Oregon, that was owned and operated by Woody Woo, Inc. Woody Woo paid its servers an hourly

442 U N I T F O U R The Business and Employment Environment

Is It Fair to Dock Employees’ Pay for Bathroom Breaks?

For some employees, “punching a time clock” means accounting for all of the time that all of the time that all they are not working. These employees must “punch in” when they arrive and “punch out” when they leave for the day, of course, but they also must clock out when they take breaks. That includes bathroom breaks, coffee breaks, and smoking breaks.

What the Law Says The Fair Labor Standards Acta does not require that an employer offer its employees personal breaks. If an employer does offer them, though, employees must be compensated during those breaks. Otherwise, the employer may effectively be in violation of federal mini- mum wage laws.

A Pennsylvania Publisher Faces Fines for Unpaid Bathroom Breaks The issue of unpaid bathroom breaks came to the fore when the U.S. Department of Labor (DOL) filed a lawsuit against American Future Systems, Inc. (doing business as Progressive Business Publications). The DOL alleged that American Future Systems had created a compensation system in which none of its six thousand employees were compensated for bathroom breaks.b

The DOL argued that all workday breaks of twenty minutes or less are compensable time.c

Because American Future Systems did not com- pensate its employees for such breaks, those employees were not properly credited for all compensable time. The result was that they had “been paid below the minimum wage estab- lished by the Fair Labor Standards Act (FLSA).”d

U.S. district court judge L. Felipe Restrepo agreed, finding American Future Systems liable for unpaid wages under the FLSA, plus damages. The company will have to pay past and current employees almost $2 million, according to DOL estimates.

The Ethical Issue Irrespective of the illegality of not paying for personal breaks, there is an ethical issue. Should workers have to face the choice of taking a bathroom break or get- ting paid? Adam Welsh, a senior trial attorney for the Department of Labor, argued that the answer was no. “I think it’s the rare employer who doesn’t allow its employees to go to the bathroom,” Welsh said.

Critical Thinking Consider a company whose employees include both smokers and nonsmokers. The smokers take numerous paid smoking breaks, while the nonsmokers do not. Is there an ethical issue here? Discuss.

ETHICS TODAY

a. 29 U.S.C. Sections 201 et seq. b. U.S. Department of Labor v. American Future Systems, Inc., Memoran-

dum, Case No. 12-6171 (E.D.Pa. 2015). c. 29 C.F.R. Section 785.18. d. 29 U.S.C. Section 206(a)(1)(c).

wage that was higher than the state’s minimum wage, but the servers were required to contribute their tips to a “tip pool.” Approximately one-third of the tip-pool funds went to the servers, and the rest was distributed to kitchen staff members, who otherwise rarely received tips for their services. When Cumbie filed a lawsuit against Woody Woo over her tips, the court held that the tip pool did not violate the FLSA.6 ■

20–2d Overtime Provisions and Exemptions

Under the FLSA, any employee who works more than forty hours per week must be paid no less than 1.5 times her or his regular pay for all hours worked over forty. The

6. Cumbie v. Woody Woo, Inc., 596 F.3d 577 (9th Cir. 2010).

FLSA overtime provisions apply only after an employee has worked more than forty hours per week. Therefore, employees who work ten hours a day, four days per week, are not entitled to overtime pay.

Certain employees are exempt from the FLSA’s over- time provisions. These employees generally include exec- utive, administrative, and professional employees, as well as outside salespersons and those who create computer code. Executive and administrative employees are those whose primary duty is management and who exercise discretion and independent judgment.discretion and independent judgment.discretion and independent judgment.discretion and independent judgment.

■ CASE IN POINT 20.6 Patty Lee Smith was a pharmaceu- tical sales representative for Johnson and Johnson (J&J). She traveled to ten physicians’ offices a day to promote the ben- efits of J&J’s drug Concerta. Smith’s work was unsupervised, she controlled her own schedule, and she received an annual salary of $66,000. When she filed a claim for overtime pay,

C H A P T E R 2 0 Employment Law 443

Background and Facts Santonias Bailey was an employee of TitleMax of Georgia, Inc., in Jones- boro, Georgia. Bailey’s supervisor told him that TitleMax did not pay overtime, so he regularly worked off the clock. For example, on some Saturdays, he would work from 8:30 A.M. to 5:30 P.M., but—as ordered by his supervisor—would log only seven hours despite having worked nine. His supervisor also edited Bailey’s time records to report fewer hours than he actually worked by, for instance, subtracting a one-hour lunch break when there had been none.

Bailey resigned from TitleMax and filed a suit in a federal district court against the employer to recover for the unpaid overtime under the Fair Labor Standards Act (FLSA). TitleMax argued that Bailey was responsible for the unpaid time. According to TitleMax, he had never complained about his supervisor, and he had violated company policy with respect to keeping accurate time records. The court issued a judgment in the defendant’s favor. Bailey appealed.

In the Language of the Court MARTIN, Circuit Judge:

* * * * * * * The goal of the FLSA is to counteract the inequality of bargaining power between employees

and employers. In the broadest sense, this principle * * * compels our holding here. If an employer knew or had rea-

son to know that its employee underreported his hours, it cannot escape FLSA liability by asserting [a] defense based on that underreporting. To hold otherwise would allow an employer to wield its superior bargaining power to pressure or even compel its employees to underreport their work hours.

* * * * If an employee has worked overtime without pay, he may bring a private FLSA action for damages.

An unpaid-overtime claim has two elements: (1) an employee worked unpaid overtime, and (2) the employer knew or should have known of the overtime work. Knowledge may be imputed [attributed] to the employer when its supervisors or management encourage artificially low reporting. [Emphasis added.]

Mr. Bailey has shown both required elements. He worked overtime without pay. TitleMax knew or should have known he worked overtime, because Mr. Bailey’s supervisor both encouraged artificially low reporting and squelched truthful timekeeping.

* * * * * * * No one disputes that his supervisor knew he was working off the clock. The supervisor’s knowl-The supervisor’s knowl-The supervisor’s knowl

edge may be imputed to TitleMax, making it liable for the FLSA violation. * * * TitleMax argues that * * * an employee [is] deprived of his FLSA claim because he underreported his time, even if knowledge of the underreporting is imputed to the employer. [Emphasis added.]

TitleMax has identified no case in which [any federal appellate court] approved the use of [this] defense as a total bar to an employee’s FLSA claim when the employer knew the employee underreported his hours.

Bailey v. TitleMax of Georgia, Inc. United States Court of Appeals, Eleventh Circuit, 776 F.3d 797 (2015).

Case 20.2

the court held that she was an administrative employee and therefore exempt from the FLSA’s overtime provisions.7 ■

An employer can voluntarily pay overtime to ineligible employees but cannot waive or reduce the overtime requirements of the FLSA. In 2016, the Department of Labor updated its overtime regulations to allow millions more employees to receive overtime

7. Smith v. Johnson and Johnson, 593 F.3d 280 (3d Cir. 2010).

pay.8 Whereas in the past, workers making more than $23,660 a year did not qualify for overtime pay, today, that threshold has been increased to $50,440 a year.

An employee’s underreporting of hours worked can undercut his or her claim for overtime. But can an employee’s underreporting support such a claim? That support such a claim? That support question was at the center of the following case.

8. 29 C.F.R. Part 541.

444 U N I T F O U R The Business and Employment Environment

* * * The dearth [scarcity] of precedent supporting TitleMax’s * * * argument is persuasive, if not conclusive, evidence that its argument is misguided.

Decision and Remedy The U.S. Court of Appeals for the Eleventh Circuit reversed the judgment of the lower court and remanded the case for further proceedings. “Where, as here, an employer knew or had reason to know that its employee underreported his hours, it cannot invoke [a] defense based on that underreporting to bar the employee’s FLSA claim.”

Critical Thinking • Legal Environment Congress enacted the FLSA in 1938. More than eight thousand FLSA suits are

filed in federal district courts each year. How do these facts support the court’s reasoning in this case?

Case 20.2 Continued

20–2e Layoffs The Worker Adjustment and Retraining Notification (WARN) Act9 applies to employers with at least one hun- dred full-time employees. The act requires these employ- ers to provide sixty days’ notice before implementing a mass layoff or closing a plant that employs more than fifty full-time workers. A mass layoff is a layoff of at least one- third of the full-time employees at a particular job site.

The WARN Act is intended to give workers advance notice so that they can start looking for new jobs while they are still employed. It is also intended to alert state agencies so that they can provide training and other resources for displaced workers. Employers thus must provide advance notice of the layoff both to the affected workers and to state and local government authorities. (An employer may notify the workers’ union representa- tive, if the workers are members of a labor union.) Even companies that anticipate filing for bankruptcy normally must provide notice under the WARN Act.

An employer that violates the WARN Act can be fined up to $500 for each day of the violation. Employees can recover back pay for each day of the violation (up to sixty days), plus reasonable attorneys’ fees.

20–3 Family and Medical Leave The Family and Medical Leave Act (FMLA)10 allows employees to take time off from work for family or medi- cal reasons or in certain situations that arise from military service. A majority of the states have similar legislation. The FMLA does not supersede any state or local law that provides more generous protection.

9. 29 U.S.C. Sections 2101 et seq. 10. 29 U.S.C. Sections 2601, 2611–2619, 2651–2654.

20–3a Coverage and Application The FMLA requires employers that have fifty or more employees to provide unpaid leave for specified reaunpaid leave for specified reaunpaid - sons. (Some employers voluntarily offer paid family leave, but this is not a requirement of the FMLA.) The FMLA expressly covers private and public (government) employees who have worked for their employers for at least a year.

An eligible employee may take up to twelve weeks of leave within a twelve-month period for any of the followleave within a twelve-month period for any of the followleave - ing reasons: 1. To care for a newborn baby within one year of birth. 2. To care for an adopted or foster child within one year

of the time the child is placed with the employee. 3. To care for the employee’s spouse, child, or parent

who has a serious health condition. 4. If the employee suffers from a serious health condi-

tion and is unable to perform the essential functions of her or his job.

5. For any qualifying exigency (nonmedical emergency) arising out of the fact that the employee’s spouse, son, daughter, or parent is a covered military member on active duty.11 For instance, an employee can take leave to arrange for child care or to deal with financial or legal matters when a spouse is being deployed overseas.

In addition, an employee may take military caregiver leave to care for a family member with a serious injury or illness incurred as a result of military duty.12 For military caregiver leave, the employee may take up to twenty-six weeks of leave within a twelve-month period.

In the following case, an employee asked for medi- cal leave to care for her mother on a trip to Las Vegas, Nevada.

11. 29 C.F.R. Section 825.126. 12. 29 C.F.R. Section 825.200.

C H A P T E R 2 0 Employment Law 445

Background and Facts Beverly Ballard worked for the Chicago Park District. She lived with her mother, Sarah, who suffered from end-stage congestive heart failure. Beverly served as Sarah’s primary caregiver with support from Horizon Hospice & Palliative Care. The hospice helped Sarah plan and secure funds for an end-of-life goal, a “family trip” to Las Vegas. To accompany Sarah as her caretaker, Beverly asked the Park District for unpaid time off under the Family and Medical Leave Act (FMLA). The employer refused, but Beverly and Sarah took the trip as planned.

Later, the Park District terminated Beverly for “unauthorized absences.” She filed a suit in a federal district court against the employer. The court issued a decision in Beverly’s favor. The Park District appealed, arguing that Beverly had been absent from work on a “recreational trip.”

In the Language of the Court FLAUM, Circuit Judge.

* * * * We begin with the text of the [FMLA]: an eligible employee is entitled to leave “in order to care for”

a family member with a “serious health condition.” * * * * * * * The FMLA’s text does not restrict care to a particular place or geographic location. For instance, it

does not say that an employee is entitled to time off “to care at home for” a family member. at home for” a family member. at home The only limitation it places on care is that the family member must have a serious health condition. We are reluctant, without good reason, to read in another limitation that Congress has not provided. [Emphasis added.]

* * * * Sarah’s basic medical, hygienic, and nutritional needs did not change while she was in Las Vegas,

and Beverly continued to assist her with those needs during the trip. In fact, * * * Beverly’s presence proved quite important indeed when a fire at the hotel made it impossible to reach their room, requiring Beverly to find another source of insulin and pain medicine. Thus, at the very least, [Beverly] requested leave in order to provide physical care.

* * * * * * * The Park District describes [Beverly’s] travel as a “recreational trip” or a “non-medically related

pleasure trip.” It also raises the specter that employees will help themselves to unpaid FMLA leave in order to take personal vacations, simply by bringing seriously ill family members along. So perhaps what the Park District means to argue is that the real reason Beverly requested leave was in order to take a free plea- sure trip, and not in order to care for her mother. * * * However, * * * an employer concerned about the risk that employees will abuse the FMLA’s leave provisions may of course require that requests be certified by the family member’s health care provider. And any worries about opportunistic leave-taking in this case should be tempered by the fact that this dispute arises out of the hospice and palliative care context.

If Beverly had sought leave to care for her mother in Chicago, her request would have fallen within the scope of the FMLA. So too if Sarah had lived in Las Vegas instead of with her daughter, and Beverly had requested leave to care for her mother there. Ultimately, other than a concern that our straightfor- ward reading will “open the door to increased FMLA requests,” the Park District gives us no reason to treat the current scenario any differently.

Decision and Remedy The U.S. Court of Appeals for the Seventh Circuit affirmed the lower court’s judg- ment. Under the FMLA, an eligible employee is entitled to take leave from work to care for a family member with a serious health condition. The care is not restricted to a particular place (such as “at home”).

Critical Thinking • What If the Facts Were Different? Suppose that Beverly had requested leave to make arrangements

for a change in Sarah’s care, such as a transfer to a nursing home. Is it likely that the result would have been different? Explain.

• Legal Environment Under the FMLA, an employee is eligible for leave when he or she is needed to care for a family member. Should “needed to care for” be interpreted to cover only ongoing physical care? Discuss.

Ballard v. Chicago Park District United States Court of Appeals, Seventh Circuit, 741 F.3d 838 (2014).

Case 20.3

446 U N I T F O U R The Business and Employment Environment

20–3b Benefits and Protections When an employee takes FMLA leave, the employer must continue the worker’s health-care coverage on the same terms as if the employee had continued to work. On returning from FMLA leave, most employees must be restored to their original position or to a comparable position (with nearly equivalent pay and benefits, for instance). An important exception allows the employer to avoid reinstating a key employee—defined as an employee key employee—defined as an employee key employee whose pay falls within the top 10 percent of the firm’s workforce.

20–3c Violations An employer that violates the FMLA can be required to provide various remedies, including the following:

1. Damages to compensate the employee for lost wages and benefits, denied compensation, and actual monetary losses (such as the cost of providing care for a family member). Compensatory damages are available up to an amount equivalent to the employee’s wages for twelve weeks.

2. Job reinstatement. 3. Promotion, if a promotion has been denied.

A successful plaintiff is also entitled to court costs and attorneys’ fees. In addition, if the plaintiff shows that the employer acted in bad faith, the plaintiff can receive two times the amount of damages awarded by a judge or jury. Supervisors can also be held personally liable, as employ- ers, for violations of the act.

Employers generally are required to notify employees when an absence will be counted against FMLA leave. If an employer fails to provide such notice, and that failure to notify causes harm to the employee, the employer can be sanctioned.13

20–4 Health, Safety, and Income Security

Under the common law, employees who were injured on the job had to file lawsuits against their employers to obtain recovery. Today, numerous state and federal stat- utes protect employees from the risk of accidental injury, death, or disease resulting from their employment. In addition, the government protects employees’ income

13. This was the United States Supreme Court’s holding in Ragsdale v. Wolverine World Wide, Inc., 535 U.S. 81, 122 S.Ct. 1155, 152 L.Ed.2d 167 (2002).

through Social Security, Medicare, unemployment insur- ance, and the regulation of pensions and health insurance plans.

20–4a The Occupational Safety and Health Act

At the federal level, the primary legislation protecting employees’ health and safety is the Occupational Safety and Health Act,14 which is administered by the Occu- pational Safety and Health Administration (OSHA). The act imposes on employers a general duty to keep the workplace safe.

To this end, OSHA has established specific safety standards that employers must follow, depending on the industry. For instance, OSHA regulations require the use of safety guards on certain mechanical equipment. It also sets maximum levels of exposure to substances in the workplace that may be harmful to workers’ health.

Notices, Records, and Reports The act requires that employers post certain notices in the workplace, maintain specific records, and submit reports. Employers with eleven or more employees are required to keep occu- pational injury and illness records for each employee. Each record must be made available for inspection when requested by an OSHA compliance officer.

Whenever a work-related injury or disease occurs, employers must make reports directly to OSHA. If an employee dies or three or more employees are hospital- ized because of a work-related incident, the employer must notify OSHA within eight hours. A company that fails to do so will be fined. Following the incident, a com- plete inspection of the premises is mandatory.

Inspections OSHA compliance officers may enter and inspect the facilities of any establishment covered by the Occupational Safety and Health Act. Employees may also file complaints of violations. Under the act, an employer cannot discharge an employee who files a complaint or who, in good faith, refuses to work in a high-risk area if bodily harm or death might result.

20–4b State Workers’ Compensation Laws State workers’ compensation laws establish an admin- istrative procedure for compensating workers injured on the job. Instead of suing, an injured worker files a claim

C H A P T E R 2 0 Employment Law 447

with the state agency or board that administers local workers’ compensation claims.

All states require employers to provide workers’ com- pensation insurance, but the specific rules vary by state. Most states have a state fund that employers pay into for workers’ compensation coverage. Usually, employers can purchase insurance from a private insurer as an alterna- tive to paying into the state fund. Most states also allow certain employers to be self-insured—that is, employers self-insured—that is, employers self-insured that show an ability to pay claims do not need to buy insurance.

No state covers all employees under its workers’ com- pensation statute. Typically, domestic workers, agricul- tural workers, temporary employees, and employees of common carriers (companies that provide transportation services to the public) are excluded. Minors are covered.

Requirements for Receiving Workers’ Com- pensation In general, the only requirements to recover benefits under state workers’ compensation laws are: 1. The existence of an employment relationship. 2. An accidental injury that accidental injury that accidental occurred on the job or in the

course of employment, regardless of fault. (An injury that occurs while an employee is commuting to or from work usually is not covered because it did not occur on the job or in the course of employment.)

An injured employee must notify her or his employer promptly (usually within thirty days of the accident). Generally, an employee must also file a workers’ com- pensation claim within a certain period (sixty days to two years) from the time the injury is first noticed, rather than from the time of the accident.

Workers’ Compensation versus Litigation If an employee accepts workers’ compensation benefits, he or she may not sue for injuries caused by the employer’s negligence. By barring lawsuits for negligence, workers’ compensation laws also prevent employers from avoiding liability by using defenses such as contributory negligence or assumption of risk. A worker may sue an employer who intentionally injures the worker, however.intentionally injures the worker, however.intentionally

20–4c Income Security Federal and state governments participate in insurance programs designed to protect employees and their fami- lies from the financial impact of retirement, disability, death, hospitalization, and unemployment. The key fed- eral law on this subject is the Social Security Act.15

15. 42 U.S.C. Sections 301–1397e.

Social Security The Social Security Act provides for old-age (retirement), survivors’, and disability insurance. The act is therefore often referred to as OASDI. Retired workers who are covered by Social Security receive monthly payments from the Social Security Administra- tion, which administers the Social Security Act. Social Security benefits are fixed by statute but increase auto- matically with increases in the cost of living.

Medicare Medicare is a federal government health- insurance program administered by the Social Security Administration for people sixty-five years of age and older and for some under age sixty-five who are disabled. It originally had two parts, one pertaining to hospital costs and the other to nonhospital medical costs, such as visits to physicians’ offices. It now offers additional coverage options and a prescription-drug plan. People who have Medicare hospital insurance can obtain additional federal medical insurance if they pay monthly premiums.

Tax Contributions Under the Federal Insurance Con- tributions Act (FICA),16 both employers and employees contribute to Social Security and Medicare, although the contributions are determined differently. The employer withholds the employee’s FICA contributions from the employee’s wages and ordinarily matches the contributions.

For Social Security, the basis for the contributions is the employee’s annual wage base—the maximum amount of the employee’s wages that is subject to the tax. As of 2016, the maximum amount subject to the tax was $118,500, and the tax rate was 12.4 percent.

The Medicare tax rate is 2.9 percent. Unlike Social Security, Medicare has no cap on the amount of wages subject to the tax. So even if an employee’s salary is well above the cap for Social Security, he or she will still owe Medicare tax on the total earned income.

For Social Security and Medicare together, typically the employer and the employee each pay 7.65 percent. This is equivalent to 6.2 percent (half of 12.4 percent) for Social Security plus 1.45 percent (half of 2.9 percent) for Medicare up to the maximum wage base. Any earned income above that threshold is taxed only for Medicare. Self-employed persons pay both the employer’s and the employee’s por- tions of the Social Security and Medicare taxes.

Under the Affordable Care Act, high-income earners are subject to an additional Medicare tax of 3.8 percent on most investment income. This additional tax applies to single wage earners making more than $200,000 and married couples making more than $250,000.

448 U N I T F O U R The Business and Employment Environment

Private Retirement Plans The major federal statute that regulates employee retirement plans is the Employee Retirement Income Security Act (ERISA).17 This act empowers a branch of the U.S. Department of Labor to enforce its provisions governing employers that have private pension funds for their employees. ERISA does not require not require not an employer to establish a pension plan. When a plan exists, however, ERISA provides standards for its management.

ERISA created the Pension Benefit Guaranty Cor- poration (PBGC), an independent federal agency, to provide timely and uninterrupted payment of voluntary private pension benefits. The pension plans pay annual insurance premiums (at set rates adjusted for inflation) to the PBGC, which then pays benefits to participants in the event that a plan is unable to do so.

A key provision of ERISA concerns vesting. Vesting gives an employee a legal right to receive pension ben- efits when she or he stops working. Before ERISA was enacted, some employees who had worked for compa- nies for many years received no pension benefits when their employment terminated because those benefits had not vested. Under ERISA, generally all employee con- tributions to pension plans vest immediately. Employee rights to employer contributions vest after five years of employment.

Unemployment Insurance The Federal Unem- ployment Tax Act (FUTA)18 created a state-administered system that provides unemployment compensation to eli- gible individuals who have lost their jobs. The FUTA and state laws require employers that fall under the provisions of the act to pay unemployment taxes at regular intervals. The proceeds from these taxes are then paid out to quali- fied unemployed workers.

To be eligible for unemployment compensation, a worker must be willing and able to work. Workers who have been fired for misconduct or who have voluntarily left their jobs are not eligible for benefits. Normally, workers must be actively seeking employment to con- tinue receiving benefits.tinue receiving benefits.tinue receiving benefits.tinue receiving benefits.

■ EXAMPLE 20.7 Martha works for Baily Snow Martha works for Baily Snow- boards in Vermont. One day at work, Martha receives a text from her son saying that he has been taken to the hospital. Martha rushes to the hospital and does not return to work for several days. Bailey hires someone else for Martha’s position, and Martha files for unemploy- ment benefits. Martha’s claim will be denied because she left her job voluntarily and made no effort to maintain contact with her employer. ■

17. 29 U.S.C. Sections 1001 et seq. 18. 26 U.S.C. Sections 3301–3310.

COBRA The Consolidated Omnibus Budget Reconcili- ation Act (COBRA)19 enables employees to continue, for a limited time, their health-care coverage after they are no longer eligible for group health-insurance plans. The workers—not the employers—pay the premiums for the continued coverage.

COBRA prohibits an employer from eliminating a worker’s medical, vision, or dental insurance when the worker’s employment is terminated or when a reduction in the worker’s hours would affect coverage. Termina- tion of employment may be voluntary or involuntary. Only workers fired for gross misconduct are excluded from protection. Employers, with some exceptions, must inform employees of COBRA’s provisions before the ter- mination or reduction of work hours.

A worker has sixty days (from the date that the group coverage would stop) to decide whether to continue with the employer’s group insurance plan. If the worker chooses to continue coverage, the employer is obligated to keep the policy active for up to eighteen months (twenty-nine months if the worker is disabled). The cov- erage must be the same as that provided to the worker (and his or her family members) prior to the termination or reduction of work. An employer that does not comply with COBRA risks substantial penalties, including a tax of up to 10 percent of the annual cost of the group plan or $500,000, whichever is less.

Employer-Sponsored Group Health Plans The Health Insurance Portability and Accountability Act (HIPAA)20 contains provisions that affect employer- sponsored group health plans. For instance, HIPAA restricts the manner in which employers collect, use, and disclose the health information of employees and their families. Employers must designate privacy officials, dis- tribute privacy notices, and train employees to ensure that employees’ health information is not disclosed to unau- thorized parties.

Failure to comply with HIPAA regulations can result in civil penalties of up to $100 per person per violation (with a cap of $25,000 per year). Employers are also subject to criminal prosecution for certain types of HIPAA viola- tions. An employer can face up to $250,000 in criminal fines and imprisonment for up to ten years if convicted.

Affordable Care Act The Affordable Care Act21 (commonly referred to as Obamacare) requires most employers with fifty or more full-time employees to offer

19. 29 U.S.C. Sections 1161–1169. 20. 29 U.S.C. Sections 1181 et seq. 21. Pub. L. No. 111-148, 124 Stat. 119, March 23, 2010, codified in vari-

C H A P T E R 2 0 Employment Law 449

health-insurance benefits. Under the act, any business offering health benefits to its employees (even if not legally required to do so) may be eligible for tax credits of up to 35 percent to offset the costs.

An employer who fails to provide health benefits as required under the statute can be fined up to $2,000 for each employee after the first thirty people. (This is known as the 50/30 rule: employers with fifty employees must provide insurance, and those failing to do so will be fined for each employee after the first thirty.) An employer who offers a plan that costs an employee more than 9.5 per- cent of the employee’s income may be assessed a penalty.

20–5 Employee Privacy Rights Concerns about the privacy rights of employees have arisen as employers have purportedly used invasive tac- tics to monitor and screen workers. Perhaps the greatest privacy concern in employment today involves electronic monitoring of employees’ activities.

20–5a Electronic Monitoring More than half of employers engage in some form of elec- tronic monitoring of their employees. Many employers review employees’ e-mail, as well as their social media posts and other Internet messages. Employers may also make video recordings of their employees at work, record their telephone conversations, and listen to their voice mail.

Employee Privacy Protection Employees of pri- vate (nongovernment) employers have some privacy protection under tort law and state constitutions. In addi- tion, state and federal statutes may limit an employer’s conduct in certain respects. For instance, the Electronic Communications Privacy Act prohibits employers from intercepting an employee’s personal electronic communi- cations unless they are made on devices and systems fur- nished by the employer.

Nonetheless, employers do have considerable leeway to monitor employees in the workplace. In addition, pri- vate employers generally are free to use filtering software to block access to certain Web sites, such as sites contain- ing sexually explicit images. The First Amendment’s pro- tection of free speech prevents only government employers from restraining speech by blocking Web sites.

Reasonable Expectation of Privacy When deter- mining whether an employer should be held liable for vio- lating an employee’s privacy rights, the courts generally

weigh the employer’s interests against the employee’s rea- sonable expectation of privacy. Normally, if employees have been informed that their communications are being monitored, they cannot reasonably expect those interac- tions to be private. In addition, a court will typically hold that employees do not have a reasonable expectation of privacy when using a system (such as an e-mail system) provided by the employer.

If employees are not informed that certain communicanot informed that certain communicanot - tions are being monitored, the employer may be held lia- ble for invading their privacy. Most employers that engage in electronic monitoring notify their employees about the monitoring. Nevertheless, a general policy may not suf-monitoring. Nevertheless, a general policy may not suf-monitoring. Nevertheless, a general policy may not suf ficiently protect an employer monitoring forms of com- munications that the policy fails to mention. For instance, notifying employees that their e-mails and phone calls may be monitored does not necessarily protect an employer who monitors social media posts or text messages.

20–5b Other Types of Monitoring In addition to monitoring their employees’ online activi- ties, employers also engage in other types of employee screening and monitoring. The practices discussed next have often been challenged as violations of employee pri- vacy rights.

Lie-Detector Tests At one time, many employers required employees or job applicants to take polygraph examinations (lie-detector tests). Today, the Employee Polygraph Protection Act22 generally prohibits employers from requiring employees or job applicants to take lie- detector tests or suggesting or requesting that they do so. The act also restricts employers’ ability to use or ask about the results of any lie-detector test or to take any negative employment action based on the results.

Certain employers are exempt from these prohibi- tions. Federal, state, and local government employers, and certain security service firms, may conduct poly- graph tests. In addition, companies that manufacture and distribute controlled substances may perform lie- detector tests. Other employers may use polygraph tests when investigating losses attributable to theft, including embezzlement and the theft of trade secrets.

Drug Testing In the interests of public safety and to reduce unnecessary costs, many employers, including the government, require their employees to submit to drug testing.

450 U N I T F O U R The Business and Employment Environment

Public Employers. Government (public) employers are constrained in drug testing by the Fourth Amendment to the U.S. Constitution, which prohibits unreasonable searches and seizures. Drug testing of public employees is allowed by statute for transportation workers, however. Courts normally uphold drug testing of certain employ- ees when drug use in a particular job may threaten public safety. Also, when there is a reasonable basis for suspecting public employees of drug use, courts often �nd that drug testing does not violate the Fourth Amendment.

Private Employers. �e Fourth Amendment does not apply to drug testing conducted by private employers. Hence, the privacy rights and drug testing of private- sector employees are governed by state law. Many states have statutes that allow drug testing by private employers

but restrict when and how the testing may be performed. A collective bargaining agreement (discussed in a later chapter) may also provide protection against drug testing (or may authorize it in certain conditions).

The permissibility of testing a private employee for drugs often hinges on whether the employer’s testing was reasonable. Random drug tests and even “zero-tolerance” policies (which deny a “second chance” to employees who test positive for drugs) have been held to be reason- able. It is also reasonable to require employees of private employers who are under contract with the federal gov- ernment to undergo standard background investigations to disclose potential drug use.23

23. See National Aeronautics and Space Administration v. Nelson, 562 U.S. 134, 131 S.Ct. 746, 178 L.Ed.2d 667 (2011).

Reviewing: Employment Law

Rick Saldona began working as a traveling salesperson for Aimer Winery in 2008. Sales constituted 90 percent of Saldona’s work time. Saldona worked an average of fifty hours per week but received no overtime pay. In June 2018, Saldona’s new supervisor, Caesar Braxton, claimed that Saldona had been inflating his reported sales calls and required Saldona to submit to a polygraph test. Saldona reported Braxton to the U.S. Department of Labor, which prohibited Aimer from requiring Saldona to take a polygraph test for this purpose.

In August 2018, Saldona’s wife, Venita, fell from a ladder and sustained a head injury while employed as a full-time agricultural harvester. Saldona presented Aimer’s Human Resources Department with a letter from his wife’s physician indicating that she would need daily care for several months, and Saldona took leave until December 2018. Aimer had sixty-three employees at that time. When Saldona returned to Aimer, he was informed that his position had been eliminated because his sales territory had been combined with an adjacent territory. Using the information presented in the chapter, answer the following questions. 1. Would Saldona have been legally entitled to receive overtime pay at a higher rate? Why or why not? 2. What is the maximum length of time Saldona would have been allowed to take leave to care for his injured spouse? 3. Under what circumstances would Aimer have been allowed to require an employee to take a polygraph test? 4. Would Aimer likely be able to avoid reinstating Saldona under the key employee exception? Why or why not?

Debate This . . . The U.S. labor market is highly competitive, so state and federal laws that require overtime pay are unnecessary and should be abolished.

Terms and Concepts employment at will 438 minimum wage 441

vesting 448 whistleblowing 439

workers’ compensation law 446 wrongful discharge 441

C H A P T E R 2 0 Employment Law 451

Issue Spotters 1. American Manufacturing Company (AMC) issues an

employee handbook that states that employees will be discharged only for good cause. One day, Greg, an AMC supervisor, says to Larry, “I don’t like your looks. You’re fired.” Can AMC be held liable for breach of contract? If so, why? If not, why? (See Employment at Will.)Employment at Will.)Employment at Will

2. Erin, an employee of Fine Print Shop, is injured on the job. For Erin to obtain workers’ compensation, must her injury have been caused by Fine Print’s negligence? Does it matter whether the action causing the injury was inten- tional? Explain. (See Health, Safety, and Income Security.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 20–1. Wrongful Discharge. Denton and Carlo were employed at an appliance plant. Their job required them to perform occasional maintenance work while standing on a wire mesh twenty feet above the plant floor. Other employ- ees had fallen through the mesh, and one of them had been killed by the fall. When their supervisor told them to perform tasks that would likely involve walking on the mesh, Denton and Carlo refused because they feared they might suffer bodily injury or death. Because they refused to do the requested work, the two employees were fired from their jobs. Was their discharge wrongful? If so, under what federal employment

law? To what federal agency or department should they turn for assistance? (See Employment at Will.) Employment at Will.) Employment at Will

20–2. Family and Medical Leave Act. Serge worked for Service Attendant Corporation (SAC). He requested time off under the Family and Medical Leave Act (FMLA) from April 29 through May 31 to undergo treatment for alcoholism. For the month of May, he was hospitalized as part of the treat- ment. When he did not return to work on June 1, SAC fired him. Did SAC violate Serge’s rights under the FMLA? Explain your answer. (See Family and Medical Leave.)

Business Case Problems 20–3. Spotlight on Coca Cola—Family and Medical Leave Act. Jennifer Willis worked for Coca Cola Enter-

prises, Inc. (CCE), in Louisiana as a senior account manager. On a Monday in May 2003, Willis called her supervisor to tell him that she was sick and would not be able to work that day.

She also said that she was pregnant, but she did not say she was sick because of the pregnancy. On Tuesday, she called to ask where to report to work and was told that she could not return without a doctor’s release. She said that she had a doc- tor’s appointment on “Wednesday,” which her supervisor understood to be the next day. Willis meant the following Wednesday.

For more than a week, Willis did not contact CCE. When she returned to work, she was told that she had violated CCE’s “No Call/No Show” policy. Under this policy “an employee absent from work for three consecutive days without notifying the supervisor during that period will be considered to have voluntarily resigned.” She was fired.

Willis filed a suit in a federal district court against CCE under the Family and Medical Leave Act (FMLA). To be eli- gible for FMLA leave, an employee must inform an employer of the reason for the leave. Did Willis meet this requirement? Did CCE’s response to Willis’s absence violate the FMLA? Explain. [Willis v. Coca Cola Enterprises, Inc., 445 F.3d 413 (5th Cir. 2006)] (See Family and Medical Leave.)

20–4. Workers’ Compensation. As a safety measure, Dynea USA, Inc., required an employee, Tony Fairbanks, to wear steel-toed boots. One of the boots caused a sore on Fairbanks’s leg. �e skin over the sore broke, and within a week, Fairbanks was hospitalized with a methicillin-resistant staphylococcus aureus (MRSA) infection. He �led a workers’ compensation claim. Dynea argued that the MRSA bacteria that caused the infection had been on Fairbanks’s skin before he came to work. What are the requirements to recover workers’ compensation bene�ts? Does this claim qualify? Explain. [Dynea USA, Inc. v. Fairbanks, 241 Or.App. 311, 250 P.3d 389 (2011)] (See Health, Safety, and Income Security.) 20–5. Exceptions to the Employment-at-Will Doctrine. Li Li worked for Packard Bioscience, and Mark Schmeizl was her supervisor. In March 2000, Schmeizl told Li to call Pack- ard’s competitors, pretend to be a potential customer, and request “pricing information and literature.” Li refused to per- form the assignment. She told Schmeizl that she thought the work was illegal and recommended that he contact Packard’s legal department. Although a lawyer recommended against the practice, Schmeizl insisted that Li perform the calls. More- over, he later wrote negative performance reviews because she was unable to get the requested information when she called competitors and identi�ed herself as a Packard employee. On June 1, 2000, Li was terminated on Schmeizl’s recommenda- tion. Can Li bring a claim for wrongful discharge? Why or

452 U N I T F O U R The Business and Employment Environment

why not? [Li Li v. Canberra Industries, 134 Conn.App. 448, 39 A.3d 789 (2012)] (See Employment at Will.) 20–6. Business Case Problem with Sample Answer— Unemployment Compensation. Fior Ramirez worked as

a housekeeper for Remington Lodging & Hospi- tality, a hotel in Atlantic Beach, Florida. After her father in the Dominican Republic su�ered a stroke, she asked her employer for time o� to be

with him. Ramirez’s manager, Katie Berkowski, refused the request. Two days later, Berkowski received a call from Ramirez to say that she was with her father. He died about a week later, and Ramirez returned to work, but Berkowski told her that she had abandoned her position. Ramirez applied for unem- ployment compensation. Under the applicable state statute, “an employee is disquali�ed from receiving bene�ts if he or she voluntarily left work without good cause.” Does Ramirez qualify for bene�ts? Explain. [Ramirez v. Reemployment Assis- tance Appeals Commission, 39 Fla.L.Weekly D317, 135 So.3d 408 (1 Dist. 2014)] (See Health, Safety, and Income Security.)

• For a sample answer to Problem 20–6, go to Appendix E at the end of this text.

20–7. Unemployment Compensation. Je�erson Partners LP entered into a collective bargaining agreement (CBA) with the Amalgamated Transit Union. Under the CBA, drivers had to either join the union or pay a fair share—85 percent—of union dues, which were used to pay for administrative costs incurred by the union. An employee who refused to pay was subject to discharge. Je�erson hired Ti�any �ompson to work as a bus driver. When told of the CBA requirement, she said that she thought it was unfair. She asserted that it was illegal to compel her to join the union and that it would be illegal to discharge her for not complying. She refused either to join the union or to pay the dues. More than two years later, she was �red on the ground that her continued refusal constituted misconduct. Is �ompson eligible for unemploy- ment compensation? Explain. [�ompson v. Je�erson Partners LP, ___ N.W.2d ___, 2016 WL 953038 (Minn.App. 2016)] (See Health, Safety, and Income Security.)

20–8. A Question of Ethics—Workers’ Compensation Law. In 1999, after working for Atchison Leather Products,

Inc., for ten years, Beverly Tull began to complain of hand, wrist, and shoulder pain. Atchison recom- mended that she contact a certain physician, who in April 2000 diagnosed the condition as carpal tunnel

syndrome “severe enough” for surgery. In August, Tull �led a claim with the state workers’ compensation board. Because Atchison changed workers’ compensation insurance companies every year, a dispute arose as to which company should pay Tull’s claim. Fear- ing liability, no insurer would authorize treatment, and Tull was forced to delay surgery until December. �e board granted her temporary total disability bene�ts for the subsequent six weeks that she missed work. On April 23, 2002, Berger Co. bought Atchison. �e new employer adjusted Tull’s work so that it was less demanding and stressful, but she continued to su�er pain. In July, a physician diagnosed her condition as permanent. �e board granted her permanent partial disability bene�ts. By May 2005, bickering over the �nancial responsibility for Tull’s claim involved �ve insurers—four of which had each covered Atchison for a sin- gle year and one of which covered Berger. [Tull v. Atchison gle year and one of which covered Berger. [Tull v. Atchison gle year and one of which covered Berger. [ Leather Products, Inc., 37 Kan.App.2d 87, 150 P.3d 316 (2007)] (See (2007)] (See (2007)] Health, Safety, and Income Security.)

(a) When an injured employee files a claim for workers’ com- pensation, a proceeding is held to assess the injury and determine the amount of compensation. Should a dis- pute between insurers over the payment of the claim be resolved in the same proceeding? Why or why not?

(b) The board designated April 23, 2002, as the date of Tull’s injury. What is the reason for determining the date of a worker’s injury? Should the board in this case have selected this date or a different date? Why?

(c) How should the board assess liability for the payment of Tull’s medical expenses and disability benefits? Would it be appropriate to impose joint and several liability on the insurers (holding each of them responsible for the full amount of damages)? Or should the individual liability of each of the insurers be determined? Explain.

Legal Reasoning Group Activity 20–9. Wrongful Discharge. Stefan Sorril, a health teacher at Madison Middle School and a triathlete, appeared shirt- less and showed o� his “ripped” body as an extra on an epi- sode of a new reality TV show. A week after the show aired, school o�cials called him into the district o�ce and asked for his resignation. Sorril later claimed that he was pressured and coerced into resigning. He said the school o�cials had informed him that—as a result of his appearance on the show—he would no longer be o�ered tenure (a senior aca- demic’s contractual right not to be terminated without just

cause). Sorril subsequently sued for wrongful discharge. (See Employment at Will.)Employment at Will.)Employment at Will (a) The first group will discuss whether Sorril was an employee

at will and how that status would affect his claim. (b) The second group will determine if Sorril can assert any of

the exceptions to the employment-at-will doctrine. (c) The third group will decide whether the school district

should be held liable for wrongful discharge and explain their reasoning.

453

C H A P T E R 2 1

VII applies to the employer, any employee—including an undocumented (alien) worker—can bring an action for employment discrimination.

21–1a The Equal Employment Opportunity Commission

The Equal Employment Opportunity Commission (EEOC) monitors compliance with Title VII. An employee alleging discrimination must file a claim with the EEOC before a lawsuit can be brought against the employer. The EEOC may investigate the dispute and attempt to obtain the parties’ voluntary consent to an out-of-court settlement. If a voluntary agreement can- not be reached, the EEOC may file a suit against the employer on the employee’s behalf.

■ EXAMPLE 21.1 Jacqueline Cote met her wife, Diana Smithson, in Maine while they were both employees at Wal-Mart. They moved to Massachusetts and were mar- ried a few days after the state legalized same-sex marriage, and they continued working at a Wal-Mart there. Smith- son eventually quit work to take care of Cote’s elderly

21–1 Title VII of the Civil Rights Act

Title VII of the Civil Rights Act prohibits job discrimina- tion against employees, applicants, and union members on the basis of race, color, national origin, religion, and gender at any stage of employment. Title VII bans dis- crimination in the hiring process, discipline procedures, discharge, promotion, and benefits.

Title VII applies to employers with fifteen or more employees and labor unions with fifteen or more mem- bers. It also applies to labor unions that operate hiring halls (where members go regularly to be assigned jobs), employment agencies, and state and local governing units or agencies. The United States Supreme Court has ruled that an employer with fewer than fifteen employees is not automatically shielded from a lawsuit filed under Title VII.4 In addition, the act prohibits discrimination in most federal government employment. When Title

4. Arbaugh v. Y&Arbaugh v. Y&Arbaugh v. Y H Corp., 546 U.S. 500, 126 S.Ct. 1235, 163 L.Ed.2d 1097 (2006).

O ut of the 1960s civil rights movement to end racial and other forms of discrimina-

tion grew a body of law protecting employees against discrimination in the workplace. Legislation, judicial decisions, and administrative agency actions restrict employers from dis- criminating against workers on the basis of race, color, religion, national origin, gender, age, or disability. A class of persons defined by one or more of these criteria is known as a protected class.

Several federal statutes pro- hibit employment discrimination against members of protected classes. The most important is Title VII of the Civil Rights Act.1 Title VII prohibits employment discrimination on the basis of race, color, religion, national origin, and gender. The Age Discrimi- nation in Employment Act2 and the Americans with Disabilities Act3 pro-

1. 42 U.S.C. Sections 2000e–2000e-17. 2. 29 U.S.C. Sections 621–634. 3. 42 U.S.C. Sections 12102–12118.

hibit discrimination on the basis of age and disability, respectively. The protections afforded under these laws also extend to U.S. citizens who are working abroad for U.S. firms or for companies that are controlled by U.S. firms.

This chapter focuses on federal statutes, including the ones just men- tioned. Many states have their own laws that protect employees against discrimination, however, and some provide more protection than federal laws do.

Employment Discrimination

454 U N I T F O U R The Business and Employment Environment

mother. Cote tried to enroll her partner in Wal-Mart’s health plan, but coverage was denied. Five years later, Smithson was diagnosed with cancer.

Cote filed a claim with the EEOC arguing that Wal- Mart had intentionally discriminated against her on the basis of sex. In 2014, the commission agreed that Cote “was treated differently and denied benefits because of her sex.” The EEOC ordered Wal-Mart to work with Cote to help pay Smithson’s medical bills. ■

The EEOC does not investigate every claim of employment discrimination. Generally, it takes only “pri- ority cases,” such as claims that affect many workers and those involving retaliatory discharge (firing an employee in retaliation for submitting a claim to the EEOC). If the EEOC decides not to investigate a claim, the EEOC issues a “right to sue” that allows the employee to bring his or her own lawsuit against the employer.

21–1b Limitations on Class Actions In an important decision, the United States Supreme Court limited the rights of employees to bring dis- crimination claims against their employer as a group, or class. The decision did not affect the rights of individual employees to sue under Title VII, however.

■ CASE IN POINT 21.2 A group of female employees sued Wal-Mart, the nation’s largest private employer. The employees alleged that store managers who had discretion over pay and promotions were biased against women and disproportionately favored men. The employees wished to bring a class action—a lawsuit in which a small num- ber of plaintiffs sue on behalf of a larger group. Lower courts ruled that the employees’ class-action suit could proceed, and Wal-Mart appealed. The Supreme Court ruled in favor of Wal-Mart, effectively blocking the class action. The Court held that the women had failed to prove a company-wide policy of discrimination that had a common effect on all women included in the class. Therefore, they could not maintain a class action.5 ■

21–1c Intentional and Unintentional Discrimination

Title VII of the Civil Rights Act prohibits both inten- tional and unintentional discrimination.

Intentional Discrimination Intentional discrimi- nation by an employer against an employee is known as

5. Wal-Mart Stores, Inc. v. Dukes, 564 U.S. 338, 131 S.Ct. 2541, 180 L.Ed.2d 374 (2011).

disparate-treatment discrimination. Because intent may sometimes be difficult to prove, courts have established certain procedures for resolving disparate-treatment cases.

Prima Facie Case. A plainti� who sues on the basis of disparate-treatment discrimination must �rst make out a prima facie case.prima facie case.prima facie Prima facie is Latin for “at �rst sight” or “on its face.” Legally, it refers to a fact that is presumed to be true unless contradicted by evidence.

To establish a prima facie case of disparate-treatment prima facie case of disparate-treatment prima facie discrimination in hiring, a plaintiff must show all of the following: 1. The plaintiff is a member of a protected class. 2. The plaintiff applied and was qualified for the job in

question. 3. The plaintiff was rejected by the employer. 4. The employer continued to seek applicants for the

position or filled the position with a person not in a protected class.

A plaintiff who can meet these relatively easy require- ments has made out a prima facie case of illegal discrimiprima facie case of illegal discrimiprima facie - nation in hiring. Therefore, the plaintiff will win in the absence of a legally acceptable employer defense.

Sometimes, current and former employees make a claim of discrimination. When the plaintiff alleges that the employer fired or took some other adverse employ- ment action against him or her, the same basic require- ments apply. To establish a prima facie case, the plaintiff prima facie case, the plaintiff prima facie must show that he or she was fired or treated adversely for discriminatory reasons.

Burden-Shifting Procedure. Once the prima facie case is established, the burden then shifts to the employer- defendant, who must articulate a legal reason for not hiring the plainti�. (Again, this also applies to �ring and other adverse employment actions.) If the employer did not have a legal reason for taking the adverse employment action, the plainti� wins.

If the employer can articulate a legitimate reason for the action, the burden shifts back to the plaintiff. To prevail, the plaintiff must then show that the employ- er’s reason is a pretext (not the true reason) and that the pretext (not the true reason) and that the pretext employer’s decision was actually motivated by discrimi- natory intent.

Unintentional Discrimination Employers often use interviews and tests to choose from among a large num- ber of applicants for job openings. Minimum educational requirements are also common. Some employer prac- tices, such as those involving educational requirements,

C H A P T E R 2 1 Employment Discrimination 455

may have an unintended discriminatory impact on a pro- tected class.

Disparate-impact discrimination occurs when a protected group of people is adversely affected by an employer’s practices, procedures, or tests, even though they do not appear to be discriminatory. In a disparate- impact discrimination case, the complaining party must first show that the employer’s practices, procedures, or tests are effectively discriminatory. Once the plaintiff has made out a prima facie case, the burden of proof shifts to prima facie case, the burden of proof shifts to prima facie the employer to show that the practices or procedures in question were justified.

There are two ways of showing that an employ- er’s practices, procedures, or tests are effectively discriminatory—that is, that disparate-impact discrimi- nation exists.

Pool of Applicants. A plainti� can prove a disparate impact by comparing the employer’s workforce to the pool of quali�ed individuals available in the local labor market. �e plainti� must show that (1) as a result of educational or other job requirements or hiring proce- dures, (2) the percentage of nonwhites, women, or mem- bers of other protected classes in the employer’s workforce (3) does not re�ect the percentage of that group in the pool of quali�ed applicants. If the plainti� can show a connection between the practice and the disparity, he or she has made out a prima facie case and need not provide prima facie case and need not provide prima facie evidence of discriminatory intent.

Rate of Hiring. A plainti� can also prove disparate- impact discrimination by comparing the employer’s selection rates of members and nonmembers of a proselection rates of members and nonmembers of a proselection rates - tected class (nonwhites and whites, for instance, or women and men). When an educational or other job requirement or hiring procedure excludes members of a protected class from an employer’s workforce at a sub- stantially higher rate than nonmembers, discrimination occurs.

Under EEOC guidelines, a selection rate for a pro- tected class that is less than four-fifths, or 80 percent, of the rate for the group with the highest rate of hiring generally rate for the group with the highest rate of hiring generally rate for the group with the highest rate of hiring generally is regarded as evidence of disparate impact. is regarded as evidence of disparate impact. is regarded as evidence of disparate impact. ■ EXAMPLE 21.3 Shady Cove District Fire Department administers Shady Cove District Fire Department administers an exam to applicants for the position of firefighter. At the exam session, one hundred white applicants take the test, and fifty pass and are hired. At the same exam ses- sion, sixty minority applicants take the test, but only twelve pass and are hired. Because twelve is only 20 per- cent of sixty, the test will be considered discriminatory under the EEOC guidelines. ■

21–1d Discrimination Based on Race, Color, and National Origin

Title VII prohibits employers from discriminating against employees or job applicants on the basis of race, color, or national origin. Race is interpreted broadly to apply to the ancestry or ethnic characteristics of a group of per- sons, such as Native Americans. National origin refers to discrimination based on a person’s birth in another coun- try or his or her ancestry or culture, such as Hispanic.

If an employer’s standards or policies for selecting or promoting employees have a discriminatory effect on employees or job applicants in these protected classes, then a presumption of illegal discrimination arises. To avoid liability, the employer must show that its standards or policies have a substantial, demonstrable relationship to realistic qualifications for the job in question.to realistic qualifications for the job in question.to realistic qualifications for the job in question.to realistic qualifications for the job in question.

■ CASE IN POINT 21.4 Jiann Min Chang was an Jiann Min Chang was an instructor at Alabama Agricultural and Mechanical Uni- versity (AAMU). When AAMU terminated his employ- ment, Chang filed a lawsuit claiming discrimination based on national origin. Chang established a prima facie case because he (1) was a member of a protected facie case because he (1) was a member of a protected facie class, (2) was qualified for the job, (3) suffered an adverse employment action, and (4) was replaced by someone outside his protected class (a non-Asian instructor).

When the burden of proof shifted to the employer, how- ever, AAMU showed that Chang had argued with a vice president and refused to comply with her instructions. The court ruled that the university had not renewed Chang’s contract for a legitimate reason—insubordination—and therefore was not liable for unlawful discrimination.6 ■

Reverse Discrimination Title VII also protects against reverse discrimination—that is, discrimination against members of a majority group, such as white against members of a majority group, such as white against members of a majority group, such as white against members of a majority group, such as white males. ■ EXAMPLE 21.5 An African American woman fires four white men from their management positions at a school district. The men file a lawsuit for reverse dis- crimination. They argue that the woman was trying to eliminate white males from the district administration in violation of Title VII. The woman claims that the termi- nations were part of a reorganization plan to cut costs.

If the judge (or jury, in a jury trial) agrees with the men that they were fired for racially discriminatory rea- sons, then they will be entitled to damages. If, however, the school district can show that the real reason for the terminations was a legitimate attempt to cut costs, then normally their case will be dismissed. ■

6. Jiann Min Chang v. Alabama Agricultural and Mechanical University, 355 Fed.Appx. 250 (11th Cir. 2009).

456 U N I T F O U R The Business and Employment Environment

Potential Section 1981 Claims Victims of racial or ethnic discrimination may also have a cause of action under 42 U.S.C. Section 1981. This section, which was enacted in 1866 to protect the rights of freed slaves, pro- hibits discrimination on the basis of race or ethnicity in the formation or enforcement of contracts. Because employment is often a contractual relationship, Section 1981 can provide an alternative basis for a plaintiff ’s action and is potentially advantageous because there is no limit on the damages that can be awarded.

21–1e Discrimination Based on Religion Title VII of the Civil Rights Act also prohibits govern- ment employers, private employers, and unions from discriminating against persons because of their religion. (This chapter’s Digital Update feature discusses how Digital Update feature discusses how Digital Update employers who examine prospective employees’ social media posts, including posts concerning religion, might engage in unlawful discrimination.)

Employers cannot treat their employees more or less favorably based on their religious beliefs or practices. They also cannot require employees to participate in any religious activity or forbid them from participating any religious activity or forbid them from participating any religious activity or forbid them from participating any religious activity or forbid them from participating in one. ■ EXAMPLE 21.6 Jason Sewell claims that his employer, a car dealership, fired him for not attending the weekly prayer meetings of dealership employees. If the dealership does require its employees to attend prayer gatherings and fired Sewell for not attending, he has a valid claim of religious discrimination. ■

Reasonable Accommodation An employer must “reasonably accommodate” the religious practices and sincerely held religious beliefs of its employees, unless to do so would cause undue hardship to the employer’s busi- ness. An employee’s religion might prohibit her or him from working on a certain day of the week, for instance, or at a certain type of job. Reasonable accommodation is required even if the belief is not based on the doctrines of a traditionally recognized religion, such as Christianity or Judaism, or of a denomination, such as Baptist.

Undue Hardship A reasonable attempt to accommo- date does not necessarily require the employer to make every change an employee requests or to make a perma- nent change for an employee’s benefit. An employer is not required to make an accommodation that would cause the employer undue hardship.

■ CASE IN POINT 21.7 Miguel Sánchez-Rodríguez Miguel Sánchez-Rodríguez sold cell phones at kiosks in shopping malls for AT&T in Puerto Rico. After six years, Sánchez informed his super- visors that he had become a Seventh Day Adventist and

could no longer work on Saturdays for religious reasons. AT&T responded that his position required rotating Sat- urday shifts and that his inability to work on Saturdays would cause the company hardship.

As a reasonable accommodation, the company sug- gested that Sánchez swap schedules with others and offered him two alternative positions that would not require work on Saturdays. Sánchez was unable to find workers to swap shifts with him, however, and declined the other jobs because they would result in less income. He began missing work on Saturdays. After a time, AT&T indicated that it would discipline him for any additional Saturdays that he missed. Eventually, he was placed on active disciplinary status. Sánchez resigned and filed a religious discrimination lawsuit. The court found in favor of AT&T, and a federal appellate court affirmed. The company had made adequate efforts at accommoda- tion by allowing Sánchez to swap shifts and offering him other positions that did not require work on Saturdays.7 ■

21–1f Discrimination Based on Gender Under Title VII and other federal acts, employers are forbidden from discriminating against employees on the basis of gender. Employers are prohibited from classify- ing or advertising jobs as male or female unless they can prove that the gender of the applicant is essential to the job. In addition, employers cannot have separate male and female seniority lists and cannot refuse to promote employees based on their gender.

Gender Must Be a Determining Factor Gen- erally, to succeed in a suit for gender discrimination, a plaintiff must demonstrate that gender was a determining factor in the employer’s decision to hire, fire, or promote him or her. Typically, this involves looking at all of the surrounding circumstances.surrounding circumstances.surrounding circumstances.surrounding circumstances.

■ CASE IN POINT 21.8 Wanda Collier worked for Turner Industries Group, LLC, in the maintenance department. She complained to her supervisor that Jack Daniell, the head of the department, treated her unfairly. Her supervisor told her that Daniell had a problem with her gender and was harder on women. The supervisor talked to Daniell about Collier’s complaint but did not take any disciplinary action.

A month later, Daniell confronted Collier, pushing her up against a wall and berating her. After this inci- dent, Collier filed a formal complaint and kept a male co-worker with her at all times. A month later, she was

7. Sánchez-Rodríguez v. AT&Sánchez-Rodríguez v. AT&Sánchez-Rodríguez v. AT T Mobility Puerto Rico, Inc., 673 F.3d 1 (1st Cir. 2012).

C H A P T E R 2 1 Employment Discrimination 457

fired. She subsequently filed a lawsuit alleging gender discrimination. The court allowed Collier’s claim to go to a jury because there was sufficient evidence that gender was a determining factor in Daniell’s conduct.8 ■

8. Collier v. Turner Industries Group, LLC, 797 F.Supp.2d 1029 (D. Idaho Collier v. Turner Industries Group, LLC, 797 F.Supp.2d 1029 (D. Idaho Collier v. Turner Industries Group, LLC 2011).

The Federal Bureau of Investigation (FBI) requires that its applicants meet certain physical fitness stan- dards. For women, the standards include the ability to complete a minimum of fourteen push-ups. Men must be able to complete at least thirty. Whether this differ- ence constitutes discrimination on the basis of gender was at issue in the following case.

Hiring Discrimination Based on Social Media Posts

Human resource officers in most companies routinely check job candidates’ social media posts when deciding whom to hire. Certainly, every young person is warned not to post photos that she or he might later regret hav- ing made available to potential employers. But a more serious issue involves standard review- ing of job candidates’ social media informa- tion. Specifically, do employers discriminate based on such information?

An Experiment in Hiring Discrimination via Online Social Networks

Two researchers at Carnegie-Mellon University con- ducted an experiment to determine whether social media information posted by prospective employees influences employers’ hiring decisions.a The researchers created false résumés and social media profiles. They submitted job applications on behalf of the fictional “candidates” to about four thousand U.S. employers. They then compared employers’ responses to differ- ent groups—for example, to Muslim candidates versus Christian candidates.

The researchers found that candidates whose public profiles indicated that they were Muslim were less likely to be called for interviews than Christian applicants. The difference was particularly pronounced in parts of the country with more conservative residents. In those locations, Muslims received callbacks only 2 percent of the time, compared with 17 percent for Christian appli- cants. According to the authors of the study, “Hiring discrimination via online searches of candidates may not be widespread, but online disclosures of personal traits can significantly influence the hiring decisions of a self-selected set of employers.”

Job Candidates’ Perception of the Hiring Process

In another study, researchers at North Carolina State University looked at how job applicants view prospective employers’ use of their social media profiles during the hiring process.b Job candidates appear to view the hiring process as

unfair when they know that their social media profiles have been used in the selection process. This percep- tion, according to the researchers, makes litigation more likely.

The EEOC Speaks Up

Since 2014, the Equal Employment Opportunity Com- mission (EEOC) has investigated how prospective employers can use social media to engage in discrimi- nation in the hiring process. Given that the Society for Human Resource Management estimates that more than three-fourths of its members use social media in employment screening, the EEOC is interested in regu- lating this procedure.

Social media sites, examined closely, can provide information to a prospective employer on the appli- cant’s race, color, national origin, disability, religion, and other protected characteristics. The EEOC has reminded employers that such information—whether it comes from social media postings or other sources— may not legally be used to make employment decisions on prohibited bases, such as race, gender, and religion.

Critical Thinking Can you think of a way a company could use information from an applicant’s social media posts without running the risk of being accused of hiring discrimination?

DIGITAL UPDATE

a. A. Acquisti and C. N. Fong, “An Experiment in Hiring Discrimina- tion via Online Social Networks,” Social Service Research Network, October 26, 2014.

b. J. W. Stoughton, L. F. Thompson, and A. W. Meade, “Examining Applicant Reactions to the Use of Social Networking Websites in Pre- Employment Screening,” Journal of Business and Psychology, Novem- ber 2013, DOI: 10.1007/s10869-013-9333-6.

458 U N I T F O U R The Business and Employment Environment

In the Language of the Court KING, Circuit Judge.

* * * * The FBI trains its Special Agent

recruits at the FBI Academy in Quan- tico, Virginia. * * * All Trainees must pass a physical fitness test (the “PFT”).

* * * The FBI requires every Special Agent recruit to pass the PFT twice: once to gain admission to the Academy, and a second time to graduate.

* * * * * * * Trainees * * * need to satisfy the

following standards * * * :

Event Men Women

Sit-ups 38 35 300-meter sprint 52.4s 64.9s Push-ups 30 14 1.5-mile run 12m, 42s 13m, 5s

* * * * After the attacks of September 11,

2001, * * * Jay Bauer resolved to con- tribute to the defense of our country by becoming a Special Agent in the FBI. [At the time,] he * * * served as an assistant professor at the University of Wisconsin–Milwaukee.

* * * Bauer took the PFT for the first time and failed. Although he achieved sixteen points on the test, Bauer completed only twenty-five push-ups * * * . The FBI allowed Bauer to retest [three months later] and he passed, that time completing thirty-two push-ups. With his fitness screening complete, the FBI invited Bauer to report to the Academy.

Bauer’s time at the Academy largely showed great potential for a career as a Special Agent. He passed all academic tests, demonstrated proficiency in his firearms and defensive tactics training, and met all expectations for the practi- cal applications and skills components of the Academy. Bauer’s classmates also selected him as the class leader and spokesperson for the Academy graduation. Unfortunately, Bauer faced

a dilemma: he was unable to pass the PFT at Quantico.

During his twenty-two weeks at the Academy, Bauer took the PFT five times. On each occasion, he would have passed but for his failure to achieve the minimum standard for push-ups. Bauer’s results, and his corresponding point scores for each event, were as follows:

Week Sit- ups

300-meter sprint

Push- ups

1.5-mile run

Total Points

Week 1 40 (2) 42.6 sec. (8) 26 (0) 10:49 (4) 14 Week 7 47 (4) 43.4 sec. (7) 25 (0) 10:24 (5) 16 Week 14 50 (6) 43.7 sec. (7) 28 (0) 10:45 (4) 17 Week 18 51 (6) 43.8 sec. (7) 27 (0) 11:09 (4) 17 Week 22 49 (5) 44.1 sec. (6) 29 (0) 10:57 (4) 15

Following his final failure of the PFT, Bauer * * * was [allowed to] resign with the possibility of future employment with the FBI * * * . Bauer * * * imme- diately signed a resignation letter. Two weeks later, the FBI offered Bauer a posi- tion as an Intelligence Analyst in its Chi- cago Field Office. He accepted and has been employed in that position since.

* * * * * * * Bauer filed this Title VII action

in [a federal district court] against [Loretta Lynch,] the Attorney General. According to the claims in Bauer’s complaint, the FBI’s use of the gender- normed PFT standards contravened * * * Title VII * * * which prohibits sex discrimination by federal employers.

* * * * In his summary judgment motion,

Bauer maintained that the FBI’s use of the gender-normed PFT standards was facially discriminatory [involving explicit categorization, such as by sex or race].

* * * * * * * The district court agreed with

Bauer, granting his motion for summary judgment.

* * * * The Attorney General * * * filed a

timely * * * appeal.

* * * * Title VII requires

that any “personnel actions affecting employees or appli- cants for employment” taken by federal employers “shall be made free from any discrimination based on * * * sex.” * * * A plaintiff is entitled to demonstrate dis- crimination by showing that the employer uses a facially discriminatory employ-

ment practice. [The Supreme Court has outlined] a “simple test” for identifying facial sex discrimination: such discrimi- nation appears “where the evi- dence shows treatment of

a person in a manner which but for that person’s sex would be differ- ent.” [Emphasis added.]

* * * The district court applied [this] test and concluded that, because Bauer would have been held to a lower minimum number of push-ups had he been a woman, the gender-normed PFT standards constitute facial sex discrimina- tion. The Attorney General maintains on appeal, however, that because the PFT assesses an overall level of physical fitness, and equally fit men and women possess innate physiological differences that lead to different performance outcomes, the PFT’s gender-normed standards actually require the same level of fitness for all Trainees. In that way, the Attorney Gen- eral contends, the PFT standards do not treat the sexes differently and therefore do not contravene Title VII.

* * * * * * * The Attorney General * * * main-

tains that * * * some differential treatment of men and women based upon inherent physiological differences is not only law- ful but also potentially required.

* * * * Men and women simply are not

physiologically the same for the purposes of physical fitness programs. * * * Physi- cal fitness standards suitable for men may not always be suitable for women,

Case Analysis 21.1 Bauer v. LynchLynchL United States Court of Appeals, Fourth Circuit, 812 F.3d 340 (2016).

C H A P T E R 2 1 Employment Discrimination 459

and accommodations addressing physi- ological differences between the sexes are not necessarily unlawful.

* * * The physiological differences between men and women impact their relative abilities to demonstrate the same levels of physical fitness. In other words, equally fit men and women demonstrate their fitness differently. Whether physical fitness standards discriminate based on sex, therefore, depends on whether they

require men and women to demonstrate different levels of fitness.

Put succinctly, an employer does not contravene Title VII when it utilizes physical fitness standards that distinguish between the sexes on the basis of their physiological differences but impose an equal burden of compliance on both men and women, requiring the same level of physical fitness of each. Because the FBI purports to assess physical fitness by

imposing the same burden on both men and women, this rule applies to Bauer’s Title VII claims. Accordingly, the district court erred in failing to apply the rule in its disposition of Bauer’s motion for summary judgment. [Emphasis added.]

* * * * Pursuant to the foregoing, we vacate

the judgment of the district court and remand for * * * further proceedings.

Legal Reasoning Questions

1. According to the reasoning of the court in the Bauer case, when do different employment standards for men and women satisfy Bauer case, when do different employment standards for men and women satisfy Bauer Title VII’s requirement of equality?

2. In what other circumstances might the rule in this case apply? 3. If Bauer had ultimately succeeded in his claim, what might the remedy have been? What else might have resulted?

Case 21.1 Continued

Pregnancy Discrimination The Pregnancy Dis- crimination Act9 expanded Title VII’s definition of gen- der discrimination to include discrimination based on pregnancy. Women affected by pregnancy, childbirth, or related medical conditions must be treated the same as other persons not so affected but similar in ability to

9. 42 U.S.C. Section 2000e(k).

work. For instance, an employer cannot discriminate against a pregnant woman by withholding benefits avail- able to others under employee benefit programs.

In the following case, an employer accommodated many of its employees who had lifting restrictions due to disabilities. The employer refused to accommodate a preg- nant employee with a similar restriction. Did this refusal constitute a violation of the Pregnancy Discrimination Act?

Background and Facts Peggy Young was a driver for United Parcel Service, Inc. (UPS). When she became pregnant, her doctor advised her not to lift more than twenty pounds. UPS required drivers to lift up to seventy pounds and told Young that she could not work under a lifting restriction. She filed a suit in a federal district court against UPS, claiming an unlawful refusal to accommodate her pregnancy-related lifting restriction. She alleged that UPS had multiple light-duty-for-injury categories to accommodate individuals whose non-pregnancy-related disabilities created work restrictions similar to hers.

UPS responded that, because Young did not fall into any of those categories, it had not discrimi- nated against her. The court issued a summary judgment in UPS’s favor. The U.S. Court of Appeals of the Fourth Circuit affirmed the judgment. Young appealed to the United States Supreme Court.

In the Language of the Court Justice BREYER delivered the opinion of the Court.

* * * * * * * A plaintiff alleging that the denial of an accommodation constituted disparate treatment under

the Pregnancy Discrimination Act * * * may make out a prima facie case by showingprima facie case by showingprima facie that she belongs to

Young v. United Parcel Service, Inc. Supreme Court of the United States, __ U.S. __, 135 S.Ct. 1338, 191 L.Ed.2d 279 (2015).

Case 21.2

460 U N I T F O U R The Business and Employment Environment

Wage Discrimination The Equal Pay Act10 requires equal pay for male and female employees working at the same establishment doing similar work. To determine whether the Equal Pay Act has been violated, a court looks to the primary duties of the two jobs—the job con- tent rather than the job description controls. If a court finds that the wage differential is due to “any factor other than gender,” such as a seniority or merit system, then it does not violate the Equal Pay Act.

The 2009 Lilly Ledbetter Fair Pay Act made discrimi- natory wages actionable under federal law regardless of

10. 29 U.S.C. Section 206(d).

when the discrimination began.11 Previously, plaintiffs had to file a complaint within a limited time period. Today, if a plaintiff continues to work for the employer while receiving discriminatory wages, the time period for filing a complaint is practically unlimited.

Discrimination against Transgender Persons In the past, most courts held that federal law (Title VII) does not protect transgender persons from discrimination. The situation may be changing, however. A growing num- ber of federal courts are interpreting Title VII’s protections against gender discrimination to apply to transsexuals.

11. Pub. L. No. 111-2, 123 Stat. 5 (January 5, 2009), amending 42 U.S.C. Section 2000e-5[e].

the protected class, that she sought accommodation, that the employer did not accommodate her, and that the employer did accommodate others similar in their ability or inability to work.

The employer may then seek to justify its refusal to accommodate the plaintiff by relying on legitimate, non- discriminatory reasons for denying her accommodation. [Emphasis added.]

If the employer offers an apparently legitimate, nondiscriminatory reason for its actions, the plaintiff may in turn show that the employer’s proffered reasons are in fact pretextual [contrived]. We believe that the plaintiff may reach a jury on this issue by providing sufficient evidence that the employer’s policies impose a significant burden on pregnant workers, and that the employer’s legitimate, nondiscriminatory reasons are not sufficiently strong to justify the burden, but rather—when considered along with the burden imposed—give rise to an inference of intentional discrimination.

The plaintiff can create a genuine issue of material fact as to whether a significant burden exists by providing evidence that the employer accommodates a large percentage of nonpregnant workers while failing to accommodate a large percentage of pregnant workers. Here, for example, if the facts are as Young says they are, she can show that UPS accommodates most nonpregnant employees with lifting limitations while categorically failing to accommodate pregnant employees with lifting limita- tions. Young might also add that the fact that UPS has multiple policies that accommodate nonpreg- nant employees with lifting restrictions suggests that its reasons for failing to accommodate pregnant employees with lifting restrictions are not sufficiently strong—to the point that a jury could find that its reasons for failing to accommodate pregnant employees give rise to an inference of intentional discrimination.

* * * * * * * A party is entitled to summary judgment if there is no genuine dispute as to any material fact

and the movant [that is, a person who applies to a court for a ruling in his or her favor] is entitled to judgment as a matter of law. * * * Viewing the record in the light most favorable to Young, there is a genuine dispute as to whether UPS provided more favorable treatment to at least some employees whose situation can- not reasonably be distinguished from Young’s. [Emphasis added.]

Decision and Remedy The United States Supreme Court vacated the judgment of the U.S. Court of Appeals for the Fourth Circuit and remanded the case for further proceedings. Young created a genuine dispute as to whether UPS had provided more favorable treatment to employees whose situation could not reasonably be distinguished from hers. On remand, the court must determine whether Young also created a genuine issue of material fact as to whether UPS’s reasons for treating Young less favorably were a pretext.

Critical Thinking • Legal Environment Could UPS have succeeded in this case if it had claimed simply that it would

be more expensive or less convenient to include pregnant women among those whom it accommodates? Explain.

Case 21.2 Continued

C H A P T E R 2 1 Employment Discrimination 461

■ CASE IN POINT 21.9 Dr. Deborah Fabian applied for a position as an on-call orthopedic surgeon at the Hospital of Central Connecticut. The hospital apparently declined to hire Fabian because she disclosed her identity as a transgender woman. Fabian sued the hospital alleging violations of Title VII of the Civil Rights Act and the Con- necticut Fair Employment Practices Act (CFEPA).

The hospital filed a summary judgment motion, argu- ing that neither Title VII nor the Connecticut statute pro- hibits discrimination on the basis of transgender identity. The federal district court rejected this argument, however, finding that discrimination on the basis of transgender identity is discrimination on the basis of sex for Title VII purposes. Fabian was entitled to take her case to a jury and argue violations of Title VII and the CFEPA.12 ■ Transgender Bathrooms In 2016, the Obama administration issued guidance directing public schools to allow transgender students to use bathrooms matching their gender identity. The goal was to ensure a support- ive and nondiscriminatory environment, but it sparked a public debate across the nation. The federal government’s guidance did not have the force of law, though.

Although the federal government and its agencies have decided to treat gender identity as the person’s sex for legal purposes, some states and schools (and employ- ers) are reluctant to do so. North Carolina, for instance, has passed a law that bans individuals from using pub- lic bathrooms that do not correspond to their biological sex. Some argue that the access of transgender persons to bathrooms should be left up to individual states to address. Nevertheless, the EEOC has ruled that a trans- gender individual who self-identified as a woman had a right to use to use the women’s bathroom at a military base in Huntsville, Alabama.13

Gender-Neutral Pronouns Another area of poten- tial dispute in today’s employment environment involves the pronouns that employers (or schools) use to refer to transgender individuals. People have tradi- tionally said he/him/his when talking about a male, or she/her/hers when discussing a female. Some transgender she/her/hers when discussing a female. Some transgender she/her/hers people, however, prefer to be referred to using corre- sponding gender-neutral pronouns, such as ze/hir/hirs.

In fact, certain cities, including New York City, now require employers, landlords, and all businesses and profesrequire employers, landlords, and all businesses and profesrequire - sionals to use a transgender individual’s preferred name, pronoun, and title. This allows transgender individuals to self-identify their name and gender. If an employer in New York City refuses to use the pronoun that a transgen- der individual (employee, client, colleague, customer, or

12. Fabian v. Hospital of Central Connecticut, ___ F.Supp.3d ___, 2016 WL 1089178 (D.Conn. 2016).

13. EEOC Appeal No. 012033395, Order (E0610), April 1, 2015.

tenant) has expressly requested, the employer can be fined. Penalties range from $125,000 to $250,000 for violations that are deemed to be the result of malicious intent.

21–1g Constructive Discharge The majority of Title VII complaints involve unlawful discrimination in decisions to hire or fire employees. In some situations, however, employees who leave their jobs voluntarily can claim that they were “constructively discharged” by the employer. Constructive discharge occurs when the employer causes the employee’s working conditions to be so intolerable that a reasonable person in the employee’s position would feel compelled to quit.

When constructive discharge is claimed, the employee can pursue damages for loss of income, including back pay. These damages ordinarily are not available to an employee who left a job voluntarily. Proving Constructive Discharge To prove con- structive discharge, an employee must present objective proof of intolerable working conditions. The employee must also show that the employer knew or had reason to know about these conditions yet failed to correct them within a reasonable time period. In addition, courts gen- erally require the employee to show causation—that the employer’s unlawful discrimination caused the working conditions to be intolerable. Put in a different way, the employee’s resignation must be a foreseeable result of the employer’s discriminatory action. Courts weigh the facts on a case-by-case basis.

Employee demotion is one of the most frequently cited reasons for a finding of constructive discharge, particularly when the employee was subjected to humiliparticularly when the employee was subjected to humiliparticularly when the employee was subjected to humiliparticularly when the employee was subjected to humili- ation. ■ EXAMPLE 21.10 Khalil’s employer humiliates him by informing him in front of his co-workers that he is being demoted to an inferior position. Khalil’s co- workers then continually insult him, harass him, and make derogatory remarks to him about his national origin (he is from Iran). The employer is aware of this discriminatory treatment but does nothing to remedy the situation, despite Khalil’s repeated complaints. After several months, Khalil quits his job and files a Title VII claim. In this situation, Khalil will likely have sufficient evidence to maintain an action for constructive discharge in violation of Title VII. ■ Applies to All Title VII Discrimination Plaintiffs can use constructive discharge to establish any type of dis- crimination claim under Title VII, including race, color, national origin, religion, gender, and pregnancy. It is most commonly asserted in cases involving sexual harassment. Constructive discharge may also be used in cases involving discrimination based on age or disability (discussed later in this chapter).Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

462 U N I T F O U R The Business and Employment Environment

Background and Facts Teresa Roberts worked for Mike’s Trucking, Ltd., in Columbus, Ohio. Her supervisor was the company’s owner, Mike Culbertson. According to Roberts, Culbertson called her his “sexretary” and constantly talked about his sex life. He often invited her to sit on “Big Daddy’s” lap, rubbed against her, trapped her at the door and asked her for hugs or kisses, and inquired if she needed help in the restroom. Roberts asked him to stop this conduct, but he did not. She became less productive and began to suffer anxiety attacks and high blood pressure. Roberts filed a suit in an Ohio state court against Mike’s, alleging a hostile work environment through sexual harassment in violation of Title VII. A jury decided in Roberts’s favor, and Mike’s appealed.

In the Language of the Court HENDRICKSON, P.J. [Presiding Judge]

* * * * * * * Conduct that is not severe or pervasive enough to create an objectively hostile or abusive work

environment—an environment that a reasonable person would find hostile or abusive—is beyond Title VII’s purview. Likewise, if the victim does not subjectively perceive the environment to be abu- sive, the conduct has not actually altered the conditions of the victim’s employment, and there is no Title VII violation. Therefore, the focus of this inquiry is: 1.) whether a reasonable person would find the environment objectively hostile; and 2.) whether the plaintiff subjectively found the conduct severe or perva- sive. [Emphasis added.]

* * * * * * * Roberts’ testimony was consistent with several witnesses affirming that Culbertson frequently

engaged in a variety of conduct ranging from inappropriate discussions to groping women. The wit- nesses stated that Culbertson often discussed his sex life, asked Roberts and the women employees if they needed help in the bathroom * * * , referred to himself as “Big Daddy,” asked Roberts and the women employees to sit in “Big Daddy’s” lap, and asked them if they would give “Big Daddy” a hug.

The evidence established that the conduct occurred frequently. Roberts testified that throughout her employment, Culbertson’s behavior became increasingly worse and that * * * he talked about sex hun- dreds of times, and attempted to corner her and hug and kiss her at least twice a week. [Former Mike’s employees] testified that Culbertson talked about sex and asked the women if they needed help with the bathroom multiple times a week. The evidence also showed that the conduct became increasingly severe as Culbertson massaged Roberts [and] rubbed up against her * * * . Roberts testified that Culbertson’s conduct was humiliating towards her as his remarks were in front of others and she often became “furious” with him. Other employees reported Roberts becoming angry towards Culbertson. Roberts also estab- lished that Culbertson’s conduct unreasonably interfered with her work performance as she stated she did

Roberts v. Mike’s Trucking, Ltd. Court of Appeals of Ohio, Twelfth District, 2014 -Ohio- 766, 9 N.E.3d 483 (2014).

Case 21.3

21–1h Sexual Harassment Title VII also protects employees against sexual harassment in the workplace. Sexual harassment can take two forms: 1. Quid pro quo harassment occurs when sexual favors

are demanded in return for job opportunities, pro- motions, salary increases, or other benefits. Quid pro quo is a Latin phrase that is often translated as “some- thing in exchange for something else.”

2. Hostile-environment harassment occurs when a pat- tern of sexually offensive conduct runs throughout the workplace and the employer has not taken steps

to prevent or discourage it. Such harassment exists when the workplace is permeated with discrimina- tory intimidation, ridicule, and insult, and this harassment is so severe or pervasive that it alters the conditions of employment.

A court considers a number of factors when determin- ing whether the sexually offensive conduct was sufficiently severe or pervasive to create a hostile environment. As the following case shows, these factors include the nature and frequency of the conduct and whether it unreasonably interfered with the victim’s work performance.

C H A P T E R 2 1 Employment Discrimination 463

Harassment by Supervisors For an employer to be held liable for a supervisor’s sexual harassment, the supervisor normally must have taken a tangible employ- ment action against the employee. A tangible employ-tangible employ-tangible employ ment action is a significant change in employment status or benefits. Such an action occurs when an employee is fired, refused a promotion, demoted, or reassigned to a position with significantly different responsibilities, for instance. Only a supervisor, or another person acting with the authority of the employer, can cause this sort of harm. A constructive discharge also qualifies as a tangible employment action.

The United States Supreme Court issued several important rulings in cases alleging sexual harassment by supervisors that established what is known as the “Ellerth/Faragher affirmative defense.”Ellerth/Faragher affirmative defense.”Ellerth/Faragher 14 The defense has two elements: 1. The employer must have taken reasonable care to

prevent and promptly correct any sexually harassing behavior (by establishing effective harassment poli- cies and complaint procedures, for instance).

2. The plaintiff-employee must have unreasonably failed to take advantage of preventive or corrective opportu- nities provided by the employer to avoid harm.

An employer that can prove both elements normally will not be liable for a supervisor’s harassment.

14. Burlington Industries, Inc. v. Ellerth, 524 U.S. 742, 118 S.Ct. 2257, 141 L.Ed.2d 633 (1998); and Faragher v. City of Boca Raton, 524 U.S. 775, 118 S.Ct. 2275, 141 L.Ed.2d 662 (1998).

Retaliation by Employers Employers sometimes retaliate against employees who complain about sexual harassment or other Title VII violations. Retaliation can take many forms. An employer might demote or fire the person, or otherwise change the terms, conditions, and benefits of employment.

Title VII prohibits retaliation, and employees can sue their employers when it occurs. In a retaliation claim, an individual asserts that she or he has suffered harm as a result of making a charge, testifying, or participating in a Title VII investigation or proceeding.

Requirements for Protection. To be protected under Title VII’s retaliation provisions, the plainti� must have opposed a practice prohibited by Title VII and su�ered an adverse employment action as a result of that oppo- sition. ■ CASE IN POINT 21.11 Myrta Morales-Cruz Myrta Morales-Cruz had a tenure-track teaching position at the University of Puerto Rico School of Law. When her probationary period was almost over, Morales-Cruz asked the uni- versity’s administrative committee to grant a one-year extension for her tenure review. �e dean recommended that the extension be granted but also called her “inse- cure,” “immature,” and “fragile.” Another professor commented that had she shown “poor judgment” and exhibited “personality �aws.”

After Morales-Cruz complained about these com- ments in writing to the chancellor, the dean recommended denying the one-year extension, and the administrative committee did just that. Morales-Cruz later filed a retali- ation lawsuit. She claimed that the dean had retaliated

Case 21.3 Continuednot want to go to work anymore, she became less productive, and she suffered anxiety attacks. Her fiancé testified that Roberts has lost confidence and that she is now prescribed anti-anxiety medication.

Consequently, there was sufficient and substantial evidence to support the jury’s finding that a rea- sonable person would find Culbertson’s conduct created a hostile environment and Roberts found the conduct to be sufficiently severe or pervasive to affect her employment.

Decision and Remedy A state intermediate appellate court affirmed the lower court’s judgment in Rob- erts’s favor. During the trial, other Mike’s employees and Roberts’s fiancé testified to corroborate Roberts’s account. The evidence sufficiently established that Culbertson’s conduct was severe or pervasive enough to create a hostile work environment for Roberts.

Critical Thinking • Ethical Was Culbertson’s conduct at any point unethical? Discuss. • Legal Environment Culbertson and some other witnesses testified that he did not engage in any sexu-

ally inappropriate behavior. Should an appellate court reverse a jury’s decision simply due to contrary evi- dence? Why or why not?

464 U N I T F O U R The Business and Employment Environment

against her for complaining to the chancellor about the “discriminatory” comments made in the course of her request for an extension.

The court held that Morales-Cruz had not provided a reasonable foundation for a retaliation action. Under Title VII, an employer may not retaliate against an employee because he or she has opposed a practice pro- hibited by Title VII. But the court found that Morales- Cruz did not allege any facts that could be construed as gender-based discrimination. Although the comments she complained about were hardly flattering, they were entirely gender-neutral. Thus, she was not engaging in protected conduct when she opposed the remarks.15 ■

Protection May Extend to Others. �e Supreme Court has ruled that Title VII’s retaliation protection extended to an employee who spoke out about discrimination against another employee during an employer’s internal investigation.16 �e Court has also held that Title VII pro- tected an employee who was �red after his �ancée �led a gender discrimination claim against their employer.17

Harassment by Co-Workers and Others When the harassment of co-workers, rather than supervisors, creates a hostile working environment, an employee may still have a cause of action against the employer. Normally, though, the employer will be held liable only if it knew or should have known about the harassment and failed to take immediate remedial action.

Occasionally, a court may also hold an employer liable for harassment by nonemployees if the employer nonemployees if the employer nonemployees knew about the harassment and failed to take correc- tive action. ■ EXAMPLE 21.12 Jordan, who owns and manages a Great Bites restaurant, knows that one of his regular customers, Dean, repeatedly harasses Kaylia, a waitress. If Jordan does nothing and permits the harass- ment to continue, he may be liable under Title VII even though Dean is not an employee of the restaurant. ■

Same-Gender Harassment In Oncale v. Sundowner Offshore Services, Inc.,18 the United States Supreme Court held that Title VII protection extends to individuals who are sexually harassed by members of the same gen- der. Proving that the harassment in same-gender cases is “based on sex” can be difficult, though. It is easier to

15. Morales-Cruz v. University of Puerto Rico, 676 F.3d 220 (1st Cir. 2012). 16. Crawford v. Metropolitan Government of Nashville and Davidson County,

Tennessee, 555 U.S. 271, 129 S.Ct. 846, 172 L.Ed.2d 650 (2009). 17. See Thompson v. North American Stainless, LP, 562 U.S. 170, 131 S.Ct.

863, 178 L.Ed.2d 694 (2011). 18. 523 U.S. 75, 118 S.Ct. 998, 140 L.Ed.2d 207 (1998).

establish a case of same-gender harassment when the harasser is homosexual.

Sexual-Orientation Harassment Federal law (Title VII) does not prohibit discrimination or harassment based on a person’s sexual orientation. Nonetheless, a growing number of states have enacted laws that prohibit sexual- orientation discrimination in private employment.19 Some states, such as Oregon, explicitly prohibit discrimination based on a person’s gender identity or expression. Many companies have also voluntarily established nondiscrimi- nation policies that include sexual orientation.

21–1i Online Harassment Employees’ online activities can create a hostile working environment in many ways. Racial jokes, ethnic slurs, or other comments contained in e-mail, texts, blogs, or social media can lead to claims of hostile-environment harass- ment or other forms of discrimination. A worker who regularly sees sexually explicit images on a co-worker’s computer screen may find the images offensive and claim that they create a hostile working environment. Nev- ertheless, employers may be able to avoid liability for online harassment by taking prompt remedial action.

21–1j Remedies under Title VII Employer liability under Title VII can be extensive. If the plaintiff successfully proves that unlawful discrimination occurred, he or she may be awarded reinstatement, back pay, retroactive promotions, and damages.

Several limits apply to damages. Compensatory dam- ages are available only in cases of intentional discrimi- nation. Punitive damages may be recovered against a private employer only if the employer acted with malice or reckless indifference to an individual’s rights. The total amount of compensatory and punitive damages that plaintiffs can recover from specific employers depends on the size of the employer. For instance, there is a $50,000 cap on damages from employers with one hundred or fewer employees.

21–2 Discrimination Based on Age Age discrimination is potentially the most widespread form of discrimination because anyone—regardless of race, color, national origin, or gender—could be a victim

C H A P T E R 2 1 Employment Discrimination 465

at some point in life. The Age Discrimination in Employ- ment Act20 (ADEA), as amended, prohibits employment discrimination on the basis of age against individuals forty years of age or older. The act also prohibits manda- tory retirement for nonmanagerial workers. In addition, the ADEA protects federal and private-sector employees from retaliation based on age-related complaints.21

For the act to apply, an employer must have twenty or more employees, and the employer’s business activities must affect interstate commerce. The EEOC adminis- ters the ADEA, but the act also permits private causes of action against employers for age discrimination.

21–2a Procedures under the ADEA The burden-shifting procedure under the ADEA dif-The burden-shifting procedure under the ADEA dif-The burden-shifting procedure under the ADEA dif fers from the procedure under Title VII. This difference resulted from a United States Supreme Court decision that dramatically changed the burden of proof in age dis- crimination cases.22

As explained earlier, if the plaintiff in a Title VII case can show that the employer was motivated, at least in part, by unlawful discrimination, the burden of proof shifts to the employer. Thus, in cases in which the employer has a “mixed motive” for discharging an employee, the employer has the burden of proving that its reason was legitimate.

Under the ADEA, in contrast, a plaintiff must show that the unlawful discrimination was not just a reason a reason a but the reason for the adverse employment action. In the reason for the adverse employment action. In the other words, the employee has the burden of establishing but for causation—that is, “but for” the employee’s age, for causation—that is, “but for” the employee’s age, for the action would not have been taken.

Prima Facie Age Discrimination To establish a prima facie case of age discrimination, the plaintiff must prima facie case of age discrimination, the plaintiff must prima facie show that she or he was the following: 1. A member of the protected age group. 2. Qualified for the position from which she or he was

discharged. 3. Discharged because of age discrimination. Then the burden shifts to the employer to give a legiti- mate nondiscriminatory reason for the adverse action.

Pretext If the employer offers a legitimate reason for its action, then the plaintiff must show that the stated reason

20. 29 U.S.C. Sections 621–634. 21. Gomez-Perez v. Potter, 553 U.S. 474, 128 S.Ct. 1931, 170 L.Ed.2d 887

(2008). 22. Gross v. FBL Financial Services, Inc., 557 U.S. 167, 129 S.Ct. 2343, 174

L.Ed.2d 119 (2009).

is only a pretext. The plaintiff is required to prove that the plaintiff ’s age was the real reason for the employer’s decision.

■ CASE IN POINT 21.13 Josephine Mora, a fund-raiser Josephine Mora, a fund-raiser for Jackson Memorial Foundation, Inc., was sixty-two years old when the foundation’s chief executive officer (CEO) fired her. Mora filed an age discrimination suit against the foundation. She asserted that when she was fired, the CEO told her, “I need someone younger I can pay less.” A witness heard that statement and also heard the CEO say that Mora was “too old to be working here anyway.” The CEO denied making these statements, and the foundation claimed that Mora had been terminated for poor job performance.

A district court granted a summary judgment in the foundation’s favor, and Mora appealed. A federal appel- late court reversed, concluding that the lower court’s analysis of causation was incorrect. The court held that a reasonable juror could have accepted that the CEO had made discriminatory remarks and could have found that these remarks were sufficient evidence of a discrimina- tory motive. If so, that could show that Mora was fired because of her age. The court therefore remanded the case to the lower court for a trial.23 ■

21–2b Replacing Older Workers with Younger Workers

Numerous age discrimination cases have been brought against employers who, to cut costs, replaced older, higher-salaried employees with younger, lower-salaried workers. In such situations, whether a firing is discrimi- natory or simply part of a rational business decision to prune the company’s ranks is not always clear.

The plaintiff must prove that the discharge was moti- vated by age bias. The plaintiff need not prove that she or he was replaced by a person “outside the protected class” (under the age of forty). The replacement worker need only be younger than the plaintiff. Nevertheless, the greater the age gap, the more likely the plaintiff will suc- ceed in showing age discrimination.

21–2c State Employees Not Covered by the ADEA

Generally, the states are immune from lawsuits brought by private individuals in federal court (unless a state consents to such a suit). This immunity stems from the

23. Mora v. Jackson Memorial Foundation, Inc., 597 F.3d 1201 (11th Cir. 2010).

466 U N I T F O U R The Business and Employment Environment

United States Supreme Court’s interpretation of the Eleventh Amendment.

State immunity under the Eleventh Amendment is not absolute. In some situations, such as when fundamental rights are at stake, Congress has the power to abrogate (abolish) state immunity to private suits through legis- lation. Such legislation must unequivocally show Con- gress’s intent to subject states to private suits.24

Generally, though, the Court has found that state employers are immune from private suits brought by employees under the ADEA. State employers are also immune from suits brought under the Americans with Disabilities Act25 and the Fair Labor Standards Act.26 They are not immune from the requirements of the Famnot immune from the requirements of the Famnot - ily and Medical Leave Act.27

21–3 Discrimination Based on Disability

The Americans with Disabilities Act (ADA)28 prohibits disability-based discrimination in all workplaces with fif-disability-based discrimination in all workplaces with fif-disability-based discrimination in all workplaces with fif teen or more workers. An exception is state government employers, who are generally immune under the Elev- enth Amendment, as just mentioned. Basically, the ADA requires that employers “reasonably accommodate” the needs of persons with disabilities unless to do so would cause the employer to suffer an “undue hardship.” The ADA Amendments Act29 broadened the coverage of the ADA’s protections, as discussed shortly.

21–3a Procedures under the ADA To prevail on a claim under the ADA, a plaintiff must show that he or she (1) has a disability, (2) is otherwise qualified for the employment in question, and (3) was excluded from the employment solely because of the dis- ability. As in Title VII cases, the plaintiff must pursue the claim through the EEOC before filing an action in court for a violation of the ADA.

The EEOC may decide to investigate and perhaps sue the employer on behalf of the employee. The EEOC can bring a suit even if the employee previously signed an agreement with the employer to submit job-related

24. Tennessee v. Lane, 541 U.S. 509, 124 S.Ct. 1978, 158 L.Ed.2d 820 (2004).

25. Board of Trustees of the University of Alabama v. Garrett, 531 U.S. 356, Board of Trustees of the University of Alabama v. Garrett, 531 U.S. 356, Board of Trustees of the University of Alabama v. Garrett 121 S.Ct. 955, 148 L.Ed.2d 866 (2001).

26. Alden v. Maine, 527 U.S. 706, 119 S.Ct. 2240, 144 L.Ed.2d 636 (1999).

27. Nevada Department of Human Resources v. Hibbs, 538 U.S. 721, 123 S.Ct. 1972, 155 L.Ed.2d 953 (2003).

28. 42 U.S.C. Sections 12103–12118. 29. 42 U.S.C. Sections 12103 and 12205a.

disputes to arbitration.30 If the EEOC decides not to sue, then the employee may do so.

Plaintiffs in lawsuits brought under the ADA may seek many of the same remedies that are available under Title VII. These include reinstatement, back pay, a lim- ited amount of compensatory and punitive damages (for intentional discrimination), and certain other forms of relief. Repeat violators may be ordered to pay fines of up to $100,000.

21–3b What Is a Disability? The ADA is broadly drafted to cover persons with physi- cal or mental impairments that “substantially limit” their everyday activities. Specifically, the ADA defines a dis- ability as including any of the following:ability as including any of the following:ability 1. A physical or mental impairment that substantially

limits one or more of the major life activities of the affected individual.

2. A record of having such an impairment. 3. Being regarded as having such an impairment.

Health conditions that have been considered dis- abilities under federal law include alcoholism, acquired immune deficiency syndrome (AIDS), blindness, can- cer, cerebral palsy, diabetes, heart disease, muscular dys- trophy, and paraplegia. Testing positive for the human immunodeficiency virus (HIV) has qualified as a dis- ability, as has morbid obesity. (A morbidly obese person weighs twice the normal weight for his or her height.)

Note, however, that obesity does not qualify as a dis- ability unless the individual’s weight is outside of the normal range and occurs as the result of a physiologi- cal disorder. In other words, people who are obese (even morbidly obese), but not because of some underlying physical ailment, are not considered disabled.

■ CASE IN POINT 21.14 Melvin Morriss applied for a machinist position at BNSF Railway Company. Because the position was safety sensitive, he was given an offer of employment conditioned upon a medical review. BNSF doctors conducted two physical examinations. In the first, Morriss weighed 285 pounds with a body mass index, or BMI, of 40.9. (BMI is a typical method of evaluating a person’s weight.) In the second exam, Mor- riss’s BMI dropped slightly to 40.4. Because BNSF had a policy of not employing workers with BMIs over 40 in safety-sensitive positions such as machinists, it rescinded its offer of employment. Morriss sued, alleging discrimi- nation on the basis of disability, but the court found that Morriss’s obesity was not a physical impairment under

30. This was the Supreme Court’s ruling in EEOC v. Waffle House, Inc., 534 U.S. 279, 122 S.Ct. 754, 151 L.Ed.2d 755 (2002).Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 2 1 Employment Discrimination 467

the ADA. Morriss was otherwise in good health and did not suffer from any disease that would result in his being obese. A federal appellate court affirmed.31 ■

Association with Disabled Persons A separate provision in the ADA prevents employers from taking adverse employment actions based on stereotypes or assumptions about individuals who associate with people who have disabilities.32 An employer cannot, for instance, refuse to hire the parent of a child with a disability based on the assumption that the person will miss work too often or be unreliable.

■ EXAMPLE 21.15 Joan, an employer, refuses to hire Edward, who has a daughter with a physical disability. She consciously bases her decision on the assumption that Edward will have to miss work frequently to care for his daughter. Edward can sue Joan for violating the ADA’s provisions. ■

Mitigating Measures At one time, the courts focused on whether a person had a disability after the use of mitiafter the use of mitiafter - gating measures, such as corrective devices or medica- tion. Thus, a person with severe myopia (nearsightedness) whose eyesight could be corrected by wearing glasses did not qualify as having a disability. With the corrective lenses, the person’s major life activities were not substan- tially impaired. Then Congress amended the ADA to strengthen its protections and prohibit employers from considering mitigating measures when determining if an individual has a disability.

Disability is now determined on a case-by-case basis. A condition may fit the definition of disability in one set of circumstances, but not in another. ■ CASE IN POINT 21.16 Larry Rohr, a welding specialist for a power district in Arizona, was diagnosed with type 2 diabetes. To keep his condition under control, Rohr was required to follow a complex regimen of daily insulin injections and blood tests, as well as a strict diet. Therefore, his physician forbade him from taking work assignments that involved overnight, out-of-town travel, which were common in his job.

Because of these limitations, the power district asked him to transfer, apply for federal disability benefits, or take early retirement. Rohr sued for disability discrimina- tion. The lower court granted summary judgment for the employer. Rohr appealed. A federal appellate court reversed. The court held that under the amended ADA, diabetes is a disability if it significantly restricts an individual’s eating (a major life activity), as it did for Rohr. Therefore, Rohr was entitled to a trial on his discrimination claim.33 ■

31. Morriss v. BNSF Railway Co., 817 F.3d 1104 (8th Cir. 2016). 32. 42 U.S.C. Section 12112(b)(4). 33. Rohr v. Salt River Project Agricultural Improvement and Power District,

555 F.3d 850 (9th Cir. 2009).

Disclosure of Confidential Medical Information ADA provisions also require employers to keep their employees’ medical information confidential.34 An employee who discovers that an employer has disclosed his or her confidential medical information has a right to sue the employer—even if the employee was not technically disabled. The prohibition against disclosure also applies to other employees acting on behalf of the employer.to other employees acting on behalf of the employer.to other employees acting on behalf of the employer.to other employees acting on behalf of the employer.

■ CASE IN POINT 21.17 George Shoun was working at his job at Best Formed Plastics, Inc., when he fell and injured his shoulder. Another Best Formed employee, Jane Stewart, prepared an accident report for the incident and processed Shoun’s workers’ compensation claim. As a result of the injury, Shoun had to take several months off work and received workers’ compensation.

Stewart posted on her Facebook page a statement about how Shoun’s shoulder injury “kept him away from work for 11 months and now he is trying to sue us.” Shoun sued Best Formed under the ADA for wrongfully disclosing confidential information about his medical condition to other people via Facebook. He claimed that the action resulted in loss of employment and impair- ment of his earning capacity. The court allowed Shoun’s claim to go forward to trial.35 ■

21–3c Reasonable Accommodation The ADA does not require that employers accommodate the needs of job applicants or employees with disabilities who are not otherwise qualified for the work. If a job applicant or an employee with a disability, with reason- able accommodation, can perform essential job functions, however, the employer must make the accommodation.

Required modifications may include installing ramps for a wheelchair, establishing flexible working hours, creating or modifying job assignments, and designing or improving training materials and procedures. Gen- erally, employers should give primary consideration to employees’ preferences in deciding what accommoda- tions should be made.

Undue Hardship Employers who do not accommo- date the needs of persons with disabilities must dem- onstrate that the accommodations would cause undue hardship in terms of being significantly difficult or expen- sive for the employer. Usually, the courts decide whether an accommodation constitutes an undue hardship on a case-by-case basis.

■ EXAMPLE 21.18 Bryan Lockhart, who uses a wheel- chair, works for a cell phone company that provides

34. 42 U.S.C. Sections 12112(d)(3)(B), (C), and 12112(d)(4)(C). 35. Shoun v. Best Formed Plastics, Inc., 28 F.Supp.3d 786 (N.D.Ind. 2014).Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

468 U N I T F O U R The Business and Employment Environment

parking for its employees. Lockhart informs his supervi- sor that the parking spaces are so narrow that he is unable to extend the ramp on his van that allows him to get in and out of the vehicle. Lockhart therefore requests that the company reasonably accommodate his needs by pay- ing a monthly fee for him to use a larger parking space in an adjacent lot. In this situation, a court will likely find that it is not an undue hardship for the employer to pay not an undue hardship for the employer to pay not for additional parking for Lockhart. ■

Job Applications and Physical Exams Employ- ers must modify their job-application and selection pro- cess so that those with disabilities can compete for jobs with those who do not have disabilities. For instance, a job announcement might be modified to allow applicants to respond by e-mail as well as by telephone, so that it does not discriminate against potential applicants with hearing impairments.

Employers are restricted in the kinds of questions they may ask on job-application forms and during pre- employment interviews. In addition, employers cannot require persons with disabilities to submit to preemploy- ment physicals unless such exams are required of all other applicants. An employer can disqualify the applicant only if the medical problems discovered during a preemploy- ment physical would make it impossible for the applicant to perform the job.

Health-Insurance Plans Workers with disabilities must be given equal access to any health insurance pro- vided to other employees and cannot be excluded from

coverage. An employer can put a limit, or cap, on health- care payments under its group health policy, but the cap must apply equally to all insured employees. Any group health-care plan that makes a disability-based distinction in its benefits violates the ADA (unless the employer can justify its actions under the business necessity defense, discussed shortly).

Substance Abusers Drug addiction is considered a disability under the ADA because it is a substantially limiting impairment. The act does not protect individuals who are actually using illegal drugs, however. Instead, the ADA protects only persons with former drug addictions—former drug addictions—former those who have completed or are now participating in a supervised drug-rehabilitation program. Individuals who have used drugs casually in the past also are not protected under the act. They are not considered addicts and there- fore do not have a disability (addiction).

People suffering from alcoholism are also protected by the ADA. Employers cannot legally discriminate against employees simply because they suffer from alcoholism. Of course, employers can prohibit the use of alcohol in the workplace and require that employees not be under the influence of alcohol while working. Employers can also fire or refuse to hire a person who is an alcoholic if (1) the person poses a substantial risk of harm to himself or herself or to others, and (2) the risk cannot be reduced by reasonable accommodation.

Exhibit 21–1 outlines the coverage of the main employ-Exhibit 21–1 outlines the coverage of the main employ-Exhibit 21–1 outlines the coverage of the main employ ment discrimination laws discussed in this chapter.

Title VII of the Civil Rights Act

Age Discrimination in Employment Act

Americans with Disabilities Act (as Amended)

Prohibits discrimination based on race, color, color, color national origin, religion, gender (including wage discrimination), and pregnancy; prohibits sexual harassment.

Prohibits discrimination against persons over forty years of age.

Applies to employers with fifteen or more employees.

Applies to employers with twenty or more employees.

Prohibits discrimination against persons with a mental or physical impairment that substantially limits a major life activity now or in the past, or who are regarded as having such an impairment, or who are associated with a disabled person.

E X H I B I T 2 1 – 1 Coverage of Employment Discrimination Laws

C H A P T E R 2 1 Employment Discrimination 469

21–4 Discrimination Based on Military Status

In 1994, Congress enacted the Uniformed Services Employment and Reemployment Rights Act (USERRA).36 The USERRA protects civilian job rights and benefits for members of the military, former military personnel, and reservists. It also provides additional protections for vet- erans who are disabled. Most importantly, the USERRA prohibits discrimination against persons who have served in the military. In effect, it makes military service and sta- tus a protected class and gives members of this class a right to sue an employer for violations.

21–4a Broad Application and Provisions The USERRA covers all employers, public and priall employers, public and priall - vate, large and small. Even an employer with only one employee is subject to its provisions.37 The act also applies to United States employers operating in foreign countries.

Under the USERRA, military plaintiffs can sue not only the employer but also individual employees who were acting in an official capacity for the employer. In other words, these employees—supervisors, for instance—can be held personally liable for violations. Additionally, there is no statute of limitations for bringing a lawsuit. The cause of action could have arisen ten weeks or ten years before the suit was filed.

The USERRA specifies that veterans can be ter- minated from their employment only “for cause.” The employer is obligated to give employees a list of all the behaviors that would trigger a for-cause termination.

21–4b Prima Facie Case of Discrimination under the USERRA

To establish a prima facie case of discrimination (and retaliation) under the USERRA, the plaintiff must estab- lish that the employer took an adverse employment action based in part on the employee’s connection with the mili- tary. The connection to the military may be through the plaintiff ’s membership, service, or application for service, or it may be through providing testimony or statements concerning the military service of another.38 If another similarly situated person who did not serve in the mili- tary or engage in a protected activity was treated more favorably than the plaintiff, the employer has violated the USERRA.

36. Pub. L. No. 103-353, codified at 38 U.S.C. Sections 4301-4335. 37. 20 C.F.R. Section 1002.34(a). 38. 38 U.S.C. Section 4311(c).

■ CASE IN POINT 21.19 Baldo Bello, a staff sergeant with the United States Marine Corps Reserve, was employed by the Village of Skokie as a police officer. Police officers in Skokie normally have nine regular days off (RDO) per month and eight sick days per year. Skokie officers who are in the reserve receive two weeks of paid leave for annual training each summer, but they do not receive pay for the required weekend military training. During his first four years as an officer at Skokie, Bello always requested RDOs to cover his weekend training drills.

After that, Bello started requesting military leave for the two to four days of drills per month, in addition to his nine RDO days. Skokie at first granted Bello mili- tary leave for monthly drills but later began to deny the requests. When Skokie officials told Bello that he needed to schedule his RDOs to cover his weekend military training, Bello filed suit in a federal district court alleg- ing violations of the USERRA. Skokie filed a motion for summary judgment, which the court denied. The court found that Bello was meeting his employer’s legitimate expectations. Bello was therefore entitled to a trial on the issue of whether Skokie had treated his leave requests less favorably than requests from other employees.39 ■

21–4c Plaintiffs May Be Entitled to Promotions

Under the USERRA, returning service members are to be reemployed in the jobs that they would have attained had they not been absent for military service. Reinstate- ment could affect their seniority, status, pay, and other rights and benefits (such as health and pension plans). In essence, this means that if a returning service member sues an employer for violations of the USERRA and is successful, she or he could receive not only damages and reinstatement but also a promotion.

21–5 Defenses to Employment Discrimination

The first line of defense for an employer charged with employment discrimination is to assert that the plaintiff has failed to meet his or her initial burden of proving that discrimination occurred. As noted, plaintiffs bringing age discrimination claims may find it difficult to meet this initial burden because they must prove that age dis- crimination was the reason for their employer’s decision.

Once a plaintiff succeeds in proving that discrimi- nation occurred, the burden shifts to the employer to

470 U N I T F O U R The Business and Employment Environment

justify the discriminatory practice. Possible justifications include that the discrimination was the result of a busi- ness necessity, a bona fide occupational qualification, or a seniority system. In some situations, as noted earlier, an effective antiharassment policy and prompt remedial action when harassment occurs may shield employers from liability for sexual harassment under Title VII.

21–5a Business Necessity An employer may defend against a claim of disparate- impact (unintentional) discrimination by asserting that a practice that has a discriminatory effect is a business necessity. ■ EXAMPLE 21.20 EarthFix, Inc., an inter- national consulting agency, requires its applicants to be fluent in at least one foreign language. If this requirement is shown to have a discriminatory effect, EarthFix can defend it based on business necessity. That is, the com- pany can argue that its workers must speak more than one language to perform their jobs at the required level of competence. If EarthFix can demonstrate a definite connection between foreign language fluency and job performance, it normally will succeed in this business necessity defense. ■

21–5b Bona Fide Occupational Qualification

Another defense applies when discrimination against a protected class is essential to a job—that is, when a par- ticular trait is a bona fide occupational qualification (BFOQ). Note that race, color, and national origin can never be BFOQs.

Generally, courts have restricted the BFOQ defense to situations in which the employee’s gender or religion is essential to the job. For instance, a women’s clothing store might legitimately hire only female sales attendants if part of an attendant’s job involves assisting clients in the store’s dressing rooms.

21–5c Seniority Systems An employer with a history of discrimination may have no members of protected classes in upper-level positions. Nevertheless, the employer may have a defense against a discrimination suit if promotions or other job benefits have been distributed according to a fair seniority system. In a seniority system, workers with more years of service are promoted first or laid off last.are promoted first or laid off last.are promoted first or laid off last.are promoted first or laid off last.

■ CASE IN POINT 21.21 Cathalene Johnson, an African Cathalene Johnson, an African American woman, was a senior service agent for Federal Express Corporation (FedEx) for more than seventeen years. She resigned in 2014 and filed suit against FedEx for discrimination based on race and gender, as well as

for violation of the Equal Pay Act. Johnson claimed that FedEx had paid a white male co-worker about two dol- lars more per hour than she had received for basically the same position. FedEx argued that the man had senior- ity. He had worked for FedEx for seven years longer, was the most senior employee at the station where Johnson worked, and had been a courier in addition to being a ser- vice agent. The court ruled that FedEx’s seniority system was fair and provided a defense to Johnson’s claims.40 ■

21–5d After-Acquired Evidence of Employee Misconduct

In some situations, employers have attempted to avoid liability for employment discrimination on the basis of “after-acquired evidence” of an employee’s miscon- duct. After-acquired evidence refers to evidence that the employer discovers after a lawsuit has been filed.

■ EXAMPLE 21.22 Pratt Legal Services fires Lucy, who then sues Pratt for employment discrimination. During pretrial investigation, Pratt discovers that Lucy made material misrepresentations on her job application. Had Pratt known of these misrepresentations, it would have had grounds to fire Lucy. ■

After-acquired evidence of wrongdoing cannot shield an employer entirely from liability for employment dis- crimination. It may, however, be used to limit the amount of damages for which the employer is liable.

21–6 Affirmative Action Federal statutes and regulations providing for equal opportunity in the workplace were designed to reduce or eliminate discriminatory practices with respect to hiring, retaining, and promoting employees. Affirmative action programs go a step further and attempt to “make up” for past patterns of discrimination by giving members of protected classes preferential treatment in hiring or pro- motion. During the 1960s, all federal and state govern- ment agencies, private companies that contracted to do business with the federal government, and institutions that received federal funding were required to implement affirmative action policies.

Title VII of the Civil Rights Act neither requires nor prohibits affirmative action. Thus, most private companies and organizations have not been required to implement affirmative action policies, though many have done so voluntarily. Affirmative action programs have been controversial, however, particularly when they have

40. Johnson v. Federal Express Corp., 996 F.Supp.2d 302 (M.D.Pa. 2014).Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

C H A P T E R 2 1 Employment Discrimination 471

Reviewing: Employment Discrimination

Amaani Lyle, an African American woman, was hired by Warner Brothers Television Productions to be a scriptwrit- ers’ assistant for the writers of Friends, a popular adult-oriented television series. One of her essential job duties was to type detailed notes for the scriptwriters during brainstorming sessions in which they discussed jokes, dialogue, and story lines. The writers then combed through Lyle’s notes after the meetings for script material. During these meetings, the three male scriptwriters told lewd and vulgar jokes and made sexually explicit comments and gestures. They often talked about their personal sexual experiences and fantasies, and some of these conversations were then used in episodes of Friends.

During the meetings, Lyle never complained that she found the writers’ conduct offensive. After four months, Lyle was fired because she could not type fast enough to keep up with the writers’ conversations during the meetings. She filed a suit against Warner Brothers, alleging sexual harassment and claiming that her termination was based on racial discrimination. Using the information presented in the chapter, answer the following questions. 1. Would Lyle’s claim of racial discrimination be for intentional (disparate-treatment) or unintentional (disparate-

impact) discrimination? Explain. 2. Can Lyle establish a prima facie case of racial discrimination? Why or why not? 3. When Lyle was hired, she was told that typing speed was extremely important to the position. At the time, she

maintained that she could type eighty words per minute, so she was not given a typing test. It later turned out that Lyle could type only fifty words per minute. What impact might typing speed have on Lyle’s lawsuit?

4. Lyle’s sexual-harassment claim is based on the hostile working environment created by the writers’ sexually offensive conduct at meetings that she was required to attend. The writers, however, argue that their behavior was essential to the “creative process” of writing for Friends, a show that routinely contained sexual innuendos and adult humor. Which defense discussed in the chapter might Warner Brothers assert using this argument?

Debate This . . . Members of minority groups and women have made enough economic progress in the last several decades that they no longer need special legislation to protect them.

resulted in reverse discrimination against members of a majority group, such as white males.

21–6a Equal Protection Issues Because of their inherently discriminatory nature, affir- mative action programs may violate the equal protection clause of the Fourteenth Amendment to the U.S. Consti- tution. Any federal, state, or local government affirmative action program that uses racial or ethnic classifications as the basis for making decisions is subject to strict scrutiny (the highest standard to meet) by the courts.

Today, an affirmative action program normally is con- stitutional only if it attempts to remedy past discrimi- nation and does not make use of quotas or preferences. Furthermore, once such a program has succeeded in the goal of remedying past discrimination, it must be changed or eliminated.

21–6b State Laws Prohibiting Affirmative Action Programs

Some states have enacted laws that prohibit affirmative action programs at public institutions (colleges, univer-

sities, and state agencies) within their borders. These states include California, Maryland, Michigan, New Hampshire, Oklahoma, Virginia, and Washington. The United States Supreme Court recognized that states have the power to enact such bans in 2014.

■ CASE IN POINT 21.23 Michigan voters passed an initiative to amend the state’s constitution to prohibit publicly funded colleges from granting preferential treat- ment to any group on the basis of race, sex, color, ethnic- ity, or national origin. The law also prohibited Michigan from considering race and gender in public hiring and contracting decisions.

A lawsuit was filed challenging the initiative as a viola- tion of the equal protection clause in the U.S. Constitu- tion. Although a federal appellate court held that the law violated the equal protection clause, the United States Supreme Court reversed. The Court ruled that a state has the inherent power to ban affirmative action within that state, but it did not rule on the constitutionality of any specific affirmative action program.41 ■

41. Schuette v. Coalition to Defend Affirmative Action, Integration and Immi- grant Rights, ___ U.S. ___, 134 S.Ct. 1623, 188 L.Ed.2d 613 (2014).

472 U N I T F O U R The Business and Employment Environment

Business Scenarios 21–1. Title VII Violations. Discuss fully whether either of the following actions would constitute a violation of Title VII of the Civil Rights Act, as amended: (See Title VII of the Civil Rights Act.) (a) Tennington, Inc., is a consulting firm with ten employ-

ees. These employees travel on consulting jobs in seven states. Tennington has an employment record of hiring only white males.

(b) Novo Films is making a movie about Africa and needs to employ approximately one hundred extras for this picture. To hire these extras, Novo advertises in all major newspa- pers in Southern California. The ad states that only Afri- can Americans need apply.

21–2. Religious Discrimination. Gina Gomez, a devout Roman Catholic, worked for Sam’s Department Stores, Inc.,

in Phoenix, Arizona. Sam’s considered Gomez a productive employee because her sales exceeded $200,000 per year. At the time, the store gave its managers the discretion to grant unpaid leave to employees but prohibited vacations or leave during the holiday season—October through December. Gomez felt that she had a “calling” to go on a “pilgrim- age” in October to a location in Bosnia where some persons claimed to have had visions of the Virgin Mary. The Catholic Church had not designated the site an official pilgrimage site, the visions were not expected to be stronger in October, and tours were available at other times. The store managers denied Gomez’s request for leave, but she had a nonrefundable ticket and left anyway. Sam’s terminated her employment, and she could not find another job. Can Gomez establish a prima facie case of religious discrimination? Explain. (See Title VII of the Civil Rights Act.)

Business Case Problems 21–3. Spotlight on Dress Code Policies—Discrimination

Based on Gender. Burlington Coat Factory Warehouse, Inc., had a dress code that required male salesclerks to wear business attire consisting of slacks, shirt, and a necktie. Female salesclerks, by contrast,

were required to wear a smock so that customers could readily identify them. Karen O’Donnell and other female employees refused to wear smocks. Instead they reported to work in business attire and were suspended. After numerous suspensions, the female employees were �red for violating Burlington’s dress code policy. All other conditions of employment, including salary, hours, and bene�ts, were the same for female and male employ-hours, and bene�ts, were the same for female and male employ-hours, and bene�ts, were the same for female and male employ ees. Was the dress code policy discriminatory? Why or why not? [O’Donnell v. Burlington Coat Factory Warehouse, Inc., 656 F.Supp. 263 (S.D. Ohio 1987)] (See Title VII of the Civil Rights Act.263 (S.D. Ohio 1987)] (See Title VII of the Civil Rights Act.263 (S.D. Ohio 1987)] (See )

21–4. Sexual Harassment by Co-Worker. Billie Brad- ford worked for the Kentucky Department of Community Based Services (DCBS). One of Bradford’s co-workers, Lisa Stander, routinely engaged in extreme sexual behavior (such as touching herself and making crude comments) in Bradford’s presence. Bradford and others regularly com- plained about Stander’s conduct to their supervisor, Angie Taylor. Rather than resolve the problem, Taylor noncha- lantly told Stander to stop, encouraged Bradford to talk to Stander, and suggested that Stander was just having fun. Assuming that Bradford was subjected to a hostile work environment, could DCBS be liable? Why or why not? [Bradford v. Department of Community Based Services, 2012 WL 360032 (E.D.Ky. 2012)] (See Title VII of the Civil Rights Act.)

Terms and Concepts a�rmative action 470 bona �de occupational

quali�cation (BFOQ) 470 business necessity 470 constructive discharge 461

disparate-impact discrimination 455

disparate-treatment discrimination 454

employment discrimination 453

prima facie case 454prima facie case 454prima facie protected class 453 seniority system 470 sexual harassment 462 tangible employment action 463

Issue Spotters 1. Ruth is a supervisor for a Subs & Suds restaurant. Tim

is a Subs & Suds employee. The owner announces that some employees will be discharged. Ruth tells Tim that if he has sex with her, he can keep his job. Is this sexual harassment? Why or why not? (See Title VII of the Civil Rights Act.)

2. Koko, a person with a disability, applies for a job at Lively Sales Corporation for which she is well qualified, but she

is rejected. Lively continues to seek applicants and even- tually fills the position with a person who does not have a disability. Could Koko succeed in a suit against Lively for discrimination? Explain. (See Discrimination Based on Disability.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

C H A P T E R 2 1 Employment Discrimination 473

21–5. Business Case Problem with Sample Answer— Age Discrimination. Beginning in 1986, Paul Rangel was a

sales professional for the pharmaceutical company sano�-aventis U.S. LLC (S-A). Rangel had satis- factory performance reviews until 2006, when S-A issued new “Expectations” guidelines that included

sales call quotas and other standards that he failed to meet. After two years of negative performance reviews, Rangel—who was then more than forty years old—was terminated. �e ter- mination was part of a nationwide reduction in force of all sales professionals who had not met the “Expectations” guidelines, including younger workers. Did S-A engage in age discrimina- tion? Discuss. [Rangel v. sano� aventis U.S. LLC, 507 Fed. Appx. 786 (10th Cir. 2013)] (See Discrimination Based on Age.) • For a sample answer to Problem 21–5, go to Appendix E at

the end of this text. 21–6. Discrimination Based on Disability. Cynthia Horn worked for Knight Facilities Management–GM, Inc., in Detroit, Michigan, as a janitor. When Horn developed a sensitivity to cleaning products, her physician gave her a “no exposure to cleaning solutions” restriction. Knight discussed possible accommodations with Horn. She suggested that rest- rooms be eliminated from her cleaning route or that she be provided with a respirator. Knight explained that she would be exposed to cleaning solutions in any situation and concluded that there was no work available within her physician’s restric- tion. Has Knight violated the Americans with Disabilities Act by failing to provide Horn with the requested accommoda- tions? Explain. [Horn v. Knight Facilities Management–GM, Inc., 556 Fed.Appx. 452 (6th Cir. 2014)] (See Discrimination Based on Disability.) 21–7. Sexual Harassment. Jamel Blanton was a male employee at a Pizza Hut restaurant operated by Newton Asso- ciates, Inc., in San Antonio, Texas. Blanton was subjected to sexual and racial harassment by the general manager, who was female. Newton had a clear, straightforward antidiscrimina- tion policy and complaint procedure. �e policy provided that in such a situation, an employee should complain to the harasser’s supervisor. Blanton alerted a shift leader and an assis- tant manager about the harassment, but they were subordinate to the general manager and did not report the harassment to higher-level management. When Blanton �nally complained

to a manager with authority over the general manager, the employer investigated and �red the general manager within four days. Blanton �led a suit in a federal district court against Newton, seeking to impose liability on the employer for the general manager’s actions. What is Newton’s best defense? Discuss. [Blanton v. Newton Associates, Inc., 593 Fed.Appx. 389 (5th Cir. 2015)] (See Title VII of the Civil Rights Act.) 21–8. Discrimination Based on Disability. Dennis Wal- lace was a deputy sheri� for Stanislaus County, California, when he injured his left knee. After surgery, he was subject to limits on prolonged standing, walking, and running. �e county assigned him to work as a baili�. �e sergeants who supervised him rated his performance above average. Less than a year later, without consulting those supervisors, the county placed him on an unpaid leave of absence, under the mistaken belief that he could not safely perform the essential functions of the job. Wallace �led an action in a California state court against the county, alleging discrimination based on disability. Under state law, discriminatory intent is shown by evidence that an actual or perceived disability was a “substantial moti- vating factor or reason” for an employer’s adverse employment action. An employee is not required to show that the action was motivated by animosity or ill will. Could Wallace likely prove the “substantial motivating factor or reason” element? Explain. [Wallace v. County of Stanislaus, 245 Cal.App.4th 109, 199 Cal.Rptr.3d 462 (5 Dist. 2016)] (See Discrimination Based on Disability.) 21–9. A Question of Ethics—Retaliation by Employers.

Shane Dawson, a male homosexual, worked for Entek International. Some of Dawson’s co-workers, including his supervisor, made derogatory comments about his sexual orientation. Dawson’s work deterio-

rated. He �led a complaint with Entek’s human resources depart-rated. He �led a complaint with Entek’s human resources depart-rated. He �led a complaint with Entek’s human resources depart ment. Two days later, he was �red. State law made it unlawful for an employer to discriminate against an individual based on sex- ual orientation. [Dawson v. Entek International,ual orientation. [Dawson v. Entek International,ual orientation. [ 630 F.3d 928 (9th Cir. 2011)] (See (9th Cir. 2011)] (See (9th Cir. 2011)] Title VII of the Civil Rights Act.) (a) Could Dawson establish a claim for retaliation? Explain. (b) Should homosexuals be a protected class under Title VII

of the Civil Rights Act? Discuss the arguments for and against amending federal law to prohibit employment dis- crimination based on sexual orientation.

Legal Reasoning Group Activity 21–10. Racial Discrimination. Two African American plainti�s sued the producers of the reality television series �e Bachelor and Bachelor and Bachelor �e Bachelorette for racial discrimination. �e �e Bachelorette for racial discrimination. �e �e Bachelorette plainti�s claimed that the shows had never featured persons of color in the lead roles. �e plainti�s also alleged that the producers did not provide people of color who auditioned for the lead roles with the same opportunities to compete as white people who auditioned. (See Title VII of the Civil Rights Act.) (a) The first group will assess whether the plaintiffs can estab-

lish a prima facie case of disparate-treatment discrimination.

(b) The second group will consider whether the plaintiffs can establish disparate-impact discrimination.

(c) The third group will assume that the plaintiffs estab- lished a prima facie case and that the burden has shifted prima facie case and that the burden has shifted prima facie to the employer to articulate a legal reason for not hir- ing the plaintiffs. What legitimate reasons might the employer assert for not hiring the plaintiffs in this situa- tion? Should the law require television producers to hire persons of color for lead roles in reality television shows? Discuss.

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C H A P T E R 2 2

sanctions employers that hire immigrants who lack work authorization.

The IRCA makes it illegal to hire, recruit, or refer for a fee someone not authorized to work in this country. Through Immigration and Customs Enforcement offi- cers, the federal government conducts random compli- ance audits and engages in enforcement actions against employers who hire undocumented workers.

I-9 Employment Verification To comply with IRCA requirements, an employer must perform I-9 veri- fications for new hires, including those hired as “contrac- tors” or “day workers” if they work under the employer’s direct supervision. Form I-9, Employment Eligibility Verification, which is available from U.S. Citizenship and Immigration Services,3 must be completed within three days of a worker’s commencement of employment. The days of a worker’s commencement of employment. The days three-day period allows the employer to check the form’s accuracy and to review and verify documents establish- ing the prospective worker’s identity and eligibility for employment in the United States.

3. U.S. Citizenship and Immigration Services is a federal agency that is part of the U.S. Department of Homeland Security.

22–1 Immigration Law The United States did not have any laws restricting immigration until the late nineteenth century. Immigra- tion law has become increasingly important in recent years, however. An estimated 12 million undocumented immigrants now live in the United States, and many of them came to find jobs. Because U.S. employers face seri- ous penalties if they hire undocumented workers, it is necessary for businesspersons to understand immigration laws. The most important laws affecting immigration in the context of employment are the Immigration Reform and Control Act (IRCA)1 and the Immigration Act.2

22–1a The Immigration Reform and Control Act (IRCA)

When the IRCA was enacted in 1986, it provided amnesty to certain groups of aliens living illegally in the United States at the time. It also established a system that

1. 29 U.S.C. Section 1802. 2. This act amended various provisions of the Immigration and Nationality

Act of 1952, 8 U.S.C. Sections 1101 et seq.

A s anyone who followed the 2016 presidential race can attest, immigration law and

policy in the United States are topics of significant national debate. To a substantial degree, the immigration debate concerns the nation’s employ- ment environment. Responding to this debate, Congress enacted legisla- tion in the late twentieth century to prohibit employers from hiring illegal immigrants. Today, immigration law has evolved into a myriad of complex rules that employers must follow.

We can trace the source of much workplace law to the Indus- trial Revolution of the nineteenth century. During the Industrial Revo- lution, fewer Americans were self- employed than ever before, and employers generally set the terms of employment. Moreover, with increasing industrialization, the size of workplaces and the number of on-the-job hazards increased. Workers came to believe that to counter the power and freedom of their employers and to protect

themselves, they needed to orga- nize into unions.

Beginning in 1932, Congress enacted a number of statutes that generally increased employees’ rights. At the heart of these rights is the right to join unions and engage in collec- tive bargaining with management to negotiate working conditions, salaries, and benefits for a group of workers. This chapter also examines strikes, lockouts, and the labor prac- tices that are considered unfair under federal law.

Immigration and Labor Law

C H A P T E R 2 2 Immigration and Labor Law 475

Documentation Requirements The employer must declare, under penalty of perjury, that an employee pro- duced documents establishing his or her identity and legal employability. A U.S. passport establishing the person’s citizenship is acceptable documentation. So is a document authorizing a foreign citizen to work in the United States, such as a permanent resident card or an Alien Registration Receipt.Receipt.Receipt

Most legal actions alleging violations of I-9 rules are brought against employees who provide false infor- mation or documentation. If the employee enters false information on the I-9 form or presents false documen- tation, the employer can fire the worker, who then may be subject to deportation. Nevertheless, employers must be honest when verifying an employee’s documentation. If an employer “should have known” that the worker was unauthorized, the employer has violated the rules.

Enforcement U.S. Immigration and Customs En- forcement (ICE) is the largest investigative arm of the U.S. Department of Homeland Security. ICE has a gen- eral inspection program that conducts random compli- ance audits. Other audits may occur if the agency receives a written complaint alleging that an employer has com- mitted violations. Government inspections include a review of an employer’s file of I-9 forms. The government does not need a subpoena or a warrant to conduct such an inspection.

If an investigation reveals a possible violation, ICE will bring an administrative action and issue a Notice of Intent to Fine, which sets out the charges against the employer. The employer has a right to a hearing on the enforcement action if it files a request within thirty days. This hearing is conducted before an administrative law judge, and the employer has a right to counsel and to discovery. The typical defense in such actions is good faith or substantial compliance with the documentation provisions.

Penalties An employer who violates the law by hiring an unauthorized worker is subject to substantial penalties. The employer can be fined up to $2,200 for each unau- thorized employee for a first offense, $5,000 per employee for a second offense, and up to $11,000 for subsequent offenses. Employers who have engaged in a “pattern or practice of violations” are subject to criminal penalties, which include additional fines and imprisonment for up to ten years. A company can also be barred from future government contracts.

In determining the penalty, ICE considers the seri- ousness of the violation (such as intentional falsification

of documents) and the employer’s past compliance. ICE regulations also identify factors that will mitigate (lessen) or aggravate (increase) the penalty under certain circum- stances. An employer that cooperates in the investiga- tion, for instance, may receive a lesser penalty than an uncooperative employer.

22–1b The Immigration Act Often, U.S. businesses find that they cannot hire enough domestic workers with specialized skills. For this reason, U.S. immigration laws have long made provisions for businesses to hire specially qualified foreign workers.

The Immigration Act of 1990 placed caps on the number of visas (entry permits) that can be issued to immigrants each year, including employment-based visas. Employment-based visas may be classified as permanent (immigrant) or temporary (nonimmigrant). Employers who wish to hire workers with either type of visa must comply with detailed government regulations.4

I-551 Alien Registration Receipts A company seeking to hire a noncitizen worker may do so if the worker is self-authorized. To be self-authorized, a worker must either be a lawful permanent resident or have a valid temporary Employment Authorization Document. A lawful permanent resident can prove his or her status to an employer by presenting an I-551 Alien Registration Receipt, known as a green card, or a properly stamped foreign passport.

Many immigrant workers are not already self- authorized, and an employer that wishes to hire them can attempt to obtain labor certification, or green cards, for them. A limited number of new green cards are issued each year. A green card can be obtained only for a person who is being hired for a permanent, full-time position. (A separate authorization system provides for the tem- porary entry and hiring of nonimmigrant visa workers.)

To gain authorization for hiring a foreign worker, an employer must show that no U.S. worker is qualified, willing, and able to take the job. The government has detailed regulations governing the advertising of posi- tions as well as the certification process. Any U.S. appli- cants who meet the stated job qualifications must be interviewed for the position. The employer must also be able to show that the qualifications required for the job are a business necessity.

4. The most relevant regulations can be found at 20 C.F.R. Section 655 (for temporary employment) and 20 C.F.R. Section 656 (for permanent employment).

476 U N I T F O U R The Business and Employment Environment

The H-1B Visa Program The most common and con- troversial visa program today is the H-1B visa system. To obtain an H1-B visa, the potential employee must be qual- ified in a “specialty occupation,” meaning that the indi- vidual has highly specialized knowledge and has attained a bachelor’s or higher degree or its equivalent. Individuals with H-1B visas can stay in the United States for three to six years and can work only for the sponsoring employer.

The recipients of these visas include numerous high- tech workers. A maximum of sixty-five thousand H-1B visas are set aside each year for new immigrants.5 That limit is typically reached within the first few weeks of the year. Consequently, tech companies often complain that Congress needs to expand the number of H-1B visas available, to encourage the best and the brightest minds to work in the United States.

Critics of the H-1B visa program, however, believe that employers are sometimes using it to replace Ameri- can workers with lower-paid foreign labor. For instance, Southern California Edison let go nearly five hundred workers from its information technology (IT) depart- ment in 2015. Shortly after that, allegations surfaced that the company had illegally replaced these employees with workers with H-1B visas, leading to a government investigation.

Labor Certification An employer who wishes to submit an H-1B application must first file a Labor Cer- tification application on a form known as ETA 9035. The employer must agree to provide a wage level at least equal to the wages offered to other individuals with simi- lar experience and qualifications. The employer must also show that the hiring will not adversely affect other workers similarly employed. The employer is required to inform U.S. workers of the intent to hire a foreign worker by posting the form. The U.S. Department of Labor reviews the applications and may reject them for omis- sions or inaccuracies.

H-2, O, L, and E Visas Other specialty temporary visas are available for other categories of employees. H-2 visas provide for workers performing agricultural labor of a seasonal nature. O visas provide entry for persons who have “extraordinary ability in the sciences, arts, education, business or athletics which has been demonstrated by sus- tained national or international acclaim.” L visas allow a company’s foreign managers or executives to work inside the United States. E visas permit the entry of certain for- eign investors or entrepreneurs.

5. Immigration reform proposals generally raise this annual limit on H-1B visas to more than one hundred thousand.

22–1c State Immigration Legislation Until 2010, federal law exclusively governed immigra- tion and the treatment of illegal immigrants. Then Arizona enacted a law that required Arizona law enforce- ment officials to identify and charge immigrants in Ari- zona who were there illegally, potentially leading to the immigrants’ deportation. Among other things, that law required immigrants to carry their papers at all times and allowed police to check a person’s immigration status during any law enforcement action.

The Supreme Court’s Decision Arizona’s law was challenged in Arizona v. United States,6 which reached the United States Supreme Court. The Court upheld the controversial “show-me-your-papers” provision, which requires police to check the immigration status of persons stopped for other violations. All other provisions of Ari- zona’s law were struck down as unconstitutional violations of the supremacy clause.

The fact that the Supreme Court did not strike down all parts of Arizona’s immigration law opened the door for other states to enact immigration legislation, and many states have done so. The Court’s decision does set limits, however. Although states may require immigrants to show their papers if stopped by law enforcement for another reason, they may not make it a crime to fail to carry documentation. States also cannot authorize law enforcement to arrest anyone based solely on a reason- able suspicion that the person is in the country illegally.

State Laws Must Not Conflict with Federal Immigration Law For courts to uphold the validity of state legislation relating to immigrants, the provisions must not conflict with the comprehensive framework of federal immigration law. ■ CASE IN POINT 22.1 Ari- zona amended its identity theft laws by passing the Legal Arizona Workers Act. The goal of the act was to curb employment-related identity theft, which has been a major problem in the state, and to solve problems stem- ming from illegal immigration. Arizona then aggressively enforced the amended employment-related identity theft laws, mainly against undocumented aliens.

An immigrant advocacy organization, Puente Ari- zona, and others challenged provisions of the amended identity theft laws as unconstitutional for violat- ing the supremacy clause. The plaintiffs claimed that because federal law (the IRCA) established a compre- hensive framework for regulating the employment of unauthorized aliens, it preempted the state’s amended

C H A P T E R 2 2 Immigration and Labor Law 477

employment-related identity theft laws. A federal district court agreed with the plaintiffs, but the U.S. Court of Appeals for the Ninth Circuit reversed. The federal appel- late court found that Arizona’s amended employment- related identity theft laws applied not only to undocu- mented aliens but also to legal residents and citizens. Therefore, the state laws were not in conflict with the IRCA’s comprehensive framework for combatting the employment of illegal aliens.7 ■

22–2 Federal Labor Laws Federal labor laws governing union-employer relations have developed considerably since the first law was enacted in 1932. Initially, the laws were concerned with protecting the rights and interests of workers. Subsequent legislation placed some restraints on unions and granted rights to employers. We look here at four major federal statutes regulating union-employer relations.

22–2a Norris-LaGuardia Act Congress protected peaceful strikes, picketing, and boy- cotts in 1932 in the Norris-LaGuardia Act.8 The statute restricted the power of federal courts to issue injunctions against unions engaged in peaceful strikes. In effect, this act declared a national policy permitting employees to organize.

22–2b National Labor Relations Act One of the foremost statutes regulating labor is the 1935 National Labor Relations Act (NLRA).9 This act estab- lished the rights of employees to engage in collective bar- gaining and to strike.

Unfair Labor Practices The NLRA specifically defined a number of employer practices as unfair to labor: 1. Interference with the efforts of employees to form,

join, or assist labor organizations or to engage in con- certed activities for their mutual aid or protection.

2. An employer’s domination of a labor organization or contribution of financial or other support to it.

3. Discrimination in the hiring of or the awarding of tenure to employees for reason of union affiliation.

7. Puente Arizona v. Arpaio, 821 F.3d 1098 (9th Cir. 2016). 8. 29 U.S.C. Sections 101–110, 113–115. 9. 20 U.S.C. Sections 151–169.

4. Discrimination against employees for filing charges under the act or giving testimony under the act.

5. Refusal to bargain collectively with the duly desig- nated representative of the employees.

The National Labor Relations Board The NLRA created the National Labor Relations Board (NLRB) to oversee union elections and to prevent employers from engaging in unfair and illegal union activities and unfair labor practices.

The NLRB has the authority to investigate employees’ charges of unfair labor practices and to file complaints against employers in response to these charges. When violations are found, the NLRB may issue a cease-and- desist order compelling the employer to stop engaging desist order compelling the employer to stop engaging desist order in the unfair practices. Cease-and-desist orders can be enforced by a federal appellate court if necessary. After the NLRB rules on claims of unfair labor practices, its decision may be appealed to a federal court.decision may be appealed to a federal court.decision may be appealed to a federal court.decision may be appealed to a federal court.

■ CASE IN POINT 22.2 Roundy’s, Inc., which oper- ates a chain of stores in Wisconsin, became involved in a dispute with a local construction union. When union members started distributing “extremely unflattering” flyers outside the stores, Roundy’s ejected them from the property. The NLRB filed a complaint against Roundy’s for unfair labor practices. An administrative law judge ruled that Roundy’s had violated the law by discrimi- nating against the union, and a federal appellate court affirmed. It is an unfair labor practice for an employer to prohibit union members from distributing flyers outside a store when it allows nonunion members to do so.10 ■

Good Faith Bargaining Under the NLRA, employ- ers and unions have a duty to bargain in good faith. Bar- gaining over certain subjects is mandatory, and a party’s refusal to bargain over these subjects is an unfair labor practice that can be reported to the NLRB. For instance, bargaining is mandatory for subjects relating to wages or working hours.

Workers Protected by the NLRA To be protected under the NLRA, an individual must be an employee or a job applicant. (If job applicants were not covered, the NLRA’s ban on discrimination in regard to hiring would mean little.) Additionally, individuals who are hired by a union to organize a company (union organizers) are to be considered employees of the company for NLRA purposes.11

10. Roundy’s, Inc. v. NLRB, 647 F.3d 638 (7th Cir. 2012). 11. See the United States Supreme Court’s landmark decision in NLRB

v. Town & Country Electric, Inc., 516 U.S. 85, 116 S.Ct. 450, 133 L.Ed.2d 371 (1995).

478 U N I T F O U R The Business and Employment Environment

Even a temporary worker hired through an employ- ment agency might qualify for protection under the ment agency might qualify for protection under the ment agency might qualify for protection under the ment agency might qualify for protection under the NLRA. ■ CASE IN POINT 22.3 Matthew Faush was an African American employee of Labor Ready, which provides temporary employees to businesses. Faush was assigned to a job stocking shelves at a Tuesday Morn- ing store in Pennsylvania. After he was fired by Tuesday Morning, Faush filed a suit alleging discrimination. Tues- day Morning argued that Faush was not its employee. A federal court, however, found that the NLRA’s protec- tions may extend to temporary workers and that Faush was entitled to a trial.12 ■

22–2c Labor-Management Relations Act The Labor-Management Relations Act (LMRA or Taft- Hartley Act) of 194713 was passed to prohibit certain unfair union practices. For instance, the act outlawed the closed shop—a firm that requires union membership as a condition of employment. The act preserved the legal- ity of the union shop, however. A union shop does not require union membership as a prerequisite for employ- ment but can, and usually does, require that workers join the union after a specified time on the job.

The LMRA also prohibited unions from refusing to bargain with employers, engaging in certain types of picketing, and featherbedding (causing employers featherbedding (causing employers featherbedding to hire more employees than necessary). In addition,

12. Faush v. Tuesday Morning, Inc., 88 F.3d 208 (3d Cir. 2015). 13. 29 U.S.C. Sections 141 et seq.

the act allowed individual states to pass right-to-work laws—laws making it illegal for union membership to be required for continued employment in any establishment. continued employment in any establishment. continued Thus, union shops are technically illegal in the twenty- seven states that have right-to-work laws.

22–2d Labor-Management Reporting and Disclosure Act

The Labor-Management Reporting and Disclosure Act (LMRDA)14 established an employee bill of rights and reporting requirements for union activities. The act also outlawed hot-cargo agreements, in which employ- ers voluntarily agree with unions not to handle, use, or deal in goods of other employers produced by nonunion employees.

The LMRDA strictly regulates unions’ internal busi- ness procedures, including elections. For instance, it requires unions to hold regularly scheduled elections of officers using secret ballots. Former convicts are prohibited from holding union office. Moreover, union officials are accountable for union property and funds. Members have the right to attend and to participate in union meetings, to nominate officers, and to vote in most union proceedings.

The LMRDA holds union officers to a high standard of responsibility and ethical conduct in administering the affairs of their union. This standard was at the core of the dispute in the following case.

14. 29 U.S.C. Sections 401 et seq.

Background and Facts The Services Employees International Union (SEIU) consists of 2.2 mil- lion members who work in health care, public services, and property services. United Health Work- ers (UHW) is affiliated with SEIU and represents 150,000 health care workers in California. The SEIU, under its constitution, has the authority to realign local unions. The SEIU constitution also grants the SEIU the authority to place a local union into trusteeship “to protect the interests of the membership.”

The SEIU proposed moving 150,000 long-term care workers from three separate unions, including 65,000 from the UHW, into a new union chartered by the SEIU. The UHW opposed the move. The SEIU placed the UHW into trusteeship. UHW officials blocked access to its buildings to prevent the trustees from entering, removed UHW property from the buildings, and instructed its members not to recognize the trustees’ authority. Meanwhile, the UHW officials, while still on the UHW payroll, created and promoted a new union—the National Union of Healthcare Workers (NUHW). The SEIU filed a suit

Services Employees International Union v. National Union of

mployees International Union v. ational Union of

mployees International Union v. Healthcare Workers

mployees International Union v. ealthcare Workers

mployees International Union v.

United States Court of Appeals, Ninth Circuit, 718 F.3d 1036 (2013).

Case 22.1

C H A P T E R 2 2 Immigration and Labor Law 479

22–2e Coverage and Procedures Coverage of federal labor laws is broad and extends to all employers whose business activity either involves or affects interstate commerce. Some workers are specifically excluded from these laws. Railroads and airlines are not covered by the NLRA but are covered by a separate act, the Railway Labor Act, which closely parallels the NLRA. Other types of workers, such as agricultural workers and domestic servants, are excluded from the NLRA and have no coverage under separate legislation.

When a union or employee believes that an employer has violated federal labor law (or vice versa), a charge is filed with a regional office of the NLRB. The charge is investi- gated, and if it is found worthy, the regional director files

a complaint. An administrative law judge (ALJ) initially hears the complaint and rules on it. The board reviews the ALJ’s findings and decision. If the NLRB finds a violation, it may issue remedial orders (such as requiring the rehir- ing of discharged workers). The NLRB decision may be appealed to a U.S. court of appeals.

22–3 Union Organization Typically, the first step in organizing a union at a particu- lar firm is to have the workers sign authorization cards. An authorization card usually states that the worker authorization card usually states that the worker authorization card desires to have a certain union, such as the United Auto

in a federal district court against the NUHW and the UHW officials for breach of fiduciary duties. The jury returned a verdict against the NUHW and the UHW, on which the court entered a judgment. The defendants appealed.

In the Language of the Court TALLMAN, Circuit Judge:TALLMAN, Circuit Judge:TALLMAN

* * * * Under Section 501 of the Labor Management Reporting and Disclosure Act (“LMRDA”), officers of labor

unions are held to the highest standards of responsibility and ethical conduct in administering the affairs of the union. [Emphasis added.]

The UHW defendants posit that they owed this duty to only the rank-and-file members of their local union. Because they subjectively believed their actions assisted those members by establishing a more democratic union with localized control, they maintain they have done no wrong under Section 501. Their argument ignores the fact that they diverted union resources to weaken their own union and form a rival union merely because they did not agree with the constitutionally permissible decision of the international union. Because no construction of the LMRDA allows such conduct based merely on the defendants’ subjective motives, we reject the defendants’ argument. [Emphasis added.]

The SEIU Executive Committee, under the authority given to it by both its constitution and the UHW constitution, carefully considered and adopted a measure it believed would better serve its mem- bers. The UHW officers disagreed, which they may do, and they voiced their opposition, which they also may do. What they may not do under the law is use their union’s resources to actively obstruct implementation of the final decision.

* * * * The judgment of liability was properly entered when a correctly instructed jury, on a sufficient fac-

tual record, found the defendants in breach of their fiduciary duties under Section 501 of the LMRDA.

Decision and Remedy The U.S. Court of Appeals for the Ninth Circuit affirmed the lower court’s judgment. Section 501 of the LMRDA creates a fiduciary duty owed by union officials to the union as an organization, not only the union’s rank-and-file members. Officials who divert union resources to establish a new competing union breach this duty.

Critical Thinking • What If the Facts Were Different? If the defendants in this case had only expressed their opinions

against the SEIU’s imposition of trusteeship and charter of a new union, could they have been held liable for a breach of fiduciary duty? Discuss.

• Ethical What standard was at the core of the dispute in this case?

Case 22.1 Continued

480 U N I T F O U R The Business and Employment Environment

Workers, represent the workforce. If a majority of the workers sign authorization cards, the union organizers (unionizers) present the cards to the employer and ask for formal recognition of the union.

The employer is not required to recognize the union at this point in the process, but it may do so voluntarily on a showing of majority support. (Under pro-labor leg- islation proposed repeatedly, the employer would have to recognize the union as soon as a majority of the work- ers had signed authorization cards—without holding an election.)15

22–3a Union Elections Sometimes, the employer refuses to voluntarily recog- nize the union or less than a majority of the workers sign authorization cards. In that situation, the union organiz- ers can petition for an election. The organizers present the authorization cards to the NLRB with a petition to hold an election on unionization. For an election to be held, they must demonstrate that at least 30 percent of the workers to be represented support a union or an election.

Appropriate Bargaining Unit Not every group of workers can form a single union. The proposed union must represent an appropriate bargaining unit. One key requirement is a mutuality of interest among all the work- ers to be represented by the union. Factors considered in determining whether there is a mutuality of interest include the similarity of the jobs of the workers to be unionized and their physical location.

New NLRB Rules Expedite Elections New NLRB rules that took effect in 2015 significantly reduce the time between the filing of a petition and the ensu- ing election. As a result, the time before an election is held has changed from an average of thirty-eight days to as little as ten days after the filing. This change favors unions because it gives employers less time to respond to organizing campaigns, which unions often spend months preparing.

The NLRB now requires that a company hold a pre- election hearing within eight days after it receives a peti- tion for an organizing election. On the day before the

15. The proposed legislation is the Employee Free Choice Act (or Card Check Bill).

hearing, the company must also submit a “statement of position” laying out every argument it intends to make against the union. Any argument that the company does not include in its position paper can be excluded from evidence at the hearing. Once the hearing is held, an elec- tion can be scheduled right away.

Voting If an election is held, the NLRB supervises the election and ensures secret voting and voter eligibility. If the proposed union receives majority support in a fair election, the NLRB certifies the union as the bargaining representative for the employees.

22–3b Union Election Campaigns Many disputes between labor and management arise dur- ing union election campaigns. Generally, the employer has control over unionizing activities that take place on company property and during working hours. Thus, the employer may limit the campaign activities of union sup- porters as long as it has a legitimate business reason for doing so. The employer may also reasonably limit when and where union solicitation may occur in the work- place, provided that the employer is not discriminating against the union. (Can union organizers use company e-mail during campaigns? See this chapter’s Managerial StrategyStrategyStrategy feature for a discussion of this topic.)Strategy feature for a discussion of this topic.)Strategy

■ EXAMPLE 22.4 A union is seeking to organize clerks at a department store owned by Amanti Enter- prises. Amanti can prohibit all union solicitation in areas of the store open to the public because the unionizing activities could interfere with the store’s business. It can also restrict union-related activities to coffee breaks and lunch hours. If Amanti allows solicitation for charitable causes in the workplace, however, it may not prohibit union solicitation. ■

An employer may campaign among its workers against the union, but the NLRB carefully monitors and regu- lates the tactics used by management. If the employer issues threats (“If the union wins, you’ll all be fired”) or engages in other unfair labor practices, the NLRB may certify the union even though the union lost the election. Alternatively, the NLRB may ask a court to order a new election.

Whether an employer violated its employees’ rights under the National Labor Relations Act during a union election campaign was at issue in the following case.

C H A P T E R 2 2 Immigration and Labor Law 481

In the Language of the Court HAMILTON, Circuit Judge.HAMILTON, Circuit Judge.HAMILTON

* * * * * * * Contemporary Cars, Inc.,

* * * sells and services cars in Maitland, Florida. Bob Berryhill, the dealership’s general manager, is responsible for the dealership’s overall operations. * * * AutoNation owns the dealership, as well as over 200 other dealerships throughout the United States.

This case focuses on the dealership’s service department [which the dealership had previously split into three teams].

* * * The International Association of Machinists began a campaign * * * to organize the service technicians. * * * The technicians talked among them- selves and held off-site meetings.

* * * * * * * The union filed its representation

petition. The [National Labor Relations Board] approved the proposed bargaining unit, and an election was scheduled.

In the weeks before the election, Ber- ryhill and AutoNation vice president * * * Brian Davis held group [and indi- vidual] meetings [with the technicians]. * * * One week before the election, * * * Berryhill * * * announced that the dealership was working on fixing prob- lems the technicians had and that he was replacing two team leaders, [Andre] Grobler and Oudit Manbahal, with new team leaders.

* * * Technician Anthony Roberts * * * was then playing a leading role in the union organizing. * * * About a week before the union election, the dealership laid off Roberts, though Roberts had a higher skill rating, more hours, and more seniority than many other technicians.

* * * *

* * * The technicians voted in favor of unionizing.

* * * After the election, the dealer- ship challenged the certification of the union as the exclusive representative of a bargaining unit consisting of ser- vice technicians. * * * The [National Labor Relations] Board affirmed the certification.

* * * The Board * * * filed a com- plaint alleging that the dealership and AutoNation had violated * * * the National Labor Relations Act. * * * An administrative law judge found * * * that the dealership and Auto- Nation had indeed violated the Act by interfering with their employees’ protected rights to engage in concerted activity and to organize a union [and] by firing Anthony Roberts due to anti-union animus [hostility]. [The judge ordered the dealership to cease its interference with its employees’ rights and to reinstate Roberts. The judge also ordered AutoNation to post a notice at all of its dealerships that it was rescinding the no-solicitation rule.] The Board affirmed the * * * order.

The dealership and AutoNation peti- tioned [the U.S. Court of Appeals for Seventh Circuit] for judicial review. [The NLRB cross-petitioned for enforcement of the order.]

* * * * The administrative law judge found,

and the Board affirmed, that the dealer- ship and AutoNation in a number of instances acted unlawfully to frustrate their employees’ protected rights to engage in concerted activity and to orga- nize a union.

* * * *

* * * The dealer- ship violated [the Act] in the run-up to the election by coercively creating an impression of surveillance of union activ- ity, interrogating employees about union activity, and soliciting and promising to remedy employee grievances.

* * * * [Team Leader] Grobler created a

coercive impression of surveillance when he commented on technician Juan Cazorla’s attendance of union meetings.

* * * Grobler asked [Cazorla] why he was in such a rush to leave work * * * , suggesting that Cazorla had “that meet- ing” to go to. Cazorla pretended not to know what Grobler was talking about, although he was in fact rushing to get to a union meeting. Again [on a differ- ent occasion] Grobler commented to Cazorla that he had “better rush” since he had a meeting * * * . It would have been reasonable for Cazorla to infer from Grobler’s comments that his union activi- ties were under management surveillance.

* * * * * * * Berryhill coercively interrogated

employees [when he] called them indi- vidually into his office and asked them about union activity. The dealership’s service director was also present. * * * The setting of the meetings in Berryhill’s office, Berryhill’s and the director’s posi- tions of authority, and the fact that each technician was alone and outnumbered by managers all support the finding of coercion.

* * * * * * * At the * * * meetings, Berryhill

asked the technicians how the dealership could improve. * * * Berryhill [stated] that he was “working on” the problems and “in progress” on the solutions.

Case Analysis 22.2 Contemporary Cars, Inc. v. National Labor Contemporary Cars, Inc. v.

ational Labor Contemporary Cars, Inc. v.

Relations Board Contemporary Cars, Inc. v.

elations Board Contemporary Cars, Inc. v.

United States Court of Appeals, Seventh Circuit, 814 F.3d 859 (2016).

Case 22.2 Continues

482 U N I T F O U R The Business and Employment Environment

22–4 Collective Bargaining If the NLRB certifies the union, the union becomes the exclusive bargaining representative of the workers. The exclusive bargaining representative of the workers. The exclusive bargaining representative central legal right of a union is to engage in collective bargaining on the members’ behalf. Collective bargain- ing is the process by which labor and management negoing is the process by which labor and management negoing - tiate the terms and conditions of employment. Collective bargaining allows the representatives elected by union members to speak on behalf of the members at the bar- gaining table.

22–4a Terms and Conditions of Employment

Wages, hours of work, and certain other conditions of employment may be discussed during collective bargain- ing sessions. For instance, subjects for negotiation may

include workplace safety, employee discounts, health- care plans, pension funds, and apprentice and scholar- ship programs.

22–4b Good Faith Bargaining Once an employer and a union sit down at the confer- ence table, they must negotiate in good faith and make a reasonable effort to come to an agreement. They are not obligated to reach an agreement. They must, however, approach the negotiations with the idea that an agree- ment is possible. Both parties may engage in hard bar- gaining, but the bargaining process itself must be geared to reaching a compromise—not avoiding a compromise.

Although good faith is a matter of subjective intent, a party’s actions can be used to evaluate the party’s good or bad faith. For instance, excessive use of delaying tactics may be proof of bad faith, as is insistence on obviously unreasonable contract terms.

* * * The * * * meetings also included inquiries about the union effort. * * * This was an effort to frustrate the union organizing drive by soliciting and at least implicitly promising to adjust grievances.

* * * * * * * AutoNation vice president * * *

Davis coercively interrogated a * * * technician, Tumeshwar Persaud * * * . Davis * * * asked him how he felt about the union election. * * * The question forced Persaud, who had not previously disclosed his union support, either to disclose his own union sympathies or to report on his perception of his fellow employees’ union support.

* * * Davis held a meeting with employees at which he solicited employee complaints and, upon hearing that management had been unrespon- sive to employee complaints in the past, said that employees could call him or talk to him at any time. This meeting

was part of a series of * * * meetings that management held in the run-up to the union election. * * * Davis was implicitly promising to remedy griev- ances with the goal of frustrating the union effort.

* * * * * * * AutoNation * * * promul-

gated [publicized] an overly broad no-solicitation policy in the employee handbook used at all of its facilities. * * * AutoNation’s policy prohibited any solicitation on AutoNation property at any time. * * * The policy * * * amounted to an unfair labor practice because of the likelihood it would chill protected con- certed activity. [Emphasis added.]

* * * * * * * The dealership’s discharge of

Anthony Roberts * * * a week before the election was motivated by anti-union animus.

* * * *

* * * Berryhill’s identification of Roberts as a troublemaker and instiga- tor of the organizational campaign established that anti-union animus was a substantial factor motivating Roberts’s layoff. * * * The dealership’s stated reason for firing Roberts—that he lacked sufficient electronic diagnostic skills—failed to establish that Roberts would have been laid off in the absence of anti-union animus. * * * Roberts was more productive and had a higher skill rating than many technicians who were retained.

* * * * Substantial evidence and a reason-

able basis in law support the Board’s order and the administrative law judge’s order to the extent affirmed by the Board. We DENY the dealership and AutoNation’s petition for review and ENFORCE the Board’s order in its entirety.

Legal Reasoning Questions

1. What might the dealership have asserted in defense to the charge that its actions violated its employees’ rights? 2. After the election but before the union was certified, the dealership laid off four technicians and cut others’ pay without

bargaining with the union, claiming economic hard times. Did these steps constitute an unfair labor practice? Discuss. 3. What could the employer have done to avoid the charge in this case?

Case 22.2 Continued

C H A P T E R 2 2 Immigration and Labor Law 483

Union Organizing Using a Company’s E-Mail System

When union organizers start an organizing drive, there are certain restrictions on what they can do, particularly within the workplace. Both employers and employees must comply with Section 7 of the National Labor Relations Act (NLRA).

Protected Concerted Activities

Under Section 7, employees have certain rights to communicate among themselves. Section 7 states, “Employees shall have the right to self-organization, . . . and to engage in other concerted activities for the purpose of collective bargaining or other mutual aid or protection. . . .”

What about communication via e-mail? Can union organizers use a company-operated e-mail system for organizing purposes? Companies typically provide e-mail systems so that employees can communicate with outsiders and among themselves as part of their jobs. Generally, company policies have prohibited the use of company-owned and -operated e-mail systems for other than job-related communications. Starting in the early 2000s, some union organizers challenged this prohibition.

The NLRB’s Perspective Evolves

The first major case concerning this issue was decided by the National Labor Relations Board (NLRB) in 2007.a

The NLRB allowed an employer’s written policy that pro- hibited the use of a company-provided e-mail system for non-job-related solicitations. This decision was affirmed in relevant part by a federal court two years later.b

In late 2014, the NLRB reversed its 2007 position. “We decide today that employee use of e-mail for statutorily protected communica- tions on non-working time must presumptively be permitted by employers who have chosen to give employees access to their e-mail systems.”c

The NLRB argued that its 2007 decision had failed to adequately protect “employees’ rights

under the NLRA.” The board also stated that it had a responsibility “to adapt the Act to the changing patterns of industrial life.”

The new rules are clear. Once an organizing election is scheduled, a company must turn over all telephone numbers and home and e-mail addresses of the com- pany’s employees to union organizers within two days. The organizers can then communicate with employees via the company’s e-mail system.

Business Questions 1. Employees meeting around the water cooler or coffee

machine have always had the right to discuss work- related matters. Is an employer-provided e-mail system or social media outlet simply a digital water cooler? Why or why not?

2. If your company instituted a policy stating that employees should “think carefully about ‘friending’ co-workers,” would that policy be lawful? Why or why not?

MANAGERIAL STRATEGY

a. Register Guard, 351 NLRB 1110 (2007). b. Guard Publishing v. NLRB, 571 F.3d 53 (D.C. Cir. 2009).

c. Purple Communications, Inc. and Communication Workers of America, AFL-CIO, Cases 21-CA-095151, 21-RC-091531, and 21-RC- 091584, March 16, 2015.

If an employer (or a union) refuses to bargain in good faith without justification, it has committed an unfair labor practice. Exhibit 22–1 illustrates some differences between good faith and bad faith bargaining.

22–5 Strikes and Lockouts Even when labor and management have bargained in good faith, they may be unable to reach a final agree- ment. When extensive collective bargaining has been conducted and an impasse results, the union may call

a strike against the employer to pressure it into making concessions.

In a strike, the unionized employees leave their jobs and refuse to work. The workers also typically picket the workplace, standing outside the facility with signs stating their complaints.

A strike is an extreme action. Striking workers lose their rights to be paid, and management loses production and may lose customers when orders cannot be filled. Labor law regulates the circumstances and conduct of strikes.

Most strikes take the form of “economic strikes,” which are initiated because the union wants a better con- tract. ■ EXAMPLE 22.5 Teachers in Eagle Point, Oregon,

484 U N I T F O U R The Business and Employment Environment

engage in an economic strike after contract negotiations with the school district fail to bring an agreement on pay, working hours, and subcontracting jobs. The unionized teachers picket outside the school building. Classes are canceled for a few weeks until the district can find substi- tute teachers who will fill in during the strike. ■

22–5a The Right to Strike The right to strike is guaranteed by the NLRA, within limits. Strike activities, such as picketing, are protected by the free speech guarantee of the First Amendment to the U.S. Constitution. Persons who are not employees have a right to participate in picketing an employer. The NLRA also gives workers the right to refuse to cross a picket line of fellow workers engaged in a lawful strike. Employers are permitted to hire replacement workers to substitute for the striking workers.

22–5b Illegal Strikes In the following situations, the conduct of the strikers may cause the strikes to be illegal: 1. Violent strikes. The use of violence (including the

threat of violence) against management employees or substitute workers is illegal.

2. Massed picketing. If the strikers form a barrier and deny management or other nonunion workers access to the plant, the strike is illegal.

3. Sit-down strikes. Strikes in which employees simply stay in the plant without working are illegal.

4. No-strike clause. A strike may be illegal if it contra- venes a no-strike clause that was in the previous col- lective bargaining agreement between the employer and the union.

5. Secondary boycotts. A secondary boycottA secondary boycottA is an illegal secondary boycott is an illegal secondary boycott strike that is directed against someone other than the strikers’ employer, such as companies that sell materi- als to the employer. ■ EXAMPLE 22.6 The unionized The unionized workers of SemiCo go out on strike. To increase their economic leverage, the workers picket the leading suppliers and customers of SemiCo in an attempt to hurt the company’s business. SemiCo is considered the primary employer, and its suppliers and custom- ers are considered secondary employers. Picketing of the suppliers or customers is a secondary boycott. ■

6. Wildcat strikes. A wildcat strike occurs when a small number of workers, perhaps dissatisfied with a union’s representation, call their own strike. The union is the exclusive bargaining representative of a group of workers, and only the union can call a strike. Therefore, a wildcat strike, unauthorized by the certified union, is illegal.

22–5c After a Strike Ends In a typical strike, the employer has a right to hire per- manent replacements during the strike. The employer

1. Negotiating with the belief that an agreement is possible

2. Seriously considering the other side’s positions

3. Making reasonable proposals

4. Being willing to compromise

5. Sending bargainers who have the authority to enter into agreements for the company

BAD FAITH BARGAINING

1. Excessive delaying tactics

2. Insistence on unreasonable contract terms

3. Rejecting a proposal without offering a counterproposal

4. Engaging in a campaign among workers to undermine the union

5. Constantly shifting positions on disputed contract terms

6. Sending bargainers who lack authority to commit

GOOD FAITH BARGAINING

the company to a contract

E X H I B I T 2 2 – 1 Good Faith versus Bad Faith in Collective Bargaining

C H A P T E R 2 2 Immigration and Labor Law 485

need not terminate the replacement workers when the economic strikers seek to return to work. In other words, striking workers are not guaranteed the right to return to their jobs after the strike if satisfactory replacement workers have been found.

If the employer has not hired replacement workers to fill the strikers’ positions, however, then the employer must rehire the economic strikers to fill any vacancies. Employers may not discriminate against former eco- nomic strikers, and those who are rehired retain their seniority rights.

22–5d Lockouts Lockouts are the employer’s counterpart to the work- ers’ right to strike. A lockout occurs when the employer shuts down to prevent employees from working. Lock- outs usually are used when the employer believes that a strike is imminent or the parties have reached a stalemate in collective bargaining.in collective bargaining.in collective bargaining.in collective bargaining.

■ EXAMPLE 22.7 Owners of the teams in the National Football League (NFL) imposed a lockout on the NFL players’ union in 2011 after negotiations on a new collec- tive bargaining agreement broke down. The NFL own- ers had proposed to reduce players’ salaries and extend the season by two games because of decreased profits due to the struggling economy. A settlement was reached before the start of the 2011 football season. The players accepted a somewhat smaller proportion of the revenue generated in exchange for better working conditions and more retirement benefits. The owners agreed to keep the same number of games per season.

The owners of the teams in the National Basketball Association (NBA) also locked out their players in 2011 after the two sides failed to reach a collective bargaining agreement. The dispute involved the division of revenue

and a salary cap. During the lockout, the players could not access NBA facilities, trainers, or staff, and the own- ers could not trade, sign, or contract with players. The lockout lasted 161 days and resulted in the cancellation of all preseason games and several weeks of regular season games. ■

Some lockouts are illegal. An employer may not use a lockout as a tool to break the union and pressure employees into decertification, which occurs when union members vote to dissociate from the union. An employer must be able to show some economic justification for the lockout.

22–6 Unfair Labor Practices The preceding sections have discussed unfair labor prac- tices involved in union elections, collective bargain- ing, and strikes. Many unfair labor practices may occur within the normal working relationship as well. The most important of these practices are discussed in the following sections and listed in Exhibit 22–2.

22–6a Employer’s Refusal to Recognize the Union and to Negotiate

As discussed, once a union has been certified, an employer must recognize and bargain in good faith with the union. Failure to do so is an unfair labor practice.

Certification places responsibility on the union as well. Because the NLRA embraces a policy of majority rule, certification of the union as the bargaining unit’s representative binds all of the employees in that bargain- ing unit. Thus, the union must fairly represent all the members of the bargaining unit.

It is unfair for employers to... It is unfair for unions to...

1. Refuse to recognize a union and refuse to bargain in good faith.

2. Interfere with, restrain, or coerce employees in their efforts to form a union and bargain collectively.

3. Dominate a union. 4. Discriminate against union workers. 5. Punish employees for engaging in concerted

activity.

1. Refuse to bargain in good faith. 2. Picket to coerce unionization without the

support of a majority of the employees. 3. Demand the hiring of unnecessary excess

workers. 4. Discriminate against nonunion workers. 5. Agree to participate in a secondary boycott. 6. Engage in an illegal strike. 7. Charge excessive membership fees.

E X H I B I T 2 2 – 2 Basic Unfair Labor Practices

486 U N I T F O U R The Business and Employment Environment

Certification does not mean that a union will continue indefinitely as the exclusive representative of the bargain- ing unit. If the union loses the support of a majority of those it represents, an employer is not obligated to con- tinue to recognize or negotiate with the union.

As a practical matter, a newly elected representative needs time to establish itself among the workers and to begin to formulate and implement its programs. There- fore, a union is immune from attack by employers and from repudiation by the employees for a period of one year after certification.

22–6b Employer’s Interference in Union Activities

The NLRA declares it to be an unfair labor practice for an employer to interfere with, restrain, or coerce employ- ees in the exercise of their rights to form a union and bargain collectively. Unlawful employer interference may take a variety of forms.

Courts have found it an unfair labor practice for an employer to make threats that may interfere with an employee’s decision to join a union. Even asking employ- ees about their views on the union may be considered coercive. Employees responding to such questioning must be able to remain anonymous and must receive assurances against employer reprisals.

Employers also may not prohibit certain forms of union activity in the workplace. If an employee has a grievance with the company, the employer cannot prevent the union’s participation in support of that employee.

If an employer has unlawfully interfered with the operation of a union, the NLRB or a reviewing court may issue a cease-and-desist order halting the practice. The company typically is required to post the order on a bulletin board and renounce its past unlawful conduct.

Protected, concerted activity can take many forms. In the following case, the question was whether an employee’s objection to another employee’s discharge was “insubordinate behavior” or a protected act.

Background and Facts Staffing Network Holdings, LLC, provides temporary and long-term employees to a variety of employers, including ReaderLink, a company that fills book orders for other businesses. ReaderLink’s workers include “pickers,” who select books to fill orders and place the books in boxes. Other employees include “stockers,” who bring the boxes to the pickers to fill.

One afternoon, Staffing Network’s on-site manager at ReaderLink, Andy Vega, fired a stocker for his “attitude.” Griselda Barrera, Olga Gutierrez, and other pickers complained that this was not fair. Vega replied that he could send them all home. Barrera told the others to “stand up against all the injustice.” Vega told her to leave. She protested but left. Later, she was told not to return.

Barrera filed a claim for unemployment compensation. The state asked Staffing Network to provide the reason for her separation from work, to which Staffing Network responded that Barrera was dis- rupting production. Barrera also filed an unfair labor practice charge with the National Labor Relations Board (NLRB). The NLRB filed a complaint against Staffing Network for terminating Barrera. An admin- istrative law judge (ALJ) rejected the employer’s claim that Barrera’s “insubordinate behavior” justified the discharge, and ordered reinstatement and payment of back wages and benefits. Staffing Network petitioned for review. The NLRB petitioned for enforcement of the ALJ’s order.

In the Language of the Court ROVNER, Circuit Judge.

* * * * Accepting the ALJ’s factual findings (which were in turn affirmed by the Board), the only * * *

question is whether those facts lend substantial evidence to the Board’s finding that the company wrong- fully terminated Barrera * * * . An employer violates [the National Labor Relations Act] when it threatens employees with discipline or discharge for engaging in concerted activity that is protected. Threats of dis- charge, discipline, other reprisals against employees for engaging in union activity violate the Act because these acts reasonably tend to coerce employees in the exercise of their rights, regardless of whether they

Staffing Network Holdings, LLC v. National Labor

taffing ational Labor taffing

Relations Board oldings, LLC v.

elations Board oldings, LLC v.

United States Court of Appeals, Seventh Circuit, 815 F.3d 296 (2016).

Case 22.3

C H A P T E R 2 2 Immigration and Labor Law 487

do, in fact, coerce. The tendency to coerce is judged from the viewpoint of the employee. [Emphasis added.]

* * * The company’s response to the State’s unemployment inquiry provides a veritable smoking gun on the issue of the reason for Barrera’s termination. Asked to provide the reason for Barrera’s involun- tary separation, Staffing Network explained that after a stocker was told to speed up his work, Barrera objected and then began “talking to some of the ladies in the line disrupting the production.” According to Vega’s own description of events, after he told Barrera to punch out and go home “if she does not want to work,” Barrera “ignored the request and continued to get the ladies in the line worked up saying this was going against the law and that they have to stand up against all the injustice we are commit- ting. Due to this, Griselda Barrera cannot return to ReaderLink.” With this response to the State, the company essentially admitted the relevant facts supporting the ALJ’s conclusion. It is well settled that a brief, on-the-job work-stoppage is a form of economic pressure entitled to protection under the Act. That is the type of action that Vega described in his response to the State in justifying Barrera’s discharge. Witness testimony also supported the finding that Staffing Network terminated Barrera because of her concerted, protected activity in protesting Vega’s treatment of [the stocker] in relation to the terms and conditions of his employment and that of the pickers. Namely, Barrera and Gutierrez both testified that Vega told Barrera to leave because she and the other pickers protested Vega’s unfair treatment of [the stocker]. Therefore, substantial evidence supports the Board’s finding that the company violated the Act when it discharged Barrera for engaging in protected, concerted activity. [Emphasis added.]

Decision and Remedy The U.S. Court of Appeals for the Seventh Circuit denied Staffing Network’s peti- tion for review and granted the NLRB’s petition for enforcement of the ALJ’s order. “The pickers’ temporary work stoppage and complaints to Vega regarding his treatment of [the fired stocker] constituted protected, concerted activity.”

Critical Thinking • Legal Environment The NLRB ordered Staffing Network to reinstate Barrera at ReaderLink and to

pay her back wages and benefits. What other remedies might be appropriate in this case? • What If the Facts Were Different? Suppose that instead of telling Barrera to leave Vega had said,

“Get back to work” and had then left the area. Would the result have been different? Discuss.

Case 22.3 Continued

22–6c Employer’s Domination of a Union In the early days of unionization, employers fought back by forming employer-sponsored unions to represent employees. These “company unions” were seldom more than the puppets of management. The NLRA outlawed company unions and any other form of employer domi- nation of workers’ unions.

Under the law against employer domination, an employer can have no say in which employees belong to the union or which employees serve as union officers. Nor may supervisors or other management personnel participate in union meetings.

Company actions that support a union may be con- sidered improper potential domination. A company cannot give union workers pay for time spent on union activities, because this is considered undue support for the union. A company may not provide financial aid to a union and may not solicit workers to join a union.

22–6d Employer’s Discrimination against Union Employees

The NLRA prohibits employers from discriminating against workers because they are union officers or are otherwise associated with a union. When workers must be laid off, the company cannot consider union partici- pation as a criterion for deciding whom to fire.

The provisions prohibiting discrimination also apply The provisions prohibiting discrimination also apply The provisions prohibiting discrimination also apply The provisions prohibiting discrimination also apply to hiring decisions. ■ EXAMPLE 22.8 Certain employees of SemiCo are represented by a union, but the company is attempting to weaken the union’s strength. The com- pany is prohibited from requiring potential new hires to guarantee that they will not join the union. ■

22–6e Union’s Unfair Labor Practices Certain union activities are declared to be unfair labor practices by the Labor-Management Relations Act.

488 U N I T F O U R The Business and Employment Environment

Secondary boycotts and illegal strikes, discussed earlier, are examples of such unfair labor practices.

Coercion Another significant unfair labor practice by a union is coercion or restraint to affect an employee’s decision to participate in or refrain from participating in union activities. Obviously, it is unlawful for a union to threaten an employee or a family with violence for failure to join the union. The law’s prohibition includes failure to join the union. The law’s prohibition includes failure to join the union. The law’s prohibition includes failure to join the union. The law’s prohibition includes economic coercion as well. ■ EXAMPLE 22.9 A union official declares, “We have a lot of power here. You had better join the union, or you may lose your job.” This threat is an unfair labor practice. ■

The NLRA provides unions with the authority to reg- ulate their own internal affairs, which includes disciplin- ing union members. This discipline cannot be used in ing union members. This discipline cannot be used in ing union members. This discipline cannot be used in an improperly coercive fashion, however. ■ EXAMPLE 22.10 Jake Kowalski is a union member who feels that the union is no longer providing proper representation for employees at his workplace. He starts a campaign to decertify the union. The union may expel Kowalski from membership, but it may not fine or otherwise discipline the worker. ■

Discrimination A union may not discriminate against workers because they refuse to join. In addition, the Labor-Management Relations Act also prohibits a union from using its influence to cause an employer to dis- criminate against workers who refuse to join the union.

A union cannot force an employer to deny promotions to workers who fail to join the union.

Other Unfair Practices Other unfair labor prac- tices by unions include demanding the hiring of unnec- essary workers, participating in picketing to coerce unionization without majority employee support, and refusing to engage in good faith bargaining with employer representatives.

Unions are allowed to bargain for certain “union security clauses” in contracts. Although closed shops are illegal, a union can bargain for a provision that requires workers to contribute to the union within thirty days after they are hired. This is typically called a union shop, or agency shop, clause.

The union shop clause can compel workers to begin paying dues to the certified union but cannot require the worker to “join” the union. Dues payment can be required to prevent workers from taking the benefits of union bargaining without contributing to the union’s efforts. The clause cannot require workers to contrib- ute their efforts to the union, however, or to go out on strike.

Even a requirement of dues payment has its limits. Excessive initiation fees or dues may be illegal. Unions often use their revenues to contribute to causes or to lobby politicians. A nonunion employee subject to a union shop clause who must pay dues cannot be required to contribute to this sort of union expenditure.

Reviewing: Immigration and Labor Law

In April 2017, several employees of Javatech, Inc., a computer hardware developer with 250 employees, started orga- nizing the Javatech Employees Union (JEU). When Javatech refused to voluntarily recognize the union, organizers petitioned the National Labor Relations Board (NLRB) for an election. In June, the NLRB conducted an election that showed that a majority of Javatech employees supported the union. JEU was certified and began bargaining with management over wages and benefits.

In January 2018, Javatech management offered the JEU a 1 percent annual wage increase for all employees with no other changes in employment benefits. The JEU countered by requesting a 3 percent wage increase and an employee health-insurance package. Javatech management responded that the 1 percent wage increase was the company’s only offer. The JEU petitioned the NLRB for an order requesting good faith bargaining. After meeting with an NLRB rep- resentative, Javatech management still refused to consider modifying its position. JEU leaders then became embroiled in a dispute about whether the JEU should accept this offer or go on strike.

New union leaders were elected in July 2018, and the employer refused to meet with the new JEU representatives, claiming that the union no longer had majority support from employees. In August 2018, a group of seven Javatech engineers began feeling ill while working with a new adhesive used in creating motherboards. The seven engineers discussed going on strike without union support. Before they had reached an agreement, one of the engineers, Rosa Molina, became dizzy while working with the adhesive and walked out of the workplace. Using the information pre- sented in the chapter, answer the following questions.

C H A P T E R 2 2 Immigration and Labor Law 489

1. How many of Javatech’s 250 employees must have signed authorization cards to allow the JEU to petition the NLRB for an election?

2. What must Javatech change in its collective bargaining negotiations to demonstrate that it is bargaining in good faith with the JEU, as required by labor law?

3. Could the seven engineers legally call a strike? What would such a strike be called? 4. Would Molina’s safety walkout be protected under the Labor-Management Relations Act? Explain.

Debate This . . . To attract the brightest minds to work in the United States, there should be no limit on the number of H-1B visas available to immigrants with highly specialized knowledge.

Terms and Concepts authorization card 479 cease-and-desist order 477 closed shop 478 collective bargaining 482 hot-cargo agreement 478

I-9 veri�cation 474 I-551 Alien Registration

Receipt 475 lockout 485 right-to-work law 478

secondary boycott 484 strike 483 union shop 478

Issue Spotters 1. Aanan Gara is the head of human resources at Skytech,

Inc., a �rm in Silicon Valley, California. Because Sky- tech cannot �nd enough domestic workers with special- ized skills, Gara wants to recruit quali�ed employees from other nations. What must Gara do under the Immigration Act to hire foreign employees for Skytech? (See Immigra- tion Law.)

2. Onyx applies for work with Precision Design Company, which tells her that it requires union membership as a

condition of employment. She applies for work with Quality Engineering, Inc., which does not require union membership as a condition of employment but requires employees to join a union after six months on the job. Are these conditions legal? Why or why not? (See Federal Labor Laws.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 22–1. Unfair Labor Practices. Consolidated Stores is undergoing a unionization campaign. Prior to the union election, management states that the union is unnecessary to protect workers. Management also provides bonuses and wage increases to the workers during this period. The employees reject the union. Union organizers protest that the wage increases during the election campaign unfairly prejudiced the vote. Should these wage increases be regarded as an unfair labor practice? Discuss. (See Unfair Labor Practices.)

22–2. Appropriate Bargaining Unit. A group of employees at the Briarwood Furniture Co.’s manufacturing plant were inter- ested in joining a union. The Briarwood Furniture Co., employs 400 unskilled workers and 100 skilled workers in its plant. The unskilled workers operate the industrial machinery used in pro- cessing Briarwood’s line of standardized plastic office furniture. The skilled workers, who work in an entirely separate part of the plant, are experienced artisans who craft Briarwood’s line of expensive wood furniture products. Do you see any problems with a single union’s representing all the workers at the Briarwood plant? Explain. (See Collective Bargaining.)Collective Bargaining.)Collective Bargaining

490 U N I T F O U R The Business and Employment Environment

Business Case Problems 22–3. Spotlight on Verizon—Collective Bargaining.

Verizon New York, Inc. (VNY), provides telecom- munications services. VNY and the Communica- tions Workers of America (CWA) are parties to collective bargaining agreements covering installa-

tion and maintenance employees. At one time, VNY supported annual blood drives. VNY, the CWA, and charitable organi- zations jointly set dates, arranged appointments, and adjusted work schedules for the drives. For each drive, about a thousand employees, including managers, spent up to four hours travel- ing to a donor site, giving blood, recovering, and returning to their jobs. Employees received full pay for the time. In 2001, VNY told the CWA that it would no longer allow employees to participate “on Company time,” claiming that it had expe- rienced problems meeting customer requests for service during the drives. �e CWA �led a complaint with the National Labor Relations Board (NLRB), asking that VNY be ordered to bar- gain over the decision. Did VNY commit an unfair labor prac- tice? Should the NLRB grant the CWA’s request? Why or why not? [Verizon New York, Inc. v. National Labor Relations Board, 360 F.3d 206 (D.C.Cir. 2004)] (See Collective Bargaining.)Collective Bargaining.)Collective Bargaining 22–4. Business Case Problem with Sample Answer—

Unfair Labor Practices. �e Laborers’ Inter- national Union of North America, Local 578, and Shaw Stone & Webster Construction, Inc., agreed on a provision in their collective bargaining agree-

ment that required all employees to pay dues to the union. Sebedeo Lopez went to work for Shaw Stone without paying the union dues. When the union pressed the company to �re him, Lopez agreed to pay. �e union continued to demand his dis- charge, however, and Shaw Stone �red him. Was the union guilty of unfair labor practices? Why or why not? [Laborers’ Interna- tional Union of North America, Local 578 v. National Labor Rela- tions Board, 594 F.3d 732 (10th Cir. 2010)] (See Unfair Labor Practices.) • For a sample answer to Problem 22–4, go to Appendix E at

the end of this text. 22–5. Collective Bargaining. SDBC Holdings, Inc., acquired Stella D’oro Biscuit Co., a bakery in New York City. At the time, a collective bargaining agreement existed between Stella D’oro and Local 50, Bakery, Confectionary, Tobacco Workers and Grain Millers International Union. During negotiations to renew the agreement, Stella D’oro refused to give the union a copy of the company’s �nancial statement. Stella D’oro did allow Local 50 to examine and take notes on the �nancial statement and o�ered the union an opportunity to make its own copy. Did Stella D’oro engage in an unfair labor practice? Discuss. [SDBC Holdings, Inc. v. National Labor Relations Board, 711 F.3d 281 (2d Cir. 2013)] (See Collective Bargaining.)Collective Bargaining.)Collective Bargaining

22–6. Labor Unions. Carol Garcia and Pedro Salgado were bus drivers for Latino Express, Inc., a transportation com- pany. Garcia and Salgado began soliciting signatures from other drivers to certify the Teamsters Local Union No. 777 as the o�cial representative of the employees. Latino Express �red Garcia and Salgado. �e two drivers �led a claim with the National Labor Relations Board (NLRB), alleging that the employer had committed an unfair labor practice. Which employer practice de�ned by the National Labor Relations Act did the plainti�s most likely charge Latino Express with committing? Is the employer’s discharge of Garcia and Sal- gado likely to be construed as a legitimate act in opposition to union solicitation? If a violation is found, what can the NLRB do? Discuss. [Ohr v. Latino Express, Inc., 776 F.3d 469 (7th Cir. 2015)] (See Union Organization.)

22–7. A Question of Ethics —Immigration Work Status. Mohammad Hashmi, a citizen of Pakistan, entered the United States in 2002 on a student visa. Two years later, when he applied for a job at Compu- Credit, he completed an I-9 form and checked the

box to indicate that he was “a citizen or national of the United States.” Soon after submitting that form, he married a U.S. citizen. Several months later, the federal immigration services claimed that Hashmi had misrepresented himself as a U.S. citi- zen. Hashmi contended that he had not misrepresented himself. At an administrative hearing, he testi�ed that when he �lled out the I-9 form he believed that he was a “national of the United States” because he was legally in the country under a student visa and was going to marry a U.S. citizen. He requested that his immigration status be adjusted to account for the fact that he was employed and married to an American. �e immigration judge rejected that request and found that Hashmi had made a false claim on the I-9 form. He ruled that Hashmi was “inadmissible” to the United States and that his legal status in the country could not be amended because of his marriage or employment. Hashmi appealed. [Hashmi v. Mukasey, appealed. [Hashmi v. Mukasey, appealed. [ 533 F.3d 700 (8th Cir. 2008)] (See Immigration Law.)

(a) Was it reasonable for Hashmi to think that he was a U.S. national? What if his misunderstanding was due to the fact that he was not proficient in the English language?

(b) Should Hashmi’s visa status be changed because of his marriage and employment? Why or why not? How should the appellate court rule in this case?

(c) Should the court consider what happens to Hashmi’s wife if he is denied legal status? In general, should the law consider the interests of family members when determining a person’s immigration status? Explain.

C H A P T E R 2 2 Immigration and Labor Law 491

Legal Reasoning Group Activity 22–8. Immigration. Nicole Tipton and Sadik Seferi owned and operated a restaurant in Iowa. Acting on a tip from the local police, agents of Immigration and Customs Enforcement executed search warrants at the restaurant and at an apartment where some restaurant workers lived. �e agents discovered six undocumented aliens working at the restaurant and living together. When the I-9 forms for the restaurant’s employees were reviewed, none were found for the six aliens. �ey were paid in cash while other employees were paid by check. Tipton and

Seferi were charged with hiring and harboring undocumented aliens. (See Immigration Law.)

(a) The first group will develop an argument that Tipton and Seferi were guilty of hiring and harboring illegal aliens.

(b) The second group will assess whether Tipton and Seferi can assert a defense by claiming that they did not know that the workers were unauthorized aliens.

492

Health Insurance and Small Business

Small businesses are the foundation of the U.S. economy. Increasing health-care costs and decreasing insurance coverage between 2000 and 2010 forced many small firms to stop offering health-care coverage to their employees.

Recent legislation put in place comprehensive health-insurance reforms intended to improve access, affordability, and quality in health care. An especially important law is the Patient Protec- tion and Affordable Care Act (ACA) of 2010 (often referred to as Obamacare). The ACA sets forth responsibilities and benefits for businesses determined in part by the size of an employer’s workforce.1

What Is a Small Business? The ACA defines a small business as a firm with fewer than fifty full-time equivalent (FTE) small business as a firm with fewer than fifty full-time equivalent (FTE) small business employees. An FTE is an employee who works thirty or more hours per week. Two half-time employees count as one FTE.

This definition fits about 96 percent of all businesses (5.8 million out of 6 million firms). In fact, 90 percent of all U.S. firms have fewer than twenty FTEs.

What Responsibilities Does the ACA Impose on Small Businesses? Large businesses—those with fifty or more FTEs—are required to offer health insurance to their employees or pay a penalty.2 For a small business, there is no requirement to offer health insurance. For a small firm that chooses to do so, the ACA imposes minimum standards on health plans.

Summary of Benefits and Coverage All employers, including small businesses, are required to provide their employees with a “Summary of Benefits and Coverage” that includes an explana- tion of the costs. The summary should be in plain language. Employees can use this information to compare their employer’s plan with private plans, which the employees may opt to buy instead. An employer is not required to contribute to the premium for an employee’s private plan.

Waiting Period Employees who are eligible for employer-sponsored health insurance must not be made to wait more than ninety days for coverage.

Notice of Marketplace Coverage Options Small businesses that do not offer health insur- ance can provide their employees with a “Notice of Marketplace Coverage Options.” The notice can inform employees about their options with respect to the health-insurance marketplace.

1. For the complete text of the ACA, see Pub. L. No. 111-148. Also significant are the health-care amendments of the Health Care and Education Reconciliation Act of 2010; see Pub. L. No. 111-152.

2. Before the ACA, more than 95 percent of these employers already offered health insurance to their employees.

U N I T F O U R Application and EthicsU N I T F O U R Application and Ethics

493

Annual Returns All employers that provide self-insured health coverage are required to file annual information returns with the Internal Revenue Service for the individuals that are covered.3

What Benefits Does the ACA Offer Small Businesses? The ACA provides benefits to small business by expanding insurance coverage options, reduc- ing related costs, and giving employers and employees more control over their own health care.

Health-Insurance Marketplace A small business can buy health-insurance coverage for its employees through the ACA’s Small Business Health Options Program (SHOP). Coverage can be offered to employees any time during the year.

The SHOP marketplace offers multiple plans from private insurance companies. An employer can choose which plans to make available to its employees, whether to cover the employees’ dependents, how much of the premiums the employer will pay, and other options.4

Small Business Health-Care Tax Credit Employers with fewer than twenty-five FTEs, each of whom are paid an average annual wage of less than $50,000, may be eligible for a health-care tax credit. To be eligible, an employer must cover at least 50 percent of the cost of the premiums for its employees’ health insurance and buy the coverage through SHOP. Dental and vision care coverage also qualifies. An employer does not need to offer coverage to part-time employees (those working fewer than thirty hours per week) or to employees’ dependents to qualify for the credit.

The amount of the credit may be as much as 50 percent of an employer’s contribution toward its employees’ premium costs. The smaller the business, the higher the credit—the credit is highest for firms with fewer than ten employees paid an average of $25,000 or less. And eli- gible small businesses can claim a business expense deduction for the premiums in excess of the credit.5

Wellness Programs A wellness program requires individuals to meet a specific standard related to health, such as a lower blood cholesterol level, to obtain a reward. Employers that promote employee health through workplace wellness programs are eligible for a reward of up to 30 percent of the cost of health coverage. The reward for a program designed to prevent or reduce the use of tobacco can be as much as 50 percent. The cost of health coverage includes employer-paid premiums and benefits.

Rebates The ACA requires insurance companies to spend at least 80 percent of premiums on medical care, not administrative costs. Insurers who do not meet this goal must provide rebates to policyholders.6 This includes employers that provide group health insurance for their employees.

3. 26 U.S.C. Section 6055. 4. See U.S. Department of Health and Human Services, SHOP Marketplace How-To Guides, Fact Sheets, Tools, and Other

Resources for Employers (December 11, 2015), available at www.healthcare.gov/small-businesses/provide-shop-coverage/Resources for Employers (December 11, 2015), available at www.healthcare.gov/small-businesses/provide-shop-coverage/Resources for Employers resources.

5. See Internal Revenue Service, Small Business Health Care Tax Credit and the SHOP Marketplace (December 11, 2015), avail-Small Business Health Care Tax Credit and the SHOP Marketplace (December 11, 2015), avail-Small Business Health Care Tax Credit and the SHOP Marketplace able at www.irs.gov/Affordable-Care-Act/Employers/Small-Business-Health-Care-Tax-Credit-and-the-SHOP-Marketplace.

6. See Internal Revenue Service, Medical Loss Ration (MLR) FAQs (December 11, 2015) at www.irs.gov/uac/Medical Loss Ration (MLR) FAQs (December 11, 2015) at www.irs.gov/uac/Medical Loss Ration (MLR) FAQs Medical-Loss-Ratio-(MLR)-FAQs.

U N I T F O U R Application and Ethics

Continues

494

Standard Operating Rules The ACA accelerated the adoption of standard operating rules for health-insurance plan administration. Operating rules are the business rules and guidelines for health-insurance plans. The ACA requires one format and one set of codes for claims, remit- tance advice, service authorization, eligibility verification, and claims status inquiry.

Nondiscriminatory Pricing The ACA ended the discriminatory insurance industry practice of increasing premiums because an employee filed a claim or got older or because a business hired a woman. At one time, premiums could increase by up to 200 percent in these circumstances.

Ethical Connection There has been considerable opposition to the ACA. For example, the mandate that large businesses offer health insurance to their employees or pay a penalty—called “the Obamacare effect”—has been much criticized. Detractors express concern that the mandate creates an incentive for large businesses to employ part-time workers instead of full-time employees. Dur- ing the period preceding the start date of the ACA and the end of 2014, however, in the private sector the number of part-time jobs decreased and the number of full-time positions decreased and the number of full-time positions decreased increased.increased.increased

To date, there is controversial evidence that employers are reducing the hours of their employees to avoid the requirements of the ACA.7 Many argue that the reduction in the per- centage of Americans who could work but are choosing to remain out of the labor force is due to Obamacare. Why? Because good-paying full-time job opportunities have shrunk due to the higher employer cost of hiring.

Ethics Question Are small businesses ethically obligated to offer their employees health insurance? Discuss.

Critical Thinking Should the mandate to offer employees health insurance be extended to include small businesses? Or should it be repealed altogether? Explain.

7. Also, in separate legal challenges to the ACA, the United States Supreme Court has upheld key parts of the act. See National Federation of Business v. Sebelius, __ U.S. __, 132 S.Ct. 2566, 183 L.Ed.2d 450 (2012); and King v. Burwell, __ U.S. __, 135 King v. Burwell, __ U.S. __, 135 King v. Burwell S.Ct. 2480, 192 L.Ed.2d 483 (2015). The Court has held certain U.S. Department of Health and Human Services regula- tions issued under the act to be invalid, however. See Burwell v. Hobby Lobby Stores, Inc., __ U.S. __, 134 S.Ct. 2751, 189 L.Ed.2d 675 (2014).

U N I T F O U R Application and Ethics

Unit Five

�e Regulatory Environment

23. Administrative Agencies

24. Consumer Protection

25. Environmental Law

26. Real Property and Land-Use Control

27. Antitrust Law

28. Investor Protection and Corporate Governance

496

Safety and Health Administration affect the way a firm manufactures its products, and the Federal Trade Com- mission influences the way it markets those products.

There are administrative agencies at the state and local levels as well. Commonly, a state agency (such as a state pollution-control agency) is created as a parallel to a federal agency (such as the Environmental Protec- tion Agency). Just as federal statutes take precedence over conflicting state statutes, so do federal agency regula- tions take precedence over conflicting state regulations. Because the rules of state and local agencies vary widely, we focus here exclusively on federal administrative law.

23–1b Agencies Provide a Comprehensive Regulatory Scheme

Often, administrative agencies at various levels of govern- ment work together and share the responsibility of creatment work together and share the responsibility of creatment work together and share the responsibility of creatment work together and share the responsibility of creat- ing and enforcing particular regulations. ■ EXAMPLE 23.1 When Congress enacted the Clean Air Act, it provided only general directions for the prevention of air pollution. The specific pollution-control requirements imposed on businesses are almost entirely the product of decisions made by the Environmental Protection Agency (EPA). Moreover, the EPA works with parallel environmental agencies at the state level to analyze existing data and determine the appropriate pollution-control standards. ■

23–1 The Practical Significance of Administrative Law

Whereas statutory law is created by legislatures, admin- istrative law is created by administrative agencies. When Congress—or a state legislature—enacts legislation, it typically adopts a rather general statute and leaves its implementation to an administrative agency. The agency then creates the detailed rules and regulations necessary to carry out the statute. The administrative agency, with its specialized personnel, has the time, resources, and expertise to make the detailed decisions required for regulation.

23–1a Administrative Agencies Exist at All Levels of Government

Administrative agencies are spread throughout the government. At the federal level, the Securities and Exchange Commission regulates a firm’s capital struc- ture and financing, as well as its financial reporting. The National Labor Relations Board oversees relations between a firm and any unions with which it may deal. The Equal Employment Opportunity Commission also regulates employer-employee relationships. The Envi- ronmental Protection Agency and the Occupational

G overnment agencies estab- lished to administer the law have a great impact on the

day-to-day operations of businesses. In its early years, the United States had a simple, nonindustrial economy with little regulation. As the econ- omy has grown and become more complex, the size of government has also increased, and so has the num- ber, size, and power of administrative agencies.

In some instances, new agencies have been created in response to a crisis. In the wake of the financial crisis that led to the latest economic recession, for instance, Congress enacted the Dodd-Frank Wall Street Reform and Consumer Protection Act. Among other things, this statute created the Financial Stability Over- sight Council to identify and respond to emerging risks in the financial sys- tem. It also created the Consumer

Financial Protection Bureau (CFPB) to protect consumers from alleged abu- sive practices by financial institutions, mortgage lenders, and credit-card companies.

As the number of agencies has multiplied, so have the rules, orders, and decisions that they issue. Today, there are rules covering almost every aspect of a business’s operations. These regulations make up the body of administrative law.

Administrative Agencies

C H A P T E R 2 3

C H A P T E R 2 3 Administrative Agencies 497

Legislation and regulations have significant ben- efits—in the example of the Clean Air Act, a cleaner environment than existed in decades past. At the same time, these benefits entail considerable costs for business. The EPA has estimated the costs of compliance with the Clean Air Act at many tens of billions of dollars yearly. Although the agency has calculated that the overall ben- efits of its regulations often exceed their costs, the burden on business is substantial. Business therefore has a strong incentive to try to influence the regulatory environment through lobbying.

23–2 Agency Creation and Powers Congress creates federal administrative agencies. By del- egating some of its authority to make and implement laws, Congress can indirectly monitor a particular area in which it has passed legislation. Delegation enables Congress to avoid becoming bogged down in the details relating to enforcement—details that are often best left to specialists.

To create an administrative agency, Congress passes enabling legislation, which specifies the name, pur- poses, functions, and powers of the agency being created. Federal administrative agencies can exercise only those powers that Congress has delegated to them in enabling legislation. Through similar enabling acts, state legisla- tures create state administrative agencies.

An agency’s enabling statute defines its legal authority. An agency cannot regulate beyond the powers granted by the statute, and it may be required to take some regulatory action by the terms of that statute. When regulated groups oppose a rule adopted by an agency, they often bring a lawsuit arguing that the rule was not authorized by the enabling statute and is therefore void. Conversely, a group may file a suit claiming that an agency has illegally failed to failed to failed pursue regulation required by the enabling statute.

23–2a Enabling Legislation—An Example Congress created the Federal Trade Commission (FTC) in the Federal Trade Commission Act.1 The act prohib- its unfair methods of competition and deceptive trade practices. It also describes the procedures that the FTC must follow to charge persons or organizations with vio- lations of the act, and it provides for judicial review of agency orders. The act grants the FTC the power to do the following:

1. 15 U.S.C. Sections 41–58.

1. Create “rules and regulations for the purpose of car- rying out the Act.”

2. Conduct investigations of business practices. 3. Obtain reports from interstate corporations concern-

ing their business practices. 4. Investigate possible violations of federal antitrust

statutes. (The FTC shares this task with the Antitrust Division of the U.S. Department of Justice.)

5. Publish findings of its investigations. 6. Recommend new legislation. 7. Hold trial-like hearings to resolve certain trade dis-

putes that involve FTC regulations or federal anti- trust laws.

The commission that heads the FTC is composed of five members. The president, with the advice and consent of the Senate, appoints each of the FTC commissioners for a term of seven years. The president also designates one of the commissioners to be the chair.

23–2b Types of Agencies There are two basic types of administrative agencies: executive agencies and independent regulatory agencies. Federal executive agencies include the cabinet departexecutive agencies include the cabinet departexecutive agencies - ments of the executive branch, which assist the president in carrying out executive functions, and the subagen- cies within the cabinet departments. The Occupational Safety and Health Administration, for instance, is a sub- agency within the U.S. Department of Labor.

Executive agencies usually have a single adminis- trator, director, or secretary who is appointed by the president to oversee the agency and can be removed by the president at any time. Exhibit 23–1 lists the cabinet departments and some of their most important subagencies.

Independent regulatory agencies, such as the Federal Trade Commission and the Securities and Exchange Commission (SEC), are outside the federal executive departments (those headed by a cabinet secretary). The president’s power is less pronounced in regard to inde- pendent agencies, whose officers serve for fixed terms and cannot be removed without just cause. See Exhibit 23–2 for a list of selected independent regulatory agencies and their principal functions.

23–2c Agency Powers and the Constitution Administrative agencies occupy an unusual niche in the U.S. governmental structure, because they exercise pow- ers that normally are divided among the three branches of government. Agencies’ powers include functions

498 U N I T F I V E The Regulatory Environment

associated with the legislature (rulemaking), the executive branch (enforcement), and the courts (adjudication).

The constitutional principle of checks and balances The constitutional principle of checks and balances The constitutional principle of allows each branch of government to act as a check on the actions of the other two branches. Furthermore, the U.S. Constitution authorizes only the legislative branch to create laws. Yet administrative agencies, to which the Constitution does not specifically refer, can make

legislative rules, or substantive rules, that are as legally binding as laws that Congress passes.

Administrative agencies also issue interpretive rules, which simply declare policy and do not affect legal rights which simply declare policy and do not affect legal rights which simply declare policy and do not affect legal rights which simply declare policy and do not affect legal rights or obligations. ■ EXAMPLE 23.2 The Equal Employ- ment Opportunity Commission periodically issues interpretive rules indicating how it plans to interpret the provisions of certain statutes, such as the Americans with

SELECTED SUBAGENCIES

Passport Office; Bureau of Diplomatic Security; Foreign Service; Bureau of Intelligence and Research

Internal Revenue Service; U.S. Mint

U.S. Fish and Wildlife Service; National Park Service; Bureau of Indian Affairs; Bureau of Land Management

Federal Bureau of Investigation; Drug Enforcement Administration; Bureau of Prisons; U.S. Marshals Service

Soil Conservation Service; Agricultural Research Service; Food Safety and Inspection Service

Bureau of the Census; Bureau of Economic Analysis; U.S. Patent and Trademark Office; National Oceanic and Atmospheric Administration

Occupational Safety and Health Administration; Bureau of Labor Statistics; Employment Standards Administration; Office of Labor-Management Standards

National Security Agency; Joint Chiefs of Staff; Departments of the Air Force, Navy, Army; Departments of the Air Force, Navy, Army; Departments of the Air Force, Navy

Government National Mortgage Association; Office of Fair Housing and Equal Opportunity

Federal Aviation Administration; Federal Highway Administration; National Highway TFederal Aviation Administration; Federal Highway Administration; National Highway TFederal A raffic Safety Administration

Office of Civilian Radioactive Waste Management; Office of Nuclear Energy; Energy Information Administration

Food and Drug Administration; Centers for Medicare and Medicaid Services; Centers for Disease Control and Prevention; National Institutes of Health

Office of Elementary and Secondary Education; Office of Postsecondary Education; Office of Vocational and Adult Education

Veterans Health Administration; Veterans Benefits Administration; National Cemetery Administration

a. Formed from the Office of the Attorney General. b. Formed from the Department of Commerce and Labor. c. Formed from the Department of War and the Department of the Navy. d. Formed from the Department of Health, Education, and Welfare.

DEPARTMENT

Treasury

Interior

Justicea

Agriculture

Commerceb

Laborb

Defensec

Housing and Urban Development

Transportation Transportation T

Energy

Health and Human Servicesd

Educationd

Veterans AfVeterans AfV fairs

State

Homeland Security U.S. Citizenship and Immigration Services; Directorate of Border and Transportation Services; U.S. Coast Guard; Federal Emergency Management Agency

E X H I B I T 2 3 – 1 Executive Departments and Important Subagencies

C H A P T E R 2 3 Administrative Agencies 499

Disabilities Act. These informal rules provide enforce- ment guidelines for agency officials. ■

The Delegation Doctrine Courts generally hold that Article I of the U.S. Constitution is the basis for all administrative law. Section 1 of that article grants all legislative powers to Congress and requires Congress to oversee the implementation of all laws. Article I, Section 8, gives Congress the power to make all laws necessary for executing its specified powers. Under what is known as the delegation doctrine, courts interpret these passages as granting Congress the power to establish administrative agencies and delegate to them the power to create rules for implementing those laws.

The three branches of government exercise certain controls over agency powers and functions, as discussed next, but in many ways administrative agencies func- tion independently. For this reason, administrative agen- cies, which constitute the bureaucracy, are sometimes referred to as the fourth branch of the U.S. government.

Executive Controls The executive branch of govern- ment exercises control over agencies both through the president’s power to appoint federal officers and through

the president’s veto power. The president may veto enabling legislation passed by Congress or congressional attempts to modify an existing agency’s authority.

Legislative Controls Congress exercises authority over agency powers through legislation. Congress gives power to an agency through enabling legislation and can take power away—or even abolish an agency altogether—through subsequent legislation. Legislative authority is required to fund an agency, and enabling legislation usually sets certain time and monetary limits on the funding of particular pro- grams. Congress can always revise these limits.

In addition to its power to create and fund agencies, Congress has the authority to investigate the implemen- tation of its laws and the agencies that it has created. Congress also has the power to “freeze” the enforcement of most federal regulations before the regulations take effect. (Another legislative check on agency actions is the Administrative Procedure Act, discussed shortly.)

The question that a court faces when confronted with an agency’s interpretation of a statute it administers is always whether the agency has acted within its statutory author- ity. At issue in the following case was an agency’s authority under a statute enacted in the nineteenth century.

E X H I B I T 2 3 – 2 Selected Independent Regulatory Agencies

PRINCIPAL DUTIES

Determines policy with respect to interest rates, credit availability, and the money Determines policy with respect to interest rates, credit availability, and the money Determines policy with respect to interest rates, credit availability supply (including various “bailouts” in the financial sector).

NAME OF AGENCY

Federal Reserve System (the Fed) Board of Governors

Federal Trade CommissionFederal Trade CommissionFederal T (FTC)

Prevents businesses from engaging in unfair trade practices; stops the formation of monopolies in the business sector.

Securities and Exchange Commission (SEC)

Regulates the nation’s stock exchanges, in which shares of stock are bought and sold; enforces the securities laws.

Federal Communications Commission (FCC)

Regulates communications by telegraph, cable, telephone, radio, satellite, Internet, and television.

National Labor Relations Board (NLRB)

Protects employees’ rights to join unions and bargain collectively with employers; attempts to prevent unfair labor practices by both employers and unions.

Equal Employment Opportunity Commission (EEOC)

Works to eliminate discrimination in employment based on religion, gender, race, rks to eliminate discrimination in employment based on religion, gender, race, rks to eliminate discrimination in employment based on religion, gender color, disabilitycolor, disabilitycolor , national origin, or age; investigates claims of discrimination., disability, national origin, or age; investigates claims of discrimination., disability

Environmental Protection Agency (EPA)Agency (EPA)Agency (EP

Undertakes programs aimed at reducing air and water pollution; works with state and local agencies to help fight environmental hazards.

Nuclear Regulatory Commission (NRC)

Ensures that electricity-generating nuclear reactors in the United States are built and operated safely; regularly inspects operations of such reactors.

500 U N I T F I V E The Regulatory Environment

Background and Facts The Internal Revenue Service (IRS) is a subagency of the U.S. Department of the Treasury. Responding to concerns about the performance of some paid tax-return preparers, the IRS issued a new rule. The rule required paid preparers to pass an initial certification exam, pay annual fees, and complete at least fifteen hours of continuing education courses each year. As authority for the rule, the IRS relied on a statute enacted in 1884 and recodified in 1982. The statute authorizes the agency to “regulate the practice of representatives of persons before the Department of the Treasury.” Three independent preparers filed a suit in a federal district court against the IRS, contending that the rule exceeded the agency’s authority. The court ruled in the plaintiffs’ favor. The IRS appealed.

In the Language of the Court KAVANAUGH, Circuit Judge.

* * * * In our view, at least six considerations foreclose the IRS’s interpretation of the statute. First is the meaning of the key statutory term “representatives.” * * * The term “representative” is traFirst is the meaning of the key statutory term “representatives.” * * * The term “representative” is traFirst -

ditionally and commonly defined as an agent with authority to bind others, a description that does not fit tax-return preparers.

Put simply, tax-return preparers are not agents. They do not possess legal authority to act on the taxpayer’s behalf. They cannot legally bind the taxpayer by acting on the taxpayer’s behalf. [Emphasis added.]behalf. They cannot legally bind the taxpayer by acting on the taxpayer’s behalf. [Emphasis added.]behalf. They cannot legally bind the taxpayer by acting on the taxpayer’s behalf.

* * * * Second is the meaning of the phrase “practice * * * before the Department of the Treasury.”Second is the meaning of the phrase “practice * * * before the Department of the Treasury.”Second * * * To “practice before” a court or agency ordinarily refers to practice during an investigation, adver-

sarial hearing, or other adjudicative proceeding. That is quite different from the process of filing a tax return. * * * Tax-return preparers do not practice

before the IRS when they simply assist in the preparation of someone else’s tax return. [Emphasis added.] * * * * Third is the history of [the statute]. The language [in the original statute included the phrase] Third is the history of [the statute]. The language [in the original statute included the phrase] Third

“agents, attorneys, or other persons representing claimants.” That original language plainly would not encompass tax-return preparers. * * * When Congress

re-codified the statute in 1982, Congress simplified the phrase * * * to the current “representatives of persons.” But * * * Congress made clear in the statute itself that * * * the 1982 Act was designed “to revise, codify, and enact” the amended provisions “without substantive change.”

* * * * Fourth is the broader statutory framework.Fourth is the broader statutory framework.Fourth * * * * * * * [By enacting other statutes specific to tax-return preparers,] multiple Congresses have acted as if

[the statute at the center of this case] did not extend so broadly as to cover tax-return preparers. * * * The meaning of one statute may be affected by other Acts, particularly where Congress has spoken * * * more specifically to the topic at hand. So it is here.

Fifth is the nature and scope of the authority being claimed by the IRS.Fifth is the nature and scope of the authority being claimed by the IRS.Fifth If we were to accept the IRS’s interpretation of [the statute,] the IRS would be empowered for the

first time to regulate hundreds of thousands of individuals in the multi-billion dollar tax-preparation industry. Yet nothing in the statute’s text or the legislative record contemplates that vast expansion of the IRS’s authority.

Sixth is the IRS’s past approach to this statute. Until [now] the IRS never interpreted the statute to Sixth is the IRS’s past approach to this statute. Until [now] the IRS never interpreted the statute to Sixth give it authority to regulate tax-return preparers.

* * * In light of the text, history, structure, and context of the statute, it becomes apparent that the IRS never before adopted its current interpretation for a reason: It is incorrect.

Loving v. Internal Revenue Service United States Court of Appeals, District of Columbia Circuit, 742 F.3d 1013 (2014).

Case 23.1

C H A P T E R 2 3 Administrative Agencies 501

Judicial Controls The judicial branch exercises con- trol over agency powers through the courts’ review of agency actions. As you will read shortly, the Administra- tive Procedure Act provides for judicial review of most agency decisions. Agency actions are not automatically subject to judicial review, however. The party seeking court review must first exhaust all administrative rem- edies under what is called the exhaustion doctrine. In other words, the complaining party normally must have exhausted all available administrative remedies before seeking court review.seeking court review.seeking court review.seeking court review.2

■ EXAMPLE 23.3 The Federal Trade Commis- sion (FTC) claims that Sysco Industries used deceptive advertising and orders it to run new ads correcting the misstatements. Sysco contends that its ads were not deceptive. Under the exhaustion doctrine, Sysco must go through the entire FTC process before it can bring a suit against the FTC in court to challenge the order. ■

23–2d The Administrative Procedure Act Sometimes, Congress specifies certain procedural requirements in an agency’s enabling legislation. In the absence of any directives from Congress concerning a particular agency procedure, the Administrative Proce- dure Act (APA)3 applies.

The Arbitrary and Capricious Test One of Con- gress’s goals in enacting the APA was to provide for more judicial control over administrative agencies. To that end, the APA provides that courts should “hold unlaw- ful and set aside” agency actions found to be “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.”4 Under this standard, parties can

2. The plaintiff must also have standing to sue the agency.standing to sue the agency.standing to sue 3. 5 U.S.C. Sections 551–706. 4. 5 U.S.C. Section 706(2)(A).

challenge regulations as contrary to law or as so irrational that they are arbitrary and capricious.

There is no precise definition of what makes a rule arbitrary and capricious, but the standard includes fac- tors such as whether the agency has done any of the following:

1. Failed to provide a rational explanation for its decision. 2. Changed its prior policy without justification. 3. Considered legally inappropriate factors. 4. Entirely failed to consider a relevant factor. 5. Rendered a decision plainly contrary to the evidence.

See this chapter’s Digital Update feature for a discus- sion of administrative rules for broadband operators that have been challenged as arbitrary and capricious.

Fair Notice The APA also includes many requirements concerning the notice that regulatory agencies must give to those affected by its regulations. For instance, an agency may change the way it applies a certain regulatory prin- ciple. Before the change can be carried out, the agency must give fair notice of what conduct will be expected in the future.

■ CASE IN POINT 23.4 The 1934 Communica The 1934 Communica- tions Act established a system of limited-term broadcast licenses subject to various conditions. One condition was the indecency ban, which prohibited the uttering of “any obscene, indecent, or profane language by means of radio communication.” For nearly thirty years, the Fed- eral Communications Commission (FCC) invoked this ban only when the offensive language had been repeated, or “dwelled on,” in the broadcast. It was not applied to “fleeting expletives” (offensive words used only briefly).

Then the FCC changed its policy, declaring that an offensive term, such as the F-word, was actionably indecent even if it was used only once. In 2006, the FCC applied this new rule to two Fox Television broadcasts, each of which

Decision and Remedy The U.S. Court of Appeals for the District of Columbia Circuit affirmed the lower court’s ruling. Under the IRS’s interpretation of the statute, the agency “would be empowered for the first time to regulate hundreds of thousands of individuals in the multi-billion dollar tax-preparation indus- try.” Nothing in the statute’s text, history, structure, or context “contemplates that vast expansion of the IRS’s authority.”

Critical Thinking • Legal Environment As a policy matter, some observers might argue that the IRS should be allowed to

regulate tax-return preparers more strictly. Under the reasoning of the court, who has the authority to give effect to such a policy, and how would it be accomplished?

Case 23.1 Continued

502 U N I T F I V E The Regulatory Environment

contained a single use of the F-word. The broadcasts had aired before the FCC’s change in policy. The FCC ruled that these two broadcasts were indecent, and Fox appealed the ruling. Ultimately, the case reached the United States Supreme Court, and the Court determined that the FCC’s order should be set aside. Because the FCC did not provide fair notice prior to the broadcasts in question that fleeting expletives could constitute actionable inde- cency, the standards were unconstitutionally vague.5 ■

23–3 The Administrative Process All federal agencies must follow specific procedural requirements as they go about fulfilling their three basic

5. Federal Communications Commission v. Fox Television Stations, Inc., __ U.S. __, 132 S.Ct. 2307, 183 L.Ed.2d 234 (2012).

functions: rulemaking, enforcement, and adjudication. These three functions make up what is known as the administrative process. As mentioned, the APA imposes requirements that all federal agencies must follow in the absence of contrary provisions in the enabling legislation. This act is an integral part of the administrative process.

23–3a Rulemaking The major function of an administrative agency is rule- making—the formulation of new regulations, or rules. making—the formulation of new regulations, or rules. making The APA defines a rule as “an agency statement of general rule as “an agency statement of general rule or particular applicability and future effect designed to implement, interpret, or prescribe law and policy.”6

Regulations are sometimes said to be legislative because, like statutes, they have a binding effect. Thus, violators of agency rules may be punished. Because 6. 5 U.S.C. Section 551(4).

Imposing a 1930s Regulatory Law on Broadband Operators

Since the advent of the Internet, it has remained largely unregulated. President Bill Clinton (1993–2001) said clearly and often that the Internet should remain lightly regulated, at most. During the Obama administration, however, pressure from the president himself applied to the Federal Communications Com- mission (FCC) started to change that thinking.

An Unsuccessful Attempt to Impose Regulation on Internet Service Providers

In 2010, under the authority of the Telecommunica- tions Act of 1996,a the FCC attempted to regulate Internet service providers (ISPs) by enacting the “Open Internet Order.” Under this order, the FCC would have required broadband ISPs to transfer data files equally, without consideration of the size or source of the files— so-called net neutrality. The policy prohibited providers from transmitting certain content at slower speeds or higher costs than other types of content. Challenged in court, the order was overturned.b

The Advent of “Obamanet”

In early 2015, the FCC commissioners voted to regu- late ISPs as “common carriers” under Title II of the Communications Act of 1934.c Normally, a common

carrier is a business that transports items from one place to another, such as a trucking company. The 1934 act widened this defini- tion to include telephone companies. Under the new FCC rules, the Internet would fall under the act as well. The new rules were upheld by a federal appellate court in June 2016,d but more legal challenges are

expected.

What the New FCC Rules Mean

Here is a summary of the new rules: • No Internet service provider can prevent a user

from accessing “legal content, applications, services, or non-harmful devices” on the Internet. The goal to is prevent censorship and discrimination.

• No Internet service provider can deliberately reduce the speed of data from particular sites or applications.

• No Internet service provider can charge content providers more to provide them with faster service.

Critical Thinking Some observers predict that numer- ous lawsuits will be filed against the FCC. Why would this be likely?

DIGITAL UPDATE

a. 47 U.S.C. Sections 1302(a), (b). b. Verizon v. Federal Communications Commission, 740 F.3d 623 (D.C.

Cir. 2014). c. 47 U.S.C. Sections 201 et seq.

d. United States Telecom Association v. Federal Communications Commission, __F.3d__, 2016 WL 3251234 (D.C.Cir. 2016).

C H A P T E R 2 3 Administrative Agencies 503

agency rules have such significant legal force, the APA established procedures for agencies to follow in creating rules.

Many rules must be adopted using the APA’s notice- and-comment rulemaking, which involves three basic steps: 1. Notice of the proposed rulemaking. 2. A comment period. 3. The final rule.

The APA recognizes some limited exceptions to its procedural requirements, but they are seldom invoked. ■ EXAMPLE 23.5 The Occupational Safety and Health Act authorized the Occupational Safety and Health Administration (OSHA) to develop and issue rules governing safety in the workplace. When OSHA wants to formulate rules regarding safety in the steel industry, it has to follow the specific procedures outlined by the APA. ■

The impetus for rulemaking may come from vari- ous sources, including Congress and the agency itself. In addition, private parties may petition an agency to begin a rulemaking (or repeal a rule). For instance, environ- mental groups have petitioned for stricter air-pollution controls to combat emissions that may contribute to cli- mate change.

Notice of the Proposed Rulemaking When a federal agency decides to create a new rule, the agency publishes a notice of the proposed rulemaking proceed- ings in the Federal Register. The Federal Register is a daily Federal Register is a daily Federal Register publication of the executive branch that prints govern- ment orders, rules, and regulations.

The agency’s notice states where and when the pro- ceedings will be held, the agency’s legal authority for making the rule (usually its enabling legislation), and the terms or subject matter of the rule. The agency must also make available to the public certain other information, such as the key scientific data underlying the proposal. The proposed rule is often reported by the news media and published in the trade journals of the industries that will be affected.

Comment Period Following the publication of the notice of the proposed rulemaking proceedings, the agency must allow ample time for persons to comment in writing on the proposed rule. The purpose of this com- ment period is to give interested parties the opportunity to express their views on the proposed rule in an effort to influence agency policy. The comments can be made in writing or, if a hearing is held, orally. All comments become a public record that others can examine.

■ EXAMPLE 23.6 Brown Trucking learns that the U.S. Department of Transportation is considering a new regulation that will have a negative impact on its ability to do business and on its profits. A notice of the rulemak- ing is published in the Federal Register. Later, a public hearing is held so that proponents and opponents can offer evidence and question witnesses. At this hearing, Brown’s owner orally expresses his opinion about the pending rule. ■

The agency need not respond to all comments, but it must respond to any significant comments that bear directly on the proposed rule. The agency responds by either modifying its final rule or explaining, in a state- ment accompanying the final rule, why it did not make any changes. In some circumstances, particularly when less formal procedures are used, an agency may accept comments after the comment period is closed.

The Final Rule After the agency reviews the comments, it drafts the final rule and publishes it in the Federal Regis- ter. A final rule must contain a “concise general statement of . . . basis and purpose” that describes the reasoning behind the rule.7 The final rule can include modifications based on the public comments. If substantial changes are made, however, a new proposal and a new opportunity for comment are required.

The final rule is later compiled along with the rules and regulations of other federal administrative agencies in the Code of Federal Regulations. Final rules have bind- ing legal effect unless the courts later overturn them.

Failure to Follow Rulemaking Procedures If an agency fails to follow proper rulemaking procedures, an agency fails to follow proper rulemaking procedures, an agency fails to follow proper rulemaking procedures, an agency fails to follow proper rulemaking procedures, the resulting rule may not be binding. ■ EXAMPLE 23.7 Members of the Hemp Industries Association (HIA) manufacture and sell food products made from hemp seed and oil. These products may contain trace amounts of THC, a component of marijuana. Without following formal rulemaking procedures, the Drug Enforcement Administration (DEA) publishes rules that effectively ban the possession and sale of HIA’s food products, treating them as controlled substances. A court will most likely overturn the rules because the DEA did not follow formal rulemaking procedures. ■

Informal Agency Actions Rather than take the time to conduct notice-and-comment rulemaking, agen- cies have increasingly been using more informal meth- ods of policymaking, such as issuing interpretive rules and guidance documents. As mentioned earlier, unlike

504 U N I T F I V E The Regulatory Environment

legislative rules, interpretive rules simply declare policy and do not affect legal rights or obligations. Guidance documents advise the public on the agencies’ legal and policy positions.

Informal agency actions are exempt from the APA’s requirements because they do not establish legal rights. A party cannot be directly prosecuted for violating an interpretive rule or a guidance document. Nevertheless, an informal action can be important because it warns regulated entities that the agency may engage in formal rulemaking if they ignore its informal policymaking.

23–3b Enforcement Although rulemaking is the most prominent agency activity, rule enforcement is also critical. Often, an agency enforces its own rules. After a final rule is issued, agencies conduct investigations to monitor compliance with the rule or the terms of the enabling statute.

An agency investigation of this kind might begin when the agency receives a report of a possible viola- tion. In addition, many agency rules require compliance reporting from regulated entities, and such a report may trigger an enforcement investigation.

Inspections and Tests In conducting investigations, many agencies gather information through on-site inspec- tions. Sometimes, inspecting an office, a factory, or some other business facility is the only way to obtain the evi- dence needed to prove a regulatory violation. At other times, an inspection or test is used in place of a formal hearing to show the need to correct or prevent an undesir- able condition.

Administrative inspections and tests cover a wide range of activities, including safety inspections of under- ground coal mines, safety tests of commercial equipment and automobiles, and environmental monitoring of fac- tory emissions. An agency may also ask a firm or individ- ual to submit certain documents or records to the agency for examination.

Normally, business firms comply with agency requests to inspect facilities or business records because it is in any firm’s interest to maintain a good relationship with regulatory bodies. In some instances, however, such as when a firm thinks an agency’s request is unreasonable and disruptive, the firm may refuse to comply with the request. In such situations, an agency may resort to the use of a subpoena or a search warrant.

Subpoenas There are two basic types of subpoenas. The subpoena ad testificandum8 (“to testify”) is an ordi- 8. Pronounced ad tes-te-fe-kan-dum.

nary subpoena. It is a writ, or order, compelling a witness to appear at an agency hearing. The subpoena duces tecumto appear at an agency hearing. The subpoena duces tecumto appear at an agency hearing. The subpoena 9 (“bring it with you”) compels an individual or organiza- tion to hand over books, papers, records, or documents to the agency. An administrative agency may use either type of subpoena to obtain testimony or documents.

There are limits on what an agency can demand. To determine whether an agency is abusing its discretion in pursuing information as part of an investigation, a court may consider such factors as the following: 1. The purpose of the investigation. An investigation must

have a legitimate purpose. Harassment is an example of an improper purpose. An agency may not issue an administrative subpoena to inspect business records if the motive is to harass or pressure the business into settling an unrelated matter.

2. The relevance of the information being sought. Infor- mation is relevant if it reveals that the law is being violated or if it assures the agency that the law is not being violated.

3. The specificity of the demand for testimony or docu- ments. A subpoena must, for instance, adequately describe the material being sought.

4. The burden of the demand on the party from whom the information is sought. For instance, the cost to the company of copying requested documents or provid- ing digital information may become burdensome. (Note that a business generally is protected from revealing information such as trade secrets.)

Search Warrants The Fourth Amendment protects against unreasonable searches and seizures by requiring that in most instances a physical search for evidence must be conducted under the authority of a search warrant. An agency’s search warrant is an order directing law enforce- ment officials to search a specific place for a specific item and seize it for the agency. It was once thought that admin- istrative inspections were exempt from the warrant require- ment, but the United States Supreme Court has held that the requirement does apply to the administrative process.10

Nevertheless, agencies can conduct warrantless searches in several situations. Warrants are not required to conduct searches in highly regulated industries. Firms that sell firearms or liquor, for instance, are automatically subject to inspections without warrants. Sometimes, a statute permits warrantless searches of certain types of hazard- ous operations, such as coal mines. Also, a warrantless inspection in an emergency situation is normally consid- ered reasonable.

9. Pronounced doo-suhs tee-kum. 10. Marshall v. Barlow’s, Inc., 436 U.S. 307, 98 S.Ct. 1816, 56 L.Ed.2d 305

C H A P T E R 2 3 Administrative Agencies 505

23–3c Adjudication After conducting an investigation of a suspected rule vio- lation, an agency may initiate an administrative action against an individual or organization. Most administra- tive actions are resolved through negotiated settlements at their initial stages. Sometimes, though, an action ends in formal adjudication—the resolution of the dispute through a hearing conducted by the agency.

Negotiated Settlements Depending on the agency, negotiations may involve a simple conversation or a series of informal conferences. Whatever form the negotia- tions take, their purpose is to rectify the problem to the agency’s satisfaction and eliminate the need for additional proceedings.

Settlement is an appealing option to firms for two reasons: to avoid appearing uncooperative and to avoid the expense involved in formal adjudication proceedings and in possible later appeals. Settlement is also an attrac- tive option for agencies. To conserve their resources and avoid formal actions, administrative agencies devote a great deal of effort to giving advice and negotiating solu- tions to problems.

Formal Complaints If a settlement cannot be reached, the agency may issue a formal complaint against reached, the agency may issue a formal complaint against reached, the agency may issue a formal complaint against reached, the agency may issue a formal complaint against the suspected violator. ■ EXAMPLE 23.8 The Environ The Environ- mental Protection Agency (EPA) finds that Acme Manu- facturing, Inc., is polluting groundwater in violation of federal pollution laws. The EPA issues a complaint against Acme in an effort to bring the plant into compliance with federal regulations. This complaint is a public document, and a press release may accompany it. Acme will respond by filing an answer to the EPA’s allegations. If Acme and the EPA cannot agree on a settlement, the case will be adjudicated. ■

The Hearing Agency adjudication may involve a trial- like arbitration procedure before an administrative law judge (ALJ). The Administrative Procedure Act (APA) requires that before the hearing takes place, the agency must issue a notice that includes the facts and law on which the complaint is based, the legal authority for the hearing, and its time and place. The administrative agency adjudication process is described next and illus- trated in Exhibit 23–3.

The Role of the Administrative Law Judge An ALJ presides over the hearing and has the power to admin- ister oaths, take testimony, rule on questions of evidence, and make determinations of fact. Technically, the ALJ, who works for the agency prosecuting the case, is not an

independent judge. Nevertheless, the law requires an ALJ to be unbiased.

Certain safeguards prevent bias on the part of the ALJ and promote fairness in the proceedings. For instance, the APA requires that the ALJ be separate from an agen- cy’s investigative and prosecutorial staff. The APA also prohibits ex parte (private) communications between the ex parte (private) communications between the ex parte ALJ and any party to an agency proceeding, including the agency and the company involved. Finally, provi- sions of the APA protect the ALJ from agency disciplin- ary actions unless the agency can show good cause for such an action.

Hearing before Administrative Law Judge

Appeal to Governing Board of Agency

Order of Administrative Law Judge

(for example, a cease-and-desist order)

Appropriate Court for Review of Agency Decision (usually an appellate court, but

it depends on the specific agency)

Complaint

Final Agency Order

Answer

Court Order

E X H I B I T 2 3 – 3 The Formal Administrative Agency Adjudication Process

506 U N I T F I V E The Regulatory Environment

Hearing Procedures Hearing procedures vary widely from agency to agency. Administrative agencies gener- ally exercise substantial discretion over the type of pro- cedure that will be used. Frequently, disputes are resolved through informal adjudication proceedings. through informal adjudication proceedings. ■ EXAMPLE 23.9 The Federal Trade Commission (FTC) charges Good Foods, Inc., with deceptive advertising. Representatives of Good Foods and the FTC, their counsel, and the ALJ meet at a table in a conference room to resolve the dispute informally. ■

A formal adjudicatory hearing, in contrast, resembles a trial in many respects. Prior to the hearing, the parties are permitted to undertake discovery—involving depo- sitions, interrogatories, and requests for documents or other information. The discovery process usually is not quite as extensive as it would be in a court proceeding, however.

The hearing itself must comply with the procedural requirements of the APA and must also meet the constitu- tional standards of due process. The burden of proof in an enforcement proceeding is placed on the agency. During the hearing, the parties may give testimony, present other evidence, and cross-examine adverse witnesses.

Trials and administrative agency hearings do differ in some respects. A significant difference is that normally much more information, including hearsay (secondhand

information), can be introduced as evidence during an administrative hearing.

Agency Orders Following a hearing, the ALJ renders an initial order, or decision, on the case. Either party can appeal the ALJ’s decision to the board or commis- sion that governs the agency. If displeased with the result, the party can appeal that decision to a federal appellate court.

■ EXAMPLE 23.10 The EPA issues a complaint against Acme Manufacturing, Inc., for polluting ground- water. The complaint results in a hearing before an ALJ, who rules in the EPA’s favor. If Acme is dissatisfied with the decision, it can appeal to the commission governing the EPA and then to a federal appellate court. ■

If no party appeals the case, the ALJ’s decision becomes the final order of the agency. The ALJ’s decision also final order of the agency. The ALJ’s decision also final order becomes final if a party appeals and the commission and the court decline to review the case. If a party appeals and the case is reviewed, the final order comes from the commission’s decision or (if that decision is appealed) the decision of the reviewing court.

In the following case, a federal appeals court reviewed the Drug Enforcement Administration’s denial of a university professor’s application to register to cultivate marijuana.

Background and Facts Dr. Lyle Craker, a professor in the University of Massachusetts’s Department of Plant, Soil and Insect Sciences, applied to the Drug Enforcement Administration (DEA) for permis- sion to register to manufacture marijuana for clinical research. He stated that “a second source of plant material is needed to facilitate privately funded Food and Drug Administration (FDA)-approved research into medical uses of marijuana, ensuring a choice of sources and an adequate supply of qual- ity, research-grade marijuana for medicinal applications.”

An administrative law judge recommended that Craker’s application be granted, but a DEA deputy administrator issued an order denying his application. Under the DEA’s interpretation, the Controlled Substances Act (CSA) requires an applicant to prove both that effective controls against diversion of the marijuana for unapproved purposes are in place and that its supply and the competition to supply it are inadequate. The administrator determined that the professor had not proved that effective con- trols against the marijuana’s diversion were in place or that supply and competition were inadequate. Craker petitioned the U.S. Court of Appeals for the First Circuit to review the order.

In the Language of the Court HOWARD, Circuit Judge.

* * * Since 1968, the National Center for Natural Products Research (“NCNPR”) at the University

of Mississippi has held the necessary registration and a government contract to grow marijuana for research purposes. The contract is administered by the National Institute on Drug Abuse (“NIDA”), a component of the National Institutes of Health (“NIH”), which, in turn, is a component of the [U.S.]

Craker v. Drug Enforcement Administration United States Court of Appeals, First Circuit, 714 F.3d 17 (2013).

Case 23.2

C H A P T E R 2 3 Administrative Agencies 507

23–4 Judicial Deference to Agency Decisions

When asked to review agency decisions, courts histori- cally granted deference to the agency’s judgment. In other words, the courts tended to accept the agency’s judgment, often citing the agency’s great expertise in the subject area of the regulation. This deference seems espe- cially appropriate when applied to an agency’s analysis of factual questions, but should it also extend to an agen- cy’s interpretation of its own legal authority? In Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc.,11 the United States Supreme Court held that it should. By 11. 467 U.S. 837, 104 S.Ct. 2778, 81 L.Ed.2d 694 (1984).

so ruling, the Court created a standard of broadened def-so ruling, the Court created a standard of broadened def-so ruling, the Court created a standard of broadened def erence to agencies on questions of legal interpretation.

23–4a The Holding of the Chevron Case At issue in the Chevron case was whether the courts should defer to an agency’s interpretation of a statute giving it authority to act. The Environmental Protection Agency (EPA) had interpreted the phrase “stationary source” in the Clean Air Act as referring to an entire manufacturing plant, and not to each facility within a plant. The agen- cy’s interpretation enabled it to adopt the so-called bub- ble policy, which allowed companies to offset increases in emissions in part of a plant with decreases elsewhere in the plant. This interpretation reduced pollution-control

Department of Health and Human Services (“HHS”). The contract is opened for competitive bidding every five years. The NCNPR is the only entity registered by the DEA to manufacture marijuana.

* * * * Dr. Craker’s argument with respect to competition is essentially that there cannot be “adequately

competitive conditions” when there is only one manufacturer of marijuana. The Administrator * * * observed that NIDA had provided marijuana manufactured by the Univer-

sity of Mississippi either at cost or free to researchers, and that Dr. Craker had made no showing of how he could provide it for less * * * . Additionally, the Administrator noted that Dr. Craker is free to bid on the contract when it comes up for renewal.

We see nothing improper in the Administrator’s approach. The [CSA’s] term “adequately competitive condi- tions” is not necessarily as narrow as the petitioner suggests. * * * That the current regime may not be the most competitive situation possible does not render it “inadequate.” [Emphasis added.]competitive situation possible does not render it “inadequate.” [Emphasis added.]competitive situation possible does not render it “inadequate.”

* * * * In finding that Dr. Craker failed to demonstrate that the current supply of marijuana was not

adequate and uninterrupted, the Administrator observed that there were over 1,000 kilograms of mari- juana in NIDA possession, an amount which far exceeds present research demands and “any foreseeable” future demand. Dr. Craker does not dispute this finding, or that the current amount is more than ninety times the amount he proposes to supply. Instead, he argues that the adequacy of supply must not be measured against NIDA-approved research, but by whether the supply is adequate to supply projects approved by the FDA. But even if we were to accept his premise—which we don’t—Dr. Craker fails to demonstrate that the supply is inadequate for those needs, either. He merely states that certain projects were rejected as “not bona-fide” by NIDA, a claim which does not address the adequacy of supply. The fact that Dr. Craker disagrees with the method by which marijuana research is approved does not under- mine the substantial evidence that supports the Administrator’s conclusion.

Decision and Remedy The U.S. Court of Appeals for the First Circuit denied Craker’s petition to review the agency’s order “because the Administrator’s interpretation of the CSA is permissible and her findings are reasonable and supported by the evidence.”

Critical Thinking • Economic Why should a court wait to review an agency’s order until the order has gone through the

entire procedural process and can be considered final? • Legal Environment Under what standard does a court defer to an agency’s interpretation of a statute?

Did the court in this case appear to have applied that standard to the DEA’s interpretation of the Con- trolled Substances Act? Discuss.

Case 23.2 Continued

508 U N I T F I V E The Regulatory Environment

compliance costs to manufacturers. An environmental group challenged the legality of the EPA’s interpretation.

The Supreme Court held that the courts should defer to an agency’s interpretation of law as well as fact. The Court found that the agency’s interpretation of the stat- ute was reasonable. The Court’s decision in the Chev- ron case created a new standard for courts to use when reviewing agency interpretations of law. This standard involves the following two questions: 1. Did Congress directly address the issue in dispute in

the statute? If so, the statutory language prevails. 2. If the statute is silent or ambiguous, is the agency’s

interpretation “reasonable”? If it is, a court should uphold the agency’s interpretation even if the court would have interpreted the law differently.

23–4b When Courts Will Give Chevron Deference to Agency Interpretation

The notion that courts should defer to agencies on mat- ters of law was controversial. Under the holding of the Chevron case, when the meaning of a particular statute’s language is unclear and an agency interprets it, the court must follow the agency’s interpretation as long as it is reasonable. This led to considerable discussion and litiga- tion to test the boundaries of the Chevron holding.

For instance, are courts required to give deference to all agency interpretations or only to those that result from adjudication or formal rulemaking procedures? The United States Supreme Court has held that in order for agency interpretations to be assured Chevron deference, they must meet the formal legal standards for notice-and-comment

rulemaking. Nevertheless, there are still gray areas, and many agency interpretations are challenged in court.many agency interpretations are challenged in court.many agency interpretations are challenged in court.many agency interpretations are challenged in court.

■ CASE IN POINT 23.11 The Federal Insurance Con- tributions Act (FICA) requires employees and employ- ers to pay Social Security taxes on all wages. The FICA excludes wages paid for any service to a school “performed by a student who is enrolled and regularly attending classes.” The Mayo Foundation for Medical Education and Research offers educational residency programs to physicians who seek instruction in a chosen specialty. In addition to receiving instruction, the physicians are paid to spend fifty to eighty hours a week caring for patients. The U.S. Treasury Department issued a rule providing that anyone who works forty or more hours per week is an employee, not a student. The Mayo Foundation asserted that the rule did not apply to its residents.

The United States Supreme Court upheld the rule. Congress gave the Treasury Department the authority to make rules to enforce the Internal Revenue Code. The employee rule was issued after notice-and-comment pro- cedures, and it was based on a reasonable determination that imposing Social Security taxes on medical residents would further the purpose of the statute. The physicians were “the kind of workers that Congress intended to both contribute to and benefit from the Social Security system.”12 ■

The following case involves a federal agency’s role in determining whether alien pilots may be certified to operate large, U.S.-registered aircraft.

12. Mayo Foundation for Medical Education and Research v. United States, 562 U.S. 44, 131 S.Ct. 704, 178 L.Ed.2d 588 (2011).

In the Language of the Court EDWARDS, Senior Circuit Judge:EDWARDS, Senior Circuit Judge:EDWARDS

* * * * I. BACKGROUND

In the aftermath of the tragic terrorist attacks on September 11, 2001, Congress created the Transportation Security Administration [TSA] to shore up our nation’s civil aviation security. [TSA is part of the U.S.] Department of Homeland Security under the direc- tion of the Secretary of Homeland Security.

* * * No pilot may serve in any capac- ity as an airman with respect to a civil aircraft * * * without an airman certifi- cate from FAA [Federal Aviation Admin- istration]. For large aircraft, pilots must obtain additional certification known as a Type Rating. [Under the Aviation and Transportation Security Act of 2001,] aliens who seek training and certification to operate large, U.S.-registered aircraft must first secure clearance by TSA. If TSA determines that an alien applicant presents a risk to aviation or national

security, then that applicant is ineligible to receive the training necessary to secure a large aircraft Type Rating from FAA.

* * * * [Alberto Olivares (Petitioner), a citi-

zen of Venezuela,] received [an] oppor- tunity to pilot a large, U.S.-registered aircraft. * * * Petitioner applied to attend an FAA-certified flight school in France, and TSA conducted a background investigation.

Case Analysis 23.3 Olivares v. Transportation Security Administration United States Court of Appeals, District of Columbia Circuit, 819 F.3d 454 (2016).

C H A P T E R 2 3 Administrative Agencies 509

* * * * * * * TSA concluded that Petitioner

was a “Threat to Transportation/ National Security” [and] sent an email to Petitioner denying his application.

* * * Petitioner filed his petition for review with this court. * * * Andrea Vara executed a sworn declaration explaining TSA’s grounds for denying Petitioner’s application for training. Ms. Vara is employed by [TSA] as the Alien Flight Student Program Manager. She has been responsible for managing TSA’s Alien Flight Student Program, which conducts security threat assessments on individu- als who are not U.S. citizens or nationals who seek flight instruction or recurrent training from FAA-certified flight train- ing providers.

The Vara Declaration makes it clear that Ms. Vara was the Government offi- cial who made the determination that Petitioner’s application should be denied * * * . The Vara Declaration states:

* * * Petitioner submitted Training Request # 565192, seeking to train at FlightSafety International—Paris Learning Center.

* * * Petitioner was subject to an investigation, which revealed the fol- lowing. In 2007, Petitioner pled guilty to conspiracy to possess with intent to distribute controlled substances and the U.S. District Court for the Northern District of Illinois sentenced him to eighty (80) months imprison- ment. Petitioner’s conviction made him inadmissible to the United States and led to the revocation of his FAA Airman’s Certificate. Petitioner was deported to his home country of Ven- ezuela in March 2010.

A public news article published after Petitioner was deported provided a U.S. address for Petitioner. Further, records indicated that Petitioner was a suspected international trafficker in firearms. There was evidence that Petitioner had previously been involved in the export of weapons and U.S. currency to Venezuela by private aircraft, was the second pilot of an aircraft from which several weapons and $500,000 was seized by local

authorities in Aruba, and that one of his associates was arrested in Aruba for smuggling firearms.

This information, viewed as a whole, demonstrated Petitioner’s will- ingness to consistently disregard the law and to use an aircraft for criminal activity, in opposition to U.S. security interests. The information also raised concerns that Petitioner may use his flight training to advance the interests of a criminal enterprise, which could include an enterprise that seeks to do harm to the United States.

Based on all the foregoing infor- mation, I concluded Petitioner posed a threat to aviation and national security and * * * denied his training request. * * * *

II. ANALYSIS A. THE COURT’S JURISDICTION

* * * An action taken by TSA on behalf of the Secretary of Homeland Security is clearly subject to review.

* * * * B. STANDARD OF REVIEW

Pursuant to the Administrative Pro- cedure Act, we must uphold TSA’s deci- sions unless they are arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.

What is important here is that, because Congress has entrusted TSA with broad authority over civil aviation security, it is TSA’s job—not * * * ours— to strike a balance between convenience and security. Therefore, in cases of this sort, we must defer to TSA actions that reasonably interpret and enforce the safety and security obligations of the agency. * * * Courts do not second-guess expert agency judgments on potential risks to national security. Rather, we defer to the informed judgment of agency officials whose obliga- tion it is to assess risks to national security. [Emphasis added.]

* * * * D. PETITIONER’S * * * CLAIM

* * * * * * * Petitioner argues that TSA

should not have used his suspected fire- arms trafficking or his Massachusetts

address to support its decision. [TSA had discovered that, even though Oli- vares had been deported with no right to return to the United States, he main- tained a local address in Massachusetts.] Petitioner claims that the Massachusetts address actually belongs to his brother, and Petitioner insists that he has never illegally entered the United States. Peti- tioner also points out that the firearms incident occurred nearly two decades ago and that he was merely suspected of being involved. In light of the lim- ited standard of review that controls the disposition of this case, these argu- ments are not persuasive. It was rational for TSA to find it suspicious and thus consider information indicating that a deported individual appeared to main- tain a current U.S. address and had been suspected of involvement in firearms trafficking. The agency’s weighing of this information, along with the information regarding Petitioner’s known criminal history, was not inconsistent with rea- soned decision making.

Given TSA’s broad authority to assess potential risks to aviation and national security, the agency’s clear and reasonable explanation offered in the Vara Declara- tion, and the limited standard of review [under the holding in the Chevron case], we are in no position to second-guess TSA’s judgment in denying Petitioner’s application. In assessing risks to national security, conclusions must often be based on informed judgment rather than concrete evidence, and that reality affects what we may reasonably insist on from the Government. When it comes to collecting evidence and drawing fac- tual inferences in this area, the lack of competence on the part of the courts is marked, and respect for the Govern- ment’s conclusions is appropriate. Where no factual certainties exist or where facts alone do not provide the answer * * * we require only that the agency so state and go on to identify the considerations it found persuasive.

It is self-evident that TSA’s action against Petitioner was related to the agency’s goals of improving the safety of air

Case 23.3 Continued

510 U N I T F I V E The Regulatory Environment

travel. TSA was not required to show that Petitioner would engage in activi- ties designed to compromise aviation or national security. Rather, the agency was merely required to give a reasonable

explanation as to why it believed that Petitioner presented a risk to aviation or national security. The Vara Declaration satisfies this legal obligation. [Emphasis added.]

III. CONCLUSION For the reasons set forth above, the

petition for review is denied.

Case 23.3 Continued

23–5 Public Accountability As a result of growing public concern over the powers exercised by administrative agencies, Congress passed several laws to make agencies more accountable through public scrutiny. Here, we discuss the most significant of these laws.

23–5a Freedom of Information Act The Freedom of Information Act (FOIA)13 requires the federal government to disclose certain records to any person or entity on written request, even if no reason is given for the request. All federal government agencies must make their records available electronically on the Internet and in other electronic formats.

The FOIA exempts certain types of records, such as those pertaining to national security and those containing those pertaining to national security and those containing those pertaining to national security and those containing those pertaining to national security and those containing information that is confidential or personal. information that is confidential or personal. ■ EXAMPLE 23.12 Juanita, a reporter from an online health maga- zine, makes an FOIA request to the Centers for Disease Control and Prevention for a list of people who have con- tracted a highly contagious virus. The Centers for Disease Control and Prevention will not have to comply, because the requested information is confidential and personal. ■

For other records, a request that complies with the FOIA procedures need only contain a reasonable descrip- tion of the information sought. An agency’s failure to comply with an FOIA request can be challenged in a federal district court. The media, industry trade associa- tions, public-interest groups, and even companies seeking 13. 5 U.S.C. Section 552.

information about competitors rely on these FOIA pro- visions to obtain information from government agencies.

23–5b Government in the Sunshine Act The Government in the Sunshine Act,14 or open meet- ing law, requires that “every portion of every meeting of an agency” be open to “public observation.” The act also requires that the public be provided with adequate advance notice of scheduled meetings and agendas.

Like the FOIA, the Sunshine Act contains certain exceptions. Closed meetings are permitted in the follow- ing situations: 1. The subject of the meeting concerns accusing any

person of a crime. 2. Open meetings would frustrate implementation of

future agency actions. 3. The subject of the meeting involves matters relating

to future litigation or rulemaking. Courts interpret these exceptions to allow open access whenever possible.

23–5c Regulatory Flexibility Act Concern over the effects of regulation on the efficiency of businesses, particularly smaller ones, led Congress to pass the Regulatory Flexibility Act15 in 1980. Under this act, whenever a new regulation will have a “significant impact upon a substantial number of small entities,” the agency

14. 5 U.S.C. Section 552b. 15. 5 U.S.C. Sections 601–612.

Legal Reasoning Questions

1. What impact did the Vara Declaration have on the court’s ruling in this case? 2. Is a court’s evaluation of an agency’s assessment of a risk to national security different from a review of other agency determina-

tions? Explain. 3. Should the agency at the center of this case have revealed the reasons for its decision before Olivares filed a suit challenging

it? Explain.

C H A P T E R 2 3 Administrative Agencies 511

must conduct a regulatory flexibility analysis. The analy- sis must measure the cost that the rule would impose on small businesses and consider less burdensome alterna- tives. The act also contains provisions to alert small busi- nesses about forthcoming regulations. The act relieved small businesses of some record-keeping burdens, espe- cially with regard to hazardous waste management.

23–5d Small Business Regulatory Enforcement Fairness Act

The Small Business Regulatory Enforcement Fairness Act16 includes various provisions intended to ease the regulatory burden on small businesses:

16. 5 U.S.C. Sections 801 et seq.

1. Federal agencies must prepare guides that explain in plain English how small businesses can comply with federal regulations.

2. Congress may review new federal regulations for at least sixty days before they take effect, giving oppo- nents of the rules time to present their arguments.

3. The courts may enforce the Regulatory Flexibil- ity Act. This provision helps to ensure that federal agencies will consider ways to reduce the economic impact of new regulations on small businesses.

4. The Office of the National Ombudsman at the Small Business Administration was set up to receive com- ments from small businesses about their dealings with federal agencies. Based on these comments, Regional Small Business Fairness Boards rate the agencies and publicize their findings.

Reviewing: Administrative Agencies

Assume that the Securities and Exchange Commission (SEC) has a rule that it will enforce statutory provisions pro- hibiting insider trading only when the insiders make monetary profits for themselves. Then the SEC makes a new rule, declaring that it will now bring enforcement actions against individuals for insider trading even if the individuals did not personally profit from the transactions. In making the new rule, the SEC does not conduct a rulemaking procedure but simply announces its decision. A stockbrokerage firm objects that the new rule was unlawfully developed without opportunity for public comment. The brokerage firm challenges the rule in an action that ultimately is reviewed by a federal appellate court. Using the information presented in the chapter, answer the following questions. 1. Is the SEC an executive agency or an independent regulatory agency? Does it matter to the outcome of this dispute?

Explain. 2. Suppose that the SEC asserts that it has always had the statutory authority to pursue persons for insider trading

regardless of whether they personally profited from the transactions. This is the only argument the SEC makes to justify changing its enforcement rules. Would a court be likely to find that the SEC’s action was arbitrary and capri- cious under the Administrative Procedure Act (APA)? Why or why not?

3. Would a court be likely to give Chevron deference to the SEC’s interpretation of the law on insider trading? Why or why not?

4. Now assume that a court finds that the new rule is merely “interpretive.” What effect would this determination have on whether the SEC had to follow the APA’s rulemaking procedures?

Debate This . . . Because an administrative law judge (ALJ) acts as both judge and jury, there should always be at least three ALJs in each administrative hearing.

Terms and Concepts adjudication 505 administrative agency 496 administrative law judge (ALJ) 505 administrative process 502 bureaucracy 499

delegation doctrine 499 enabling legislation 497 exhaustion doctrine 501 �nal order 506 initial order 506

interpretive rule 498 legislative rule 498 notice-and-comment

rulemaking 503 rulemaking 502

512 U N I T F I V E The Regulatory Environment

Issue Spotters 1. The U.S. Department of Transportation (DOT) some-

times hears an appeal from a party whose contract with the DOT has been canceled. An administrative law judge (ALJ) who works for the DOT hears this appeal. What safeguards promote the ALJ’s fairness? (See The Administrative Process.)

2. Techplate Corporation learns that a federal administrative agency is considering a rule that will have a negative impact

on the firm’s ability to do business. Does the firm have any opportunity to express its opinion about the pending rule? Explain. (See The Administrative Process.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 23–1. Rulemaking and Adjudication Powers. For decades, the Federal Trade Commission (FTC) resolved fair trade and advertising disputes through individual adjudica- tions. In the 1960s, the FTC began promulgating rules that defined fair and unfair trade practices. In cases involving vio- lations of these rules, the due process rights of participants were more limited and did not include cross-examination. Although anyone charged with violating a rule would receive a full adjudication, the legitimacy of the rule itself could not be challenged in the adjudication. Furthermore, a party charged with violating a rule was almost certain to lose the adjudication. Affected parties complained to a court, argu- ing that their rights before the FTC were unduly limited by the new rules. What would the court examine to determine whether to uphold the new rules? (See The Administrative Process.)

23–2. Informal Rulemaking. Assume that the Food and Drug Administration (FDA), using proper procedures, adopts a rule describing its future investigations. This new rule covers all future circumstances in which the FDA wants to regulate food additives. Under the new rule, the FDA is not to regulate food additives without giving food companies an opportunity to cross-examine witnesses. Later, the FDA wants to regulate methylisocyanate, a food additive. The FDA undertakes an informal rulemaking procedure, without cross-examination, and regulates methylisocyanate. Producers protest, saying that the FDA promised them the opportunity for cross-examina- tion. The FDA responds that the Administrative Procedure Act does not require such cross-examination and that it is free to withdraw the promise made in its new rule. If the produc- ers challenge the FDA in court, on what basis would the court rule in their favor? Explain. (See The Administrative Process.)

Business Case Problems 23–3. Rulemaking. �e Investment Company Act prohib- its a mutual fund from engaging in certain transactions when there may be a con�ict of interest between the manager of the fund and its shareholders. Under rules issued by the Securi- ties and Exchange Commission (SEC), however, a fund that meets certain conditions may engage in an otherwise prohib- ited transaction. In June 2004, the SEC added two new condi- tions. A year later, the SEC reconsidered the new conditions in terms of the costs that they would impose on the funds. Within eight days, and without asking for public input, the SEC readopted the conditions. �e Chamber of Commerce of the United States asked a federal appellate court to review the new rules. �e Chamber argued that in readopting the rules, the SEC relied on materials not in the “rulemaking record” without providing an opportunity for public comment. �e SEC countered that the information was otherwise “pub- licly available.” In adopting a rule, should an agency consider information that is not part of the rulemaking record? Why or why not? [Chamber of Commerce of the United States v. Securi- ties and Exchange Commission, 443 F.3d 890 (D.C.Cir. 2006)] (See �e Administrative Process.)

23–4. Business Case Problem with Sample Answer— Agency Powers. A well-documented rise in global tempera-

tures has coincided with a signi�cant increase in the concentration of carbon dioxide in the atmo- sphere. Many scientists believe that the two trends are related, because when carbon dioxide is

released into the atmosphere, it produces a greenhouse e�ect, trapping solar heat. Under the Clean Air Act (CAA), the Envi- ronmental Protection Agency (EPA) is authorized to regulate “any” air pollutants “emitted into . . . the ambient air” that in its “judgment cause, or contribute to, air pollution.”

A group of private organizations asked the EPA to regulate carbon dioxide and other “greenhouse gas” emissions from new motor vehicles. The EPA refused, stating, among other things, that Congress last amended the CAA in 1990 with- out authorizing new, binding auto emissions limits. Nine- teen states, including Massachusetts, asked a district court to review the EPA’s denial. Did the EPA have the authority to regulate greenhouse gas emissions from new motor vehicles? If so, was its stated reason for refusing to do so consistent with that authority? Discuss. [Massachusetts v. Environmental

C H A P T E R 2 3 Administrative Agencies 513

Protection Agency, 549 U.S. 497, 127 S.Ct. 1438, 167 L.Ed.2d 248 (2007)] (See Agency Creation and Powers.) • For a sample answer to Problem 23–4, go to Appendix E at

the end of this text.

23–5. Judicial Deference. After Dave Conley died of lung cancer, his widow �led for bene�ts under the Black Lung Ben- e�ts Act. To qualify for bene�ts under the act, she had to show that exposure to coal dust was a substantial contributing factor to her husband’s death. Conley had been a coal miner, but he had also been a longtime smoker. At the bene�ts hearing, a physician testi�ed that coal dust was a substantial factor in Conley’s death. No evidence was presented to support this conclusion, however. �e administrative law judge awarded bene�ts. On appeal, should a court defer to this decision? Dis- cuss. [Conley v. National Mines Corp., 595 F.3d 297 (6th Cir. 2010)] (See Judicial Deference to Agency Decisions.)

23–6. Arbitrary and Capricious Test. Michael Manin, an airline pilot, was twice convicted of disorderly conduct, a minor misdemeanor. To renew his �ight certi�cation with the National Transportation Safety Board (NTSB), Manin �led an application that asked him about his criminal history. He did not disclose his two convictions. When these came to light more than ten years later, Manin argued that he had not known that he was required to report convictions for minor misdemeanors. �e NTSB’s policy was to consider an appli- cant’s understanding of what information a question sought before determining whether an answer was false. But without explanation, the agency departed from this policy, refused to consider Manin’s argument, and revoked his certi�cation. Was this action arbitrary or capricious? Explain. [Manin v. National this action arbitrary or capricious? Explain. [Manin v. National this action arbitrary or capricious? Explain. [ Transportation Safety Board, 627 F.3d 1239 (D.C.Cir. 2011)] (See Agency Creation and Powers.)

23–7. Adjudication. Mechanics replaced a brake assembly on the landing gear of a CRJ–700 plane operated by GoJet Airlines, LLC. �e mechanics installed gear pins to lock the assembly in place during the repair but failed to remove one of the pins after they had �nished. On the plane’s next �ight, a warning light alerted the pilots that the landing gear would not retract after takeo�. �ere was a potential for danger, but the pilots �ew the CRJ–700 safely back to the departure airport. No one was injured, and no property was damaged. �e Federal Aviation Administration (FAA) cited GoJet for violating FAA regulations by “carelessly or recklessly oper- ating an unairworthy airplane.” GoJet objected to the cita- tion. To which court can GoJet appeal for review? On what ground might that court decline to review the case? [GoJet Airlines, LLC v. F.A.A., 743 F.3d 1168 (8th Cir. 2014)] (See �e Administrative Process.)

23–8. Judicial Deference to Agency Decisions. Knox Creek Coal Corporation operates coal mines in West Virginia. �e U.S. Department of Labor charged Knox’s Tiller No. 1 Mine with “signi�cant and substantial” (S&S) violations of

the Federal Mine Safety and Health Act. According to the charges, inadequately sealed enclosures of electrical equipment in the mine created the potential for an explosion. �e Mine Act designates a violation as S&S when it “could signi�cantly could signi�cantly could and substantially contribute to the cause and e�ect of a coal or other mine safety or health hazard.” Challenging the S&S determination, Knox �led a suit against the secretary of labor. �e secretary argued that “could” means “merely possible”—if there is a violation, the existence of a hazard is assumed. �is position was consistent with agency and judicial precedent and the Mine Act’s history and purpose. Knox argued that “could” requires proof of the likelihood of a hazard. When does a court defer to an agency’s interpretation of law? Do those circumstances exist in this case? Discuss. [Knox Creek Coal Corp v. Secretary of Labor, 811 F.3d 148 (4th Cir. 2016)] (See Judicial Deference to Agency Decisions.) 23–9. A Question of Ethics—Rulemaking. To ensure

highway safety and protect driver health, Congress charged federal agencies with regulating the hours of service of commercial motor vehicle operators. Between 1940 and 2003, the regulations that

applied to long-haul truck drivers were mostly unchanged. (Long- haul drivers are those who operate beyond a 150-mile radius of their base.) In 2003, the Federal Motor Carrier Safety Adminis- tration (FMCSA) revised the regulations signi�cantly, increasing the number of daily and weekly hours that drivers could work. �e agency had not considered the impact of the changes on the health of the drivers, however, and the revisions were overturned.

The FMCSA then issued a notice that it would reconsider the revisions and opened them up for public comment. The agency analyzed the costs to the industry and the crash risks due to driver fatigue under different options. It concluded that the safety ben- efits of not increasing the hours were less than the economic costs. In 2005, the agency issued a rule that was nearly identical to the 2003 version. Public Citizen, Inc., and others, including the Owner-Operator Independent Drivers Association, asked the U.S. Court of Appeals for the District of Columbia Circuit to review the 2005 rule as it applied to long-haul drivers. [Owner-review the 2005 rule as it applied to long-haul drivers. [Owner-review the 2005 rule as it applied to long-haul drivers. [ Operator Independent Drivers Association, Inc. v. Federal Motor Carrier Safety Administration, 494 F.3d 188 (D.C.Cir. 2007)] (See 2007)] (See 2007)] The Administrative Process.)

(a) The FMCSA’s cost-benefit analysis included new meth- ods that were not disclosed to the public in time for comments. Was this unethical? Should the agency have disclosed the new methodology sooner? Why or why not?

(b) The FMCSA created a graph to show the risk of a crash as a function of the time a driver spent on the job. The graph plotted the first twelve hours of a day individually, but the rest of the time was depicted with an aggregate figure at the seventeenth hour. This made the risk at those hours appear to be lower. Is it unethical for an agency to manipulate data? Explain.

514 U N I T F I V E The Regulatory Environment

Legal Reasoning Group Activity 23–10. Investigation. Maureen Droge was a �ight atten- dant for United Air Lines, Inc. (UAL). After being assigned to work in Paris, France, she became pregnant. Because UAL does not allow its �ight attendants to �y during their third tri- mester of pregnancy, Droge was placed on involuntary leave. She applied for temporary disability bene�ts through the French social security system. Her request was denied because UAL does not contribute to the French system on behalf of its U.S.-based �ight attendants. Droge �led a charge of dis- crimination with the U.S. Equal Employment Opportunity Commission (EEOC), alleging that UAL had discriminated against her and other Americans. �e EEOC issued a sub- poena, asking UAL to detail all bene�ts received by all UAL

employees living outside the United States. UAL refused to provide the information on the ground that it was irrelevant and compliance would be unduly burdensome. �e EEOC �led a suit in a federal district court against UAL. (See �e Administrative Process.) (a) The first group will decide whether the court should

enforce the subpoena and explain why. (b) The second group will discuss whether the EEOC should

be able to force a U.S. company operating overseas to provide the same disability benefits to employees located there as it does to employees in the United States. Should UAL be required to contribute to the French social secu- rity system for employees who reside in France?

515

C H A P T E R 2 4

24–1 Advertising, Marketing, and Sales

Numerous federal laws have been passed to define the duties of sellers and the rights of consumers. Exhibit 24–1 shows many of the areas of consumer law that are regu- lated by federal statutes. We begin our discussion of this legislation by examining some of the laws and regulations relating to advertising, marketing, and sales. Although we focus on federal law, realize that state consumer pro- tection laws in these and other areas often provide more sweeping and significant protections than do federal laws.

24–1a Deceptive Advertising One of the most important federal consumer protection laws is the Federal Trade Commission Act.1 The act cre- ated the Federal Trade Commission (FTC) to carry out the broadly stated goal of preventing unfair and decep- tive trade practices, including deceptive advertising.

Generally, deceptive advertising occurs if a reasondeceptive advertising occurs if a reasondeceptive advertising - able consumer would be misled by the advertising claim. Vague generalities and obvious exaggerations are permis- sible. These claims are known as puffery. When a claim

1. 15 U.S.C. Sections 41–58.

takes on the appearance of authenticity, however, it may create problems.

Claims That Appear to Be Based on Factual Evi- dence Advertising that appears to be based on factual eviappears to be based on factual eviappears - dence but, in fact, is not reasonably supported by evidence will be deemed deceptive. ■ CASE IN POINT 24.1 MedLab, Inc., advertised that its weight-loss supplement (“The New Skinny Pill”) would cause users to lose substantial amounts of weight rapidly. The ads claimed that “clinical studies prove” that people who take the pill lose “as much as 15 to 18 pounds per week and as much as 50 percent of all excess weight in just 14 days, without dieting or exercising.” The FTC sued MedLab for deceptive advertising.

An expert hired by the FTC to evaluate the claim testified that to lose this much weight, “a 200-pound individual would need to run between 57 and 68 miles every day”—the equivalent of more than two marathons per day. The court concluded that the advertisement was false and misleading, granted the FTC a summary judg- ment, and issued a permanent injunction to stop Med- Lab from running the ads.2 ■

The following case involved an advertising claim based on limited scientific evidence.

2. Federal Trade Commission v. MedLab, Inc, 615 F.Supp.2d 1068 (N.D.Cal. 2009).

A ll statutes, agency rules, and common law judicial deci- sions that serve to protect the

interests of consumers are classified as consumer law. Traditionally, in disputes involving consumers, it was assumed that the freedom to contract carried with it the obligation to live by the deal made. Over time, this attitude has changed considerably.

Today, countless federal and state laws attempt to protect consumers

from unfair trade practices, unsafe products, discriminatory or unrea- sonable credit requirements, and other problems related to consumer transactions. Nearly every agency and department of the federal gov- ernment has an office of consumer affairs, and most states have one or more such offices to help consumers. Also, typically the attorney general’s office assists consumers at the state level.

In recent years, there has been a renewed interest in attempting to protect consumers in their dealings with credit-card companies, finan- cial institutions, and insurance com- panies. Congress has enacted new credit-card regulations and finan- cial reforms to regulate the nation’s largest banks. It has also enacted health-care reforms and revised food safety laws.

Consumer Protection

516 U N I T F I V E The Regulatory Environment

Advertising

Example—The Federal Trade Commission Act

Food and Drugs

Example—The Federal Food, Drug, and

Cosmetic Act Product Safety

Example—The Consumer Product Safety Act

Credit Protection

Example—The Consumer Credit Protection Act

Sales

Example—The FTC Mail-Order Rule

Labeling and Packaging

Example—The Fair Packaging and

Labeling Act

CONSUMER LAWCONSUMER LAWCONSUMER LA

E X H I B I T 2 4 – 1 Selected Areas of Consumer Law Regulated by Statutes

Background and Facts POM Wonderful, LLC, makes and sells pomegranate-based products. In ads, POM touted medical studies claiming to show that daily consumption of its products could treat, prevent, or reduce the risk of heart disease, prostate cancer, and erectile dysfunction. These ads mis- characterized the scientific evidence.

The Federal Trade Commission (FTC) charged POM with, and held POM liable for, making false, misleading, and unsubstantiated representations in violation of the FTC Act. POM was barred from running future ads asserting that its products treat or prevent any disease unless “randomized, controlled, human clinical trials” (RCTs, for “randomized controlled trials”) demonstrated statistically significant results. POM petitioned the U.S. Court of Appeals for the District of Columbia Circuit to review this injunctive order.

In the Language of the Court SRINIVASAN, Circuit Judge:

* * * * * * * POM’s ads * * * convey the net impression that clinical studies or trials show that a causal rela-

tion has been established between the consumption of the challenged POM products and its efficacy to treat, prevent or reduce the risk of the serious diseases in question. The Commission found that experts in the relevant fields would require RCTs * * * to establish such a causal relationship.

The Commission examined each of the studies invoked by petitioners in their ads, concluding that the referenced studies fail to qualify as RCTs of the kind that could afford adequate substantiation. Peti- tioners’ claims therefore were deceptive.

POM Wonderful, LLC v. Federal Trade Commission United States Court of Appeals, District of Columbia Circuit, 777 F.3d 478 (2015).

Case 24.1

C H A P T E R 2 4 Consumer Protection 517

Claims Based on Half-Truths Some advertisements contain “half-truths,” meaning that the presented infor- mation is true but incomplete and may therefore lead consumers to a false conclusion. ■ EXAMPLE 24.2 The maker of Campbell’s soups advertised that “most” Camp- bell’s soups are low in fat and cholesterol and thus helpful in fighting heart disease. What the ad did not say was that many Campbell’s soups are high in sodium and that high- sodium diets may increase the risk of heart disease. Hence, the FTC ruled that Campbell’s claims were deceptive. ■ In addition, advertising that contains an endorsement by a celebrity may be deemed deceptive if the celebrity does not actually use the product.

Bait-and-Switch Advertising The FTC has issued rules that govern specific advertising techniques. One of the most important rules is contained in the FTC’s “Guides Against Bait Advertising.”3

3. 16 C.F.R. Part 238.

Some retailers systematically advertise merchandise at low prices to get customers into their stores. But when the customers arrive, they find that the merchandise is not in stock. Salespersons then encourage them to purchase more expensive items instead. This practice, known as bait-and-switch advertising, is a form of deceptive advertising. The low price is the “bait” to lure the consumer into the store. The salesperson is instructed to “switch” the consumer to a different, more expensive item.

Under the FTC guidelines, bait-and-switch advertis- ing occurs if the seller does any of the following:

1. Refuses to show the advertised item. 2. Fails to have a reasonable quantity of the item in

stock. 3. Fails to promise to deliver the advertised item within

a reasonable time. 4. Discourages employees from selling the advertised

item.

* * * * * * * The Commission’s finding is supported by substantial record evidence. That evidence includes

written reports and testimony from medical researchers stating that experts in the fields of cardiology and urology require randomized, double-blinded, placebo-controlled clinical trials to substantiate any claim that a product treats, prevents, or reduces the risk of disease.

The Commission drew on that expert testimony to explain why the attributes of well-designed RCTs are necessary to substantiate petitioners’ claims. A control group, for example, allows investigators to distinguish between real effects from the intervention, and other changes, including those due to the mere act of being treated (placebo effect) and the passage of time. Random assignment of a study’s sub- jects to treatment and control groups increases the likelihood that the treatment and control groups are similar in relevant characteristics, so that any difference in the outcome between the two groups can be attributed to the treatment. And when a study is double-blinded ([that is,] when neither the study par- ticipants nor the investigators know which patients are in the treatment group and which patients are in the control group), it is less likely that participants or investigators will consciously or unconsciously take actions potentially biasing the results.

* * * * * * * The need for RCTs is driven by the claims petitioners have chosen to make. * * * An advertiser * * *

may assert a health-related claim backed by medical evidence falling short of an RCT if it includes an effective disclaimer disclosing the limitations of the supporting research. Petitioners did not do so. [Emphasis added.]

Decision and Remedy The U.S. Court of Appeals for the District of Columbia Circuit enforced the FTC’s order with respect to POM’s ads. The court pointed out that “An advertiser who makes express representa- tions about the level of support for a particular claim must possess the level of proof claimed in the ad and must convey that information to consumers in a non-misleading way.”

Critical Thinking • Ethical POM claimed that it is unethical to require RCTs to substantiate disease-related claims about

food products. It argued that, for instance, “doctors cannot . . . ethically deprive a control group of patients of all Vitamin C for a decade to determine whether Vitamin C helps prevent cancer.” Is this a valid argu- ment? Why or why not?

Case 24.1 Continued

518 U N I T F I V E The Regulatory Environment

Online Deceptive Advertising Deceptive advertis- ing occurs in the online environment as well as offline. The FTC actively monitors online advertising. It has iden- tified hundreds of Web sites that have made false or decep- tive claims for products and services ranging from medical treatments to exercise equipment and weight-loss aids.

The FTC has issued guidelines to help online busi- nesses comply with existing laws prohibiting decep- tive advertising. These guidelines include the following requirements: 1. All ads—both online and offline—must be truthful

and not misleading. 2. The claims made in an ad must be substantiated—

that is, advertisers must have evidence to back up their claims.

3. Ads cannot be unfair, which the FTC defines as “likely to cause substantial consumer injury that consumers could not reasonably avoid and that is not outweighed by the benefit to consumers or competition.”

4. Ads must disclose relevant limitations and qualify- ing information concerning the claims advertisers are making.

5. Required disclosures must be “clear and conspicuous.” For instance, because consumers may not read an entire Web page, an online disclosure should be placed as close as possible to the claim being qualified. Gener- ally, hyperlinks to a disclosure are recommended only for lengthy disclosures. If hyperlinks are used, they should be obvious and should be placed as close as possible to the relevant information it qualifies.

The FTC creates additional guidelines as needed to respond to new issues that arise with online advertising. One new issue involves so-called native ads, which are discussed in this chapter’s Digital Update feature.

Federal Trade Commission Actions The FTC receives complaints from many sources, including com- petitors of alleged violators, consumers, trade associations, Better Business Bureaus, and government organizations and officials. When the agency receives numerous and widespread complaints about a particular problem, it will investigate.

Formal Complaint. If the FTC concludes that a given advertisement is unfair or deceptive, it drafts a formal complaint, which is sent to the alleged o�ender. �e com- pany may agree to settle the complaint without further proceedings. If not, the FTC can conduct a hearing in which the company can present its defense.

FTC Orders and Remedies. If the FTC succeeds in prov- ing that an advertisement is unfair or deceptive, it usually issues a cease-and-desist order requiring the company to cease-and-desist order requiring the company to cease-and-desist order stop the challenged advertising. In some circumstances, it may also impose a sanction known as counteradver- tising. �is requires the company to advertise anew—in print, on the Internet, on radio, and on television—to inform the public about the earlier misinformation. �e FTC sometimes institutes a multiple product order, which requires a �rm to stop false advertising for all of its products, not just the product involved in the original action.

Damages When Consumers Are Injured. When a com- pany’s deceptive ad involves wrongful charges to con- sumers, the FTC may seek other remedies, including sumers, the FTC may seek other remedies, including sumers, the FTC may seek other remedies, including sumers, the FTC may seek other remedies, including damages. ■ CASE IN POINT 24.3 �e FTC sued Bron �e FTC sued Bron- son Partners, LLC, for deceptively advertising two prod- ucts—Chinese Diet Tea and Bio-Slim Patch. Bronson’s ads claimed that the diet tea “eliminates 91 percent of absorbed sugars,” “prevents 83 percent of fat absorption,” and “doubles your metabolic rate to burn calories fast.” �e Bio-Slim Patch ads promised “lasting weight loss” and claimed that “ugly fatty tissue will disappear at a spectacu- lar rate” as product users wear the patch while carrying on their normal lifestyle.

Eventually, Bronson conceded that it had engaged in deceptive advertising, and the FTC sought damages. The court awarded the FTC $1,942,325, which was the amount of Bronson’s revenues from the two products.4 ■

Restitution Possible. When a company’s deceptive ad leads to wrongful payments by consumers, the FTC may leads to wrongful payments by consumers, the FTC may leads to wrongful payments by consumers, the FTC may leads to wrongful payments by consumers, the FTC may seek other remedies, including restitution. seek other remedies, including restitution. ■ CASE IN CASE IN POINT 24.4 Verity International, Ltd., billed phone-line Verity International, Ltd., billed phone-line subscribers who accessed certain online pornography sites at the rate for international calls to Madagascar. When consumers complained about the charges, Verity told them that the charges were valid and had to be paid, or the consumers would face further collection actions. A federal appellate court held that this representation of “uncontestability” was deceptive and a violation of the FTC act. �e court ordered Verity to pay nearly $18 mil- lion in restitution to consumers.5 ■

4. Federal Trade Commission v. Bronson Partners, LLC, 664 F.3d 359 (2d Cir. 2011).

5. Federal Trade Commission v. Verity International, Ltd., 443 F.3d 48 (2d Cir. 2006).

C H A P T E R 2 4 Consumer Protection 519

False Advertising Claims under the Lanham Act The Lanham Act6 protects trademarks, as discussed elsewhere. The act also covers false advertising claims. To state a successful claim for false advertising under this act, a business must establish each of the following elements: 1. An injury to a commercial interest in reputation or

sales.

6. 15 U.S.C. Sections 1051–1128.

2. Direct causation of the injury by false or deceptive advertising.

3. A loss of business from buyers who were deceived by the advertising.

The dispute between the parties in the following case focused initially on a mimicked microchip. When the case reached the United States Supreme Court, the question was whether Static Control Components, Inc., could sue Lexmark International, Inc., for false advertis- ing under the Lanham Act.

Regulating “Native” Ads on the Internet

Sponsored content on the Internet—content that someone pays to put there—is every- where. One particular type of sponsored con- tent is the “native” ad. Here, native describes advertisements that follow the natural form and function of the user experience into which they are placed. Thus, such an ad matches the rest of a Web page’s content, including the visual design, as if it were “native” to the page.

Native Ad Integration on Desktops and Mobile Devices

Perhaps the most obvious native ads are in search engine results. When you type “native ads” in a Google search box, you will find that the first several “hits” listed in the search results are actually sponsored ads. Yet they have the look and feel of the rest of the search results.

Additionally, native ads are often placed within sto- ries in online publications. Suppose, for instance, that you are reading a story on new fashions on your smart- phone. You will likely see a native ad that looks as if it is part of the story but that is actually sponsored and perhaps written by a clothing company.

Some native ads are delivered via “recommenda- tion widgets.” Usually, the widgets are integrated into a page but do not mimic the appearance of the page. Rather, they direct you to a different Web page—per- haps telling you that “you might like” that site. Clicking the widget takes you to the site.

Native ads have become increasingly popular because desktop, smartphone, and tablet users have figured out how to block traditional online ads. More- over, native ads are less intrusive than traditional online

ads—important because of the increasing number of consumers who most often access small screens, such as those on smartphones.

The Federal Trade Commission Takes Action

In response to the growth in native advertis- ing, the Federal Trade Commission (FTC) has

issued guidelines.a The FTC starts out with the basic question “[A]s native advertising evolves, are consum- ers able to differentiate advertising from other con- tent?” In its guidance document,b the FTC suggests the following: • Disclosures should be placed where consumers will

notice them. • Disclosures should be placed not after the native ad,

but before or above it. • Disclosures should remain with native ads if the ads

are republished. • Once consumers arrive on a click- or tap-into page

where the complete native ad appears, disclosures should be placed as close as possible to where con- sumers will look first.

• Disclosures should stand out and should be understandable.

Critical Thinking What is the equivalent of native advertising in commercially released movies?

DIGITAL UPDATE

a. Federal Trade Commission, Native Advertising: A Guide to Business, December 2015.

b. Federal Trade Commission, .com Disclosures: How to Make Effective Disclosures in Digital Advertising, March 2013, avail- able at www.ftc.gov/tips-advice/business-center/guidance/ com-disclosures-how-make-effective-disclosures-digital.

520 U N I T F I V E The Regulatory Environment

Background and Facts Lexmark International, Inc., sells the only style of toner cartridges that work with the company’s laser printers. Other businesses—known as remanufacturers—acquire and refurbish used Lexmark cartridges to sell in competition with the cartridges sold by Lexmark. To deter remanufacturing, Lexmark introduced a program that gave customers a 20 percent discount on new toner cartridges if they agreed to return the empty cartridges to Lexmark. Static Control Components, Inc., makes and sells components for the remanufactured cartridges, including microchips that mimic the chips in Lexmark’s cartridges.

Lexmark released ads that claimed Static Control’s microchips illegally infringed Lexmark’s patents. Lexmark then filed a suit in a federal district court against Static Control, alleging violations of intellec- tual property law. Static Control counterclaimed, alleging that Lexmark had engaged in false advertis- ing in violation of the Lanham Act. The court dismissed the counterclaim. It held that Static Control lacked standing to bring that claim. On Static Control’s appeal, the U.S. Court of Appeals for the Sixth Circuit reversed the dismissal. Lexmark appealed to the United States Supreme Court.

In the Language of the Court Justice SCALIA delivered the opinion of the Court.

* * * * First, * * * a statutory cause of action extends only to plaintiffs whose interests fall within the zone of

interests protected by the law invoked. * * * * * * * To come within the zone of interests in a suit for false advertising under [the Lanham Act,] a

plaintiff must allege an injury to a commercial interest in reputation or sales. * * * * Second, * * * a statutory cause of action is limited to plaintiffs whose injuries are proximately caused

by violations of the statute. * * * * * * * A plaintiff suing under [the Lanham Act] ordinarily must show economic or reputational injury

flowing directly from the deception wrought by the defendant’s advertising; and that occurs when decep- tion of consumers causes them to withhold trade from the plaintiff.

* * * * Applying those principles to Static Control’s false-advertising claim, we conclude that Static Control

comes within the class of plaintiffs whom Congress authorized to sue under [the Lanham Act]. To begin, Static Control’s alleged injuries—lost sales and damage to its business reputation—are inju-

ries to precisely the sorts of commercial interests the Act protects. Static Control is suing not as a deceived consumer, but [in the words of the statute] as a “person engaged in * * * commerce within the control of Con- gress” whose position in the marketplace has been damaged by Lexmark’s false advertising. There is no doubt gress” whose position in the marketplace has been damaged by Lexmark’s false advertising. There is no doubt gress” whose position in the marketplace has been damaged by Lexmark’s false advertising that it is within the zone of interests protected by the statute. [Emphasis added.]

Static Control also sufficiently alleged that its injuries were proximately caused by Lexmark’s misrepresentations.

First, Static Control alleged that Lexmark disparaged its business and products by asserting that Static Control’s business was illegal. When a defendant harms a plaintiff ’s reputation by casting aspersions [abuse] on its business, the plaintiff ’s injury flows directly from the audience’s belief in the disparaging statements. [Emphasis added.]

* * * * The District Court emphasized that Lexmark and Static Control are not direct competitors [since

Static Control is not itself a remanufacturer]. But when a party claims reputational injury from dispar- agement, competition is not required for proximate cause; and that is true even if the defendant’s aim was to harm its immediate competitors, and the plaintiff merely suffered collateral damage.

Lexmark International, Inc. v. Static Control Components, Inc. Supreme Court of the United States, __ U.S. __, 134 S.Ct. 1377, 188 L.Ed.2d 392 (2014).

Case 24.2

C H A P T E R 2 4 Consumer Protection 521

24–1b Marketing In addition to regulating advertising practices, Congress has passed several laws to protect consumers against other marketing practices.

Telephone Solicitation The Telephone Consumer Protection Act (TCPA)7 prohibits telephone solicitation using an automatic telephone dialing system or a prere- corded voice. In addition, most states have statutes reg- ulating telephone solicitation. The TCPA also makes it illegal to transmit ads via fax without first obtaining the recipient’s permission.

The Federal Communications Commission (FCC) enforces the TCPA. The FCC imposes substantial fines ($11,000 each day) on companies that violate the junk fax provisions of the act.8 The TCPA also gives consum- ers a right to sue for either $500 for each violation of the act or for the actual monetary losses resulting from a violation, whichever is greater. If a court finds that a defendant willfully or knowingly violated the act, the court has the discretion to treble (triple) the amount of damages awarded.

Fraudulent Telemarketing The Telemarketing and Consumer Fraud and Abuse Prevention Act9 directed the FTC to establish rules governing telemarketing and to bring actions against fraudulent telemarketers.

7. 47 U.S.C. Sections 227 et seq. 8. See, for instance, Imhoff Investment, LLC v. Alfoccinio, Inc., 792 F.3d 627

(6th Cir. 2015). 9. 15 U.S.C. 6101–6108.

The FTC’s Telemarketing Sales Rule (TSR)10 requires a telemarketer to identify the seller’s name, describe the product being sold, and disclose all material facts related to the sale (such as the total cost). The TSR makes it illegal for telemarketers to misrepresent information or facts about their goods or services. A telemarketer must also remove a consumer’s name from its list of potential contacts if the customer so requests.

An amendment to the TSR established the national Do Not Call Registry. Telemarketers must refrain from calling those consumers who have placed their names on the list. Significantly, the TSR applies to any offer made to consumers in the United States—even if the offer comes from a foreign firm. Thus, the TSR helps to protect con- sumers from illegal cross-border telemarketing operations.

24–1c Sales A number of statutes protect consumers by requiring the disclosure of certain terms in sales transactions and providing rules governing unsolicited merchandise. The FTC has regulatory authority in this area, as do some other federal agencies.

Many states and the FTC have “cooling-off ” laws that permit the buyers of goods sold door to door to can- cel their contracts within three business days. The FTC rule also requires that consumers be notified in Spanish of this right if the oral negotiations for the sale were in that language.

The contracts that fall under these cancellation rules include trade show sales contracts, contracts for home

10. 16 C.F.R. Sections 310.1–310.8.

In addition, Static Control adequately alleged proximate causation by alleging that it designed, manufactured, and sold microchips that both (1) were necessary for, and (2) had no other use than, refurbishing Lexmark toner cartridges. It follows from that allegation that any false advertising that reduced the remanufacturers’ business necessarily injured Static Control as well.

Decision and Remedy The United States Supreme Court affirmed the lower court’s ruling. Static Control had adequately pleaded the elements of a cause of action under the Lanham Act for false advertis- ing. The Court’s decision clarified that businesses do not need to be direct competitors to bring an action for false advertising under the act.

Critical Thinking • What If the Facts Were Different? Suppose that Lexmark had issued a retraction of its advertising

claims before this case reached the Supreme Court. Would the outcome have been different? Discuss. • Legal Environment Under the Court’s ruling in this case, is Static Control now entitled to relief ? Under the Court’s ruling in this case, is Static Control now entitled to relief ? Under the Court’s ruling in this case, is Static Control now entitled to relief

Explain your answer.

Case 24.2 Continued

522 U N I T F I V E The Regulatory Environment

equity loans, Internet purchase contracts, and home (door-to-door) sales contracts. In addition, certain states have passed laws allowing consumers to cancel contracts for dating services, gym memberships, and weight loss programs.

The FTC Mail or Telephone Order Merchandise Rule11 protects consumers who purchase goods via mail, Internet, phone, or fax. Merchants are required to ship orders within the time promised in their advertisements and to notify consumers when orders cannot be shipped on time. If the seller does not give an estimated shipping time, it must ship within thirty days. Merchants must also issue a refund within a specified period of time when a consumer cancels an order.

24–2 Labeling and Packaging Laws A number of federal and state laws deal specifically with the information given on labels and packages. In general, labels must be accurate, and they must use words that are easily understood by the ordinary consumer. In some instances, labels must specify the raw materials used in the product, such as the percentage of cotton, nylon, or other fiber used in a garment. In other instances, the product must carry a warning, such as those required on cigarette packages and advertising.12

24–2a Automobile Fuel Economy Labels The Energy Policy and Conservation Act (EPCA)13 requires automakers to attach an information label to every new car. The label must include the Environmental Protection Agency’s fuel economy estimate for the vehiProtection Agency’s fuel economy estimate for the vehiProtection Agency’s fuel economy estimate for the vehiProtection Agency’s fuel economy estimate for the vehi- cle. ■ CASE IN POINT 24.5 Gaetano Paduano bought a Gaetano Paduano bought a new Honda Civic Hybrid in California. The information label on the car included the fuel economy estimate from the Environmental Protection Agency (EPA). Honda’s sales brochure added, “Just drive the Hybrid like you would a conventional car and save on fuel bills.”

When Paduano discovered that the car’s fuel economy was less than half of the EPA’s estimate, he sued Honda for deceptive advertising under a California law. The automaker claimed that the federal law (the EPCA) pre- empted the state’s deceptive advertising law. The court held in Paduano’s favor, finding that the federal statute

11. 16 C.F.R. Sections 435.1–435.2. 12. 15 U.S.C. Sections 1331–1341. 13. 49 U.S.C. Section 32908(b)(1).

did not preempt a claim for deceptive advertising made under state law.14 ■

24–2b Food Labeling Because the quality and safety of food are so important to consumers, several statutes deal specifically with food labeling. The Fair Packaging and Labeling Act requires that food product labels identify (1) the product, (2) the net quantity of the contents (and, if the number of serv- ings is stated, the size of a serving), (3) the manufacturer, and (4) the packager or distributor. The act includes additional requirements concerning descriptions on packages, savings claims, components of nonfood prod- ucts, and standards for the partial filling of packages.

Nutritional Content of Food Products Food products must bear labels detailing the nutritional con- tent, including the number of calories and the amounts of various nutrients that the food contains. The Nutrition Labeling and Education Act15 requires food labels to pro- vide standard nutrition facts and regulates the use of such terms as fresh and fresh and fresh low fat.low fat.low fat

The U.S. Food and Drug Administration (FDA) and the U.S. Department of Agriculture (USDA) are the primary agencies that issue regulations on food label- ing. These rules are published in the Federal Register and updated annually.

Caloric Content of Restaurant Foods The health-care reforms enacted in 2010 (the Affordable Care Act, or Obamacare) included provisions aimed at com- bating the problem of obesity in the United States. All restaurant chains with twenty or more locations are now required to post the caloric content of the foods on their menus so that customers will know how many calories the foods contain.16 Foods offered through vending machines must also be labeled so that their caloric content is visible to would-be purchasers.

In addition, restaurants must post guidelines on the number of calories that an average person requires daily so that customers can determine what portion of a day’s calories a particular food will provide. The hope is that consumers, armed with this information, will con- sider the number of calories when they make their food choices. The federal law on menu labeling supersedes all previous state and local laws in this area.

14. Paduano v. American Honda Motor Co., 169 Cal.App.4th 1453, 88 Cal. Rptr.3d 90 (2009).

15. 21 U.S.C. Section 343.1. 16. See Section 4205 of the Patient Protection and Affordable Care Act,

C H A P T E R 2 4 Consumer Protection 523

24–3 Protection of Health and Safety

Although labeling and packaging laws promote con- sumer health and safety, there is a significant distinction between regulating the information dispensed about a product and regulating the actual content of the prod- uct. The classic example is tobacco products. Producers of tobacco products must use labels that warn consumers about the health hazards associated with their use, but the sale of tobacco products has not been subjected to signifi- cant restrictions. We now examine various laws that regu- late the actual products made available to consumers.

24–3a The Federal Food, Drug, and Cosmetic Act

The most important federal legislation regulating food and drugs is the Federal Food, Drug, and Cosmetic Act (FDCA).17 The act protects consumers against adulter- ated (contaminated) and misbranded foods and drugs. The FDCA establishes food standards, specifies safe lev- els of potentially hazardous food additives, and provides classifications of foods and food advertising. Most of these statutory requirements are monitored and enforced by the Food and Drug Administration (FDA).

Interestingly, the European Union and a number of other countries, such as Canada, have banned some foods that the FDA assumes to be safe. These foods include brominated vegetable oil (a common ingredient in sports drinks, such as Gatorade) and Olestra/Olean (a choles- terol-free fat substitute found in certain potato chips). Food products containing such substances may not be sold in the European Union. Similarly, certain food col- orings found in processed foods in the United States (in M&Ms and Kraft macaroni and cheese, for instance) are not allowed in foods in some other countries.

Tainted Foods In the last twenty years or so, many people in the United States have contracted food poison- ing from eating foods that were contaminated, often with ing from eating foods that were contaminated, often with ing from eating foods that were contaminated, often with ing from eating foods that were contaminated, often with salmonella or E. coli bacteria. E. coli bacteria. E. coli ■ EXAMPLE 24.6 During During 2015 and 2016, hundreds of people across the United States were sickened by eating tainted food at the popular restaurant chain Chipotle Mexican Grill. Causes of illness in these outbreaks included E-coli and salmonella, as well E-coli and salmonella, as well E-coli as the highly contagious norovirus. ■

In response to the problem of food contamination, Congress enacted the Food Safety Modernization Act

17. 21 U.S.C. Sections 301–393.

(FSMA)18 to provide greater government control over the U.S. food safety system. The act gives the FDA authority to directly recall any food products that it suspects are tainted, rather than relying on the producers to recall items.

The FSMA requires anyone who manufactures, pro- cesses, packs, distributes, receives, holds, or imports food products to pay a fee and register with the U.S. Depart- ment of Health and Human Services. (There are some exceptions for small farmers.) Owners and operators of such facilities are required to analyze and identify food safety hazards, implement preventive controls, monitor effectiveness, and take corrective actions. The FSMA places additional restrictions on importers of food and requires them to verify that imported foods meet U.S. safety standards.

Drugs and Medical Devices The FDA is also responsible under the FDCA for ensuring that drugs are safe and effective before they are marketed to the public. Because the FDA must ensure the safety of new medica- tions, there is always a delay before drugs are available to the public, and this sometimes leads to controversy.

■ CASE IN POINT 24.7 A group of citizens petitioned the FDA to allow everyone access to “Plan B”—the morning-after birth control pill—without a prescription. The FDA denied the petition and continued to require women under the age of seventeen to obtain a prescrip- tion. The group appealed to a federal district court, claim- ing that the prescription requirement can delay access to the pill. The pill should be taken as soon as possible after sexual intercourse, preferably within twenty-four hours. The court ruled in favor of the plaintiffs and ordered the FDA to make the morning-after pill available to people of any age without a prescription.19 ■

24–3b The Consumer Product Safety Act The Consumer Product Safety Act20 created a compre- hensive regulatory scheme over consumer safety matters and established the Consumer Product Safety Commis- sion (CPSC).

The CPSC’s Authority The CPSC conducts research on the safety of individual consumer products and main- tains a clearinghouse on the risks associated with various products. The Consumer Product Safety Act authorizes the CPSC to do the following:

18. Pub. L. No. 111-353, 124 Stat. 3885 (January 4, 2011). This statute affected numerous parts of Title 21 of the U.S.C.

19. Tummino v. Hamburg, 936 F.Supp.2d 162 (E.D.N.Y. 2013). 20. 15 U.S.C. Sections 2051–2083.

524 U N I T F I V E The Regulatory Environment

1. Set safety standards for consumer products. 2. Ban the manufacture and sale of any product that

the commission believes poses an “unreasonable risk” to consumers. (Products banned by the CPSC have included various types of fireworks, cribs, and toys, as well as many products containing asbestos or vinyl chloride.)

3. Remove from the market any products it believes to be imminently hazardous. The CPSC frequently works in conjunction with manufacturers to con- duct voluntary recalls of defective products from stores. ■ EXAMPLE 24.8 In cooperation with the CPSC, the Scandinavian company IKEA recalled three million baby bed canopies and thirty million wall-mounted children’s lamps because they posed a strangulation risk to children. ■

4. Require manufacturers to report on any products already sold or intended for sale if the products have proved to be hazardous.

5. Administer other product-safety legislation, includ- ing the Child Protection and Toy Safety Act21 and the Federal Hazardous Substances Act.22

Notification Requirements The Consumer Prod- uct Safety Act requires the distributors of consumer products to notify the CPSC immediately if they receive information that a product “contains a defect which . . . creates a substantial risk to the public” or “an unreason- able risk of serious injury or death.”able risk of serious injury or death.”able risk of serious injury or death.”able risk of serious injury or death.”

■ EXAMPLE 24.9 A company that sells juicers receives A company that sells juicers receives twenty-three letters from customers complaining that during operation the juicer suddenly exploded, sending pieces of glass and razor-sharp metal across the room. The company must immediately notify the CPSC because the alleged defect creates a substantial risk to the public. ■

24–3c Health-Care Reforms The health-care reforms enacted in 2010 gave Americans new rights and benefits with regard to health care.23 The legislation also prohibited certain insurance company practices.

Expanded Coverage for Children and Seniors The reforms enabled more children to obtain health- insurance coverage and allowed young adults (under age

21. 15 U.S.C. Section 1262(e). 22. 15 U.S.C. Sections 1261–1273. 23. Patient Protection and Affordable Health Care Act of 2010, Pub. L.

No.111-148, 124 Stat. 119 (March 23, 2010); and the Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, 124 Stat. 1029 (March 30, 2010).

twenty-six) to remain on their parents’ health insurance policies. The legislation also ended lifetime limits and most annual limits on care, and gave insured persons access to recommended preventive services (such as cancer screen- ing and vaccinations) without cost. People can no longer be denied insurance because of preexisting conditions. Medicare recipients now receive a 50 percent discount on name-brand drugs, and the reforms will eliminate a gap in Medicare’s prescription drug coverage by 2020.

Controlling Costs of Health Insurance In an attempt to control the rising costs of health insurance, certain restrictions were placed on insurance companies. Insurance companies must spend at least 85 percent of all premium dollars collected from large employers (80 percent of the premiums collected from individuals and small employers) on benefits and quality improvement. If insurance companies do not meet these goals, they must provide rebates to consumers. Additionally, states can require insurance companies to justify any premium increases to be eligible to participate in the new health- insurance exchanges. In spite of the legislation, health insurance costs have continued to increase.

24–4 Credit Protection Credit protection is one of the more important aspects of consumer protection legislation. Many U.S. consum- ers have credit cards, and most carry a balance on these cards—a total of about $2.5 trillion of debt nationwide. The Consumer Financial Protection Bureau (CFPB) is the agency that oversees the credit practices of banks, mortgage lenders, and credit-card companies.24

24–4a The Truth-in-Lending Act A key statute regulating the credit and credit-card indus- tries is the Truth-in-Lending Act (TILA), the name commonly given to Title I of the Consumer Credit Pro- tection Act, as amended.25 The TILA is basically a disclo- sure law. It is administered by the Federal Reserve Board and requires sellers and lenders to disclose credit terms and loan terms so that individuals can shop around for the best financing arrangements.

24. Title 10 of the Restoring American Financial Stability Act of 2010, S.B. 3217, April 15, 2010.

C H A P T E R 2 4 Consumer Protection 525

Application TILA requirements apply only to those who, in the ordinary course of business, lend funds, sell on credit, or arrange for the extension of credit. Thus, sales or loans made between two consumers do not come under the protection of the act. Additionally, this law pro- tects only debtors who are natural persons (as opposed to the artificial “person” of a corporation). It does not extend to other legal entities.

Disclosure Requirements The TILA’s disclosure requirements are contained in Regulation Z, issued by the Federal Reserve Board of Governors. If the contracting parties are subject to the TILA, the requirements of Regu- lation Z apply to any transaction involving an installment sales contract that calls for payment to be made in more than four installments. Transactions subject to Regulation Z typically include installment loans, retail and installment sales, car loans, home-improvement loans, and certain real estate loans if the amount of financing is less than $25,000.

Under the provisions of the TILA, all of the terms of a credit instrument must be clearly and conspicuously disclosed. A lender must disclose the annual percentage rate (APR), finance charge, amount financed, and total payments (the sum of the amount loaned, plus any fees, finance charges, and interest). If a creditor fails to follow the exact procedures required by the TILA, the creditor exact procedures required by the TILA, the creditor exact risks contract rescission (cancellation) under the act.

Equal Credit Opportunity Congress enacted the Equal Credit Opportunity Act (ECOA)26 as an amend- ment to the TILA. The ECOA prohibits the denial of credit solely on the basis of race, religion, national ori- gin, color, gender, marital status, or age. The act also prohibits credit discrimination on the basis of whether an individual receives certain forms of income, such as public-assistance benefits.

Under the ECOA, a creditor may not require a cosigner on a credit instrument if the applicant quali- fies under the creditor’s standards of creditworthiness for the amount and terms of the credit request. ■ CASE IN POINT 24.10 T.R. Hughes, Inc., and Summit Pointe, LLC, obtained financing from Frontenac Bank to con- struct two real estate developments near St. Louis, Mis- souri. The bank also required the builder, Thomas R. Hughes, and his wife, Carolyn Hughes, to sign personal guaranty agreements for the loans.

When the borrowers failed to make the loan pay- ments, the bank sued the two companies and Thomas and Carolyn Hughes personally, and foreclosed on the properties. Carolyn claimed that the personal guaranty

26. 15 U.S.C. Sections 1691–1691f.

contracts that she signed were obtained in violation of the ECOA. The court held that because the applicant, Thomas R. Hughes, was creditworthy, the personal guar- antys of Carolyn Hughes were obtained in violation of the ECOA and therefore unenforceable.27 ■

Credit-Card Rules The TILA also contains provisions regarding credit cards. One provision limits the liability of a cardholder to $50 per card for unauthorized charges made before the creditor is notified that the card has been lost. If a consumer receives an unsolicited credit card in the unsolicited credit card in the unsolicited mail that is later stolen, the company that issued the card cannot charge the consumer for any unauthorized charges.

Another provision requires credit-card companies to disclose the balance computation method that is used to determine the outstanding balance and to state when finance charges begin to accrue. Other provisions set forth procedures for resolving billing disputes with the credit-card company. These procedures are used if, for instance, a cardholder thinks that an error has occurred in billing or wishes to withhold payment for a faulty product purchased by credit card.

Amendments to Credit-Card Rules Amend- ments to the TILA’s credit-card rules added the follow- ing protections:

1. A company may not retroactively increase the inter- est rates on existing card balances unless the account is sixty days delinquent.

2. A company must provide forty-five days’ advance notice to consumers before changing its credit-card terms.

3. Monthly bills must be sent to cardholders twenty- one days before the due date.

4. The interest rate charged on a customer’s credit-card balance may not be increased except in specific situa- tions, such as when a promotional rate ends.

5. A company may not charge over-limit fees except in specified situations.

6. When the customer has balances at different interest rates, payments in excess of the minimum amount due must be applied first to the balance with the highest rate. (For instance, a higher interest rate is commonly charged for cash advances.)

7. A company may not compute finance charges based on the previous billing cycle (a practice known as double-cycle billing). This practice hurts consum- ers because they are charged interest for the previous cycle even if they have paid the bill in full.

27. Frontenac Bank v. T.R. Hughes, Inc., 404 S.W.3d 272 (Mo.App. 2012). Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

526 U N I T F I V E The Regulatory Environment

24–4b The Fair Credit Reporting Act The Fair Credit Reporting Act (FCRA)28 protects con- sumers against inaccurate credit reporting and requires that lenders and other creditors report correct, relevant, and up-to-date information. The act provides that con-

28. 15 U.S.C. Sections 1681–1681t.

sumer credit reporting agencies may issue credit reports to users only for specified purposes. Legitimate purposes include the extension of credit, the issuance of insurance policies, and responding to the consumer’s request.

Whether an Internet service provider had a legitimate purpose to pull a customer’s credit report was at issue in the following case.

In the Language of the Court John Z. LEE, United States District Judge LEE, United States District Judge LEE

* * * * I. Factual and Procedural Background

[Keith Santangelo filed a complaint in a federal district court against Com- cast Corporation, alleging a violation of the Fair Credit Reporting Act (FCRA).] Santangelo alleges * * * that he contacted Comcast through the company’s online customer service “Chat” function * * * and requested Internet service for his new apartment. During the chat ses- sion, a Comcast representative asked Santangelo for permission to run a credit inquiry. Santangelo asked if any option was available to avoid the credit inquiry. The Comcast representative told him that the company would forgo the inquiry if he paid a $50 deposit.

The option to pay a $50 deposit in order to avoid a credit inquiry was an explicit part of Comcast’s official Risk Management Policy * * * .The policy also required a $50 deposit from any prospective customer who agreed to a credit inquiry but whose credit score proved to be unsatisfactory. According to Santangelo, the deposit policy “reflects Comcast’s calculated business decision and belief that the collection of a $50 deposit is sufficient to cover the risk pre- sented by a person with bad credit and is sufficient to cover the risk presented by a person who refuses a credit pull.”

Santangelo opted to pay the $50 deposit in lieu of a credit inquiry. * * * Nevertheless, Comcast, without Sant- angelo’s authorization, pulled his credit

report * * * . This credit inquiry depleted [lowered] Santangelo’s credit score.

* * * * * * * Comcast now moves to dismiss

the * * * complaint. II. Analysis

* * * * FCRA prohibits the obtaining of a

“consumer report,” commonly known as a credit report, except for purposes authorized by that statute. The statute lists specific permissible purposes, such as * * * any * * * “legitimate business need * * *“legitimate business need * * *“legitimate business need in connec- tion with a business transaction that is initiated by the consumer.” These limitainitiated by the consumer.” These limitainitiated by the consumer.” - tions are intended to produce a balance between consumer privacy and the needs of a modern, credit-driven economy. [Emphasis added.]

Santangelo contends that Comcast did not have a permissible purpose for obtaining his credit report after he paid the $50 deposit in exchange for the com- pany’s promise not to check his credit. If he is correct and the company’s viola- tion was willful, he would be entitled to recover attorney’s fees and either actual damages or statutory damages between $100 and $1,000. If the company’s vio- lation was merely negligent, Santangelo would be permitted to recover only attorney’s fees and actual damages. 1. Standing

Comcast first argues that Santangelo lacks standing to bring his FCRA claim. To establish standing * * * a plaintiff must show * * * the injury is fairly trace- able to the challenged action of the defendant.

According to Comcast, Santangelo has not alleged an injury-in-fact that is fairly traceable to the FCRA violation he claims. Santan- gelo responds that he has sustained three injuries-in-fact: the loss of the $50 he paid as a deposit, the violation of his legal right not to have his credit report pulled without a permissible purpose, and the resulting depletion of his credit score.

* * * * * * * It was the very fact that Com-

cast received the $50 from Santangelo before it performed the credit check that made it illegal. * * * And once Comcast checked Santangelo’s credit, it should have refunded the deposit immediately, rather than keeping it. Comcast’s receipt and withholding of the $50, therefore, is inextricable [inseparable] from the FCRA violation and can be said to be fairly traceable to the FCRA violation. * * * Even if the $50.00 deposit were fully refundable, Santangelo still has standing based on the lost time-value of the money.

* * * Santangelo also has sufficiently alleged an injury-in-fact by alleging that Comcast obtained his credit report with- out a permissible purpose in violation of the FCRA.

Because the FCRA grants consumers a legally protected interest in limiting access to their credit reports and provides redress for violations, * * * Santangelo’s allega- tions about Comcast’s interference with that legally protected interest are sufficient

Case Analysis 24.3 Santangelo v. Comcast Corporation United States District Court, Northern District of Illinois, Eastern Division, __ F.Supp.3d __, 2016 WL 464223 (2016).

C H A P T E R 2 4 Consumer Protection 527

Consumer Notification and Inaccurate Infor- mation Any time a consumer is denied credit or insur- ance on the basis of her or his credit report, the consumer must be notified of that fact. The notice must include the name and address of the credit-reporting agency that issued the report. The same notice must be sent to consumers who are charged more than others ordinarily would be for credit or insurance because of their credit reports.

Under the FCRA, consumers may request the source of any information used by the credit agency, as well as the identity of anyone who has received an agency’s report.

Consumers are also permitted to access the information about them contained in a credit reporting agency’s files.

If a consumer discovers that an agency’s files con- tain inaccurate information, he or she should report the problem to the agency. On the consumer’s written (or electronic) request, the agency must conduct a systematic examination of its records. Any unverifiable or erroneous information must be deleted within a reasonable period of time.

Remedies for Violations A credit reporting agency that fails to comply with the act is liable for actual

to establish * * * standing. [Emphasis added.]

* * * Santangelo also alleges that the FCRA violation in this case depleted his credit score. In response, Comcast contends that a reduced credit score, without resulting damages, does not constitute an injury.

* * * The Court agrees with Sant- angelo that a depleted credit score is sufficient to constitute an injury * * * . Credit scores are of great importance in our economy, and a depleted credit score could affect a consumer in numerous ways, inflicting harm that often may be difficult to prove or quantify. Congress has the power to discourage the needless depletion of consumers’ credit scores even when the depleted score cannot be neatly tied to a financial harm. 2. Sufficiency of Santangelo’s allegations

Comcast next argues that Santan- gelo’s allegations do not state an FCRA claim.

* * * * In his * * * complaint, Santangelo

* * * alleges that Comcast’s deposit poli- cies demonstrate its lack of a legitimate need to run credit checks with respect

to consumers who paid a $50 deposit. According to the * * * complaint, Comcast’s established policy is to forgo a credit check in exchange for a $50 deposit. The company also has a policy of accepting a $50 deposit from con- sumers who opt for a credit check but prove to have poor credit. Santangelo compares this situation to that of a car dealer who accepts a cash payment for the full purchase price of a car. * * * The car dealer * * * does not have a legitimate need to obtain the purchaser’s credit report. Similarly, a landlord does not have a legitimate need to obtain a ten- ant’s credit report if the tenant is entitled to a lease renewal without regard to creditworthiness.

In response, Comcast * * * argues that it had a legitimate business need to establish Santangelo’s creditworthiness despite his deposit because—unlike in the car dealer example—his $50 deposit would cover less than two months of service in a long-term contract. * * * [Santangelo] contends that, under com- pany policy, his creditworthiness was irrelevant to Comcast’s determination of his eligibility for service once the deposit

was collected, much like the tenants in [the landlord example].

* * * * * * * Comcast’s mere violation of its

alleged agreement not to pull Santan- gelo’s credit report does not support an FCRA claim. But the possibility that the company itself believed that its custom- ers’ creditworthiness was irrelevant if they paid a deposit is enough.

Comcast’s final argument for dis- missing Santangelo’s FCRA claim is that he neither explicitly alleges that the company’s actions were willful, which is necessary to trigger statutory damages, nor identifies any actual damages that he could recover if Comcast acted only neg- ligently. Although [Santangelo] does not use the word willful in his complaint, he alleges that the company obtained his credit report despite that it “knew that it did not have a legitimate business need.” This allegation implies recklessness at the very least, and reckless conduct qualifies as willful conduct under the FCRA.

* * * * III. Conclusion

* * * The Court denies Comcast’s motion to dismiss.

Case 24.3 Continued

Legal Reasoning Questions

1. Comcast argued that it had refunded Santangelo’s $50, plus interest in the amount of $10, four months after pulling his credit report. Does this argument undercut the plaintiff ’s claim to have standing? Why or why not?

2. What might discovery reveal that would affect the outcome in this case? Explain. 3. What damages might Santangelo be able to prove based on the depletion of his credit score?

528 U N I T F I V E The Regulatory Environment

damages, plus additional damages not to exceed $1,000 and attorneys’ fees.29 Creditors and other companies that use information from credit reporting agencies may also be liable for violations of the FCRA. The United States Supreme Court has held that an insurance company’s fail- ure to notify new customers that they were paying higher insurance rates as a result of their credit scores was a will-will-will ful violation of the FCRA.ful violation of the FCRA.ful 30

■ CASE IN POINT 24.11 Branch Banking & Trust Company of Virginia (BB&T) gave Rex Saunders an auto loan but failed to give him a payment coupon book and refused his attempts to make payments on the loan. In fact, BB&T told him that it had not extended a loan to him. Eventually, BB&T discovered its mistake and demanded full payment, plus interest and penalties.

When payment was not immediately forthcoming, BB&T declared that Saunders was in default. It then repossessed the car and forwarded adverse credit infor- mation about Saunders to credit reporting agencies, without noting that Saunders disputed the informa- tion. Saunders filed a lawsuit alleging violations of the FCRA and was awarded $80,000 in punitive damages. An appellate court found that the damages award was reasonable, given BB&T’s willful violation.31 ■

24–4c The Fair and Accurate Credit Transactions Act

Congress passed the Fair and Accurate Credit Transac- tions (FACT) Act in an effort to combat identity theft.32 The act established a national fraud alert system. Con- sumers who suspect that they have been or may be vic- timized by identity theft can place an alert on their credit files. When a consumer establishes that identify theft has occurred, the credit reporting agency must stop reporting allegedly fraudulent account information.

The act also requires the major credit reporting agen- cies to provide consumers with free copies of their own credit reports every twelve months. Another provision requires account numbers on credit-card receipts to be truncated (shortened). Merchants, employees, or others who may have access to the receipts can no longer obtain the consumers’ names and full credit-card numbers. Financial institutions must work with the FTC to identify

29. 15 U.S.C. Section 1681n. 30. Safeco Insurance. Co. of America v. Burr, 551 U.S. 47, 127 S.Ct. 2201,

167 L.Ed.2d 1045 (2007). 31. Saunders v. Branch Banking & Trust Co. of Virginia, 526 F.3d 142 (4th

Cir. 2008). 32. Pub. L. No. 108-159, 117 Stat. 1952.

“red flag” indicators of identity theft and to develop rules for the disposal of sensitive credit information.

24–4d The Fair Debt Collection Practices Act

The Fair Debt Collection Practices Act (FDCPA)33 attempts to curb perceived abuses by collection agencies. The act applies only to specialized debt-collection agen- cies and attorneys who regularly attempt to collect debts on behalf of someone else, usually for a percentage of the amount owed. Creditors attempting to collect debts are not covered by the act unless, by misrepresenting them- selves, they cause debtors to believe they are collection agencies.

Requirements of the Act Under the FDCPA, a col- lection agency may not do any of the following: 1. Contact the debtor at the debtor’s place of employ-

ment if the debtor’s employer objects. 2. Contact the debtor at inconvenient or unusual times

(such as three o’clock in the morning), or at any time if the debtor is being represented by an attorney.

3. Contact third parties other than the debtor’s parents, spouse, or financial adviser about payment of a debt unless a court authorizes such action.

4. Harass or intimidate the debtor (by using abusive language or threatening violence, for instance) or make false or misleading statements (such as posing as a police officer).

5. Communicate with the debtor at any time after receiving notice that the debtor is refusing to pay the debt, except to advise the debtor of further action to be taken by the collection agency.

The FDCPA also requires a collection agency to include a validation notice when it initially contacts a debtor for payment of a debt or within five days of that initial contact. The notice must state that the debtor has thirty days in which to dispute the debt and to request a written verification of the debt from the collection agency.

Enforcement of the Act The Federal Trade Com- mission is primarily responsible for enforcing the FDCPA. A debt collector who fails to comply with the act is liable for actual damages, plus additional damages not to exceed $1,000 and attorneys’ fees.

33. 15 U.S.C. Section 1692.

C H A P T E R 2 4 Consumer Protection 529

Debt collectors who violate the act are exempt from liability if they can show that the violation was not inten- tional and resulted from a bona fide error. Furthermore, the error must have occurred in spite of procedures the company had already put in place to avoid such errors. The “bona fide error” defense typically has been applied

to mistakes of fact or clerical errors. A few courts have gone further and allowed the good faith error defense in other circumstances.34

34. See, for instance, Zortman v. J.C. Christensen & Associates, Inc., 2012 WL 1563918 (D.Minn. 2012); see also Mbaku v. Bank of America, N.A., 2013 WL 425981 (D.Colo. 2013).

Reviewing: Consumer Protection

Leota Sage saw a local motorcycle dealer’s newspaper advertisement offering a MetroRider EZ electric scooter for $1,699. When she went to the dealership, however, she learned that the EZ model had been sold out. The salesperson told Sage that he still had the higher-end MetroRider FX model in stock for $2,199 and would sell her one for $1,999. Sage was disappointed but decided to purchase the FX model.

When Sage said that she wished to purchase the scooter on credit, she was directed to the dealer’s credit department. As she filled out the credit forms, the clerk told Sage, who is an Asian American, that she would need a cosigner to obtain a loan. Sage could not understand why she would need a cosigner and asked to speak to the store manager. The manager apologized, told her that the clerk was mistaken, and said that he would “speak to” the clerk. The manager completed Sage’s credit application, and Sage then rode the scooter home. Seven months later, Sage received a letter from the manufacturer informing her that a flaw had been discovered in the scooter’s braking system and that the model had been recalled. Using the information presented in the chapter, answer the following questions. 1. Did the dealer engage in deceptive advertising? Why or why not? 2. Suppose that Sage had ordered the scooter through the dealer’s Web site but the dealer was unable to deliver it by

the date promised. What would the FTC have required the merchant to do in that situation? 3. Assuming that the clerk required a cosigner based on Sage’s race or gender, what act prohibits such credit

discrimination? 4. What organization has the authority to ban the sale of scooters based on safety concerns?

Debate This . . . Laws against bait-and-switch advertising should be abolished because no consumer is ever forced to buy anything.

Terms and Concepts bait-and-switch advertising 517 cease-and-desist order 518 consumer law 515

“cooling-o�” laws 521 counteradvertising 518 deceptive advertising 515

multiple product order 518 Regulation Z 525 validation notice 528

Issue Spotters 1. United Pharmaceuticals, Inc., believes that it has devel-

oped a new drug that will be effective in the treatment of patients with AIDS. The drug has had only limited test- ing, but United wants to make the drug widely available as soon as possible. To market the drug, what must United prove to the U.S. Food and Drug Administration? (See Protection of Health and Safety.)

2. Gert buys a notebook computer from EZ Electronics. She pays for it with her credit card. When the computer proves defective, she asks EZ to repair or replace it, but EZ refuses. What can Gert do? (See Credit Protection.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

530 U N I T F I V E The Regulatory Environment

Business Scenarios 24–1. Unsolicited Merchandise. Andrew, a resident of California, received an advertising circular in the U.S. mail announcing a new line of regional cookbooks distributed by the Every-Kind Cookbook Co. Andrew didn’t want any books and threw the circular away. Two days later, Andrew received in the mail an introductory cookbook entitled Lower Mon- golian Regional Cookbook, as announced in the circular, on a “trial basis” from Every-Kind. Andrew was not interested but did not go to the trouble to return the cookbook. Every- Kind demanded payment of $20.95 for the Lower Mongolian Regional Cookbook. Discuss whether Andrew can be required to pay for the book. (See Advertising, Marketing, and Sales.) 24–2. Credit-Card Rules. Maria Ochoa receives two new credit cards on May 1. She has solicited one of them from

Midtown Department Store, and the other arrives unsolic- ited from High-Flying Airlines. During the month of May, Ochoa makes numerous credit-card purchases from Midtown Department Store, but she does not use the High-Flying Air- lines card. On May 31, a burglar breaks into Ochoa’s home and steals both credit cards, along with other items. Ochoa notifies the Midtown Department Store of the theft on June 2, but she fails to notify High-Flying Airlines. Using the Mid- town credit card, the burglar makes a $500 purchase on June 1 and a $200 purchase on June 3. The burglar then charges a vacation flight on the High-Flying Airlines card for $1,000 on June 5. Ochoa receives the bills for these charges and refuses to pay them. Discuss Ochoa’s liability for the charges. (See Credit Protection.)

Business Case Problems 24–3. Spotlight on McDonald’s—Food Labeling.

McDonald’s Corp.’s Happy Meal® meal selection consists of an entrée, a small order of french fries, a small drink, and a toy. In the early 1990s, McDonald’s began to aim its Happy Meal mar-

keting at children aged one to three. In 1995, McDonald’s began making nutritional information for its food products available in documents known as “McDonald’s Nutrition Facts.” Each document lists the food items that the restaurant serves and provides a nutritional breakdown, but the Happy Meal is not included.

Marc Cohen filed a suit against McDonald’s in an Illinois state court. Among other things, Cohen alleged that McDon- ald’s had violated a state law prohibiting consumer fraud and deceptive business practices by failing to adhere to the Nutri- tion Labeling and Education Act (NLEA). The NLEA sets out different requirements for products specifically intended for children under the age of four—for instance, the products’ labels cannot declare the percent of daily value of nutritional components. Does it make sense to have different require- ments for children of this age? Why or why not? Should a state court impose such regulations? Explain. [Cohen v. McDonald’s Corp., 347 Ill.App.3d 627, 808 N.E.2d 1, 283 Ill.Dec. 451 (1 Dist. 2004)] (See Labeling and Packaging Laws.) 24–4. Deceptive Advertising. Brian Cleary and Rita Burke �led a suit against cigarette maker Philip Morris USA, Inc., seeking class-action status for a claim of deceptive adver- tising. Cleary and Burke claimed that “light” cigarettes, such as Marlboro Lights, were advertised as safer than regular ciga- rettes, even though the health e�ects are the same. �ey con- tended that the tobacco companies concealed the true nature of light cigarettes. Philip Morris correctly claimed that it was authorized by the government to advertise cigarettes, includ- ing light cigarettes. Assuming that is true, should the plainti�s still be able to bring a deceptive advertising claim against the

tobacco company? Why or why not? [Cleary v. Philip Morris USA, Inc., 683 F.Supp.2d 730 (N.D.Ill. 2010)] (See Advertis- ing, ing, ing Marketing, and Sales.) 24–5. Business Case Problem with Sample Answer— Fair Debt-Collection Practices. Bank of America hired

Atlantic Resource Management, LLC, to collect a debt from Michael E. Engler. Atlantic called Engler’s employer and asked his supervisor about the company’s policy concerning the execution of

warrants. �e caller then told the supervisor that, to stop pro- cess of the warrant, Engler needed to call Atlantic about “Case Number 37291 NY0969” during the �rst three hours of his next shift. When Engler’s supervisor told him about the call, Engler feared that he might be arrested, and he experienced discomfort, embarrassment, and emotional distress at work. Can Engler recover under the Fair Debt Collection Practices Act? Why or why not? [Engler v. Atlantic Resource Manage- ment, LLC, 2012 WL 464728 (W.D.N.Y. 2012)] (See ment, LLC, 2012 WL 464728 (W.D.N.Y. 2012)] (See ment, LLC Credit Protection.)

• For a sample answer to Problem 24–5, go to Appendix E at the end of this text.

24–6. Deceptive Advertising. Innovative Marketing, Inc. (IMI), sold “scareware”—computer security software. IMI’s Internet ads redirected consumers to sites where they were told that a scan of their computers had detected dangerous �les— viruses, spyware, and “illegal” pornography. In fact, no scans were conducted. Kristy Ross, an IMI cofounder and vice presi- dent, reviewed and edited the ads, and was aware of the many complaints that consumers had made about them. An indi- vidual can be held liable under the Federal Trade Commission Act’s prohibition of deceptive practices if the person (1) partic- ipated directly in the deceptive practices or had the authority to control them and (2) had or should have had knowledge of them. Were IMI’s ads deceptive? If so, can Ross be held liable?

C H A P T E R 2 4 Consumer Protection 531

Explain. [Federal Trade Commission v. Ross, 743 F.3d 886 (4th Cir. 2014)] (See Advertising, Marketing, and Sales.)

24–7. A Question of Ethics—Fair Debt-Collection Prac- tices. Barry Sussman graduated from law school, but also served

time in prison for attempting to collect debts by pos- ing as an FBI agent. He theorized that if a debt- collection business collected only debts that it owned as a result of buying checks written on accounts with

insu�cient funds (NSF checks), it would not be subject to the Fair Debt Collection Practices Act (FDCPA). Sussman formed Check Investors, Inc., to act on his theory. Check Investors bought more than 2.2 million NSF checks, with an estimated face value of about $348 million, for pennies on the dollar. Check Investors added a fee of $125 or $130 (more than the legal limit in most states) to the face amount of each check and aggressively pursued its drawer to collect. �e �rm’s employees were told to accuse draw- ers of being criminals and to threaten them with arrest and pros- ecution. �e threats were false. Check Investors never took steps to

initiate a prosecution. �e employees contacted the drawers’ family members and used “saturation phoning”—phoning a drawer numerous times in a short period. �ey used abusive language, referring to drawers as “deadbeats,” “retards,” “thieves,” and “idi- ots.” Between January 2000 and January 2003, Check Investors netted more than $10.2 million from its e�orts. [Federal Trade netted more than $10.2 million from its e�orts. [Federal Trade netted more than $10.2 million from its e�orts. [ Commission v. Check Investors, Inc., 502 F.3d 159 (3d Cir. 2007)] (See Credit Protection.) (a) The Federal Trade Commission filed a suit in a federal

district court against Check Investors and others, alleging, in part, violations of the FDCPA. Was Check Investors a “debt collector,” collecting “debts,” within the meaning of the FDCPA? If so, did its methods violate the FDCPA? Were its practices unethical? What might Check Investors argue in its defense? Discuss.

(b) Are “deadbeats” the primary beneficiaries of laws such as the FDCPA? If not, how would you characterize debtors who default on their obligations?

Legal Reasoning Group Activity 24–8. Consumer Protections. Many states have enacted laws that go even further than federal law to protect consum- ers. �ese laws vary tremendously from state to state. (See Advertising, Marketing, and Sales.) (a) The first group will decide whether having different laws

is fair to sellers who may be prohibited from engaging in a practice in one state that is legal in another.

(b) The second group will consider how these different laws might affect a business.

(c) A third group will determine whether it is fair that resi- dents of one state have more protection than residents of another.

532

C H A P T E R 2 5

To obtain relief from pollution under the nuisance doctrine, a property owner may have to identify a dis- tinct harm separate from that affecting the general pub- lic. This harm is referred to as a “private” nuisance. Under the common law, individuals were denied standing (access to the courts) unless they suffered a harm distinct from that suffered by the public at large. Some states still require this. A public authority (such as a state’s attorney general), however, can sue to stop a “public” nuisance.

25–1b Negligence and Strict Liability An injured party may sue a business polluter in tort under negligence and strict liability theories. A negli- gence action is based on a business’s alleged failure to use reasonable care toward a party whose injury was foresee- able and was caused by the lack of reasonable care. For instance, employees might sue an employer whose failure to use proper pollution controls has contaminated the air, causing the employees to suffer respiratory illnesses. Lawsuits for personal injuries caused by exposure to a toxic substance, such as asbestos, radiation, or hazard- ous waste, have given rise to a growing body of tort law known as toxic torts.

Businesses that engage in ultrahazardous activities— such as the transportation of radioactive materials—are strictly liable for any injuries the activities cause. In a strict liability action, the injured party does not have to prove that the business failed to exercise reasonable care.

25–1 Common Law Actions Common law remedies against environmental pollution originated centuries ago in England. Those responsible for operations that created dirt, smoke, noxious odors, noise, or toxic substances were sometimes held liable under common law theories of nuisance or negligence. Today, individuals who have suffered a harm from pollu- tion continue to rely on the common law to obtain dam- ages and injunctions against business polluters.

25–1a Nuisance Under the common law doctrine of nuisance, persons may be held liable if they use their property in a manner that unreasonably interferes with others’ rights to use or enjoy their own property. Courts typically balance the harm caused by the pollution against the costs of stop- ping it.

Courts have often denied injunctive relief on the ground that the hardships that would be imposed on the polluter and on the community are greater than the hardpolluter and on the community are greater than the hardpolluter and on the community are greater than the hard- ships suffered by the plaintiff. ■ EXAMPLE 25.1 Hewitt’s factory causes neighboring landowners to suffer from smoke, soot, and vibrations. But if the factory is the core of the local economy, a court may leave it in operation and award monetary damages to the injured parties. Damages can include compensation for any decline in the value of their property caused by Hewitt’s operation. ■

C oncern over the degradation of the environment has increased over time in response to the

environmental effects of population growth, urbanization, and industrial- ization. Environmental protection is not without a price, however. For many businesses, the costs of complying with

environmental regulations are high, and for some they may seem too high. A constant tension exists between the desire to increase profits and pro- ductivity and the need to protect the environment.

To a great extent, environmental law consists of statutes passed by

federal, state, or local governments and regulations issued by administra- tive agencies. Before examining statu- tory and regulatory environmental laws, however, we look at the rem- edies against environmental pollution that are available under the common law.

Environmental Law

C H A P T E R 2 5 Environmental Law 533

25–2 Federal, State, and Local Regulations

All levels of government in the United States regulate some aspect of the environment. In this section, we look at some of the ways in which the federal, state, and local governments control business activities and land use in the interests of environmental preservation and protection.

25–2a State and Local Regulations In addition to the federal regulations to be discussed shortly, many states have enacted laws to protect the envi- ronment. State laws may restrict a business’s discharge of chemicals into the air or water or regulate its disposal of toxic wastes. States may also regulate the disposal or recycling of other wastes, including glass, metal, plastic containers, and paper. Additionally, states may restrict emissions from motor vehicles.

City, county, and other local governments also regu- late some aspects of the environment. For instance, local zoning laws may be designed to inhibit or regulate the growth of cities and suburbs. In the interest of safeguard- ing the environment, such laws may prohibit certain land uses. Even when zoning laws permit a business’s pro- posed development plan, the plan may have to be altered to lessen the development’s environmental impact. In addition, cities and counties may impose rules regulating methods of waste removal, the appearance of buildings, the maximum noise level, and other aspects of the local environment.

State and local regulatory agencies also play a signifi- cant role in implementing federal environmental legisla- tion. Typically, the federal government relies on state and local governments to enforce federal environmental stat- utes and regulations, such as those regulating air quality.

25–2b Federal Regulations Congress has passed a number of statutes to control the impact of human activities on the environment. Exhibit 25–1 lists and summarizes the major federal environmental statutes discussed in this chapter. Most of these statutes are designed to address pollution in the air, water, or land. Some specifically regulate toxic chemicals, including pesticides, herbicides, and hazardous wastes.

Environmental Regulatory Agencies The pri- mary federal agency regulating environmental law is the Environmental Protection Agency (EPA). Other federal agencies with authority to regulate specific environmen- tal matters include the Department of the Interior, the Department of Defense, the Department of Labor, the Food and Drug Administration, and the Nuclear Regula- tory Commission. In addition, as mentioned, state and local agencies play an important role in enforcing federal environmental legislation.

Most federal environmental laws provide that citizens can sue to enforce environmental regulations if govern- ment agencies fail to do so. Similarly, citizens can sue to limit enforcement actions if agencies go too far in their actions. Typically, a threshold hurdle in such suits is meeting the requirements for standing to sue.

In the following case, an animal advocacy organization brought a suit to stop the “taking” (killing or capture) of migratory birds at New York City’s John F. Kennedy International Airport (JFK). Birds had been involved in several near-catastrophes at JFK. A collision between her- ring gulls and a passenger jet, for instance, had caused the jet’s engine to explode and the aircraft to catch fire.

To reduce the risks, the Port Authority of New York and New Jersey—which operates JFK—obtained a per- mit from the U.S. Fish and Wildlife Service (FWS) to “take” certain birds that threatened to interfere with air- craft at JFK. The advocacy organization, Friends of Ani- mals, challenged the issuance of this permit.

In the Language of the Court José A. CABRANES, Circuit Judge. CABRANES, Circuit Judge. CABRANES

* * * * BACKGROUND

The taking of migratory birds is governed by the Migratory Bird Treaty Act (“MBTA”). The MBTA, which

implements a series of treaties as federal law, prohibits the taking of any bird protected by those treaties unless and except as permitted by regulations pro- mulgated [declared] under the statute. * * * One such regulation is 50 C.F.R. [Code of Federal Regulations] Section

21.41. Under Section 21.41, FWS may issue “depredation permits” that authorize the taking (or possession or transport) of migratory birds that are causing injury to certain human interests.

Case Analysis 25.1 Friends of Animals v. Clay United States Court of Appeals, Second Circuit, 811 F.3d 94 (2016).

534 U N I T F I V E The Regulatory Environment

* * * * [Friends of Animals (FOA) filed a

suit in a federal district court against William Clay, Deputy Administrator in the U.S. Department of Agriculture and others, including the U.S. Fish and Wildlife Service (FWS), challenging the issuance of the permit. The court issued a summary judgment in favor of the defendants. FOA appealed to the U.S. Court of Appeals for the Second Circuit.]

The permit * * * identifies eighteen species of migratory birds that have, in the past, compromised public safety at JFK, and authorizes the Port Authority to take a quota of birds of each species.

In addition to setting out these species-specific quotas, the challenged permit contains an “emergency-take” provision. This provision empowers the Port Authority, “in emergency situations only,” to take any migratory bird (except bald eagles, golden eagles, or endangered or threatened species) that poses a “direct threat to human safety”—defined as a “threat of serious bodily injury or a risk to human life”—even if it is of a species not listed on the permit. FWS rarely includes an emergency take provision in its migratory bird permits, but—mindful of the grave risks that arise when birds congregate near aircraft—it makes an exception for airports. DISCUSSION

FOA directs its challenge at the * * * permit’s emergency-take provision. According to FOA, Section 21.41 does not authorize FWS to issue a permit that allows the emergency take of a migratory bird irrespective of its species. Instead, FOA argues, permit applicants like the Port Authority must provide species- specific information to FWS, and FWS may authorize the taking of only those species specifically listed on the permit.

Contending that FWS’s alleged failure to abide by the requirements of Section 21.41 has resulted in the Port Authority’s unlawful taking of a number of migra- tory birds, * * * FOA asks us to invali- date the operative permit as the product of agency action that was arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.

* * * * FWS’s authority to issue depredation

permits under Section 21.41 is limited in certain respects by subsections (c) and (d) of that provision. Subsection (d) provides, for instance, that a permit’s duration is limited to one year. Subsec- tion (c) sets forth conditions common to all permits, such as the prohibition of certain hunting practices and mandatory steps for disposing of birds that have been killed; it also states that depreda- tion permits are subject to the general conditions set forth in 50 C.F.R. Part 13. Various provisions in Part 13, in turn, further hem in the agency’s permitting authority. But among the express limita- tions on FWS’s discretion imposed by Sec- tion 21.41(c)–(d) and Part 13, we find nothing to indicate that FWS may not issue a permit that contains an emergency- take provision. Accordingly, unless some other feature of the regulatory regime coun- sels otherwise, we must conclude that FWS has authority to issue permits of the type challenged here. [Emphasis added.]

FOA argues that this other feature is found in Section 21.41(b). This pro- vision states that an application for a depredation permit must [identify] * * * “the particular species of migratory birds committing [an] injury.” According to FOA, that regulation, when read in connection with Section 21.41(c)(1)— which provides that “permittees may not kill migratory birds unless specifi- cally authorized on the permit”—makes

clear that a depredation permit may not authorize the taking of bird species not listed on the permit’s face.

We disagree. Section 21.41(b) by its terms governs the conduct of applicants, not FWS, and specifies what informa- tion must be included in the permit application, not the permit itself. Indeed, the provision is styled as a direct address to applicants, to whom it gives point-by- point instructions for seeking a permit. FOA identifies no particular reason why we should read this subsection, contrary to its plain language, as a limit on FWS’s authority to issue permits rather than as a means to ensure that applicants pro- vide FWS with information germane to the permitting determination. Section 21.41(b) is a hopelessly slender reed on which to rest the argument that FWS is powerless to authorize the Port Author- ity to take migratory birds that threaten air safety.

Nor does the language of Section 21.41(c)(1) alter this conclusion. True, this subsection provides that permittees must “not kill migratory birds unless specifically authorized on the permit.” But this is in no way inconsistent with the * * * permit’s emergency-take pro- vision. The permit authorizes the Port Authority, in emergency situations, to “take * * * any migratory birds * * * when the migratory birds * * * are posing a direct threat to human safety.” The permit thus threat to human safety.” The permit thus threat to human safety.” specifically authorizes the taking of migratory birds if certain conditions are met—and one method of taking a bird is killing it. [Emphasis added.]

* * * * CONCLUSION

In sum, we hold that FWS did not run afoul of Section 21.41 in issuing to the Port Authority the * * * depredation permit. The * * * order of the District Court is accordingly AFFIRMED.

Legal Reasoning Questions

1. In what circumstance might the Port Authority—or anyone else—take a migratory bird without a permit and not be sanctioned?not be sanctioned?not 2. Under the plaintiff ’s suggested reading of the regulation at issue in this case, what difficult choice would the Port Authority face? 3. Why is the taking of birds, or any wildlife, protected by treaty and federal law? What should be the limit to this protection?

Case 25.1 Continued

C H A P T E R 2 5 Environmental Law 535

Environmental Impact Statements All agencies of the federal government must take environmental fac- tors into consideration when making significant decisions. The National Environmental Policy Act1 requires that an environmental impact statement (EIS) be prepared for every major federal action that significantly affects the quality of the environment. (See Exhibit 25–2.) An EIS must analyze the following: 1. The impact that the action will have on the

environment. 2. Any adverse effects on the environment and alterna-

tive actions that might be taken. 3. Any irreversible effects the action might generate.

1. 42 U.S.C. Sections 4321–4370d.

An action qualifies as “major” if it involves a sub- stantial commitment of resources (monetary or other- wise). An action is “federal” if a federal agency has the wise). An action is “federal” if a federal agency has the wise). An action is “federal” if a federal agency has the wise). An action is “federal” if a federal agency has the power to control it. ■ EXAMPLE 25.2 Development of Development of a ski resort by a private developer on federal land may require an EIS. Construction or operation of a nuclear plant, which requires a federal permit, necessitates an EIS, as does creation of a dam as part of a federal project. ■

If an agency decides that an EIS is unnecessary, it must issue a statement supporting this conclusion. Pri- vate individuals, consumer interest groups, businesses, and others who believe that a federal agency’s activities threaten the environment often use EISs as a means to challenge those activities.

Federal Insecticide, Fungicide, and Rodenticide Act

Federal Water Pollution Control Act

To eliminate the discharge of To eliminate the discharge of T pollutants from major sources into navigable waters.

Clean Air Act To control air pollution from mobile To control air pollution from mobile T and stationary sources.

National Environmental Policy Act

To prohibit the dumping of To prohibit the dumping of T radiological, chemical, and biological warfare agents and high-level radioactive waste into the ocean.

42 U.S.C. Sections 300f–300j-25.

15 U.S.C. Sections 2601–2692.Toxic Substances ContrToxic Substances ContrT ol Act

Comprehensive Environmental Response, Compensation, and Liability Act

Small Business Liability Relief and Brownfields Revitalization Act

To allow developers who comply with To allow developers who comply with T state voluntary clean-up programs to avoid federal liability for the properties that they decontaminate and develop.

42 U.S.C. Section 9628.

POPULAR NAME PURPOSE STATUTE REFERENCE

Rivers and Harbors Appropriations Act

To prohibit ships and manufacturers To prohibit ships and manufacturers T from discharging and depositing refuse in navigable waterways.

33 U.S.C. Sections 401–418.

To control the use of pesticides andTo control the use of pesticides andT herbicides.

7 U.S.C. Sections 136–136y.

33 U.S.C. Sections 1251–1387.

42 U.S.C. Sections 7401–7671q.

To limit environmental harm from To limit environmental harm from T federal government activities.

42 U.S.C. Sections 4321–4370d.

Ocean Dumping Act 16 U.S.C. Sections 1401–1445.

Endangered Species Act To protect species that are threatened To protect species that are threatened T with extinction.

16 U.S.C. Sections 1531–1544.

Safe Drinking Water Act To regulate pollutants in public To regulate pollutants in public T drinking water systems.

To regulate toxic chemicals and To regulate toxic chemicals and T chemical compounds.

To regulate the clean-up of hazardous To regulate the clean-up of hazardous T waste–disposal sites.

42 U.S.C. Sections 9601–9675.

E X H I B I T 2 5 – 1 Major Federal Environmental Statutes

536 U N I T F I V E The Regulatory Environment

25–3 Air Pollution Federal involvement with air pollution goes back to the 1950s and 1960s, when Congress authorized funds for air-pollution research and enacted the Clean Air Act.2 The Clean Air Act provides the basis for issuing regula- tions to control multistate air pollution. It covers both mobile sources (such as automobiles and other vehicles) and stationary sources (such as electric utilities and industrial plants) of pollution.

25–3a Mobile Sources Regulations governing air pollution from automobiles and other mobile sources specify pollution standards and establish time schedules for meeting the standards. The EPA periodically updates the pollution standards in light of new developments and data, usually reducing the amount of emissions allowed.

Reducing Emissions The Obama administration set a long-term goal of reducing emissions, including those from cars and sport utility vehicles, by 80 percent by 2050. The administration also ordered the EPA to develop national standards regulating fuel economy and

2. 42 U.S.C. Sections 7401–7671q.

emissions for medium- and heavy-duty trucks starting with 2014 models.

Authority to Regulate Greenhouse Gases A growing concern among many scientists and others around the world is that greenhouse gases, such as carbon dioxide (CO2), contribute to climate change. The Clean Air Act, as amended, however, does not specifically men- tion CO2 emissions. Therefore, the EPA did not regulate CO2 emissions from motor vehicles until 2009, after the Supreme Court ruled that it had the authority to do so.

■ CASE IN POINT 25.3 Environmental groups and sev- eral states, including Massachusetts, sued the EPA in an effort to force the agency to regulate CO2 emissions from motor vehicles. The case eventually reached the United States Supreme Court. The EPA argued that the plaintiffs lacked standing because global climate change has wide- spread effects, so the individual plaintiffs could not show particularized harm. Furthermore, the agency claimed that it did not have authority under the Clean Air Act to address global climate change and regulate CO2.

The Court, however, ruled that Massachusetts had standing because its coastline, including state-owned lands, faced an imminent threat from rising sea levels purportedly caused by climate change. The Court also held that the Clean Air Act’s broad definition of “air pollutant” gives the EPA authority to regulate CO2. The Clean Air Act requires the EPA to regulate any air

E X H I B I T 2 5 – 2 Environmental Impact Statements

Environmental Impact Statements

No EIS required, but the agency must issue a statement

supporting its conclusion.

Major federal action that affects the

environment.

Federal action that, according to the agency involved, will have no significant effect

on the environment.

EIS required.

C H A P T E R 2 5 Environmental Law 537

pollutants that might “endanger public health or wel- fare.” Accordingly, the Court ordered the EPA to deter- mine whether CO2 was a pollutant that endangered public health.3 ■

The EPA later concluded that greenhouse gases, including CO2 emissions, do constitute a public danger. In fact, in 2015, the EPA started regulating greenhouse gas emissions from airplanes.

Controlling Climate Change In 2016, a federal district court in Oregon allowed an unprecedented law- suit to go forward against the U.S. government for doing suit to go forward against the U.S. government for doing suit to go forward against the U.S. government for doing suit to go forward against the U.S. government for doing too little to control climate change. too little to control climate change. ■ CASE IN POINT 25.4 A group of young people (aged eight to nineteen) filed a suit against the federal government, as well as the fossil fuel industry. The plaintiffs argued that the gov- ernment has known for years that CO2 pollution causes climate change and threatens catastrophic consequences. By failing to address the causes of this pollution, they claimed, the government has violated their constitutional rights.

The court found that the plaintiffs had alleged par- ticular, concrete harms to young people and future gen- erations sufficient to give them standing to pursue their claims in court. Of course, this ruling means only that the plaintiffs have met their threshold burden of estab- lishing standing. The court simply denied the govern- ment’s motion to dismiss—it did not decide the merits of the case or grant relief to the plaintiffs. Those issues have yet to be resolved.4 ■

25–3b Stationary Sources The Clean Air Act also authorizes the EPA to estab- lish air-quality standards for stationary sources (such as manufacturing plants). But the act recognizes that the primary responsibility for implementing these standards rests with state and local governments. The standards are aimed at controlling hazardous air pollutants—those likely to cause death or a serious, irreversible, or inca- pacitating condition, such as cancer or neurological or reproductive damage.

The EPA sets primary and secondary levels of ambient standards—that is, maximum permissible levels of cer- tain pollutants—and the states formulate plans to achieve

3. Massachusetts v. Environmental Protection Agency, 549 U.S. 497, 127 S.Ct. 1438, 167 L.Ed.2d 248 (2007).

4. Juliana v. United States, ___ F.Supp.3d ___, 2016 WL 1442435 (D.Or. 2016).

those standards. Different standards apply depending on whether the sources of pollution are located in clean areas or polluted areas and whether they are existing sources or major new sources.

Hazardous Air Pollutants The Clean Air Act requires the EPA to list all hazardous air pollutants (HAPs) on a prioritized schedule. In all, nearly two hundred sub- stances—including asbestos, benzene, beryllium, cad- mium, mercury, and vinyl chloride—have been classified as hazardous. They are emitted from stationary sources by a variety of business activities, including smelting (melt- ing ore to produce metal), dry cleaning, house painting, and commercial baking.

Maximum Achievable Control Technology Instead of establishing specific emissions standards for each hazardous air pollutant, the Clean Air Act requires major new sourcesnew sourcesnew 5 to use pollution-control equipment that represents the maximum achievable control technology, or MACT, to reduce emissions. The EPA issues guidelines as to what equipment meets this standard.6

25–3c Violations of the Clean Air Act For violations of emission limits under the Clean Air Act, the EPA can assess civil penalties of up to $25,000 per day. Additional fines of up to $5,000 per day can be assessed for other violations, such as failure to main- tain the required records. To penalize those who find it more cost-effective to violate the act than to comply with it, the EPA is authorized to impose a penalty equal to the violator’s economic benefits from noncompli- ance. Persons who provide information about violators may be paid up to $10,000. Private citizens can also sue violators.

Those who knowingly violate the act, including cor- porate officers, may be subject to criminal penalties. For instance, knowingly making false statements or failing to report violations may be punishable by fines of up to $1 million and imprisonment for up to two years.

In the following case, the phrase “knowingly violate” was at the center of the dispute in an individual’s appeal of his conviction for Clean Air Act violations.

5. The term major new sources includes existing sources modified by a major new sources includes existing sources modified by a major new sources change in a method of operation that increases emissions.

6. The EPA has also issued rules to regulate hazardous air pollutants emitted by landfills. See 40 C.F.R. Sections 60.750–60.759.

538 U N I T F I V E The Regulatory Environment

Background and Facts Duane O’Malley owned and operated Origin Fire Protection. Michael Pinski hired Origin to remove and dispose of 2,200 feet of insulation from a building Pinski owned in Kankakee, Illinois. The insulation contained asbestos, which Pinski, O’Malley, and O’Malley’s employ- ees recognized. O’Malley did not have a license to remove asbestos, and none of his employees were trained in complying with federal asbestos regulations. Nevertheless, Origin removed the debris and disposed of it at various sites, including a vacant lot where it spilled onto the soil, resulting in clean-up costs of nearly $50,000.

In a federal district court, a jury convicted O’Malley of removing, transporting, and dumping asbestos in violation of the Clean Air Act. The court sentenced him to 120 months of imprisonment, three years of supervised release, a fine of $15,000, and $47,085.70 in restitution to the Environmen- tal Protection Agency (EPA). O’Malley appealed.

In the Language of the Court TINDER, Circuit Judge.

* * * * On appeal to this court, O’Malley * * * claims that because the [EPA’s regulations] define “asbestos-

containing material” as only six types of regulated asbestos, the government was required to prove that O’Malley knew that the asbestos in the building was one of the six forms of regulated asbestos. He asserts that the government did not present evidence to demonstrate O’Malley’s knowledge of the type of asbestos in the building.

* * * * O’Malley is correct that not all forms of asbestos are subject to regulation. The Clean Air Act [under

Section 7412] authorizes the regulation of hazardous air pollutants, one of which is asbestos. “Because asbestos is not typically emitted through a conveyance designed and constructed to emit or capture it, such as a pipe or smokestack, but rather escapes from more diffuse sources such as open construction or demolition sites, EPA adopted a work-practice standard for the handling of asbestos in building demoli- tion and renovation.” * * * The work practice standard promulgated for the handling of asbestos applies only to the six types of “regulated asbestos-containing material (RACM),” [which includes “friable asbes- tos material”]. “Friable asbestos material” is defined as “any material containing more than 1 percent asbestos * * * that, when dry, can be crumbled, pulverized, or reduced to powder by hand pressure.” Thus, there is no question that the material in [this case]—which was both friable and contained asbes- tos at concentrations ranging from four percent to forty-eight percent—was indeed “regulated asbestos- containing material.”

* * * * The Clean Air Act makes it a crime for any person to “knowingly violate any * * * requirement or prohi-

bition of * * * Section 7412, * * * including a requirement of any rule” promulgated under Section 7412. * * * The district court instructed the jury on the knowledge elements as follows: “The government must prove * * * the defendant knew that asbestos-containing material was in the building.” [Emphasis added.]

O’Malley argues that the knowledge element instruction should have required the government to prove that the defendant knew that regulated asbestos-containing material, not simply asbestos- containing material, was in the building. But this cannot be correct. * * * The phrase “knowingly violates” does not “carv[e] out an exception to the general rule that ignorance of the law is no excuse.” The mens rea [criminal intent] required by the phrase is one that is higher than strict liability mens rea [criminal intent] required by the phrase is one that is higher than strict liability mens rea * * * . But it is certainly much lower than specific intent, especially when, as here, “dangerous * * * materials are * * * materials are * * * involved,” because “the probability of regulation is so great that anyone who is aware that he is in posses- sion of them or dealing with them must be presumed to be aware of the regulation.” The very fact that O’Malley was knowingly working with asbestos-containing material met the mens rea requirement.mens rea requirement.mens rea

United States v. O’Malley United States Court of Appeals, Seventh Circuit, 739 F.3d 1001 (2014).

Case 25.2

C H A P T E R 2 5 Environmental Law 539

25–4 Water Pollution Water pollution stems mostly from industrial, munici- pal, and agricultural sources. Pollutants entering streams, lakes, and oceans include organic wastes, heated water, sediments from soil runoff, nutrients (including fertiliz- ers and human and animal wastes), and toxic chemicals and other hazardous substances.

Federal regulations governing water pollution can be traced back to the 1899 Rivers and Harbors Appro- priations Act.7 These regulations prohibited ships and manufacturers from discharging or depositing refuse in navigable waterways without a permit.8 In 1948, Con- gress passed the Federal Water Pollution Control Act (FWPCA),9 but its regulatory system and enforcement powers proved to be inadequate.

25–4a The Clean Water Act In 1972, Congress passed amendments to the FWPCA, and the amended act became known as the Clean Water Act (CWA). The CWA established the following goals: (1) make waters safe for swimming, (2) protect fish and wildlife, and (3) eliminate the discharge of pollutants into the water. The CWA also set specific schedules, which were later extended by amendment and by the Water Quality Act.10 Under these schedules, the EPA limits the discharge of various types of pollutants based on the technology available for controlling them.

Permit System for Point-Source Emissions The CWA established a permit system for regulating discharges

7. 33 U.S.C. Sections 401–418. 8. The term navigable waters is interpreted today as including navigable waters is interpreted today as including navigable waters intrastate

lakes and streams used by interstate travelers and industries, as well as coastal and freshwater wetlands.

9. 33 U.S.C. Sections 1251–1387. 10. This act amended 33 U.S.C. Section 1251.

from “point sources” of pollution, which include indus- trial, municipal (such as sewage pipes and treatment plants), and agricultural facilities.11 Under this system, called the National Pollutant Discharge Elimination System (NPDES), any point source emitting pollutants into water must have a permit. Pollution not from point sources, such as runoff from small farms, is not subject to much regulation.

NPDES permits can be issued by the EPA and autho- rized state agencies and Indian tribes. The permits may be issued only if the discharge will not violate water- quality standards, and they must be reissued every five years. Although initially the NPDES system focused mainly on industrial wastewater, it was later expanded to cover stormwater discharges.

In practice, the NPDES system under the CWA includes the following elements: 1. National effluent (pollution) standards set by the

EPA for each industry. 2. Water-quality standards set by the states under EPA

supervision. 3. A discharge permit program that sets water-quality

standards to limit pollution. 4. Special provisions for toxic chemicals and for oil

spills. 5. Construction grants and loans from the federal gov-

ernment for publicly owned treatment works, pri- marily sewage treatment plants.

Standards for Equipment Regulations generally specify that the best available control technology, or BACT, be installed. The EPA issues guidelines as to what equip- ment meets this standard. Essentially, the guidelines require the most effective pollution-control equipment available.

New sources must install BACT equipment before beginning operations. Existing sources are subject to

11. 33 U.S.C. Section 1342.

Decision and Remedy The U.S. Court of Appeals for the Seventh Circuit affirmed the lower court’s judgment. The appellate court disagreed with O’Malley’s claim that the government was required to prove he knew the asbestos was one of the six types of regulated asbestos. “The very fact that O’Malley was knowingly working with asbestos-containing material met the mens rea requirement.”

Critical Thinking • What If the Facts Were Different? Suppose that O’Malley had been licensed to remove the asbestos.

Would the result have been different? Why or why not?

Case 25.2 Continued

540 U N I T F I V E The Regulatory Environment

timetables for the installation of BACT equipment and must immediately install equipment that utilizes the best practical control technology, or BPCT. The EPA also issues guidelines as to what equipment meets this standard.

Exhibit 25–3 graphically illustrates the pollution- control equipment standards required under the Clean Air Act and the Clean Water Act.

The EPA must take into account many factors when issuing and updating its rules. Some provisions of the CWA instruct the EPA to weigh the cost of the technol- ogy required relative to the benefits achieved. The provi- sion that covers power plants, however, neither requires nor prohibits a cost-benefit analysis. The question in the following case was whether the EPA could base its deci- sion on such an analysis.

THE CLEAN AIR ACT

• Major sources of pollution must use pollution- control equipment that represents the maximum achievable control technologyachievable control technologyachievable control technolog , or MACTy, or MACTy , to , or MACT, to , or MACT reduce emissions.

THE CLEAN WATHE CLEAN WATHE CLEAN W TER ACTATER ACTA

• New sources of pollution must install the best available control technology, or BACTavailable control technology, or BACTavailable control technology , before , or BACT, before , or BACT beginning operations.

• Existing sources must immediately install equipment that utilizes the best practical control technology, or BPCTcontrol technology, or BPCTcontrol technology , and meet a , or BPCT, and meet a , or BPCT timetable for installing BACT equipment.

E X H I B I T 2 5 – 3 Pollution-Control Equipment Standards under the Clean Air Act and the Clean Water Act

Background and Facts As part of its implementation of the Clean Water Act, the Environmen- tal Protection Agency (EPA) developed two sets of rules that apply to the cooling systems of power plants. Phase I rules require new power plants to restrict their inflow of water “to a level commensu- rate with that which can be attained by a closed-cycle recirculating cooling water system.” Phase II rules apply “national performance standards” to more than five hundred existing plants but do not require closed-cycle systems.

The EPA had found that converting these existing facilities to closed-cycle operations would cost $3.5 billion per year. The facilities would then produce less power while burning the same amount of coal. Moreover, other technologies can attain nearly the same results as closed-cycle systems. Phase II rules also allow a variance from the national performance standards if a facility’s cost of compliance “would be significantly greater than the benefits.”

Environmental organizations, including Riverkeeper, Inc., challenged the Phase II regulations, arguing that existing plants should be required to convert to closed-cycle systems. The U.S. Court of Appeals for the Second Circuit issued a ruling in the plaintiffs’ favor. Power-generating companies, including Entergy Corporation, appealed to the United States Supreme Court.

In the Language of the Court Justice SCALIA delivered the opinion of the Court.

* * * * In setting the Phase II national performance standards and providing for site-specific cost-benefit

variances, the EPA relied on its view that [the] “best technology available” standard permits consider- ation of the technology’s costs and of the relationship between those costs and the environmental ben- efits produced.

* * * The “best” technology—that which is “most advantageous”—may well be the one that produces the most of some good, here a reduction in adverse environmental impact. But “best technology” may also describe the technology that most efficiently produces some good. In common parlance one could

Entergy Corp. v. Riverkeeper, Inc. Supreme Court of the United States, 556 U.S. 208, 129 S.Ct. 1498, 173 L.Ed.2d 369 (2009).

Case 25.3

C H A P T E R 2 5 Environmental Law 541

Wetlands The CWA prohibits the filling or dredging of wetlands unless a permit is obtained from the Army Corps of Engineers. The EPA defines wetlands as “those wetlands as “those wetlands areas that are inundated or saturated by surface or ground water at a frequency and duration sufficient to support . . . vegetation typically adapted for life in saturated soil conditions.” Wetlands are thought to be vital to the eco- system because they filter streams and rivers and provide habitat for wildlife.

■ CASE IN POINT 25.5 To build a home in Idaho, Michael and Chantell Sackett filled part of their resi- dential lot with dirt and rock. A few months later, they received a compliance order from the EPA that required them to restore their property immediately or face fines of $75,000 a day. The EPA order claimed that, because their property was near a major lake, the Sacketts had polluted wetlands in violation of the Clean Water Act.

The Sacketts requested a hearing with the EPA, but it was denied. They then sued the EPA in federal dis- trict court, asserting, among other things, that the com- pliance order was “arbitrary and capricious” under the Administrative Procedure Act. The district court held that it could not review the EPA’s compliance order because it was not a final agency action. An appellate court affirmed, but the United States Supreme Court reversed. The Court held that the Sacketts could chal- lenge the EPA’s compliance order in federal court. The government could not force them to comply with the EPA order without providing an opportunity for judicial review.12 ■

12. Sackett v. Environmental Protection Agency, ___ U.S. ___, 132 S.Ct. 1367, 182 L.Ed.2d 367 (2012).

certainly use the phrase “best technology” to refer to that which produces a good at the lowest per-unit cost, even if it produces a lesser quantity of that good than other available technologies. [Emphasis added.]

* * * This latter reading is [not] precluded by the statute’s use of the phrase “for minimizing adverse environmental impact.” Minimizing * * * Minimizing * * * Minimizing is a term that admits of degree and is not necessarily used to refer exclusively to the “greatest possible reduction.” [Emphasis added.]exclusively to the “greatest possible reduction.” [Emphasis added.]exclusively to the “greatest possible reduction.”

Other provisions in the Clean Water Act also suggest the agency’s interpretation. When Congress wished to mandate the greatest feasible reduction in water pollution, it did so in plain language: The provision governing the discharge of toxic pollutants into the Nation’s waters requires the EPA to set “effluent limitations which shall require the elimination of discharges of all pollutants * * * .” The less ambitious goal of “minimizing adverse environmental impact” suggests, we think, that the agency retains some discretion to determine the extent of reduction that is warranted under the circumstances. That determination could plausibly involve a consideration of the benefits derived from reductions and the costs of achieving them.

* * * [Under other Clean Water Act provisions that impose standards on sources of pollution,] the EPA is instructed to consider, among other factors, “the total cost of application of technology in rela- tion to the * * * benefits to be achieved.”

* * * * This * * * comparison of * * * statutory factors * * * leads us to the conclusion that it was well within

the bounds of reasonable interpretation for the EPA to conclude that cost-benefit analysis is not categori- cally forbidden.

* * * * While not conclusive, it surely tends to show that the EPA’s current practice is a reasonable and hence

legitimate exercise of its discretion to weigh benefits against costs that the agency has been proceeding in essentially this fashion for over 30 years.

Decision and Remedy The United States Supreme Court concluded that the EPA had permissibly relied on a cost-benefit analysis to set national performance standards and to allow for variances from those standards. The Court reversed the lower court’s judgment and remanded the case.

Critical Thinking • Ethical In this case, aquatic organisms were most directly at risk. Is it acceptable to apply cost-benefit

analyses to situations in which the lives of people are directly affected? Explain. • Global In analyzing the costs and benefits of an action that affects the environment, should a line be

drawn at a nation’s borders? Why or why not?

Case 25.3 Continued

542 U N I T F I V E The Regulatory Environment

Jurisdictional Determination It is sometimes dif-It is sometimes dif-It is sometimes dif ficult to determine whether certain water—such as a seasonal stream or pond—qualifies for protection as wet- lands under the CWA. In addition, the permitting process can be lengthy and expensive (and sometimes requires the landowner to file numerous assessments of various fea- tures of the property). Therefore, the government allows landowners to seek a jurisdictional determination (JD) from the U.S. Army Corps of Engineers as to whether the CWA applies. If the CWA does apply, the landowner will be required to procure a permit before filling or dredging the property. If the CWA does not apply, no permit is required.

In 2016, the United States Supreme Court decided that landowners have a right to appeal a jurisdictional that landowners have a right to appeal a jurisdictional that landowners have a right to appeal a jurisdictional that landowners have a right to appeal a jurisdictional determination in court. ■ CASE IN POINT 25.6 Hawkes Company and two affiliates sought to mine peat from 530 acres of land owned in Minnesota close to their existing peat-mining operation. Peat is an organic mate- rial that forms in waterlogged grounds, such as wetlands and bogs, and is widely used for soil improvement and burned as fuel. Because Hawkes hoped to escape the high costs of the CWA permitting process, it requested a JD. The U.S. Army Corps of Engineers determined that the property was wetlands under the CWA because it had a “significant nexus [connection]” to the Red River located some 120 miles away.

Hawkes then sought judicial review of the JD. The U.S. Army Corps of Engineers argued that a JD is not a final agency action that can be reviewed by a court under administrative law. A federal district court agreed and dismissed the case, but that decision was reversed on appeal. Ultimately, the United States Supreme Court held that a JD is a final agency action that can be chal- lenged in court.13 ■

Violations of the Clean Water Act Because point- source water pollution control is based on a permit sys- tem, the permits are the key to enforcement. States have primary responsibility for enforcing the permit system, subject to EPA monitoring.

Discharging emissions into navigable waters with- out a permit, or in violation of pollution limits under a permit, violates the CWA. Violators are subject to a variety of civil and criminal penalties. Depending on the violation, civil penalties range from $10,000 to $25,000 per day, but not more than $25,000 per violation. Lying

13. U.S. Army Corps of Engineers v. Hawkes Co., Inc., ___ U.S. ___, 136 S.Ct. 1807, 195 L.Ed.2d 77 (2016).

about a violation is more serious than admitting the truth about improper discharges.

Criminal penalties apply only if a violation was inten- tional. Criminal penalties range from a fine of $2,500 per day and imprisonment for up to one year to a fine of $1 million and fifteen years’ imprisonment. Injunctive relief and damages can also be imposed. The polluting party can be required to clean up the pollution or pay for the cost of doing so.

25–4b Drinking Water The Safe Drinking Water Act14 requires the EPA to set maximum levels for pollutants in public water systems. The operators of public water systems must come as close as possible to meeting the EPA’s standards by using the best available technology that is economically and tech- nologically feasible.

Under the act, each supplier of drinking water is required to send an annual statement describing the source of its water to every household it supplies. The statement must also disclose the level of any contami- nants in the water and any possible health concerns asso- ciated with the contaminants.

■ EXAMPLE 25.7 In 2014, Flint, Michigan, changed In 2014, Flint, Michigan, changed its source of drinking water from the Detroit water system to the Flint River. Detroit’s water had been treated to prevent lead from leaching from aging lead pipes into the water. Flint River water was not treated, which allowed lead to leach into the water from the pipes. Flint’s drinking water became contaminated with lead—a serious public health hazard. By the time Flint sent out the required EPA notices, thousands of chil- dren had been exposed to drinking water with high lead levels. Several civil lawsuits have been filed against gov- ernment officials as a result of the incident, and three individuals face criminal prosecution. The city will end up paying millions to fix the problem. ■ Since the inci- dent in Flint, the EPA has revealed data showing that it has found excessive lead levels present in drinking water systems in numerous states across the country in recent years.

25–4c Ocean Dumping The Marine Protection, Research, and Sanctuaries Act15 (popularly known as the Ocean Dumping Act) regulates the transportation and dumping of pollutants into ocean

14. 42 U.S.C. Sections 300f to 300j-25. 15. 16 U.S.C. Sections 1401–1445.

C H A P T E R 2 5 Environmental Law 543

waters. It prohibits the ocean dumping of any radiologi- cal, chemical, and biological warfare agents and high- level radioactive waste.

The act also established a permit program for trans- porting and dumping other materials, and designated certain areas as marine sanctuaries. Each violation of any provision or permit requirement in the Ocean Dump- ing Act may result in a civil penalty of up to $50,000. A knowing violation is a criminal offense that may result in a $50,000 fine, imprisonment for not more than a year, or both. A court may also grant an injunction to prevent an imminent or continuing violation.

25–4d Oil Pollution When more than 10 million gallons of oil leaked into Alaska’s Prince William Sound from the Exxon Valdez supertanker in 1989, Congress responded by passing the Oil Pollution Act.16 (At that time, the Exxon Valdez disaster was the worst oil spill in U.S. history, but the British Petroleum oil spill in the Gulf of Mexico in 2010 surpassed it.)

Under the Oil Pollution Act, any oil facility, oil ship- per, vessel owner, or vessel operator that discharges oil into navigable waters or onto an adjoining shore may be liable for clean-up costs and damages. The polluter can also be ordered to pay for damage to natural resources, private property, and the local economy, including the increased cost of providing public services.

25–5 Toxic Chemicals and Hazardous Waste

Originally, most environmental clean-up efforts were directed toward reducing smog and making water safe for fishing and swimming. Today, control of toxic chemicals and hazardous waste has become increasingly important. If not properly disposed of, these substances may seri- ously endanger human health and the environment—for instance, by contaminating public drinking water.

25–5a Pesticides and Herbicides The Federal Insecticide, Fungicide, and Rodenticide Act (FIFRA)17 regulates the use of pesticides and herbicides. These substances must be (1) registered before they can

16. 33 U.S.C. Sections 2701–2761. 17. 7 U.S.C. Sections 136–136y.

be sold, (2) certified and used only for approved applica- tions, and (3) used in limited quantities when applied to food crops.

EPA Actions The EPA can cancel or suspend registra- tion of substances that it has identified as harmful and can inspect the factories where the chemicals are made. A substance is deemed harmful if human exposure to the substance, including exposure through eating food, results in a risk of one in a million (or higher) of develop- ing cancer.18

Violations and Penalties It is a violation of FIFRA to sell a pesticide or herbicide that is either unregistered or has had its registration canceled or suspended. It is also a violation to sell a pesticide or herbicide with a false or misleading label. For instance, it is an offense to sell a substance that has a chemical strength that is different from the concentration described on the label. It is also a violation to destroy or deface any labeling required under the act.

Penalties for commercial dealers include imprison- ment for up to one year and a fine of up to $25,000 (producers can be fined up to $50,000). Farmers and other private users of pesticides or herbicides who violate the act are subject to a $1,000 fine and incarceration for up to thirty days.

Note that a state can also regulate the sale and use Note that a state can also regulate the sale and use Note that a state can also regulate the sale and use Note that a state can also regulate the sale and use of federally registered pesticides. ■ CASE IN POINT 25.8 The EPA conditionally registered Strongarm, a weed- killing pesticide made by Dow Agrosciences, LLC. Dow sold Strongarm to Texas peanut farmers. When the farm- ers applied it, Strongarm damaged their crops and failed to control the growth of weeds. The farmers sued Dow for violations of Texas law, but the lower courts ruled that FIFRA preempted their claims. The farmers appealed to the United States Supreme Court. The Court held that under a specific provision of FIFRA, a state can regulate the sale and use of federally registered pesticides so long as the regulation does not permit anything that FIFRA prohibits.19 ■

25–5b Toxic Substances The Toxic Substances Control Act20 regulates chemicals and chemical compounds that are known to be toxic,

18. 21 U.S.C. Section 346a. 19. Bates v. Dow Agrosciences, LLC, 544 U.S. 431, 125 S.Ct. 1788, 161 Bates v. Dow Agrosciences, LLC, 544 U.S. 431, 125 S.Ct. 1788, 161 Bates v. Dow Agrosciences, LLC

L.Ed.2d 687 (2005). 20. 15 U.S.C. Sections 2601–2692.

544 U N I T F I V E The Regulatory Environment

such as asbestos and polychlorinated biphenyls (PCBs). The act also controls the introduction of new chemical compounds by requiring investigation of any possible harmful effects from these substances.

Under the act, the EPA can require that manufactur- ers, processors, and other entities planning to use chemi- cals first determine their effects on human health and the environment. The EPA can regulate substances that could pose an imminent hazard or an unreasonable risk of injury to health or the environment. The EPA can also require special labeling, limit the use of a substance, set produc- tion quotas, or prohibit the use of a substance altogether.

25–5c The Resource Conservation and Recovery Act

The Resource Conservation and Recovery Act (RCRA)21 was Congress’s response to growing concerns about the effects of hazardous waste materials on the environment. The RCRA required the EPA to determine which forms of solid waste should be considered hazardous and to establish regulations to monitor and control hazardous waste disposal.

Among other things, the act requires all producers of hazardous waste materials to label and package properly any hazardous waste to be transported. Amendments to the RCRA decrease the use of land containment in the disposal of hazardous waste and require smaller genera- tors of hazardous waste to comply with the act.

Under the RCRA, a company may be assessed a civil penalty of up to $25,000 for each violation.22 The pen- alty is based on the seriousness of the violation, the prob- ability of harm, and the extent to which the violation deviates from RCRA requirements. Criminal penalties include fines of up to $50,000 for each day of violation, imprisonment for up to two years (in most instances), or both. Criminal fines and the time of imprisonment can be doubled for certain repeat offenders.

25–5d Superfund The Comprehensive Environmental Response, Compen- sation, and Liability Act (CERCLA),23 commonly known as Superfund, regulates the clean-up of disposal sites in which hazardous waste is leaking into the environment. CERCLA, as amended, has four primary elements:

21. 42 U.S.C. Sections 6901–6986. 22. 42 U.S.C. Section 6928(a). 23. 42 U.S.C. Sections 9601–9675.

1. It established an information-gathering and analysis system that enables the government to identify chem- ical dump sites and determine the appropriate action.

2. It authorized the EPA to respond to emergencies and to arrange for the clean-up of a leaking site directly if the persons responsible fail to clean up the site.

3. It created a Hazardous Substance Response Trust Fund (also called Superfund ) to pay for the clean-up of hazardous sites using funds obtained through taxes on certain businesses.

4. It allowed the government to recover the cost of clean-up from persons who were (even remotely) responsible for hazardous substance releases.

Potentially Responsible Parties Superfund pro- vides that when a release or a potential release of hazard- ous chemicals from a site occurs, the following persons may be held responsible for cleaning up the site: 1. The person who generated the wastes disposed of at

the site. 2. The person who transported the waste to the site. 3. The person who owned or operated the site at the

time of the disposal. 4. The current owner or operator.

A person falling within one of these categories is referred to as a potentially responsible party (PRP). If the PRPs do not clean up the site, the EPA can clean up the site and recover the clean-up costs from the PRPs.

Strict Liability of PRPs. Superfund imposes strict liabil- ity on PRPs, and that liability cannot be avoided through transfer of ownership. �us, selling a site where hazardous wastes were disposed of does not relieve the seller of liabil- ity, and the buyer also becomes liable for the clean-up.

Liability also extends to businesses that merge with or buy corporations that have violated CERCLA. A parent corporation is not automatically liable for the violations of its subsidiary. It can be held liable, however, if the sub- sidiary was merely a shell company or if the parent corpo- ration participated in or controlled the facility.24

Joint and Several Liability of PRPs. Liability under Superfund is usually joint and several. In other words, a PRP who generated only a fraction of the hazardous waste disposed of at a site may nevertheless be liable for all of all of all the clean-up costs. CERCLA authorizes a party who has incurred clean-up costs to bring a “contribution action”

24. The landmark case establishing the liability of a parent corporation under CERCLA is United States v. Bestfoods, 524 U.S. 51, 118 S.Ct. 1876, 141 L.Ed.2d 43 (1998).

C H A P T E R 2 5 Environmental Law 545

Reviewing: Environmental Law

Residents of Lake Caliopa, Minnesota, began noticing an unusually high number of lung ailments among the local pop- ulation. Several concerned citizens pooled their resources and commissioned a study to compare the frequency of these health conditions in Lake Caliopa with national averages. The study concluded that residents of Lake Caliopa experi- enced four to seven times the rate of frequency of asthma, bronchitis, and emphysema as the population nationwide.

During the study period, citizens began expressing concerns about the large volume of smog emitted by the Cotton Design apparel manufacturing plant on the outskirts of town. The plant had a production facility two miles east of town beside the Tawakoni River and employed seventy full-time workers. Just downstream on the Tawakoni River, the city of Lake Caliopa operated a public water works facility, which supplied all city residents with water.

The Minnesota Pollution Control Agency required Cotton Design to install new equipment to control air and water pollution. Later, citizens sued Cotton Design for various respiratory ailments allegedly caused or compounded by smog from Cotton Design’s factory. Using the information presented in the chapter, answer the following questions. 1. Under the common law, what would each plaintiff be required to identify in order to be given relief by the court? 2. What standard for limiting emissions into the air does Cotton Design’s pollution-control equipment have to meet? 3. If Cotton Design’s emissions violated the Clean Air Act, how much can the EPA assess in fines per day? 4. What information must the city send to every household that it supplies with water?

Debate This . . . The courts should reject all cases in which the wetlands in question do not consist of actual bodies of water that exist during the entire year.

against any other person who is liable or potentially liable for a percentage of the costs.

Minimizing Liability One way for a business to min- imize its potential liability under Superfund is to conduct environmental compliance audits of its own operations regularly. That is, the business can investigate its own operations and property to determine whether any envi- ronmental hazards exist.

The EPA encourages companies to conduct self-audits and promptly detect, disclose, and correct wrongdoing. Companies that do so are subject to lighter penalties for violations of environmental laws. (Fines may be reduced as much as 75 percent.)

In addition, under EPA guidelines, the EPA will waive all fines if a small company corrects environmental viola- tions within 180 days after being notified of the viola- tions (or 360 days if pollution-prevention techniques are involved). The policy does not apply to criminal viola- tions of environmental laws, though, or to violations that pose a significant threat to public health, safety, or the environment.

Defenses There are a few defenses to liability under CERCLA. The most important is the innocent landowner

defense.25 This defense may protect a landowner who acquired the property after it was used for hazardous waste disposal.

The landowner claiming the innocent landowner defense must not have had a contractual or employment relationship with the person (or other entity) who owned the land when the contamination occurred. Because land is often transferred by contract, it would seem that this defense would not normally be available. However, a landowner who can show that he or she had no knowl- edge of the hazardous waste disposal at the time of pur- chase can still assert the defense.

To succeed, the landowner must show that at the time the property was acquired, she or he had no reason to know that it had been used for hazardous waste disposal. The landowner must also show that at the time of the purchase, she or he undertook “all appropriate inquiries.” That is, he or she investigated the previous ownership and uses of the property to determine whether there was reason for concern about hazardous substances. In effect, then, this defense protects only property owners who took precautions and investigated the possibility of envi- ronmental hazards before buying the property.

25. 42 U.S.C. Section 9601(35)(B).

546 U N I T F I V E The Regulatory Environment

Issue Spotters 1. Resource Refining Company’s plant emits smoke and

fumes. Resource’s operation includes a short railway system, and trucks enter and exit the grounds continu- ously. Constant vibrations from the trains and trucks rattle nearby residential neighborhoods. The residents sue Resource. Are there any reasons why the court might refuse to issue an injunction against Resource’s operation? Explain. (See Common Law Actions.)

2. ChemCorp generates hazardous wastes from its opera- tions. Disposal Trucking Company transports those wastes

to Eliminators, Inc., which owns a site for hazardous waste disposal. Eliminators sells the property on which the disposal site is located to Fluid Properties, Inc. If the Environmental Protection Agency cleans up the site, from whom can it recover the cost? (See Toxic Chemicals and Hazardous Waste.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 25–1. The Clean Water Act. Fruitade, Inc., is a processor of a soft drink called Freshen Up. Fruitade uses returnable bottles, which it cleans with a special acid to allow for further beverage processing. The acid is diluted with water and then allowed to pass into a navigable stream. Fruitade crushes its broken bottles and throws the crushed glass into the stream. Discuss fully any environmental laws that Fruitade has vio- lated. (See Water Pollution.) 25–2. Environmental Protection. Moonbay is a home- building corporation that primarily develops retirement com- munities. Farmtex owns a number of feedlots in Sunny Valley.

Moonbay purchases 20,000 acres of farmland in the same area and begins building and selling homes on this acreage. In the meantime, Farmtex continues to expand its feedlot business, and eventually only 500 feet separate the two operations. Because of the odor and flies from the feedlots, Moonbay finds it difficult to sell the homes in its development. Moon- bay wants to enjoin (prevent) Farmtex from operating its feed- lot in the vicinity of the retirement home development. Under what common law theory would Moonbay file this action? Has Farmtex violated any federal environmental laws? Dis- cuss. (See Common Law Actions.)

Business Case Problems 25–3. Spotlight on the Grand Canyon—Environmen- tal Impact Statement. �e U.S. National Park Service

(NPS) manages the Grand Canyon National Park in Arizona under a management plan that is sub- ject to periodic review. In 2006, after nine years of background work and the completion of a com-

prehensive environmental impact statement, the NPS issued a new management plan for the park. �e plan allowed for the continued use of rafts on the Colorado River, which runs through the Grand Canyon. �e number of rafts was limited, however. Several environmental groups criticized the plan because they felt that it still allowed too many rafts on the river. �e groups asked a federal appellate court to overturn the plan, claiming that it violated the wilderness status of the national park. When can a federal court overturn a determina- tion by an agency such as the NPS? Explain. [River Runners for

Wilderness v. Martin, 593 F.3d 1064 (9th Cir. 2010)] (See Fed-Fed-Fed eral, State, and Local Regulations.) 25–4. Superfund. A by-product of phosphate fertilizer production is pyrite waste, which contains arsenic and lead. From 1884 to 1906, seven phosphate fertilizer plants oper- ated on a forty-three-acre site in Charleston, South Caro- lina. Planters Fertilizer & Phosphate Co. bought the site in 1906 and continued to make fertilizer. In 1966, Planters sold the site to Columbia Nitrogen Corp. (CNC), which also operated the fertilizer plants. In 1985, CNC sold the site to James Holcombe and J. Henry Fair. Holcombe and Fair subdivided and sold the site to Allwaste Tank Cleaning Inc., Robin Hood Container Express, the city of Charles- ton, and Ashley II of Charleston, Inc. Ashley spent almost $200,000 cleaning up the contaminated soil. Who can be held liable for the cost? Why? [PCS Nitrogen Inc. v. Ashley II

Terms and Concepts environmental impact

statement (EIS) 535 nuisance 532

potentially responsible party (PRP) 544

toxic tort 532

wetlands 541

C H A P T E R 2 5 Environmental Law 547

of Charleston LLC, 714 F.3d 161 (4th Cir. 2013)] (See of Charleston LLC, 714 F.3d 161 (4th Cir. 2013)] (See of Charleston LLC Toxic Chemicals and Hazardous Waste.) 25–5. Business Case Problem with Sample Answer— Environmental Impact Statements. �e U.S. Forest Ser-

vice (USFS) proposed a travel management plan (TMP) for the Beartooth Ranger District in the Pryor and Absaroka Mountains in the Custer National Forest of southern Montana. �e TMP

would convert unauthorized user-created routes within the wil- derness to routes authorized for motor vehicle use. It would also permit o�-road “dispersed vehicle camping” within 300 feet of the routes, with some seasonal restrictions. �e TMP would ban cross-country motorized travel outside the designated routes. Is an environmental impact statement required before the USFS implements the TMP? If so, what aspects of the envi- ronment should the USFS consider in preparing it? Discuss. [Pryors Coalition v. Weldon, 551 Fed.Appx. 426 (9th Cir. 2014)] (See Federal, State, and Local Regulations.) • For a sample answer to Problem 25–5, go to Appendix E at

the end of this text.

25–6. The Clean Water Act. ICG Hazard, LLC, oper- ates the �under Ridge surface coal mine in Leslie County, Kentucky, under a National Pollutant Discharge Elimination System permit issued by the Kentucky Division of Water (KDOW). As part of the operation, ICG discharges selenium into the surrounding water. Selenium is a naturally occurring element that endangers aquatic life once it reaches a certain concentration. KDOW knew when it issued the permit that mines in the area could produce selenium but did not specify discharge limits for the element in ICG’s permit. Instead, the agency imposed a one-time monitoring requirement, which ICG met. Does ICG’s discharge of selenium violate the Clean Water Act? Explain. [Sierra Club v. ICG Hazard, LLC, 781 F.3d 281 (6th Cir. 2015)] (See Water Pollution.)

25–7. Special Case Analysis—Environmental Regula- tory Agencies. Go to Case Analysis 25.1, Friends of Animals v. Clay. Read the excerpt and answer the following questions. (a) Issue: What regulation was at issue in this case? What

activity does it regulate? (b) Rule of Law: What rule of statutory interpretation did

the court apply to construe this regulation?

(c) Applying the Rule of Law: How did the plaintiff want the regulation to be interpreted? What was the court’s response?

(d) Conclusion: What were the results of the court’s interpre- tation of the regulation?

25–8. A Question of Ethics—Clean Air Act. In the Clean Air Act, Congress allowed California, which has par- ticular problems with clean air, to adopt its own standard for emissions from cars and trucks. Califor- nia’s standard is subject to the approval of the Envi-

ronmental Protection Agency (EPA) based on certain criteria. Congress also allowed other states to adopt California’s standard after the EPA’s approval.

In 2004, in an effort to address climate change, the California Air Resources Board amended the state’s standard to attain “the maximum feasible and cost-effective reduction of GHG [green- house gas] emissions from motor vehicles.” The regulation, which applies to new passenger vehicles and light-duty trucks for 2009 and later, imposes decreasing limits on emissions of carbon dioxide through 2016. While EPA approval was pending, Vermont and other states adopted similar standards.

Green Mountain Chrysler Plymouth Dodge Jeep and other auto dealers, automakers, and associations of automakers filed a suit in a federal district court against George Crombie (then the secretary of the Vermont Agency of Natural Resources) and oth- ers, seeking relief from the state regulations. [Green Mountain [Green Mountain [ Chrysler Plymouth Dodge Jeep v. Crombie, 508 F.Supp.2d 295 (D.Vt. 2007)] (See 295 (D.Vt. 2007)] (See 295 (D.Vt. 2007)] Air Pollution.) (a) Under the Environmental Policy and Conservation Act

(EPCA) of 1975, the National Highway Traffic Safety Administration sets fuel economy standards for new cars. The plaintiffs argued, among other things, that the EPCA, which prohibits states from adopting separate fuel economy standards, preempts Vermont’s GHG regulation. Do the GHG rules equate to the fuel economy standards? Discuss.

(b) Do Vermont’s rules tread on the efforts of the federal gov- ernment to address climate change internationally? Who should regulate GHG emissions? The federal govern- ment? The state governments? Both? Neither? Why?

(c) The plaintiffs claimed that they would go bankrupt if they were forced to adhere to the state’s GHG standards. Should they be granted relief on this basis? Does history support their claim? Explain.

Legal Reasoning Group Activity 25–9. Clean-Up Costs. It has been estimated that for every dollar spent cleaning up hazardous waste sites, administrative agencies spend seven dollars in overhead. (See Toxic Chemicals and Hazardous Waste.)

(a) The first group will list and explain possible ways to trim these administrative costs.

(b) The second group will evaluate whether the laws pertain- ing to hazardous waste clean-up can or should be changed to reduce the costs to government.

548

C H A P T E R 2 6

26–1 The Nature of Real Property Real property (or realty) consists of land and everything permanently attached to it, including structures and other fixtures. Real property encompasses airspace and subsurface rights, as well as rights to plants and vegeta- tion. In essence, real property is immovable.

26–1a Land and Structures Land includes the soil on the surface of the earth and the natural products or artificial structures that are attached to it. Land further includes all the waters contained on or under its surface and much, but not necessarily all, of the airspace above it. The exterior boundaries of land extend down to the center of the earth and up to the farthest reaches of the atmosphere (subject to certain qualifications).

26–1b Airspace and Subsurface Rights The owner of real property has rights to both the airspace above the land and the soil and minerals underneath it. Any limitations on either airspace rights or subsurface rights, called encumbrances, normally must be indicated on the document that transfers title at the time of purchase.

The ways in which ownership rights in real property can be limited will be examined later in this chapter.

Airspace Rights Disputes concerning airspace rights may involve the right of commercial and private planes to fly over property and the right of individuals and govern- ments to seed clouds and produce artificial rain. Flights over private land normally do not violate property rights unless the flights are so low and so frequent that they directly interfere with the owner’s enjoyment and use of the land. Leaning walls or projecting eave spouts or roofs may also violate the airspace rights of an adjoining prop- erty owner.

Subsurface Rights In many states, ownership of land can be separated from ownership of its subsurface. In other words, the owner of the surface may sell subsurface rights to another person. When ownership is separated into surface and subsurface rights, each owner can pass title to what she or he owns without the consent of the other owner.

Subsurface rights can be extremely valuable, as these rights include the ownership of minerals, oil, or natural gas. But a subsurface owner’s rights would be of little value if he or she could not use the surface to exercise those rights. Hence, a subsurface owner has a right (called a

F rom the earliest times, property has provided a means for survival. Primitive peoples lived off the

fruits of the land, eating the vegeta- tion and wildlife. Later, as the wildlife was domesticated and the vegetation cultivated, property provided pas- tures and farmland. Throughout his- tory, property has continued to be an indicator of family wealth and social position. In the Western world, the

protection of an individual’s right to his or her property has become one of our most important rights.

In this chapter, we look at the nature of real property and the ways in which it can be owned. We exam- ine the legal requirements involved in the transfer of real property. We even consider, in this chapter’s Spotlight Case, whether the buyer of a haunted house can rescind the sale.

Realize that real property rights are never absolute. There is a higher right—that of the government to take, for compensation, private land for public use. Later in the chapter, we discuss this right, as well as other restrictions on the ownership or use of property. We conclude the chapter with a discussion of land-use control and zoning laws.

Real Property and Land-Use Control

C H A P T E R 2 6 Real Property and Land-Use Control 549

profit, discussed later in this chapter) to go onto the surprofit, discussed later in this chapter) to go onto the surprofit - face of the land to, for instance, find and remove minerals.

Of course, conflicts can arise between the surface owner’s use of the property and the subsurface owner’s need to extract minerals, oil, or natural gas. In that situ- ation, one party’s interest may become subservient (sec- ondary) to the other party’s interest either by statute or by case law. If the owners of the subsurface rights exca- vate, they are absolutely (strictly) liable if their excavation causes the surface to collapse. Many states have statutes that also make the excavators liable for any damage to structures on the land. Typically, these statutes set out precise requirements for excavations of various depths.

26–1c Plant Life and Vegetation Plant life, both natural and cultivated, is also considered to be real property. In many instances, the natural veg- etation, such as trees, adds greatly to the value of realty. When a parcel of land is sold and the land has growing crops on it, the sale includes the crops, unless otherwise specified in the sales contract. When crops are sold by themselves, however, they are considered to be personal property, or goods. Consequently, the sale of crops is a sale of goods and is governed by the Uniform Commer- cial Code (UCC) rather than by real property law.

26–1d Fixtures Certain personal property can become so closely associated with the real property to which it is attached that the law views it as real property. Such property is known as a fix- ture—an item affixed to realty, meaning that it is attached ture—an item affixed to realty, meaning that it is attached ture to the real property in a permanent way. The item may be embedded in the land or permanently attached to the property or to another fixture on the property by means of cement, plaster, bolts, nails, or screws. An item, such as a statue, may even sit on the land without being attached, as long as the owner intends it to be a fixture.intends it to be a fixture.intends

Fixtures are included in the sale of land unless the sales contract specifies otherwise. The issue of whether an item is a fixture (and thus real estate) or not a fixture (and thus personal property) often arises with respect to land sales, real property taxation, insurance coverage, and divorces. How the issue is resolved can have important consequences for the parties involved.

Typical Fixtures Some items can only be attached to property permanently—such as tile floors, cabinets, and carpeting. Because such items are attached permanently,

it is assumed that the owner intended them to be fixtures. Also, when an item of property is custom-made for instal- lation on real property, as storm windows are, the item usually is classified as a fixture.

In addition, an item that is firmly attached to the land and integral to its use may be deemed a fixture. For instance, a mobile home or a complex irrigation system bolted to a cement slab on a farm can be a fixture. The courts assume that owners, in making such installations, intend the objects to become part of their real property.

The Role of Intent Generally, when the courts need to determine whether a certain item is a fixture, they examine the intention of the party who placed the object on the real property. When the intent of that party is in dispute, the courts will usually deem that the item is a fixture if either or both of the following are true: • The property attached cannot be removed without

causing substantial damage to the remaining realty. • The property attached is so adapted to the rest of the

realty as to have become a part of it. ■ CASE IN POINT 26.1 Terminal 5, a facility owned by

the Port of Seattle (Port), was used in loading and unload- ing the shipping containers used to transport goods by ship. APL Limited entered into a long-term lease with the Port for use of Terminal 5 and for use of Port-owned con- tainer cranes. Terminal 5 was substantially rebuilt, and steel cranes were constructed and installed. The cranes were 100 feet apart, 198 feet tall, and 85 feet wide, and were mounted on rails embedded in concrete. They were hard-wired to a dedicated high-voltage electrical system built specifically for Terminal 5 and were attached to the power substation by cables.

APL later filed a lawsuit against the state of Washing- ton for a refund of sales tax it had paid on the lease of the cranes. The state argued that the cranes were personal property and, as such, subject to sales tax. The trial court ruled in favor of the state, but a Washington appellate court reversed. The reviewing court found that the trial court had not sufficiently taken the Port’s intent into account in determining that the cranes were personal property, not fixtures. “When the owner and the person that [attaches property to realty] are one and the same, a rebuttable presumption arises that the owner’s intention was for the [property] to become part of the realty.” The reviewing court remanded the case so the lower court could examine evidence of the Port’s intent.1 ■

1. APL Limited v. Washington State Department of Revenue, 154 Wash.App. 1020 (2010).

550 U N I T F I V E The Regulatory Environment

Trade Fixtures Are Personal Property Trade fix- tures are an exception to the rule that fixtures are a part of the real property to which they are attached. A trade fix- ture is personal property that is installed for a commercial purpose by a tenant (one who rents real property from the by a tenant (one who rents real property from the by a tenant owner, or landlord).

Trade fixtures remain the property of the tenant unless removal would irreparably damage the building or realty. A walk-in cooler, for instance, purchased and installed by a tenant who uses the premises for a restaurant, is a trade fixture. The tenant can remove the cooler from the premises when the lease terminates but ordinarily must repair any damage that the removal causes or compensate the landlord for the damage.

26–2 Ownership and Other Interests in Real Property

Ownership of property is an abstract concept that cannot exist independently of the legal system. No one can actu- ally possess, or hold, a piece of land, the air above it, the earth below it, and all the water contained on it. One can only possess rights in real property.rights in real property.rights

Numerous rights are involved in real property owner- ship, which is why property ownership is often viewed as a bundle of rights. One who possesses the entire bundle of rights is said to hold the property in fee simple, which is the most complete form of ownership. When only some of the rights in the bundle are transferred to another per- son, the effect is to limit the ownership rights of both the transferor of the rights and the recipient.

Ownership interests in real property have tradition- ally been referred to as estates in land, which include fee simple estates, life estates, and leasehold estates. We examine these types of estates in this section, and we also discuss several forms of concurrent ownership of prop- erty. Finally, we describe certain interests in real property that is owned by others.

26–2a Ownership in Fee Simple In a fee simple absolute, the owner has the greatest aggregation of rights, privileges, and power possible. The owner can give the property away or dispose of the property by deed or by deed or by deed will. When there is no will, will. When there is no will, will the fee simple passes to the owner’s legal heirs on her or his death. A fee simple absolute is potentially infi- nite in duration and is assigned forever to a person and

her or his heirs without limitation or condition.2 The owner has the rights of exclusive possession and use of exclusive possession and use of exclusive the property.

The rights that accompany a fee simple absolute include the right to use the land for whatever purpose the owner sees fit. Of course, other laws, including appli- cable zoning, noise, and environmental laws, may limit the owner’s ability to use the property in certain ways. A person who uses his or her property in a manner that unreasonably interferes with others’ right to use or enjoy their own property can be liable for the tort of nuisance.

■ CASE IN POINT 26.2 Nancy and James Biglane Nancy and James Biglane owned and lived in a building next door to the Under the Hill Saloon, a popular bar that featured live music. During the summer, the Saloon, which had no air-conditioning, opened its windows and doors, and live music echoed up and down the street. The Biglanes installed extra insula- tion, thicker windows, and air-conditioning units in their building. Nevertheless, the noise from the Saloon kept the Biglanes awake at night. Eventually, they sued the owners of the Saloon for nuisance. The court held that the noise from the bar unreasonably interfered with the Biglanes’ right to enjoy their property and prohibited the Saloon from opening its windows and doors while play- ing music.3 ■

26–2b Life Estates A life estateA life estateA is an estate that lasts for the life of some specified individual. A conveyance, or transfer of real property, “to A for his life” creates a life estate.4 The life tenant’s ownership rights cease to exist on the life tenant’s death.

The life tenant has the right to use the land, provided that he or she commits no waste (injury to the land). In other words, the life tenant cannot use the land in a man- ner that would adversely affect its value. The life tenant can use the land to harvest crops or, if mines and oil wells are already on the land, can extract minerals and oil from it, but the life tenant cannot establish new wells or mines. The life tenant can also create liens, easements (discussed easements (discussed easements shortly), and leases, but none can extend beyond the life

2. In another type of estate, the fee simple defeasible, ownership in fee simple automatically terminates if a stated event occurs. For instance, property might be conveyed (transferred) to a school only as long as it is used for school purposes. In addition, the fee simple may be subject to a condition subsequent. This means that if a stated event occurs, the prior owner of the property can bring an action to regain possession of the property.

3. Biglane v. Under the Hill Corp., 949 So.2d 9 (Miss.Sup. 2007). 4. A less common type of life estate is created by the conveyance “to A for

the life of B.” This is known as an estate pur autre vie—that is, an estate for the duration of the life of another.

C H A P T E R 2 6 Real Property and Land-Use Control 551

of the tenant. In addition, with few exceptions, the life tenant has an exclusive right to possession during his or her lifetime.

Along with these rights, the life tenant also has some duties—to keep the property in repair and to pay prop- erty taxes. In short, the owner of the life estate has the

same rights as a fee simple owner except that she or he must maintain the value of the property during her or his tenancy.

In the following case, the life tenant refused to pay the taxes and the premiums for the insurance on the prop- erty. Was this waste?

Background and Facts Craig Matus held a life estate in certain residential real property in Hunting- ton, New York. On the termination of the life estate, title to the property was to transfer to Main Omni Realty Corporation, a wholly owned subsidiary of New York Community Bank. For a dozen years, Matus refused to pay premiums for insurance on the property. He also refused to pay the property taxes, resulting in tax liens.

To preserve its interest in the property, Main Omni paid the premiums and the liens, which avoided a foreclosure and sale of the property. Main Omni then filed a suit in a New York state court against Matus, seeking to recover the amount of the premiums and taxes on the ground of unjust enrichment. In addition, it sought to extinguish (end) the life estate on the ground of waste based on Matus’s refusal to pay the taxes. The court denied Main Omni’s motion for summary judgment. Main Omni appealed.

In the Language of the Court Ruth C. BALKIN, J.P. [Judge Presiding], L. Priscilla HALL, Leonard B. AUSTIN, and Betsey BARROS, JJ. [Judges].

* * * * The essential inquiry in any action for unjust enrichment or restitution is whether it is against equity

and good conscience to permit the defendant to retain what is sought to be recovered. A plaintiff must show that (1) the other party was enriched, (2) at the plaintiff ’s expense, and (3) that it is against equity and good conscience to permit the other party to retain what is sought to be recovered. [Emphasis added.]

The plaintiffs established their prima facie entitlement to judgment as a matter of law on their prima facie entitlement to judgment as a matter of law on their prima facie first cause of action, which alleged unjust enrichment and sought restitution, and their second cause of action, which alleged waste and sought to extinguish the defendant’s life estate. As life tenant, the defendant was obligated to pay the property taxes and * * * insurance on the subject property, and the intentional failure to do so constitutes waste. It is undisputed that the defendant intentionally failed to pay the property taxes and * * * insurance on the subject property, and he has clearly expressed his inten- tion not to do so in the future. Under these circumstances, the remainder interest in the subject property is in constant danger of forfeiture in a tax lien sale, unless the plaintiffs continue paying the property taxes and * * * insurance premiums the defendant is otherwise obligated to pay. The plaintiffs therefore demonstrated, prima facie, that the defendant was unjustly enriched by the plaintiffs’ payment of these expenses for the defendant, and that equity warrants extinguishing his life estate in the subject property.

Decision and Remedy A state intermediate appellate court reversed the lower court’s denial of Main Omni’s motion and ordered a summary judgment in the plaintiff’s favor. Because Matus continued to refuse to pay the taxes on the property, the court ended his life estate.

Critical Thinking • Economic Why would the owner of a life estate refuse to pay the taxes and insurance premiums on the

property of the estate? Should any reason for this refusal have influenced the court’s decision in this case?

Main Omni Realty Corp. v. Matus New York Supreme Court, Appellate Division, Second Department, 124 A.D.3d 604, 1 N.Y.S.3d 319 (2015).

Case 26.1

552 U N I T F I V E The Regulatory Environment

26–2c Concurrent Ownership Persons who share ownership rights simultaneously in particular property (including real property and personal property) are said to have concurrent ownership. There are two principal types of concurrent ownership: tenancy in common and joint tenancy. Concurrent ownership rights can also be held in a tenancy by the entirety or as tenancy by the entirety or as tenancy by the entirety community property, but these types of concurrent owner- ship are less common.

Tenancy in Common The term tenancy in common refers to a form of co-ownership in which each of two or more persons owns an undivided interest in the prop- erty. The interest is undivided because each tenant shares rights in the whole property. On the death of a tenant in common, that tenant’s interest in the property passes to her or his heirs.

■ EXAMPLE 26.3 Four friends purchase a condo Four friends purchase a condo- minium unit in Hawaii together as tenants in common. This means that each of them has a one-fourth owner- ship interest in the whole. If one of the four owners dies a year after the purchase, his ownership interest passes to his heirs (his wife and children, for example) rather than to the other tenants in common. ■

Unless the co-tenants have agreed otherwise, a tenant in common can transfer her or his interest in the prop- erty to another without the consent of the remaining co- owners. In most states, it is presumed that a co-tenancy is a tenancy in common unless there is specific language indicating the intent to establish a joint tenancy.

Joint Tenancy In a joint tenancy, each of two or more persons owns an undivided interest in the property, but a deceased joint tenant’s interest passes to the surviving joint tenant or tenants.

Right of Survivorship. �e right of a surviving joint ten- ant to inherit a deceased joint tenant’s ownership inter- est—referred to as a right of survivorship—distinguishes —distinguishes —distinguishes a joint tenancy from a tenancy in common. a joint tenancy from a tenancy in common. a joint tenancy from a tenancy in common. ■ EXAMPLE 26.4 Jerrold and Eva are married and purchase a house as joint tenants. �e title to the house clearly expresses the intent to create a joint tenancy because it refers to Jerrold and Eva as “joint tenants with right of survivorship.” Jer- rold has three children from a prior marriage. If Jerrold dies, his interest in the house automatically passes to Eva rather than to his children from the prior marriage. ■

Termination of a Joint Tenancy. A joint tenant can transfer her or his rights by sale or gift to another without

the consent of the other joint tenants. Doing so termi- nates the joint tenancy, however. �e person who pur- chases the property or receives it as a gift becomes a tenant chases the property or receives it as a gift becomes a tenant chases the property or receives it as a gift becomes a tenant chases the property or receives it as a gift becomes a tenant in common, not a joint tenant. ■ EXAMPLE 26.5 �ree brothers, Brody, Saul, and Jacob, own a parcel of land as joint tenants. Brody is experiencing �nancial di�culties and sells his interest in the real property to Beth. �e sale terminates the joint tenancy, and now Beth, Saul, and Jacob hold the property as tenants in common. ■

A joint tenant’s interest can also be levied against (seized by court order) to satisfy the tenant’s judgment creditors. If this occurs, the joint tenancy terminates, and the remaining owners hold the property as tenants in common. (Judgment creditors can also seize the interests of tenants in a tenancy in common.)

Tenancy by the Entirety A less common form of shared ownership of real property by married persons is a tenancy by the entirety. It differs from a joint tenancy in that neither spouse may separately transfer his or her interest during his or her lifetime unless the other spouse consents. In some states in which statutes give the wife the right to convey her property, this form of concur- rent ownership has effectively been abolished. A divorce, either spouse’s death, or mutual agreement will terminate a tenancy by the entirety.

Community Property A limited number of states5 allow married couples to own property as community property. If property is held as community property, each spouse technically owns an undivided one-half interest in the property. This type of ownership applies to most property acquired by the husband or the wife during the course of the marriage. It generally does not apply to not apply to not property acquired prior to the marriage or to property acquired by gift or inheritance as separate property dur- ing the marriage. After a divorce, community property is divided equally in some states and according to the discre- tion of the court in other states.

26–2d Leasehold Estates A leasehold estate is created when a real property owner or lessor (landlord) agrees to convey the right to pos- sess and use the property to a lessee (tenant) for a cer- tain period of time. The tenant’s right to possession is

5. These states include Alaska, Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Puerto Rico allows property to be owned as community property as well.

C H A P T E R 2 6 Real Property and Land-Use Control 553

temporary, which is what distinguishes a tenant from a purchaser, who acquires title to the property.

In every leasehold estate, the tenant has a qualified right to exclusive possession. It is qualified because the landlord has a right to enter onto the premises to ensure that no waste is being committed. In addition, the tenant can use the land—for instance, by harvesting crops—but cannot injure it by such activities as cutting down timber to sell or extracting oil.

Fixed-Term Tenancy A fixed-term tenancy, also called a tenancy for years, is created by an express contract stating that the property is leased for a specified period of time, such as a month, a year, or a period of years. Sign- ing a one-year lease to occupy an apartment, for instance, creates a fixed-term tenancy. Note that the term need not be specified by date and can be conditioned on the occur- rence of an event, such as leasing a cabin for the summer or an apartment during Mardi Gras.

At the end of the period specified in the lease, the lease ends (without notice), and possession of the prop- erty returns to the lessor. If the tenant dies during the period of the lease, the lease interest passes to the tenant’s heirs as personal property. Often, leases include renewal or extension provisions.

Periodic Tenancy A periodic tenancy is created by a lease that does not specify a term but does specify that rent is to be paid at certain intervals, such as weekly, monthly, or yearly. The tenancy is automatically renewed for another rental period unless properly terminated. ■ EXAMPLE 26.6 Jewel, LLC, enters into a lease with Capital Prop- erties. The lease states, “Rent is due on the tenth day of every month.” This provision creates a periodic tenancy from month to month. ■ A periodic tenancy sometimes arises after a fixed-term tenancy ends when the landlord allows the tenant to retain possession and continue paying monthly or weekly rent.

Under the common law, to terminate a periodic ten- ancy, the landlord or tenant must give at least one peri- od’s notice to the other party. If the tenancy is month to month, for instance, one month’s notice must be given prior to the last month’s rent payment. Today, however, state statutes often require a different period of notice before the termination of a tenancy.

Tenancy at Will With a tenancy at will, either party can terminate the tenancy without notice. This type of tenancy can arise if a landlord rents property to a tenant “for as long as both agree” or allows a person to live on the premises without paying rent. Tenancy at will is rare today

because most state statutes require a landlord to provide some period of notice to terminate a tenancy. States may also require a landowner to have sufficient cause (a legiti- mate reason) to end a residential tenancy.

Tenancy at Sufferance The mere possession of land without right is called a tenancy at sufferance. A tenancy at sufferance is not a true tenancy because it is created when a tenant wrongfully retains possession of property. wrongfully retains possession of property. wrongfully Whenever a tenancy for years or a periodic tenancy ends and the tenant continues to retain possession of the prem- ises without the owner’s permission, a tenancy at suffer- ance is created.

26–2e Nonpossessory Interests In contrast to the types of property interests just described, some interests in land do not include any rights to pos- sess the property. These interests are therefore known as nonpossessory interests. They include easements, profits, and licenses.

An easement is the right of a person to make limited easement is the right of a person to make limited easement use of another person’s real property without taking any- thing from the property. The right to walk across anoth- er’s property, for example, is an easement. In contrast, a profit is the right to go onto land owned by another and profit is the right to go onto land owned by another and profit take away some part of the land itself or some product of the land. ■ EXAMPLE 26.7 Shawn owns real property known as the Dunes. Shawn gives Carmen the right to go there and remove all of the sand and gravel that she needs for her cement business. Carmen has a profit. ■

Easements and profits can be classified as either appurtenant orappurtenant orappurtenant in gross. Because easements and profits are similar and the same rules apply to both, we discuss them together.

Easement or Profit Appurtenant An easement (or profit) appurtenant arises when the owner of one appurtenant arises when the owner of one appurtenant piece of land has a right to go onto (or remove some- thing from) an adjacent piece of land owned by another. The land that is benefited by the easement is called the dominant estate, and the land that is burdened is called the servient estate.

Because easements appurtenant are intended to ben- efit the land, they run (are conveyed) with the land when it is transferred. ■ EXAMPLE 26.8 Owen has a right to drive his car across Green’s land, which is adjacent to Owen’s property. This right-of-way over Green’s property is an easement appurtenant to Owen’s land. If Owen sells his land, the easement runs with the land to benefit the new owner. ■

554 U N I T F I V E The Regulatory Environment

Easement or Profit in Gross In an easement or profit in gross, the right to use or take things from anoth- er’s land is given to one who does not own an adjacent tract of land. These easements are intended to benefit a particular person or business, not a particular piece of land, and cannot be transferred.

■ EXAMPLE 26.9 Avery owns a parcel of land with a marble quarry. Avery conveys to Classic Stone Corpo- ration the right to come onto her land and remove up to five hundred pounds of marble per day. Classic Stone owns a profit in gross and cannot transfer this right to another. ■ Similarly, when a utility company is granted an easement to run its power lines across another’s prop- erty, it obtains an easement in gross.

Creation of an Easement or Profit Most ease- ments and profits are created by an express grant in a contract, deed, or will. This allows the parties to include terms defining the extent and length of time of use. In some situations, however, an easement or profit can be created without an express agreement.

An easement or profit may arise by implication when the circumstances surrounding the division of a parcel of the circumstances surrounding the division of a parcel of the circumstances surrounding the division of a parcel of the circumstances surrounding the division of a parcel of property imply its creation. ■ EXAMPLE 26.10 Barrow Barrow divides a parcel of land that has only one well for drink- ing water. If Barrow conveys the half without a well to Dean, a profit by implication arises because Dean needs drinking water. ■

An easement may also be created by necessity. An easement by necessity does not require division of prop- erty for its existence. A person who rents an apartment, for instance, has an easement by necessity in the private road leading up to it.

An easement arises by prescription when one person exercises an easement, such as a right-of-way, on another person’s land without the landowner’s consent. The use must be apparent and continue for the length of time required by the applicable statute of limitations. (In much the same way, title to property may be obtained by adverse possession, as will be discussed later in this chapter.)chapter.)chapter.)chapter.)

■ CASE IN POINT 26.11 Junior and Wilma Thomp- son sold twenty-one of their fifty acres of land in Mis- souri to Walnut Bowls, Inc. The deed expressly reserved an easement to the Thompsons’ remaining twenty-nine acres, but it did not fix a precise location for the ease- ment. James and Linda Baker subsequently bought the remaining acreage of the Thompsons’ land.

Many years later—on learning of the easement to the Bakers’ property—a potential buyer of Walnut Bowls’ property refused to go through with the sale. Walnut

Bowls then put steel cables across its driveway entrances, installed a lock and chain on an access gate, and bolted a “No Trespassing” sign facing the Bakers’ property. The Bakers filed a suit in a Missouri state court to determine the location of the easement. Citing the lack of an express location, the court held that there was no easement.

The Bakers appealed, and a state intermediate appel- late court reversed that decision. The reviewing court held that an easement existed and instructed the trial court to determine its location. An easement can be created by deed even though its specific location is not identified. The location can later be fixed by agreement between the parties or inferred from use. If the easement is not identi- fied in either of these ways, a court must determine the location.6 ■

Termination of an Easement or Profit An ease- ment or profit can be terminated or extinguished in sev- eral ways. The simplest way is to deed it back to the owner of the land that is burdened by it. Similarly, if the owner of an easement or profit acquires the property burdened by it, then it is merged into the property.

Another way to terminate an easement or profit is to abandon it and provide evidence of the intent to relin- quish the right to use it. Mere nonuse will not extinguish an easement or profit, however, unless the nonuse is accom- panied by an overt act showing the intent to abandon. An overt act might be, for instance, installing and using a different access road to one’s property and discontinuing using an easement across the neighboring property. In any case, a court must be convinced that there was an intent to abandon the easement or profit.

License In the context of real property, a license is the revocable right of a person to come onto another person’s land. It is a personal privilege that arises from the consent of the owner of the land and can be revoked by the owner. A ticket to attend a movie at a theater or a concert is an example of a license.

In essence, a license grants a person the authority to enter the land of another and perform a specified act or series of acts without obtaining any permanent interest in the land. When a person with a license exceeds the authority granted and undertakes some action on the property that is not permitted, the property owner can sue that person for the tort of trespass.sue that person for the tort of trespass.sue that person for the tort of trespass.sue that person for the tort of trespass.

■ CASE IN POINT 26.12 A Catholic church granted Prince Realty Management, LLC, a three-month license to use a three-foot strip of its property adjacent to

6. Baker v. Walnut Bowls, Inc., 423 S.W.3d 293 (Mo.App. 2014).

C H A P T E R 2 6 Real Property and Land-Use Control 555

Prince’s property. The license authorized Prince to “put up plywood panels,” creating a temporary fence to pro- tect Prince’s property during the construction of a new building. During the license’s term, Prince installed steel piles and beams on the licensed property. When Prince ignored the church’s demands that these structures be removed, the church sued Prince for trespass. The court concluded that the license allowed only temporary structures and that Prince had exceeded its authority by installing steel piles and beams. Therefore, the church was entitled to damages.7 ■

Exhibit 26–1 illustrates the various interests in real property discussed in this chapter.

26–3 Transfer of Ownership Ownership interests in real property are frequently trans- ferred by sale, and the terms of the transfer are specified in a real estate sales contract. When real property is sold, the type of interest being transferred and the conditions of the transfer normally are set forth in a deed executed by deed executed by deed the person who is conveying the property. Real property ownership can also be transferred by gift, by will or inher- itance, by adverse possession, or by eminent domain.

7. Roman Catholic Church of Our Lady of Sorrows v. Prince Realty Manage- ment, LLC, 47 A.D.3d 909, 850 N.Y.S.2d 569 (2008).ment, LLC, 47 A.D.3d 909, 850 N.Y.S.2d 569 (2008).ment, LLC

26–3a Real Estate Sales Contracts In some ways, a sale of real estate is similar to a sale of goods because it involves a transfer of ownership, often with specific warranties. A sale of real estate, however, is a more complicated transaction that involves certain formalities that are not required in a sale of goods. In part because of these complications, real estate brokers or agents who are licensed by the state assist the buyers and sellers during the sales transaction.

Usually, after substantial negotiation (offers, counter- offers, and responses), the parties enter into a detailed contract setting forth their agreement. A contract for a sale of land includes such terms as the purchase price, the type of deed the buyer will receive, the condition of the premises, and any items that will be included.

Unless the buyer pays cash for the property, the buyer must obtain financing through a mortgage loan. Real estate sales contracts are often contingent on the buy- er’s ability to obtain financing at or below a specified rate of interest. The contract may also be contingent on certain events, such as the completion of a land survey or the property’s passing one or more inspections. Nor- mally, the buyer is responsible for having the premises inspected for physical or mechanical defects and for insect infestation.

Closing Date and Escrow The contract usually fixes a date for performance, or closing, that frequently is four to twelve weeks after the contract is signed. On this day,

DESCRIPTION

1. Fee simple—The most complete form of ownership. 2. Life estate—An estate that lasts for the life of a specified individual. 3. Concurrent ownership—When two or more persons hold title to property

together, concurrent ownership exists.together, concurrent ownership exists.together a. Tenancy in common. Tenancy in common. T b. Joint tenancy c. Tenancy by the entirety. Tenancy by the entirety. T d. Community property

TYPE OF INTEREST

Ownership Interests

Leasehold Estates 1. Fixed-term tenancy (tenancy for years) 2. Periodic tenancy 3. Tenancy at will Tenancy at will T 4. Tenancy at suf Tenancy at suf T ferance

Nonpossessory Interests 1. Easements 2. Profits 3. Licenses

E X H I B I T 2 6 – 1 Interests in Real Property

556 U N I T F I V E The Regulatory Environment

the seller conveys the property to the buyer by deliver- ing the deed to the buyer in exchange for payment of the purchase price.

Deposits toward the purchase price normally are held in a special account, called an escrow account, until all of the conditions of sale have been met. Once the closing takes place, the funds in the escrow account are trans- ferred to the seller.

Marketable Title The title to a particular parcel of property is especially important to the buyer. A grantor (seller) is obligated to transfer marketable title, or good title, to the grantee (buyer). Marketable title means that the grantor’s ownership is free from encumbrances (except those disclosed by the grantor) and free of defects.

If the buyer signs a purchase contract and then dis- covers that the seller does not have a marketable title, the buyer can withdraw from the contract. ■ EXAMPLE 26.13 Chan enters into an agreement to buy Fortuna Ranch from Hal. Chan then discovers that Hal has given Pearl an option to purchase the ranch and the option has not expired. In this situation, the title is not marketable, because Pearl could exercise the option and Hal would be compelled to sell the ranch to her. Therefore, Chan can withdraw from the contract to buy the property. ■

The most common way of ensuring title is through title insurance, which insures the buyer against loss from defects in title to real property. When financing the purchase of real property, almost all lenders require title insurance to protect their interests in the collateral for the loan.

Implied Warranties in the Sale of New Homes The common law rule of caveat emptor (“let the buyer caveat emptor (“let the buyer caveat emptor beware”) held that the seller of a home made no warranty as to its soundness or fitness (unless the contract or deed stated otherwise). Today, however, most states imply a

warranty—the implied warranty of habitability—in the implied warranty of habitability—in the implied warranty of habitability sale of new homes.

Under this warranty, the seller of a new house war- rants that it will be fit for human habitation even if the deed or contract of sale does not include such a warranty. Essentially, the seller is warranting that the house is in reasonable working order and is of reasonably sound con- struction. The seller can be liable if the home is defective. In some states, the warranty protects not only the first purchaser but any subsequent purchaser as well.

Seller’s Duty to Disclose Hidden Defects In most jurisdictions, courts impose on sellers a duty to dis- close any known defect that materially affects the value of the property and that the buyer could not reasonably discover. Failure to disclose such a defect gives the buyer a right to rescind the contract and to sue for damages based on fraud or misrepresentation.

There is normally a limit to the time within which the buyer can bring a suit against the seller based on the defect. Time limits run from either the date of the sale or the day that the buyer discovered (or should have discovered) the defect. ■ EXAMPLE 26.14 Ian Newson Ian Newson partially renovates a house in Louisiana and sells it to Jerry and Tabitha Moreland for $87,000. Two months after the Morelands move in, they discover rotten wood behind the tile in the bathroom and experience problems with the plumbing. The state statute specifies that the Morelands have one year from the date of the sale or the discovery of the defect to file a lawsuit. Therefore, the Morelands must file suit within twelve months of discov- ering the defects (which would be fourteen months from the date of the sale). ■

In the following Spotlight Case, the court had to decide whether the buyer of a house had the right to rescind the sales contract because he was not told that the house was allegedly haunted.

Background and Facts Jeffrey Stambovsky signed a contract to buy Helen Ackley’s home in Nyack, New York. After the contract was signed, Stambovsky discovered that the house was widely reputed to be haunted. The Ackley family claimed to have seen poltergeists on numerous occasions over the prior nine years. The Ackleys had been interviewed and quoted in both a national publication (Reader’s Digest) and the local newspaper. The house was described as “a riverfront Victorian (with ghost)” Digest) and the local newspaper. The house was described as “a riverfront Victorian (with ghost)” Digest

Spotlight on Sales of Haunted Houses

Case 26.2 Case 26.2 Stambovsky v. Ackley Supreme Court, Appellate Division, New York, 572 N.Y.S.2d 672, 169 A.D.2d 254 (1991).Supreme Court, Appellate Division, New York, 572 N.Y.S.2d 672, 169 A.D.2d 254 (1991).Supreme Court, Appellate Division, New York, 572 N.Y.S.2d 672, 169 A.D.2d 254 (1991).

C H A P T E R 2 6 Real Property and Land-Use Control 557

when it was part of a walking tour of Nyack, New York. When Stambovsky discovered the house’s reputation, he sued to rescind the contract and recover his down payment. He alleged that Ackley and her real estate agent made material misrepresentations when they failed to disclose Ackley’s belief that the home was haunted. Ackley argued that, under the doctrine of caveat emptor, she was under no duty to disclose to the buyer the home’s haunted reputation. The trial court dismissed Stambovsky’s case. Stambovsky appealed.

In the Language of the Court Justice RUBIN delivered the opinion of the court.RUBIN delivered the opinion of the court.RUBIN

* * * * While I agree with [the trial court] that the real estate broker, as agent for the seller, is under no duty

to disclose to a potential buyer the phantasmal reputation of the premises and that, in his pursuit of a legal remedy for fraudulent misrepresentation against the seller, plaintiff hasn’t a ghost of a chance, I am nevertheless moved by the spirit of equity to allow the buyer to seek rescission of the contract of sale and recovery of his down payment. New York law fails to recognize any remedy for damages incurred as a result of the seller’s mere silence, applying instead the strict rule of caveat emptor. Therefore, the theoreti- cal basis for granting relief, even under the extraordinary facts of this case, is elusive if not ephemeral [short-lived].

* * * * The doctrine of caveat emptor requires that a buyer act prudently to assess the fitness and value of his

purchase and operates to bar the purchaser who fails to exercise due care from seeking the equitable remedy of rescission. * * * Applying the strict rule of caveat emptor to a contract involving a house possessed by pol- tergeists conjures up visions of a psychic or medium routinely accompanying the structural engineer and Terminix man on an inspection of every home subject to a contract of sale. It portends [warns] that the prudent attorney will establish an escrow account lest the subject of the transaction come back to haunt him and his client—or pray that his malpractice insurance coverage extends to supernatural disasters. In the interest of avoiding such untenable consequences, the notion that a haunting is a condition which can and should be ascertained upon reasonable inspection of the premises is a hobgoblin which should be exorcised from the body of legal precedent and laid quietly to rest. [Emphasis added.]

* * * * In the case at bar [under consideration], defendant seller deliberately fostered the public belief that

her home was possessed. Having undertaken to inform the public at large, to whom she has no legal relationship, about the supernatural occurrences on her property, she may be said to owe no less a duty to her contract vendee. It has been remarked that the occasional modern cases, which permit a seller to take unfair advantage of a buyer’s ignorance so long as he is not actively misled are “singularly unappetiz- ing.” Where, as here, the seller not only takes unfair advantage of the buyer’s ignorance but has created and perpetuated a condition about which he is unlikely to even inquire, enforcement of the contract (in whole or in part) is offensive to the court’s sense of equity. Application of the remedy of rescission, within the bounds of the narrow exception to the doctrine of caveat emptor set forth herein, is entirely caveat emptor set forth herein, is entirely caveat emptor appropriate to relieve the unwitting purchaser from the consequences of a most unnatural bargain.

Decision and Remedy The New York appellate court found that the doctrine of caveat emptor did not apply in this case. The court allowed Stambovsky to rescind the purchase contract and recover the down payment.

Critical Thinking • Ethical In not disclosing the house’s reputation to Stambovsky, was Ackley’s behavior unethical? If so,

was it unethical because she knew something he did not, or was it unethical because of the nature of the information she omitted? What if Ackley had failed to mention that the roof leaked or that the well was dry—conditions that a buyer would normally investigate? Explain your answer.

• Legal Environment Why did the court decide that applying the strict rule of caveat emptor was inap- propriate in this case? How would applying this doctrine increase costs for the purchaser?propriate in this case? How would applying this doctrine increase costs for the purchaser?

Case 26.2 Continued

558 U N I T F I V E The Regulatory Environment

26–3b Deeds Possession and title to land are passed from person to per- son by means of a deed—the instrument used to transfer deed—the instrument used to transfer deed real property. Deeds must meet certain requirements, but unlike a contract, a deed does not have to be supported by legally sufficient consideration. Gifts of real property are common, and they require deeds even though there is no consideration for the gift.

To be valid, a deed must include the following: 1. The names of the grantor (the giver or seller) and the

grantee (the donee or buyer). 2. Words evidencing the intent to convey (for instance,

“I hereby bargain, sell, grant, or give”). No specific words are necessary. If the deed does not specify the type of estate being transferred, it presumptively transfers the property in fee simple absolute.

3. A legally sufficient description of the land. The description must include enough detail to distinguish the property being conveyed from every other parcel of land. The property can be identified by reference to an official survey or recorded plat map, or each bound- ary can be described by metes and bounds. Metes and bounds is a system of measuring boundary lines by the distance between two points, often using physical features of the local geography. A property description might say, for instance, “beginning at the southwest- erly intersection of Court and Main Streets, then West 40 feet to the fence, then South 100 feet, then North- east approximately 120 feet back to the beginning.”

4. The grantor’s (and usually his or her spouse’s) signature. 5. Delivery of the deed.

Different types of deeds provide different degrees of protection against defects of title, as discussed next.

Warranty Deeds A warranty deed contains the warranty deed contains the warranty deed greatest number of warranties and thus provides the most extensive protection against defects of title. In most states, special language is required to create a general warranty deed. Warranty deeds commonly include the following covenants: 1. A covenant that the grantor has the title to, and the

power to convey, the property. 2. A covenant of quiet enjoyment (a warranty that the

buyer will not be disturbed in her or his possession of the land).

3. A covenant that transfer of the property is made without knowledge of adverse claims of third parties.

Generally, the warranty deed makes the grantor liable for all defects of title during the time that the property was held by the grantor and previous

titleholders. ■ EXAMPLE 26.15 Sanchez sells a two-acre Sanchez sells a two-acre lot and office building by warranty deed to Fast Tech, LLC. Subsequently, Amy shows that she has better title than Sanchez had and evicts Fast Tech. Here, Fast Tech can sue Sanchez for breaching the covenant of quiet enjoyment. Fast Tech can recover the purchase price of the land, plus any other damages incurred as a result. ■

Special Warranty Deed A special warranty deed, or limited warranty deed,or limited warranty deed,or in contrast, warrants only that the grantor or seller held good title during his or her own- ership of the property. In other words, the seller does not guarantee that there are no adverse claims by third parties against any previous owners of the property.

If the special warranty deed discloses all liens or other encumbrances, the seller will not be liable to the buyer if a third person subsequently interferes with the buyer’s ownership. If the third person’s claim arises out of, or is related to, some act of the seller, however, the seller will be liable to the buyer for damages.

Quitclaim Deed A quitclaim deed offers the least quitclaim deed offers the least quitclaim deed protection against defects in the title. Basically, a quit- claim deed conveys to the grantee whatever interest the grantor had. If the grantor had no interest, then the grantee receives no interest. (Naturally, if the grantor had a defective title or no title at all, a conveyance by warranty deed or special warranty deed would not cure the defect. Such a deed, however, would give the buyer a cause of action to sue the seller.)

Quitclaim deeds are often used when the seller, or grantor, is uncertain as to the extent of his or her rights in the property. They may also be used to release a party’s interest in a particular parcel of property. This may be necessary, for instance, in divorce settlements or busi- ness dissolutions when the grantors are dividing up their interests in real property.

Grant Deed With a grant deed, the grantor sim- ply states, “I grant the property to you” or “I convey, or bargain and sell, the property to you.” By state statute, grant deeds carry with them an implied warranty that the grantor owns the property and has not previously trans- ferred it to someone else or encumbered it, except as set out in the deed.

26–3c Recording Statutes Once the seller delivers the deed to the buyer (at clos- ing), legal title to the property is conveyed. Nevertheless,

C H A P T E R 2 6 Real Property and Land-Use Control 559

the buyer should promptly record the deed with the state records office. Every state has a recording statute, which allows deeds to be recorded in the public record for a fee. Deeds generally are recorded in the county in which the property is located. Many state statutes require that the grantor sign the deed in the presence of two witnesses before it can be recorded.

Recording a deed gives notice to the public that a certain person is now the owner of a particular par- cel of real estate. By putting everyone on notice as to the true owner, recording a deed prevents the previous owners from fraudulently conveying the land to other purchasers.

26–3d Adverse Possession A person who wrongfully possesses the real property of another (by occupying or using the property) may eventually acquire title to it through adverse possession. Adverse possession is a means of obtaining title to land without delivery of a deed and without the consent of— or payment to—the true owner. Thus, adverse possession is a method of involuntarily transferring title to the propinvoluntarily transferring title to the propinvoluntarily - erty from the true owner to the adverse possessor.

Essentially, when one person possesses the real prop- erty of another for a certain statutory period of time, that person acquires title to the land. The statutory period varies from three to thirty years, depending on the state, with ten years being most common.

Requirements for Adverse Possession For prop- erty to be held adversely, four elements must be satisfied: 1. Possession must be actual and exclusive. The possessor

must physically occupy the property. This require- ment is clearly met if the possessor lives on the prop- erty, but it may also be met if the possessor builds fences, erects structures, plants crops, or even grazes animals on the land.

2. The possession must be open, visible, and notorious, not secret or clandestine. The possessor must occupy the land for all the world to see. This requirement ensures that the true owner is on notice that someone is possessing the owner’s property wrongfully.

3. Possession must be continuous and peaceable for the required period of time. This requirement means that the possessor must not be interrupted in the occu- pancy by the true owner or by the courts. Continu- ous does not mean constant. It simply means that the possessor has continuously occupied the property in some fashion for the statutory time. Peaceable means that no force was used to possess the land.

4. Possession must be hostile and adverse. In other words, the possessor cannot be living on the property with the owner’s permission and must claim the property as against the whole world. ■ CASE IN POINT 26.16 Charles Scarborough and

Mildred Rollins were adjoining landowners, sharing one common boundary. Based on Rollins’s survey of the property, Rollins believed that she owned a portion of a gravel road located to the south of the apartment build- ings she owned. In contrast, Scarborough believed that the gravel road was located totally on his property and that he owned some property north of the gravel road toward Rollins’s apartment buildings.

Scarborough filed a complaint seeking a court order stating that he had title to the property and was its sole owner. The court, however, ruled that Rollins owned a portion of the gravel road by adverse possession. She had used it openly for more than thirty-five years, it was gen- erally thought to be part of her apartment complex, and she had paid taxes on it.8 ■

The following case raises the question of whether a landowner next to a rail line can acquire a portion of the right-of-way by adverse possession.

8. Scarborough v. Rollins, 44 So.3d 381 (Miss.App. 2010).

In the Language of the Court Glenn T. HARRELL, Jr., J. [Judge]

Driving that train, high on cocaine, Casey Jones you better watch your speed. Trouble ahead, trouble behind,

And you know that notion just crossed my mind. —The Grateful Dead, Casey Jones, on Workingman’s Dead (Warner Bros. Records 1970).

Although the record of the pres- ent case does not reflect a comparable level of drama as captured by the refrain of “Casey Jones,”

Case Analysis 26.3 Montgomery County v. Bhatt Court of Appeals of Maryland, 446 Md. 79, 130 A.3d 424 (2016).

560 U N I T F I V E The Regulatory Environment

Case 26.3 Continued

it hints at plenty of potential trouble, both ahead and behind, for a pair of public works projects (one in place and the other incipient [in development]) cherished by the government and some citizens of Montgomery County.

The Capital Crescent Trail is a well-known hiker/biker route that runs between Georgetown in the District of Columbia and Silver Spring, Mary- land. Its path was used formerly as the Georgetown Branch of the Baltimore & Ohio (B&O) Railroad. After the trains stopped running in 1985, the property was transferred in 1988 to the government of Montgomery County, Maryland, via a quitclaim deed for a consideration of $10 million. It is planned that the Maryland portion of the former rail line (and current interim hiker/biker trail) will become the pro- posed Purple Line, a commuter light rail project.

BACKGROUND * * * Ajay Bhatt owns 3313 Coque-

lin Terrace (a subdivided, single-family residential lot—“Lot 8”—improved by a dwelling) in Chevy Chase, Montgomery County, Maryland. He purchased this property in 2006 from his aunt, who owned the property since at least the 1970s. The lot abuts the Georgetown Branch of the B&O Railroad/Capital Crescent Trail. In 1890, the right-of-way that was the rail line (and is today the hiker/biker trail) was conveyed in a fee- simple deed from George Dunlop, grantor, to the Metropolitan Southern Railroad Company (“the Railroad”), grantee.

The right-of-way was obtained by the County * * * from the Railroad pursu- ant to the federal Rails-to-Trails Act. [Federal regulations] allow the County to preserve the land as a hiker/biker trail until the County chooses whether and when to restore a form of rail service within the right-of-way.

On 18 October 2013, Montgomery County issued to Bhatt a civil citation asserting a violation of Section 49-10(b) of the Montgomery County Code, which prohibits a property owner from

erecting or placing “any structure, fence, post, rock, or other object in a public right-of-way.” The * * * claimed viola- tion was the placement and maintenance by Bhatt’s predecessors-in-interest of Lot 8 of a fence and shed within the former rail line (and current hiker/biker trail) right-of-way, without a permit. * * * The District Court of Maryland, sitting in Montgomery County, * * * found Bhatt guilty * * * and ordered him to remove the fence and shed encroaching upon the County’s right-of-way.

The appeal was heard de novo by the [Maryland] Circuit Court. [When a court hears a case de novo, it decides the issues without reference to the legal conclusions or assumptions made by the previous court.]

* * * * Bhatt’s defense to the charged viola-

tion of Section 49–10(b) was that he owned the encroached-upon land by adverse possession.

Bhatt argued that, because the fence had been located beyond the property line of Lot 8 since at least 1963, the Railroad was obliged to take action to remove it prior to the maturation of the twenty-year period for adverse possession.

* * * The Circuit Court vacated the District Court’s judgment and dismissed the violation citation. * * * The Cir- cuit Court concluded ultimately that Bhatt had a creditable claim for adverse possession.

The County petitioned this Court for a writ of certiorari. * * * We granted the Petition.

* * * * DISCUSSION I. Contentions

* * * The County contends * * * that, because this Court has considered previ- ously a railroad line to be analogous to a public highway for most purposes, the land in question is not subject to an adverse possession claim.

* * * Bhatt rejects the public high- way-railroad line analogy because the land was in private, not public, use dur- ing its operation as a rail line.

II. Analysis

a. Railroads as Public Highways A railroad is in many essential

respects a public highway, and the rules of law applicable to one are generally applicable to the other. Railroads are owned frequently by private corpora- tions, but this has never been considered a matter of any importance * * * because the function performed is that of the State. Railroad companies operate as a public use and are not viewed strictly as private corporations since they are pub- licly regulated common carriers. Essen- tially, a railroad is a highway dedicated to the public use. [Emphasis added.]

* * * * b. May a public highway (or any portion of its right-of-way, no matter the type of real property interest by which it is held) be possessed adversely by an abutting private citizen?

* * * Nothing is more solidly established than the rule that title to property held by a municipal corporation in its governmen- tal capacity, for a public use, cannot be acquired by adverse possession. [Emphasis added.]

* * * * * * * Because time does not run

against the state, or the public, * * * pub- lic highways are not subject to a claim for adverse possession, except in the limited circumstances of a clear aban- donment by the State. By parity [equiva- lence] of reasoning applied to the present case, railway lines [are] also not * * * subject to a claim for adverse possession, without evidence of clear abandonment or a clear shift away from public use.

c. Use of the right-of-way * * * We do not find in this record,

however, that there is any evidence of abandonment by the rail line operator (or Montgomery County) or that the right-of-way was taken out of public use such that a claim for adverse possession could ripen within this right-of-way.

* * * * The 1890 Dunlop Deed shows that

C H A P T E R 2 6 Real Property and Land-Use Control 561

Purpose of the Doctrine There are a number of public-policy reasons for the adverse possession doctrine. These include society’s interest in resolving boundary disputes, in determining title when title to property is in question, and in assuring that real property remains in the stream of commerce. More fundamentally, the doctrine punishes owners who do not take action when they see adverse possession and rewards possessors for putting land to productive use.

26–4 Limitations on the Rights of Property Owners

No ownership rights in real property can ever really be absolute—that is, an owner of real property cannot always do whatever she or he wishes on or with the prop- erty. Nuisance and environmental laws, for instance, restrict certain types of activities. Property ownership is also conditional on the payment of property taxes. Zon- ing laws and building permits frequently restrict the use of realty. In addition, if a property owner fails to pay debts, the property may be seized to satisfy judgment creditors. In short, the rights of every property owner are subject to certain conditions and limitations.

26–4a Eminent Domain Even ownership in fee simple absolute is limited by a superior ownership. Just as the king was the ultimate

landowner in medieval England, today the government has an ultimate ownership right in all land in the United States. This right, known as eminent domain, is some- times referred to as the condemnation power of governcondemnation power of governcondemnation power - ment to take land for public use. It gives the government the right to acquire possession of real property in the manner directed by the U.S. Constitution and the laws of the state whenever the public interest requires it.

The power of eminent domain generally is invoked The power of eminent domain generally is invoked The power of eminent domain generally is invoked through condemnation proceedings. ■ EXAMPLE 26.17 When a new public highway is to be built, the govern- ment decides where to build it and how much land to condemn. After the government determines that a par- ticular parcel of land is necessary for the highway, it will first offer to buy the property. If the owner refuses the offer, the government brings a judicial (condemnation) proceeding to obtain title to the land. ■

Condemnation proceedings usually involve two dis- tinct phases. The first seeks to establish the government’s right to take the property, and the second determines the fair value of the property.

The Taking When the government takes land owned by a private party for public use, it is referred to as a tak-tak-tak ing. Under the takings clause of the Fifth Amendment to takings clause of the Fifth Amendment to takings clause the U.S. Constitution, the government may take private property for public use, but it must pay “just compen- sation” to the owner. State constitutions contain similar provisions. In the first phase of condemnation proceed- ings, the government must prove that it needs to acquire privately owned property for a public use.

Case 26.3 Continued

from a private landowner. There was no evidence adduced [offered] by Bhatt sup- porting a conclusion that the right-of-way was abandoned and was not being used by the public, even during the period from 1985 when the freight service ended and 1988 when the property was con- veyed to the County and became a hiker/ biker trail as an interim public use.

* * * *

Because no evidence was presented by Bhatt to show that the current use of the right-of-way by Montgomery County is unreasonable or that the Rail- road or the County abandoned the right- of-way, no claim for adverse possession will lie. Accordingly, we shall reverse the judgment of the Circuit Court. Bhatt’s fence and shed encroached upon the right-of-way in violation of Montgomery

County Code Section 49–10(b). The District Court got it right.

JUDGMENT OF THE CIRCUIT COURT FOR MONTGOMERY COUNTY REVERSED. CASE REMANDED TO THAT COURT WITH INSTRUCTIONS TO AFFIRM THE JUDGMENT OF THE DIS- TRICT COURT OF MARYLAND, SIT-TRICT COURT OF MARYLAND, SIT-TRICT COURT OF MARYLAND, SIT TING IN MONTGOMERY COUNTY.

Legal Reasoning Questions

1. Bhatt claimed to have met all of the requirements to acquire a strip of public land through adverse possession. Which element did the court find had not been met? Why?not been met? Why?not

2. What is the “potential trouble, both ahead and behind, for a pair of public works projects” hinted at in this case? In whose favor is that “trouble” likely to be resolved?

3. Should a private party, by encroaching on a public right-of-way, be able to acquire title adverse to the public rights? Discuss.

562 U N I T F I V E The Regulatory Environment

■ EXAMPLE 26.18 Franklin County, Iowa, engages Bosque Systems to build a liquefied natural gas pipeline that crosses the property of more than two hundred land- owners. Some property owners consent to this use and accept the Bosque’s offer of compensation. Others refuse the offer. A court will likely deem the pipeline to be a public use. Therefore, the government can exert its emi- nent domain power to “take” the land, provided that it pays just compensation to the property owners. ■

The Compensation The U.S. Constitution and state constitutions require that the government pay just com- pensation to the landowner when invoking its condemna- tion power. Just compensation means fair value. In the second phase of the condemnation proceeding, the court determines the fair value of the land, which usually is approximately equal to its market value.

Property may be taken by the government only for public use, not for private benefit. But can eminent domain be used to promote private development when the development is deemed to be in the public interest? See this chapter’s Ethics Today for a discussion of this issue.Ethics Today for a discussion of this issue.Ethics Today

26–4b Inverse Condemnation Typically, a government agency exercises the power of eminent domain in the manner just discussed. Inverse condemnation, in contrast, occurs when a government simply takes private property from a landowner without paying any compensation, thereby forcing the landowner to sue the government for compensation.

The taking can be physical, as when a government agency uses or occupies the land, or it may be construc- tive, as when an agency regulation results in loss of prop- erty value. The United States Supreme Court has held that even temporary flooding of land by the government may result in liability under the takings clause.may result in liability under the takings clause.may result in liability under the takings clause.may result in liability under the takings clause.9

■ CASE IN POINT 26.19 In Walton County, Florida, water flows through a ditch from Oyster Lake to the Gulf of Mexico. When Hurricane Opal caused the water to rise in Oyster Lake, Walton County reconfigured the drainage to divert the overflow onto the nearby property of William and Patricia Hemby. The flow was eventually

9. Arkansas Game and Fish Commission v. United States, ___ U.S. ___, 133 S.Ct. 511, 184 L.Ed.2d 417 (2012).

Should Eminent Domain Be Used to Promote Private Development?

Issues of fairness often arise when the govern- ment takes private property for public use. One issue is whether it is fair for a government to take property by eminent domain and then convey it to private developers.

For instance, suppose a city government decides that it is in the public interest to have a larger parking lot for a local, privately owned sports stadium. Or suppose it decides that its citizens would benefit from having a manufacturing plant locate in the city to create more jobs. The government may condemn certain tracts of existing housing or busi- ness property and then convey the land to the privately owned stadium or manufacturing plant.

Such actions may bring in private developers and businesses that provide jobs and increase tax revenues, thus revitalizing communities. But is the land really being taken for “public use,” as required by the Fifth Amendment to the U.S. Constitution?

The Supreme Court’s Ruling In 2005, the United States Supreme Court ruled that the power of eminent domain may be used to further

economic development.a At the same time, the Court recognized that individual states have the right to pass laws that prohibit tak- ings for economic development.

The States’ Responses Since then, the vast majority of the states have passed laws to curb the government’s ability

to take private property and subsequently give it to pri- vate developers. Nevertheless, loopholes in some state legislation still allow takings for redevelopment of slum areas. Thus, the debate over whether (and when) it is fair for the government to take citizens’ property for economic development continues.

Critical Thinking At what point might the predicted benefits of a new private commercial endeavor outweigh the constitutional requirement of a taking only for public use?

ETHICS TODAY

a. Kelo v. City of New London, Connecticut, 545 U.S. 469, 125 S.Ct. 2655, 162 L.Ed.2d 439 (2005).

C H A P T E R 2 6 Real Property and Land-Use Control 563

restored to pre-hurricane conditions, but during a later emergency, water was diverted onto the Hembys’ prop- erty again. This diversion was not restored.

The Hembys filed a suit against the county. After their deaths, their daughter Cozette Drake pursued the claim. The court found that by allowing the water diversion to remain on Drake’s property long after the emergency had passed, the county had engaged in a permanent or continuous physical invasion. This invasion rendered Drake’s property useless and deprived her of its beneficial enjoyment. Drake was therefore entitled to receive com- pensation from the county.10 ■

26–4c Restrictive Covenants A private restriction on the use of land is known as a restrictive covenant. If the restriction is binding on the party who initially purchases the property and on subse- quent purchasers as well, it is said to “run with the land.” A covenant running with the land must be in writing (usually it is in the deed), and subsequent purchasers must have reason to know about it.

■ EXAMPLE 26.20 In the course of developing a fifty- lot suburban subdivision, Levitt records a declaration of restrictions effectively limiting construction on each lot to one single-family house. Each lot’s deed includes a reference to the declaration with a provision that the purchaser and her or his successors are bound to those restrictions. Thus, each purchaser assumes ownership with notice of the restrictions. If an owner attempts to build a duplex (or any noncompliant structure) on a lot, the other owners may obtain a court order to prevent the construction.

Alternatively, Levitt might simply have included the restrictions on the subdivision’s map, filed the map in the appropriate public office, and included a reference to the map in each deed. Under these circumstances, each owner would still have been held to have constructive notice of the restrictions. ■

26–5 Land-Use Control and Zoning The rules and regulations that collectively manage the development and use of land are known as zoning laws. Zoning laws were first used in the United States to seg- regate slaughterhouses, distilleries, kilns, and other busi- nesses that might pose a nuisance to nearby residences. The growth of modern urban areas led to an increased

10. Drake v. Walton County, 6 So.3d 717 (Fla.App. 2009).

need to organize uses of land. Today, zoning laws enable municipalities to control the speed and type of develop- ment within their borders by creating different zones and regulating the use of property allowed in each zone.

The United States Supreme Court has held that zon- ing is a constitutional exercise of a government’s police powers.11 Therefore, as long as zoning ordinances are rationally related to the health, safety, or welfare of the community, a municipal government has broad discre- tion to carry out zoning as it sees fit.

26–5a Purpose and Scope of Zoning Laws The purpose of zoning laws is to manage the land within a community in a way that encourages sustainable and organized development while controlling growth in a manner that serves the interests of the community. One of the basic elements of zoning is the classification of land by permissible use, but zoning extends to other aspects of land use as well.

Permissible Uses of Land Municipalities generally divide their available land into districts according to the land’s present and potential future uses. Typically, land is classified into the following types of permissible uses: 1. Residential. In areas dedicated for residential use,

landowners can construct buildings for human habitation.

2. Commercial. Land assigned for business activities is designated as being for commercial use, sometimes called business use. An area with a number of retail stores, offices, supermarkets, and hotels might be designated as a commercial or business district. Land used for entertainment purposes, such as movie the- aters and sports stadiums, also falls into this category, as does land used for government activities.

3. Industrial. Areas designated for industrial use typi- cally encompass light and heavy manufacturing, shipping, and heavy transportation. For instance, undeveloped land with easy access to highways and railroads might be classified as suitable for future use by industry. Although industrial uses can be profit- able for a city seeking to raise tax revenue, such uses can also result in noise, smoke, or vibrations that interfere with others’ enjoyment of their property. Consequently, areas zoned for industrial use generally are kept as far as possible from residential districts and some commercial districts.

11. Village of Euclid v. Ambler Realty Co., 272 U.S. 365, 47 S.Ct. 114, 71 L.Ed. 303 (1926).

564 U N I T F I V E The Regulatory Environment

4. Conservation districts. Some municipalities also establish certain areas that are dedicated to carry- ing out local soil and water conservation efforts. For instance, wetlands might be designated as a conserva- tion district.

A city’s residential, commercial, and industrial dis- tricts may be divided, in turn, into subdistricts. For instance, zoning ordinances may regulate the type, den- sity, size, and approved uses of structures within a given district. Thus, a residential district may be divided into low-density (single-family homes with large lots), high- density (single- and multiple-family homes with small lots), and planned-unit (condominiums or apartments) subdistricts.

Other Zoning Restrictions Zoning rules extend to much more than the permissible use of land. In residential districts, for instance, an ordinance may require a house or garage to be set back a specific number of feet from a neighbor’s property line.

In commercial districts, zoning rules may attempt to maintain a certain visual aesthetic. Therefore, businesses may be required to construct buildings of a certain height and width so that they conform to the style of other com- mercial buildings in the area.

Businesses may also be required to provide parking for patrons or take other measures to manage traffic. Some- times, municipalities limit construction of new busi- nesses to prevent traffic congestion.

Zoning laws may even attempt to regulate the public morals of the community. For instance, cities commonly impose severe restrictions on the location and operation of adult businesses and medical (or recreational) mari- juana dispensaries.

26–5b Exceptions to Zoning Laws Zoning restrictions are not absolute. It is impossible for zoning laws to account for every contingency. The pur- pose of zoning is to control development, not to prevent it altogether or to limit the government’s ability to adapt to changing circumstances or unforeseen needs. Hence, legal processes have been developed to allow for excep- tions to zoning laws, such as variances and variances and variances special-use permits.

Variances A property owner who wants to use his or her land in a manner not permitted by zoning rules can request a variance, which allows an exception to the rules. The property owner making the request must demon- strate that the requested variance:

1. Is necessary for reasonable development. 2. Is the least intrusive solution to the problem. 3. Will not alter the essential character of the

neighborhood.

Hardship Situations. Property owners normally request variances in hardship situations—that is, when complying hardship situations—that is, when complying hardship situations with the zoning rules would be too di�cult or costly due with the zoning rules would be too di�cult or costly due with the zoning rules would be too di�cult or costly due with the zoning rules would be too di�cult or costly due to existing property conditions. ■ EXAMPLE 26.21 Lin, a homeowner, wants to replace her single-car garage with a two-car garage. If she does so, however, the garage will be closer to her neighbor’s property than is permitted by the zoning rules. In this situation, she may ask for a vari- ance. She can claim that the con�guration of her prop- erty would make it di�cult and costly to comply with the zoning code, so compliance would create a hardship for her. ■

Similarly, a church might request a variance from height restrictions in order to erect a new steeple. Or a furniture store might ask for a variance from footprint limitations so that it can expand its showroom. (A build- ing’s footprint is the area of ground that it covers.)

Note that the hardship may not be self-created. In other words, a person who buys property with zoning restrictions in effect cannot usually then argue that he or she needs a variance in order to use the property as intended.

Public Hearing. In almost all instances, before a variance is granted, there must be a public hearing with adequate notice to neighbors who may object to the exception. After the public hearing, a hearing examiner appointed by the municipality (or the local zoning board or commis- sion) determines whether to grant the exception. When a variance is granted, it applies only to the speci�c parcel of land for which it was requested and does not create a regulation-free zone.

Special-Use Permits Sometimes, zoning laws permit a certain use only if the property owner complies with specific requirements to ensure that the proposed use does not harm the immediate neighborhood. In such instances, the zoning board can issue special-use permits, also called conditional-use permits.

■ EXAMPLE 26.22 An area is designated as a residen An area is designated as a residen- tial district, but small businesses are permitted to operate there so long as they do not affect the characteristics of the neighborhood. A bank asks the zoning board for a special-use permit to open a branch in the area. At the public hearing, the bank demonstrates that the branch will be housed in a building that conforms to the style of other structures in the area. The bank also shows that

C H A P T E R 2 6 Real Property and Land-Use Control 565

adequate parking will be available and that landscap- ing will shield the parking lot from public view. Unless there are strong objections from the branch’s prospective neighbors, the board will likely grant the permit. ■

Special Incentives In addition to granting excep- tions to zoning regulations, municipalities may also wish

to encourage certain kinds of development. To do so, they offer incentives, often in the form of lower tax rates or tax credits. For instance, to attract new businesses that will provide jobs and increase the tax base, a city may offer lower property tax rates for a period of years. Similarly, homeowners may receive tax credits for historic preserva- tion if they renovate and maintain older homes.

Reviewing: Real Property and Landlord-Tenant Law

Vern Shoepke purchased a two-story home from Walter and Eliza Bruster in the town of Roche, Maine. The warranty deed did not specify what covenants would be included in the conveyance. The property was adjacent to a public park that included a popular Frisbee golf course. (Frisbee golf is a sport similar to golf but using Frisbees.) Wayakichi Creek ran along the north end of the park and along Shoepke’s property. The deed allowed Roche citizens the right to walk across a five-foot-wide section of the lot beside Wayakichi Creek as part of a two-mile public trail system. Teenagers regularly threw Frisbee golf discs from the walking path behind Shoepke’s property over his yard to the adjacent park. Shoepke habitually shouted and cursed at the teenagers, demanding that they not throw objects over his yard. Using the information presented in the chapter, answer the following questions. 1. What is the term for the right of Roche citizens to walk across Shoepke’s land on the trail? 2. What covenants would most courts infer were included in the warranty deed that was used in the property transfer

from the Brusters to Shoepke? 3. Suppose that Shoepke wants to file a trespass lawsuit against some teenagers who continually throw Frisbees over

his land. Shoepke discovers, however, that when the city put in the Frisbee golf course, the neighborhood home- owners signed an agreement that limited their right to complain about errant Frisbees. What is this type of promise or agreement called in real property law?

Debate This . . . Under no circumstances should a local government be able to condemn property in order to sell it later to real estate developers for private use.

Terms and Concepts adverse possession 559 closing 555 commercial use 563 community property 552 concurrent ownership 552 condemnation 561 conveyance 550 deed 558 easement 553 eminent domain 561 escrow account 556 fee simple absolute 550 �xed-term tenancy 553 �xture 549 grant deed 558 implication 554

implied warranty of habitability 556 industrial use 563 inverse condemnation 562 joint tenancy 552 leasehold estate 552 license 554 life estate 550 marketable title 556 metes and bounds 558 necessity 554 nonpossessory interest 553 periodic tenancy 553 prescription 554 pro�t 553 quitclaim deed 558 recording statute 559

residential use 563 restrictive covenant 563 special-use permit 564 special warranty deed 558 taking 561 tenancy at su�erance 553 tenancy at will 553 tenancy by the entirety 552 tenancy in common 552 title insurance 556 trade �xture 550 variance 564 warranty deed 558 waste 550 zoning laws 563

566 U N I T F I V E The Regulatory Environment

Issue Spotters 1. Bernie sells his house to Consuela under a warranty deed.

Later, Delmira appears, holding a better title to the house than Consuela has. Delmira wants to have Consuela evicted from the property. What can Consuela do? (See Transfer of Ownership.)

2. Grey owns a commercial building in fee simple. Grey transfers temporary possession of the building to Haven

Corporation. Can Haven transfer possession for even less time to Idyll Company? Explain. (See Ownership and Other Interests in Real Property.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 26–1. Property Ownership. Madison owned a tract of land, but he was not sure that he had full title to the property. When Rafael expressed an interest in buying the land, Madison sold it to Rafael and executed a quitclaim deed. Rafael properly recorded the deed immediately. Several months later, Madison learned that he had had full title to the tract of land. He then sold the land to Linda by warranty deed. Linda knew of the ear- lier purchase by Rafael but took the deed anyway and later sued to have Rafael evicted from the land. Linda claimed that because she had a warranty deed, her title to the land was better than that conferred by Rafael’s quitclaim deed. Will Linda succeed in claiming title to the land? Explain. (See Transfer of Ownership.) 26–2. Zoning. The county intends to rezone an area from industrial use to residential use. Land within the affected area is largely undeveloped, but nonetheless it is expected that the proposed action will reduce the market value of the affected land by as much as 50 percent. Will the landowners be suc- cessful in suing to have the action declared a taking of their property, entitling them to just compensation? Why or why not? (See Land-Use Control and Zoning.)Land-Use Control and Zoning.)Land-Use Control and Zoning

26–3. Eminent Domain. Some Catholic organizations propose to build a private independent middle school in a run-down neighborhood in Philadelphia, Pennsylvania. They asked the Redevelopment Authority of the City of Philadelphia to acquire specific land for the project and sell it to them for a nominal price. The land included a house on North Eighth Street owned by Mary Smith, whose daughter Veronica lived there with her family. The Authority offered Smith $12,000 for the house and initiated a taking of the property.

Smith filed a suit in state court against the Authority, admitting that the house was a “substandard structure in a blighted area,” but arguing that the taking was unconstitu- tional because its beneficiary was private. The Authority asserted that only the public purpose of the taking should be considered, not the status of the property’s developer. On what basis can a government entity use the power of eminent domain to take property? What are the limits to this power? How should the court rule? Why? (See Limitations on the Rights of Property Owners.)

Business Case Problems 26–4. Zoning and Variances. Joseph and Lois Ryan hired a contractor to build a home in Weston, Connecticut. �e contractor submitted plans to the town that included a roof height of thirty-eight feet for the proposed dwelling. �is exceeded the town’s roof-height restriction of thirty-�ve feet. �e contractor and the architect revised the plans to meet the restriction, and the town approved the plans and issued a zoning permit and a building permit. After the roof was con- structed, a code enforcement o�cer discovered that it mea- sured thirty-seven feet, seven inches high.

The officer issued a cease-and-desist order requiring the Ryans to “remove the height violation and bring the structure into compliance.” The Ryans appealed to the zoning board, claiming that the error was not theirs but that of their general contractor and architect. The zoning board upheld the cease- and-desist order but later granted the Ryans a variance because “the roof height was out of compliance by approximately two feet, . . . the home [was] perched high on the land and [was] not a detriment to the neighborhood, and . . . the hardship was created by the contractor’s error.”

Neighbors (including Curtis Morikawa) appealed to a court. They argued that the hardship claimed was solely eco- nomic. In addition, they argued that even though it was unin- tended, the hardship was self-created. The trial court ruled in favor of the neighbors, and the Ryans appealed. How should the court rule? Were there legitimate grounds for granting a variance? Discuss. [Morikawa v. Zoning Board of Appeals of Town of Weston, 126 Conn.App. 400, 11 A.3d 735 (2011)] (See Land-Use Control and Zoning.)

26–5. Business Case Problem with Sample Answer— Adverse Possession. �e McKeag family operated a

marina on their lakefront property in Bolton, New York. For more than forty years, the McKeags used a section of property belonging to their neighbors, the Finleys, as a beach for the

marina’s customers. �e McKeags also stored a large �oat on the beach during the winter months, built their own retaining wall, and planted bushes and �owers there. �e McKeags pre- vented others from using the property, including the Finleys.

C H A P T E R 2 6 Real Property and Land-Use Control 567

Nevertheless, the families always had a friendly relationship, and one of the Finleys gave the McKeags permission to con- tinue using the beach in 1992. He also reminded them of his ownership several times, to which they said nothing. �e McKeags also asked for permission to mow grass on the prop- erty and once apologized for leaving a jet ski there. Can the McKeags establish adverse possession over the statutory period of ten years? Why or why not? [McKeag v. Finley, 939 N.Y.S.2d 644 (N.Y.App.Div. 2012)] (See Transfer of Ownership.) • For a sample answer to Problem 26–5, go to Appendix E at

the end of this text.

26–6. Real Estate Sales Contracts. A California state statute requires sellers to provide a real estate “Transfer Dis- closure Statement” (TDS) to buyers of residential property consisting of one to four dwelling units. Required disclosures include information about signi�cant defects, including hazard- ous materials, encroachments, easements, �ll, settling, �ooding, drainage problems, neighborhood noise, damage from natural disasters, and lawsuits. Mark Hartley contracted with Randall Richman to buy Richman’s property in Ventura, California. �e property included a commercial building and a residen- tial duplex with two dwelling units. Richman did not provide a TDS, claiming that it was not required because the property was “mixed use”—that is, it included both a commercial building and a residential building. Hartley refused to go through with the deal. Did Hartley breach their contract, or did Richman’s failure to provide a TDS excuse Hartley’s nonperformance? Discuss. [Richman v. Hartley, 224 Cal.App.4th 1182, 169 Cal. Rptr.3d 475 (2 Dist. 2014)] (See Transfer of Ownership.) 26–7. Ownership and Other Interests in Real Property. Arthur and Diana Ebanks owned three properties in the Cay- man Islands in joint tenancy. With respect to joint tenan- cies, Cayman law is the same as U.S. law. When the Ebanks divorced, the decree did not change the tenancy in which the properties were held. On the same day as the divorce �ling, Arthur executed a will providing that “any property in my name and that of another as joint tenants . . . will pass to the survivor, and I instruct my Personal Representative to make

no claim thereto.” Four years later, Arthur died. His brother Curtis, the personal representative of his estate, asserted that Arthur’s interest in the Cayman properties was part of the estate. Diana said that the sole interest in the properties was hers. Who do the Cayman properties belong to? Why? [Ebanks v. Ebanks, __ So.3d __, 41 Fla. L. Weekly D291 (2 Dist. 2016)] (See Ownership and Other Interests in Real Property.)

26–8. Special Case Analysis—Adverse Possession. Go to Case Analysis 26.3, Montgomery County v. Bhatt. Read the excerpt, and answer the following questions.

(a) Issue: What conflict, and between which parties, did this case highlight?

(b) Rule of Law: On which specific requirement of what rule of law did the outcome in this case depend?

(c) Applying the Rule of Law: What exception to the applied rule of law might have resulted in a decision in the plaintiff ’s favor? Why did that exception not apply in this case?

(d) Conclusion: In light of the rule of law applied in this case, what was the judgment?

26–9. A Question of Ethics—Adverse Possession. Alana Mansell built a garage on her property that encroached on the property of her neighbor, Betty Hunter, by fourteen feet. Hunter knew of the encroachment and informally agreed to it, but she

did not transfer ownership of the property to Mansell. A survey twenty-eight years later con�rmed the encroachment, and Hunter sought the removal of the garage. Mansell asked a court to declare that she was the owner of the property by adverse possession. [Hunter v. Mansell, [Hunter v. Mansell, [ 240 P.3d 469 (Colo.App. 2010)] (See 240 P.3d 469 (Colo.App. 2010)] (See 240 P.3d 469 (Colo.App. 2010)] Transfer of Ownership.)

(a) Did Mansell obtain title by adverse possession? Would the open occupation of the property for nearly thirty years be in Mansell’s favor? Why or why not?

(b) Was Mansell’s conduct in any way unethical? Discuss.

Legal Reasoning Group Activity 26–10. Adverse Possession. �e Wallen family owned a cabin on Lummi Island in the state of Washington. A drive- way ran from the cabin across their property to South Nugent Road. Floyd Massey bought the adjacent lot and built a cabin on it in 1980. To gain access to his property, Massey used a bulldozer to extend the driveway, without the Wallens’ per- mission but also without their objection. In 2005, the Wal- lens sold their property to Wright Fish Company. Massey continued to use and maintain the driveway without permis- sion or objection. In 2011, Massey sold his property to Robert Drake. Drake and his employees continued to use and main- tain the driveway without permission or objection, although Drake knew it was located largely on Wright’s property. In 2013, Wright sold its lot to Robert Smersh. �e next year, Smersh told Drake to stop using the driveway. Drake �led a suit against Smersh, claiming an easement by prescription

(which is created by meeting the same requirements as adverse possession). (See Transfer of Ownership.) (a) The first group will decide whether Drake’s use of the

driveway meets all of the requirements for adverse posses- sion (easement by prescription).

(b) The second group will determine how the court should rule in this case and why. Does it matter that Drake knew the driveway was located largely on Wright’s (and then Smersh’s) property? Should it matter? Why or why not?

(c) A third group will evaluate the underlying policy and fair- ness of adverse possession laws. Should the law reward persons who take possession of someone else’s land for their own use? Does it make sense to punish owners who allow someone else to use their land without complaint? Explain.

568

C H A P T E R 2 7

27–1a Major Provisions of the Sherman Act Sections 1 and 2 contain the main provisions of the Sher- man Act: 1. Every contract, combination in the form of trust

or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations, is hereby declared to be illegal [and is a fel- ony punishable by fine and/or imprisonment].

2. Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations, shall be deemed guilty of a felony [and is similarly punishable].

27–1b Differences between Section 1 and Section 2

The two sections of the Sherman Act are quite different. Section 1 requires two or more persons, because a person cannot contract, combine, or conspire alone. Thus, the

27–1 The Sherman Antitrust Act The author of the Sherman Antitrust Act, Senator John Sherman, was the brother of the famed Civil War general William Tecumseh Sherman. He was also a recognized financial authority. He had been concerned for years about what he saw as diminishing competition within U.S. industry and the emergence of monopolies. He told Congress that the Sherman Act “does not announce a new principle of law, but applies old and well-recognized principles of the common law.”5

Indeed, today’s antitrust laws are the direct descen- dants of common law actions intended to limit restraints of trade (agreements between or among firms that have the effect of reducing competition in the marketplace). Such actions date to the fifteenth century in England. The common law was not always consistent, however, and had not been effective in curbing the trusts. That is why Sherman proposed the Sherman Antitrust Act, often simply called the Sherman Act.

5. 21 Congressional Record 2456 (1890).Congressional Record 2456 (1890).Congressional Record

A fter the Civil War (1861–1865), the American public became increasingly concerned about

declining competition in the market- place. Large corporate enterprises were attempting to reduce or elimi- nate competition by legally tying themselves together in business trusts.

The most famous trust was the Standard Oil trust of the late 1800s. Participants in the trust transferred their stock to a trustee. The trustee then fixed prices, controlled pro- duction, and established exclusive geographic markets for all of the oil companies that were members of

the trust. Some observers began to argue that the trust wielded so much economic power that corporations outside the trust could not compete effectively.

Eventually, legislators at both the state and the federal level began to enact laws to rein in the trusts. Hence, the laws regulating economic compe- tition in the United States today are referred to as antitrust laws.

At the national level, antitrust legislation began when Congress passed the Interstate Commerce Act1

1. 49 U.S.C. Sections 501–526

in 1887, followed by the Sherman Antitrust Act2 in 1890. In 1914, Con- gress passed the Clayton Act3 and the Federal Trade Commission Act.4

The purpose of antitrust legislation was—and still is—to foster competi- tion. Behind these laws lies our soci- ety’s belief that competition leads to lower prices, better products, a wider selection of goods, and more product information.

2. 15 U.S.C. Sections 1–7. 3. 15 U.S.C. Sections 12–27. 4. 15 U.S.C. Sections 41–58a.

Antitrust Law

C H A P T E R 2 7 Antitrust Law 569

essence of the illegal activity is the act of joining together. Section 2, though, can apply either to one person or to two or more persons because it refers to “every person.” Thus, unilateral conduct can result in a violation of Sec- tion 2.

It follows that the cases brought to the courts under Section 1 of the Sherman Act differ from those brought under Section 2. Section 1 cases are often concerned with whether an agreement (written or oral) leads to a restraint of trade. Section 2 cases deal with the structure of a monopoly that exists in the marketplace.

The term monopoly generally is used to describe a monopoly generally is used to describe a monopoly market in which there is a single seller or a very limited number of sellers. Whereas Section 1 focuses on agree- ments that are restrictive—that is, agreements that have a wrongful purpose—Section 2 looks at the so-called mis- use of monopoly power in the marketplace. Monopoly monopoly power in the marketplace. Monopoly monopoly power power exists when a firm has an extreme amount of mar- ket power—the ability to affect the market price of its ket power—the ability to affect the market price of its ket power product.

Both Section 1 and Section 2 seek to curtail market practices that result in undesired monopoly pricing and output behavior. For a case to be brought under Sec- tion 2, however, the “threshold” or “necessary” amount of monopoly power must already exist. We illustrate the different requirements for violating these two sections of the Sherman Act in Exhibit 27–1.

27–1c Jurisdictional Requirements The Sherman Act applies only to restraints that have a significant impact on interstate commerce. Courts have generally held that any activity that substantially affects interstate commerce falls within the scope of the Sherman Act. As will be discussed later in this chapter, the Sher- man Act also extends to U.S. nationals abroad who are engaged in activities that affect U.S. foreign commerce.

Federal courts have exclusive jurisdiction over anti- trust cases brought under the Sherman Act. State laws regulate local restraints on competition, and state courts decide claims brought under those laws.

27–2 Section 1 of the Sherman Act The underlying assumption of Section 1 of the Sherman Act is that society’s welfare is harmed if rival firms are permitted to join in an agreement that consolidates their market power or otherwise restrains competition. The types of trade restraints that Section 1 of the Sherman Act prohibits generally fall into two broad categories: horizontal restraints and horizontal restraints and horizontal restraints vertical restraints, both of which will be discussed shortly. First, though, we look at the rules that the courts may apply when assessing the anti- competitive impact of alleged restraints of trade.

27–2a Per Se Violations versus the Rule of Reason

Some restraints are so substantially anticompetitive that they are deemed per se violations—illegal per se (inherper se (inherper se - ently)—under Section 1. Other agreements, however, even though they result in enhanced market power, do not unreasonably restrain trade and are therefore lawful. unreasonably restrain trade and are therefore lawful. unreasonably Using the rule of reason, the courts analyze anticom- petitive agreements that allegedly violate Section 1 of the Sherman Act to determine whether they actually consti- tute reasonable restraints of trade.

Rationale for the Rule of Reason The need for a rule-of-reason analysis of some agreements in restraint of trade is obvious. If the rule of reason had not been

SECTION 1 VIOLATION REQUIREMENTS

1. An agreement between two or more parties that

2. Unreasonably restrains competition and

3. Affects interstate commerce.

SECTION 2 VIOLATION REQUIREMENTS

1. The possession of monopoly power in the relevant market, and

2. The willful acquisition or maintenance of that power as distinguished from its growth or development as a consequence of a superior product, business acumen, or historic accident.

E X H I B I T 2 7 – 1 Required Elements of a Sherman Act Violation

570 U N I T F I V E The Regulatory Environment

developed, almost any business agreement could conceiv- ably be held to violate the Sherman Act. United States Supreme Court Justice Louis Brandeis effectively phrased this sentiment in Chicago Board of Trade v. United States, a case decided in 1918:

Every agreement concerning trade, every regulation of trade, restrains. To bind, to restrain, is of their very essence. The true test of legality is whether the restraint imposed is such as merely regulates and perhaps thereby promotes competition or whether it is such as may sup- press or even destroy competition.6

Factors That Courts Consider When analyzing an alleged Section 1 violation under the rule of reason, a court will consider the following factors: 1. The purpose of the agreement. 2. The parties’ ability to implement the agreement to

achieve that purpose. 3. The effect or potential effect of the agreement on

competition. 4. Whether the parties could have relied on less restric-

tive means to achieve their purpose. ■ CASE IN POINT 27.1 A group of consumers sued A group of consumers sued

NBC Universal, the Walt Disney Company, and other broadcasters, as well as cable and satellite distributors. The consumers claimed that the bundling together of high-demand and low-demand television channels in cable and satellite programming packages violates the Sherman Act. Bundling forces consumers to pay for channels they do not watch to have access to channels they watch regularly.

The consumers argued that the defendants, through their control of high-demand programming, exercised market power that made it impossible for any distribu- tor to offer unbundled programs. A federal appellate court ruled in favor of the defendants and dismissed the case. The court reasoned that the Sherman Act applies to actions that diminish competition and that the bundling of channels does not injure competition.7 ■

27–2b Horizontal Restraints The term horizontal restraint is encountered frequently horizontal restraint is encountered frequently horizontal restraint in antitrust law. A horizontal restraint is any agree- ment that in some way restrains competition between rival firms competing in the same market. Horizontal restraints may include price-fixing, group boycotts, mar- ket divisions, and trade associations.

6. 246 U.S. 231, 38 S.Ct. 242, 62 L.Ed. 683 (1918). 7. Brantley v. NBC Universal, Inc., 675 F.3d 1192 (9th Cir. 2012).

Price Fixing Any price-fixing agreement—an agreeprice-fixing agreement—an agreeprice-fixing agreement - ment among competitors to fix prices—constitutes a per se violation of Section 1. The agreement on price need not se violation of Section 1. The agreement on price need not se be explicit. As long as it restricts output or artificially fixes price, it violates the law.

The Reason Behind the Agreement Is Not a Defense. A price-�xing agreement is always a violation of Section 1, price-�xing agreement is always a violation of Section 1, price-�xing agreement is always a violation of Section 1, price-�xing agreement is always a violation of Section 1, even if there are good reasons behind it. even if there are good reasons behind it. ■ CASE IN POINT 27.2 In a classic price-�xing case, independent oil pro- ducers in Texas and Louisiana were caught between fall- ing demand due to the Great Depression of the 1930s and increasing supply from newly discovered oil �elds. A group of the major re�ning companies agreed to buy “dis- tress” gasoline (excess supplies) from the independents so as to dispose of it in an “orderly manner.” Although there was no explicit agreement as to price, it was clear that the purpose of the agreement was to limit the supply of gaso- line on the market and thereby raise prices.

There may have been good reasons for the agree- ment. Nonetheless, the United States Supreme Court recognized the potentially adverse effects that such an agreement could have on open and free competition. The Court held that the reasonableness of a price-fixing agreement is never a defense. Any agreement that restricts output or artificially fixes price is a per se violation of Secper se violation of Secper se - tion 1.8 ■

Price-Fixing Cartels Today. Price-�xing cartels (groups) are still commonplace in today’s business world, par- ticularly among global companies. �e U.S. govern- ment actively pursues companies that it suspects of being involved in price-�xing cartels. International price-�xing cartels have been alleged in numerous industries, includ- ing air freight, auto parts, computer monitors, digital commerce, and drug manufacturers.commerce, and drug manufacturers.commerce, and drug manufacturers.commerce, and drug manufacturers.

■ CASE IN POINT 27.3 After Amazon.com released the Kindle e-book reader, it began selling e-book down- loads at $9.99 (lower than the actual cost) and made up the difference by selling more Kindles. When the iPad entered the e-book scene, Apple and some book publish- ers agreed to use Apple’s “agency” model, which Apple was already using for games and apps. The agency model allowed the book publishers to set their own prices while Apple kept 30 percent as a commission.

The U.S. government sued Apple and the publish- ers for price fixing. Because the publishers involved in the arrangement chose prices that were relatively simi- lar, the government argued that price fixing was evident

8. United States v. Socony-Vacuum Oil Co., 310 U.S. 150, 60 S.Ct. 811, 84 L.Ed. 1129 (1940).

C H A P T E R 2 7 Antitrust Law 571

and “would not have occurred without the conspiracy among the defendants.” Ultimately, a federal appellate court held that Apple’s agreement with publishers to raise e-book prices was a per se illegal price-fixing conspiracy. per se illegal price-fixing conspiracy. per se As a result, Apple was ordered to pay $400 million to consumers and $50 million in attorneys’ fees.9 ■

Group Boycotts A group boycott is an agreement group boycott is an agreement group boycott by two or more sellers to refuse to deal with (that is, to boycott) a particular person or firm. Because they involve concerted action, group boycotts have been held to con- stitute per se violations of Section 1 of the Sherman Act.per se violations of Section 1 of the Sherman Act.per se

To prove a violation of Section 1, the plaintiff must demonstrate that the boycott or joint refusal to deal was undertaken with the intention of eliminating competition or preventing entry into a given market. Although most boycotts are illegal, a few, such as group boycotts against a supplier for political reasons, may be protected under the First Amendment right to freedom of expression.

Horizontal Market Division It is a per se violation of per se violation of per se Section 1 of the Sherman Act for competitors to divide up territories or customers. ■ EXAMPLE 27.4 Axm Electron- ics Basics, Halprin Servo Supplies, and Aicarus Prime Elec- tronics compete against each other in the states of Kansas, Nebraska, and Oklahoma. The three firms agree that Axm will sell products only in Kansas, Halprin will sell only in Nebraska, and Aicarus will sell only in Oklahoma.

This concerted action violates Section 1 of the Sher- man Act. It reduces marketing costs and allows all three firms (assuming there is no other competition) to raise the price of the goods sold in their respective states. The same violation would take place if the three firms divided up their customers by class rather than region. They might agree that Axm would sell only to institutional purchasers (such as governments and schools) in all three states, Halprin only to wholesalers, and Aicarus only to retailers. The result would be the same. ■

Trade Associations Businesses in the same general industry or profession frequently organize trade associa- tions to pursue common interests. A trade association may engage in various joint activities, such as exchanging information, representing the members’ business interests before governmental bodies, and conducting advertising campaigns. Trade associations also frequently are involved in setting regulatory standards to govern the industry or profession.

9. United States v. Apple, Inc., 791 F.3d 290 (2d Cir. 2015). Apple had previously agreed to settle the case for these amounts if its appeal was unsuccessful.

Generally, the rule of reason is applied to many of these horizontal actions. If a court finds that a trade association practice or agreement that restrains trade is sufficiently beneficial both to the association and to the public, it may deem the restraint reasonable.

In concentrated industries, however, trade associations can be, and have been, used as a means to facilitate anti- competitive actions, such as fixing prices or allocating markets. A concentrated industry is one in which either concentrated industry is one in which either concentrated industry a single firm or a small number of firms control a large percentage of market sales. When trade association agree- ments have substantially anticompetitive effects, a court will consider them to be in violation of Section 1 of the Sherman Act.

Joint Ventures Joint ventures undertaken by com- petitors are also subject to antitrust laws. If a joint ven- ture does not involve price fixing or market divisions, the agreement will be analyzed under the rule of reason. Whether the joint undertaking violates Section 1 will then depend on the factors stated earlier in this chapter. A court will look at the venture’s purpose, the potential benefits relative to the likely harms, and whether there are less restrictive alternatives for achieving the same goals.

27–2c Vertical Restraints A vertical restraint of trade results from an agreement vertical restraint of trade results from an agreement vertical restraint between firms at different levels in the manufacturing and distribution process. In contrast to horizontal relation- ships, which occur at the same level of operation, vertical relationships encompass the entire chain of production.

The chain of production normally includes the pur- chase of inventory, basic manufacturing, distribution to wholesalers, and eventual sale of a product at the retail level. For some products, these distinct phases are car- ried on by different firms. In other instances, a single firm carries out two or more of the separate functional phases. Such enterprises are said to be vertically inte- grated firms.

Even though firms operating at different functional levels are not in direct competition with one another, they are in competition with other firms. Thus, agree- ments between firms standing in a vertical relationship may affect competition. Some vertical restraints are per se violations of Section 1. Others are judged under the se violations of Section 1. Others are judged under the se rule of reason.

Territorial or Customer Restrictions In arrang- ing for the distribution of its products, a manufactur- ing firm often wishes to insulate dealers from direct

572 U N I T F I V E The Regulatory Environment

competition with other dealers selling its products. To do so, the manufacturer may institute territorial restric- tions or attempt to prohibit wholesalers or retailers from reselling the products to certain classes of buyers, such as competing retailers.

May Have Legitimate Purpose. A �rm may have legiti- mate reasons for imposing territorial or customer restric- tions. For instance, an electronics manufacturer may wish to prevent a dealer from reducing costs and under- cutting rivals by o�ering its products without promotion or customer service. In this situation, the cost-cutting dealer reaps the bene�ts (sales of the product) paid for by other dealers who undertake promotion and arrange for customer service. By not providing customer service (and relying on a nearby dealer to provide these services), the cost-cutting dealer may also harm the manufacturer’s reputation.

Judged under the Rule of Reason. Territorial and cus- tomer restrictions were once considered per se violations per se violations per se of Section 1.10 In 1977, the United States Supreme Court held that they should be judged under the rule of reaheld that they should be judged under the rule of reaheld that they should be judged under the rule of reaheld that they should be judged under the rule of rea- son. ■ CASE IN POINT 27.5 �e Supreme Court case involved GTE Sylvania, Inc., a manufacturer of television sets. Sylvania limited the number of retail franchises that it granted in any given geographic area. It also required each franchisee to sell only Sylvania products from the location at which it was franchised. Sylvania retained sole discretion to increase the number of retailers in an area.

When Sylvania decided to open a new franchise, it terminated the franchise of Continental T.V., Inc., an existing franchisee in that area that would have been in competition with the new franchise. Continental filed a lawsuit claiming that Sylvania’s vertically restrictive fran- chise system violated Section 1 of the Sherman Act. The United States Supreme Court found that “vertical restric- tions promote interbrand competition by allowing the manufacturer to achieve certain efficiencies in the dis- tribution of his products.” Therefore, Sylvania’s vertical system, which was not price restrictive, did not constitute a per se violation of Section 1 of the Sherman Act.per se violation of Section 1 of the Sherman Act.per se 11 ■

The decision in the Continental case marked a definite Continental case marked a definite Continental shift from rigid characterization of territorial and cus- tomer restrictions to a more flexible, economic analysis

10. See United States v. Arnold, Schwinn & Co., 388 U.S. 365, 87 S.Ct. 1856, 18 L.Ed.2d 1249 (1967).

11. Continental T.V., Inc. v. GTE Sylvania, Inc., 433 U.S. 36, 97 S.Ct. 2549, 53 L.Ed.2d 568 (1977).

of these vertical restraints under the rule of reason. This rule is still applied in most vertical restraint cases.

Resale Price Maintenance Agreements An agree- ment between a manufacturer and a distributor or retailer in which the manufacturer specifies what the retail prices of its products must be is known as a resale price mainte- nance agreement. Such agreements were once considered to be per se violations of Section 1 of the Sherman Act.per se violations of Section 1 of the Sherman Act.per se

Today, however, both maximum resale price main- tenance agreements and minimum resale price mainte- nance agreements are judged under the rule of reason.12 The setting of a maximum price that retailers and dis- tributors can charge for a manufacturer’s products may sometimes increase competition and benefit consumers.

27–3 Section 2 of the Sherman Act Section 1 of the Sherman Act proscribes certain con- certed, or joint, activities that restrain trade. In contrast, Section 2 condemns “every person who shall monopo- lize, or attempt to monopolize.” Thus, two distinct types of behavior are subject to sanction under Section 2: monopolization and attempts to monopolize.

One tactic that may be involved in either offense is predatory pricing. Predatory pricing occurs when one Predatory pricing occurs when one Predatory pricing firm (the predator) attempts to drive its competitors from the market by selling its product at prices substan- tially below the normal costs of production. Once the below the normal costs of production. Once the below competitors are eliminated, the predator presumably will raise its prices far above their competitive levels to recap- ture its losses and earn higher profits.

27–3a Monopolization The United States Supreme Court has defined monopo- lization as involving the following two elements: 1. The possession of monopoly power in the relevant

market. 2. “The willful acquisition or maintenance of the power

as distinguished from growth or development as a

12. The United States Supreme Court ruled that maximum resale price agreements should be judged under the rule of reason in State Oil Co. v. Khan, 522 U.S. 3, 118 S.Ct. 275, 139 L.Ed.2d 199 (1997). In Leegin Creative Leather Products, Inc. v. PSKS, Inc., 551 U.S. 877, 127 S.Ct. 2705, 168 L.Ed.2d 623 (2007), the Supreme Court found that the rule of reason also applies to minimum resale price agreements.

C H A P T E R 2 7 Antitrust Law 573

consequence of a superior product, business acumen, or historic accident.”13

To establish a violation of Section 2, a plaintiff must prove both of these elements—monopoly power and an intent to monopolize.intent to monopolize.intent

Defining Monopoly Power The Sherman Act does not define monopoly. In economic theory, monopoly refers to control of a specific market by a single entity. It is well established in antitrust law, however, that a firm may be a monopolist even though it is not the sole seller in a market.

Additionally, size alone does not determine whether a firm is a monopoly. ■ EXAMPLE 27.6 A “mom and pop” A “mom and pop” grocery located in the isolated town of Happy Camp, Idaho, is a monopolist if it is the only grocery serving that particular market. Size in relation to the market is what matters, because monopoly involves the power to affect prices. ■

Proving Monopoly Power Monopoly power can be proved by direct evidence that the firm used its power to control prices and restrict output.14 Usually, though, there is not enough evidence to show that the firm intentionally controlled prices, so the plaintiff has to offer indirect, or circumstantial, evidence of monopoly power.

To prove monopoly power indirectly, the plaintiff must show that the firm has a dominant share of the rel- evant market and that there are significant barriers for evant market and that there are significant barriers for evant market and that there are significant barriers for evant market and that there are significant barriers for new competitors entering that market. new competitors entering that market. ■ CASE IN POINT 27.7 DuPont manufactures and sells para-aramid fiber, DuPont manufactures and sells para-aramid fiber, a synthetic fiber used to make body armor, fiber-optic cables, and tires, among other things. Although several companies around the world manufacture this fiber, only three sell in the U.S. market—DuPont (based in the United States), Teijin (based in the Netherlands), and Kolon Industries, Inc. (based in Korea). DuPont is the industry leader, and at times has produced 60 percent of all para-aramid fibers purchased in the United States.

After DuPont brought suit against Kolon for theft and misappropriation of trade secrets, Kolon counterclaimed that DuPont had illegally monopolized and attempted to monopolize the U.S. para-aramid market in violation of Section 2. Kolon claimed that, to deter competition, DuPont had illegally used multiyear supply agreements for all of its high-volume para-aramid customers. A

13. United States v. Grinnell Corp., 384 U.S. 563, 86 S.Ct. 1698, 16 L.Ed.2d 778 (1966).

14. See, for instance, Broadcom Corp. v. Qualcomm, Inc., 501 F.3d 297 (3d Cir. 2007).

federal appellate court, however, found that there was insufficient proof that DuPont had possessed monopoly power in the U.S. market during the relevant time period (between 2006 and 2009). Additionally, the court con- cluded that Kolon had not shown that the supply agree- ments foreclosed competition. Therefore, the court held in favor of DuPont on the antitrust claims. 15 ■

Relevant Market Before a court can determine whether a firm has a dominant market share, it must define the relevant market. The relevant market consists of two elements: (1) a relevant product market and (2) a relevant geographic market.

Relevant Product Market. �e relevant product mar- ket includes all products that have identical attributes (all brands of tea, for instance), as well as products that are reasonably interchangeable with them. Products are considered reasonably interchangeable if consumers treat them as acceptable substitutes. For instance, tea and co�ee are reasonably interchangeable, so they may be included in the same relevant product market.

Establishing the relevant product market is often the key issue in monopolization cases because the way the market is defined may determine whether a firm has monopoly power. When the product market is defined narrowly, the degree of a firm’s market power appears greater.greater.greater.greater.

■ EXAMPLE 27.8 White Whale Apps acquires Spring White Whale Apps acquires Spring- leaf Apps, its main competitor in nationwide Android- based mobile phone apps. White Whale maintains that the relevant product market consists of all online retailers of mobile phone apps. The Federal Trade Commission (FTC), however, argues that the relevant product mar- ket consists of retailers that sell only apps for Android mobile phones. Under the FTC’s narrower definition, White Whale can be seen to have a dominant share of the relevant product market. Thus, the FTC can take appropriate actions against White Whale. ■

In the following case, the FTC alleged that the lead- ing U.S. producer of domestic ductile iron pipe fittings sought to maintain monopoly power in violation of anti- trust law. The FTC filed this action under Section 5 of the Federal Trade Commission Act. Section 5, like Sec- tion 2 of the Sherman Act, requires proof of both the possession of monopoly power in the relevant market and the willful acquisition or maintenance of that power.

15. Kolon Industries, Inc. v. E.I. DuPont de Nemours & Co., 748 F.3d 160 (4th Cir. 2014).

574 U N I T F I V E The Regulatory Environment

In the Language of the Court MARCUS, Circuit Judge:

* * * * * * * Pipe fittings join together pipes

and help direct the flow of pressurized water in pipeline systems. They are sold primarily to municipal water authorities and their contractors. Although there are several thousand unique configura- tions of fittings (different shapes, sizes, coatings, etc.), approximately 80% of the demand is for about 100 commonly used fittings.

Fittings are commodity products produced to American Water Works Association (“AWWA”) standards, and any fitting that meets AWWA specifica- tions is interchangeable, regardless of the country of origin.

* * * Certain municipal, state, and federal laws require [government] water- works projects to use domestic-only fittings. Domestic fittings sold for use in projects with domestic-only speci- fications command higher prices than imported fittings.

* * * * * * * In late 2009, McWane [Inc.,

headquartered in Birmingham, Ala- bama,] was the only supplier of domestic fittings.

* * * Looking to take advantage of the increased demand for domestic fit- tings prompted by [the passage of the American Recovery and Reinvestment Act of 2009 (ARRA), which provided a large infusion of money for waterworks projects that required domestic pipe fittings, Star Pipe Products] decided to enter the market for domestic [fittings].

In response to Star’s forthcoming entry into the * * * market, McWane implemented its “Full Support Program” in order “to protect its domestic brands and market position.” * * * McWane informed customers that if they did not “fully support McWane branded

products for their domestic fitting and accessory requirements,” they “may forgo participation in any unpaid rebates they had accrued for domestic fittings and accessories or shipment of their domestic fitting and accessory orders of McWane products for up to 12 weeks.”

* * * * * * * The FTC issued a * * * com-

plaint charging * * * that McWane’s * * * Full Support Program constituted unlawful maintenance of a monopoly over the domestic fittings market.

* * * * * * * The Commission found that

the relevant market was the supply of domestically manufactured fittings for use in domestic-only waterworks proj- ects, because imported fittings are not a substitute for domestic fittings for such projects. The Commission noted that this conclusion was bolstered by the higher prices charged for domestic fittings used in domestic-only proj- ects. The Commission also found that McWane had monopoly power in that market, with 90–95% market share * * * and [that there were] substantial barri- ers to entry in the form of major capital outlays required to produce domestic fittings.

The Commission [also found] that McWane’s Full Support Program * * * foreclosed Star’s access to distributors for domestic fittings and harmed com- petition, thereby contributing signifi- cantly to the maintenance of McWane’s monopoly power in the market. It noted that * * * the country’s two largest water- works distributors (with a combined 60% market share), prohibited their branches from purchasing domestic fittings from Star after the Full Sup- port Program was announced * * * . Unable to attract [customers], Star was prevented from generating the revenue needed to acquire its own foundry, a

more efficient means of producing domes- tic fittings; thus, its growth into a rival that could challenge McWane’s monopoly power was artifi- cially stunted.

Moreover, the Commission found that * * * McWane’s * * * conduct had an impact on price: after the Full Support Program was implemented, McWane raised domestic fittings prices and increased its gross profits despite flat production costs, and it did so across states, regardless of whether Star had entered the market as a competitor.

* * * * [The Commission issued an order

directing McWane to stop requiring exclusivity from its customers.] McWane filed a timely petition in this Court seek- ing review of the Commissioner’s order.

* * * * * * * Given the identification of per-

sistent price differences between domestic fittings and imported fittings, the distinct customers, and the lack of reasonable sub- stitutes in this case, there was sufficient evi- dence to support the Commission’s market definition. [Emphasis added.]

* * * * * * * The evidence of McWane’s

overwhelming market share (90%), the large capital outlays required to enter the domestic fittings market, and McWane’s undeniable continued power over domestic fittings prices amount to suf-domestic fittings prices amount to suf-domestic fittings prices amount to suf ficient evidence that a reasonable mind might accept as adequate to support the Commission’s conclusion [that McWane possessed monopoly power in the rel- evant market].

* * * * * * * We agree that [McWane’s] con-

duct amounts to a violation of Section 5 of the Federal Trade Commission Act.

Accordingly, we AFFIRM.

Case Analysis 27.1 McWane, Inc. v. Federal Trade Commission United States Court of Appeals, Eleventh Circuit, 783 F.3d 814 (2015).

C H A P T E R 2 7 Antitrust Law 575

Relevant Geographic Market. �e second component of the relevant market is the geographic extent of the mar- ket in which the �rm and its competitors sell the product or services. For products that are sold nationwide, the geographic boundaries of the market can encompass the entire United States.

If transportation costs are significant or a producer and its competitors sell in only a limited area (one in which customers have no access to other sources of the product), then the geographic market is limited to that area. A national firm may thus compete in several dis- tinct areas and have monopoly power in one geographic area but not in another.

Generally, the geographic market is that section of the country within which a firm can increase its price a bit without attracting new sellers or losing many customers to alternative suppliers outside that area. Of course, the Internet is changing perceptions of the size and limits of a geographic market. It may become difficult to perceive any geographic market as local, except for products that are not easily transported, such as concrete.

The Intent Requirement Monopoly power, in and of itself, does not constitute the offense of monopoliza- tion under Section 2 of the Sherman Act. The offense also requires an intent to monopolize.intent to monopolize.intent

A dominant market share may be the result of good business judgment or the development of a superior prod- uct. It may simply be the result of a historical accident. In these situations, the acquisition of monopoly power is not an antitrust violation. Indeed, it would be contrary to society’s interest to condemn every firm that acquired a position of power because it was well managed and effi- cient and marketed a product desired by consumers.

If a firm possesses market power as a result of carrying out some purposeful act to acquire or maintain that power through anticompetitive means, then it is in violation of

Section 2. In most monopolization cases, intent may be inferred from evidence that the firm had monopoly power and engaged in anticompetitive behavior.

Unilateral Refusals to Deal As discussed previ- ously, joint refusals to deal (group boycotts) are subject to close scrutiny under Section 1 of the Sherman Act. A single manufacturer acting unilaterally, though, normally is free to deal, or not to deal, with whomever it wishes.16

Nevertheless, in some instances, a unilateral refusal to deal will violate Section 2 of the Sherman Act. These instances occur only if (1) the firm refusing to deal has— or is likely to acquire—monopoly power and (2) the refusal is likely to have an anticompetitive effect on a par- ticular market.

■ EXAMPLE 27.9 Clark Industries owns three of the Clark Industries owns three of the four major downhill ski areas in Blue Hills, Idaho. Clark refuses to continue participating in a jointly offered six-day “all Blue Hills” lift ticket. Clark’s refusal to cooperate with its smaller competitor is a violation of Section 2 of the Sher- man Act. Because Clark owns three-fourths of the local ski areas, it has monopoly power. Thus, its unilateral refusal to deal has an anticompetitive effect on the market. ■

27–3b Attempts to Monopolize Section 2 also prohibits attempted monopolization of a market, which requires proof of the following three elements: 1. Anticompetitive conduct. 2. The specific intent to exclude competitors and garner

monopoly power.

16. For a classic case in this area, see United States v. Colgate & Co., 250 U.S. 300, 39 S.Ct. 465, 63 L.Ed. 992 (1919). See also Pacific Bell Tele- phone Co. v. Linkline Communications, Inc., 555 U.S. 438, 129 S.Ct. 1109, 172 L.Ed.2d 836 (2009).

Legal Reasoning Questions

1. How did McWane’s Full Support Program harm competition? Explain. 2. What did the Federal Trade Commission conclude? What “factual and economic” evidence supported this conclusion? 3. Instead of imposing an exclusivity policy, what action might McWane have taken to benefit its customers and compete

with Star?

Case 27.1 Continued

576 U N I T F I V E The Regulatory Environment

3. A “dangerous” probability of success in achieving monopoly power. The probability cannot be danger- ous unless the alleged offender possesses some degree of market power. Only serious threats of monopoliza- tion are condemned as violations.

As mentioned earlier, predatory pricing is a form of anticompetitive conduct that, in theory, could be used by firms that are attempting to monopolize. Related to predatory pricing is predatory bidding. This practice predatory bidding. This practice predatory bidding involves the acquisition and use of monopsony power,

which is market power on the buy side of a market. Predbuy side of a market. Predbuy - atory bidding occurs when a buyer bids up the price of an input too high for its competitors to pay, causing them to leave the market. The predatory bidder then attempts to drive down input prices to reap above-competitive prof-drive down input prices to reap above-competitive prof-drive down input prices to reap above-competitive prof its and recoup any losses it suffered in bidding up the input prices.

The question in the following Spotlight Case was Spotlight Case was Spotlight Case whether a claim of predatory bidding was sufficiently similar to a claim of predatory pricing that the same anti- trust test should apply to both.

Background and Facts Weyerhaeuser Company entered the Pacific Northwest’s hardwood lumber market in 1980. By 2000, Weyerhaeuser owned six mills processing 65 percent of the red alder logs in the region. Meanwhile, Ross-Simmons Hardwood Lumber Company operated a single competing mill. When the prices of the logs rose and those for the lumber fell, Ross-Simmons suffered heavy losses. Several million dollars in debt, the mill closed in 2001.

Ross-Simmons filed a suit in a federal district court against Weyerhaeuser, alleging attempted monopolization under Section 2 of the Sherman Act. Ross-Simmons claimed that Weyerhaeuser used its dominant position in the market to bid up the prices of logs and prevent its competitors from being profitable. Weyerhaeuser argued that the antitrust test for predatory pricing applies to a claim of predatory bidding and that Ross-Simmons had not met this standard. The district court ruled in favor of the plaintiff, the U.S. Court of Appeals for the Ninth Circuit affirmed, and Weyerhaeuser appealed to the United States Supreme Court.

In the Language of the Court Justice THOMAS delivered the opinion of the Court.THOMAS delivered the opinion of the Court.THOMAS

* * * * Predatory-pricing and predatory-bidding claims are analytically similar. This similarity results from

the close theoretical connection between monopoly and monopsony. The kinship between monopoly and monopsony suggests that similar legal standards should apply to claims of monopolization and to claims of monopsonization.

* * * Both claims involve the deliberate use of unilateral pricing measures for anticompetitive pur- poses. And both claims logically require firms to incur short-term losses on the chance that they might reap supracompetitive [above-competitive] profits in the future.

* * * * * * * “Predatory pricing schemes are rarely tried, and even more rarely successful.” Predatory pricing

requires a firm to suffer certain losses in the short term on the chance of reaping supracompetitive profits in the future. A rational business will rarely make this sacrifice. The same reasoning applies to predatory bidding. [Emphasis added.]

* * * * * * * A failed predatory-pricing scheme may benefit consumers. * * * Failed predatory-bidding

schemes can also * * * benefit consumers. In addition, predatory bidding presents less of a direct threat of consumer harm than predatory pric-

ing. A predatory-pricing scheme ultimately achieves success by charging higher prices to consumers. By

Spotlight on Weyerhaeuser

Case 27.2 Weyerhaeuser Co. v. Case 27.2 Weyerhaeuser Co. v. Ross-S Case 27.2 Weyerhaeuser Co. v.

S Case 27.2 Weyerhaeuser Co. v.

immons immons Case 27.2 Weyerhaeuser Co. v.

immons Case 27.2 Weyerhaeuser Co. v. Case 27.2 Weyerhaeuser Co. v.

immons Case 27.2 Weyerhaeuser Co. v.

Hardwood Lumber Co. Case 27.2 Weyerhaeuser Co. v.

ardwood Lumber Co. Case 27.2 Weyerhaeuser Co. v.

Supreme Court of the United States, 549 U.S. 312, 127 S.Ct. 1069, 166 L.Ed.2d 911 (2007).Supreme Court of the United States, 549 U.S. 312, 127 S.Ct. 1069, 166 L.Ed.2d 911 (2007).Supreme Court of the United States, 549 U.S. 312, 127 S.Ct. 1069, 166 L.Ed.2d 911 (2007).

C H A P T E R 2 7 Antitrust Law 577

27–4 The Clayton Act Congress enacted the Clayton Act to strengthen federal antitrust laws. The act was aimed at specific anticom- petitive or monopolistic practices that the Sherman Act did not cover. The substantive provisions of the act—set out in Sections 2, 3, 7, and 8—deal with four distinct forms of business behavior, which are declared illegal but not criminal. For each provision, the act states that the behavior is illegal only if it tends to substantially lessen com- petition or to create monopoly power.

27–4a Section 2—Price Discrimination Section 2 of the Clayton Act prohibits price discrimina- tion, which occurs when a seller charges different prices to competing buyers for identical goods or services. Congress strengthened this section by amending it with the passage of the Robinson-Patman Act in 1936. As amended, Section 2 prohibits price discrimination that cannot be justified by differences in production costs, transportation costs, or cost differences due to other

reasons. In short, a seller cannot charge one buyer a lower price than it charges that buyer’s competitor.

Requirements To violate Section 2, the seller must be engaged in interstate commerce, the goods must be of like grade and quality, and the goods must have been sold to two or more purchasers. In addition, the effect of the price discrimination must be to substantially lessen com- petition, tend to create a monopoly, or otherwise injure competition. Without proof of an actual injury resulting from the price discrimination, the plaintiff cannot recover damages.

Note that price discrimination claims can arise from discounts, offsets, rebates, or allowances given to one buyer over another. Moreover, giving favorable credit terms, delivery, or freight charges to some buyers, but not others, can also lead to allegations of price discrimination. For instance, when a seller offers goods to different custom- ers at the same price but includes free delivery for certain buyers, it may violate Section 2 in some circumstances.

Defenses There are several statutory defenses to liabil- ity for price discrimination.

contrast, a predatory-bidding scheme could succeed with little or no effect on consumer prices because a predatory bidder does not necessarily rely on raising prices in the output market to recoup its losses.

* * * * * * * [Thus,] our two-pronged [predatory pricing] test should apply to predatory-bidding claims. * * * A plaintiff must prove that the alleged predatory bidding led to below-cost pricing of the preda-

tor’s outputs. That is, the predator’s bidding on the buy side must have caused the cost of the relevant output to rise above the revenues generated in the sale of those outputs. * * * Given the multitude of procompetitive ends served by higher bidding for inputs, the risk of chilling procompetitive behavior with too lax a liability standard is * * * serious * * *. Consequently, only higher bidding that leads to below-cost pricing in the relevant output market will suffice as a basis for liability for predatory bidding.

A predatory-bidding plaintiff also must prove that the defendant has a dangerous probability of recouping the losses incurred in bidding up input prices through the exercise of monopsony power. Absent proof of likely recoupment, a strategy of predatory bidding makes no economic sense because it would involve short-term losses with no likelihood of offsetting long-term gains.

Ross-Simmons has conceded that it has not satisfied [this] standard. Therefore, its predatory-bidding theory of liability cannot support the jury’s verdict.

Decision and Remedy The United States Supreme Court held that the antitrust test that applies to claims of predatory pricing also applies to claims of predatory bidding. Because Ross-Simmons conceded that it had not met this standard, the Court vacated the lower court’s judgment and remanded the case.

Critical Thinking • Social Do predatory-bidding schemes ever benefit consumers? Explain your answer. • Economic Why does a plaintiff alleging predatory bidding have to prove that the defendant’s “bidding

on the buy side caused the cost of the relevant output to rise above the revenues generated in the sale of those outputs”?

Case 27.2 Continued

578 U N I T F I V E The Regulatory Environment

1. Cost justification. If the seller can justify the price reduction by demonstrating that a particular buyer’s purchases saved the seller costs in producing and sell- ing the goods, the seller will not be liable for price discrimination.

2. Meeting a competitor’s prices. If the seller charged the lower price in a good faith attempt to meet an equally low price of a competitor, the seller will not be liable for price discrimination. ■ EXAMPLE 27.10 Rogue, Rogue, Inc., is a retail dealer of Mercury Marine outboard motors in Shady Cove, Oregon. Mercury Marine also sells its motors to other dealers in the Shady Cove area. When Rogue discovers that Mercury is selling its outboard motors at a substantial discount to Rogue’s largest competitor, it files a price discrimination law- suit. Mercury Marine can defend itself by showing that the discounts given to Rogue’s competitor were made in good faith to meet the low price charged by another manufacturer of marine motors. ■

3. Changing market conditions. A seller may lower its price on an item in response to changing conditions affecting the market for or the marketability of the goods concerned. Sellers are allowed to readjust their prices to meet the realities of the market without liability for price discrimination. Thus, if an advance in technology makes a particular product less mar- ketable than it was previously, a seller can lower the product’s price.

27–4b Section 3—Exclusionary Practices Under Section 3 of the Clayton Act, sellers or lessors can- not condition the sale or lease of goods on the buyer’s or lessee’s promise not to use or deal in the goods of the sell- er’s competitor. In effect, this section prohibits two types of vertical agreements involving exclusionary practices— exclusive-dealing contracts and tying arrangements.

Exclusive-Dealing Contracts A contract under which a seller forbids a buyer to purchase products from the seller’s competitors is called an exclusive-dealing contract. A seller is prohibited from making an exclu- sive-dealing contract under Section 3 if the effect of the contract is “to substantially lessen competition or tend to create a monopoly.”

In the past, courts were more inclined to find that exclusive-dealing contracts substantially lessened comexclusive-dealing contracts substantially lessened comexclusive-dealing contracts substantially lessened comexclusive-dealing contracts substantially lessened com- petition. ■ CASE IN POINT 27.11 In one classic case, In one classic case, Standard Oil Company, the largest gasoline seller in the nation in the late 1940s, made exclusive-dealing con- tracts with independent stations in seven western states.

The contracts involved 16 percent of all retail outlets, whose sales were approximately 7 percent of all retail sales in that market. The United States Supreme Court ruled that the market was substantially concentrated because the seven largest gasoline suppliers all used exclusive- dealing contracts with their independent retailers and together controlled 65 percent of the market.

Looking at market conditions after the arrangements were instituted, the Court found that market shares were extremely stable and that entry into the market was apparently restricted. Thus, the Court held that the Clay- ton Act had been violated because competition was “fore- closed in a substantial share” of the relevant market.17 ■ Note that since the Supreme Court’s 1949 decision, a number of subsequent decisions have called the holding in this case into doubt.

Today, it is clear that to violate antitrust law, an exclusive-dealing agreement (or a tying arrangement, discussed next) must qualitatively and substantially harm competition. To prevail, a plaintiff must present affirma- tive evidence that the performance of the agreement will foreclose competition and harm consumers.

Tying Arrangements When a seller conditions the sale of a product (the tying product) on the buyer’s agreement to purchase another product (the tied product) produced or distributed by the same seller, a tying arrangement results. tying arrangement results. tying arrangement The legality of a tying arrangement (or tie-in sales agree- ment) depends on several factors, such as the purpose of ment) depends on several factors, such as the purpose of ment the agreement. Courts also focus on the agreement’s likely effect on competition in the relevant markets (the market for the tying product and the market for the tied product).

Section 3 of the Clayton Act has been held to apply only to commodities, not to services. Tying arrange- ments, however, can also be considered agreements that restrain trade in violation of Section 1 of the Sherman Act. Thus, cases involving tying arrangements of services have been brought under Section 1 of the Sherman Act. Although earlier cases condemned tying arrangements as illegal per se, courts now evaluate tying agreements under the rule of reason.18

■ CASE IN POINT 27.12 James Batson bought a James Batson bought a nonrefundable ticket from Live Nation Entertainment, Inc., to attend a rock concert at the Charter One Pavil- ion in Chicago. The front of the ticket noted that the

17. Standard Oil Co. of California v. United States, 337 U.S. 293, 69 S.Ct. 1051, 93 L.Ed. 1371 (1949).

18. Illinois Tool Works, Inc. v. Independent Ink, Inc., 547 U.S. 28, 126 S.Ct. 1281, 164 L.Ed.2d 26 (2006). This decision was the first time the Supreme Court recognized that tying arrangements can have legitimate business justifications.

C H A P T E R 2 7 Antitrust Law 579

price included a nine-dollar parking fee. Batson did not have a car to park, however. In fact, he had walked to the concert venue and had bought the ticket just before the performance.

Frustrated at being charged for parking that he did not need, Batson filed a suit in a federal district court against Live Nation. He argued that the bundled parking fee was unfair because consumers were forced to pay it or forego the concert. He asserted that this was a tying arrangement in violation of Section 1 of the Sherman Act. The court dismissed the suit, and a federal appel- late court affirmed. The court was unable to identify a product (or service) market in which Live Nation had sufficient power to force consumers who wanted to attend a concert (the tying product) to buy “useless park- ing rights” (the tied product). While such bundles may be annoying, there was no evidence that Live Nation’s parking tie-in restrained competition for parking in Chicago.19 ■

27–4c Section 7—Mergers Under Section 7 of the Clayton Act, a person or business organization cannot hold stock or assets in more than one business when “the effect . . . may be to substantially lessen competition.” Section 7 is the statutory authority for preventing mergers or acquisitions that could result in monopoly power or a substantial lessening of competi- tion in the marketplace. Section 7 applies to both hori- zontal and vertical mergers, as discussed in the following subsections.

A crucial consideration in most merger cases is mar- ket concentration. Determining market concentration involves allocating percentage market shares among the various companies in the relevant market. When a small number of companies share a large part of the market, number of companies share a large part of the market, number of companies share a large part of the market, number of companies share a large part of the market, the market is concentrated. ■ EXAMPLE 27.13 If the four largest grocery stores in Chicago account for 80 per- cent of all retail food sales, the market is concentrated in those four firms. If one of these stores absorbs the assets and liabilities of another, so that the other ceases to exist, the result is a merger that further concentrates the market and possibly diminishes competition. ■

Competition is not necessarily diminished solely as a result of market concentration, however. Courts will consider other factors in determining if a merger violates Section 7. One factor of particular importance is whether the merger will make it more difficult for potential compotential compotential - petitors to enter the relevant market.

19. Batson v. Live Nation Entertainment, Inc., 746 F.3d 827 (7th Cir. 2014).

Horizontal Mergers Mergers between firms that compete with each other in the same market are called horizontal mergers. If a horizontal merger creates an entity with a significant market share, the merger may be considered illegal because it increases market concentra- tion. The Federal Trade Commission (FTC) and the U.S. Department of Justice (DOJ) have established guidelines for determining which mergers will be challenged.20

When analyzing the legality of a horizontal merger, the courts consider three additional factors. The first fac- tor is the overall concentration of the relevant market. The second is the relevant market’s history of tending toward concentration. The final factor is whether the merger is apparently designed to establish market power or restrict competition.

Vertical Mergers A vertical merger occurs when a vertical merger occurs when a vertical merger company at one stage of production acquires a company at a higher or lower stage of production. An example of a vertical merger is a company merging with one of its sup- pliers or retailers.

Whether a vertical merger will be deemed illegal generally depends on several factors, such as whether the merger creates a single firm that controls an undue percentage share of the relevant market. The courts also analyze the concentration of firms in the market, barriers to entry into the market, and the apparent intent of the merging parties. If a merger does not prevent competitors of either of the merging firms from competing in a seg- ment of the market, the merger will not be condemned as foreclosing competition and thus is legal.

27–4d Section 8— Interlocking Directorates

Section 8 of the Clayton Act deals with interlocking direc- torates—that is, the practice whereby individuals serve as torates—that is, the practice whereby individuals serve as torates directors on the boards of two or more competing com- panies simultaneously. Specifically, no person may be a director for two or more competing corporations at the same time if either of the corporations has capital, surplus, or undivided profits aggregating more than $31,841,000 or competitive sales of $3,184,100 or more. The Federal Trade Commission adjusts these threshold amounts each year. (The amounts given here are those announced by the commission in 2016.)

20. These guidelines include a formula for assessing the degree of concen- tration in the relevant market called the Herfindahl-Hirschman Index (HHI), which is available at www.justice.gov/atr/public/guidelines/ hmg-2010.html.

580 U N I T F I V E The Regulatory Environment

27–5 Enforcement and Exemptions The federal agencies that enforce the federal antitrust laws are the U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC), which was established by the Federal Trade Commission Act.21 Section 5 of that act condemns all forms of anticompetitive behavior that are not covered under other federal antitrust laws.

27–5a Agency Actions Only the DOJ can prosecute violations of the Sherman Act, which can be either criminal or civil offenses. Viola- tions of the Clayton Act are not crimes, but the act can be enforced by either the DOJ or the FTC through civil proceedings.

The DOJ or the FTC may ask the courts to impose various remedies, including divestiture (making a com- pany give up one or more of its operations) and dissolu- tion. A meatpacking firm, for instance, might be forced to divest itself of control or ownership of butcher shops.

The FTC has sole authority to enforce violations of Section 5 of the Federal Trade Commission Act. FTC actions are effected through administrative orders, but if a firm violates an FTC order, the FTC can seek court sanctions for the violation.

27–5b Private Actions A private party who has been injured as a result of a vio- lation of the Sherman Act or the Clayton Act can sue for treble damages (three times the actual damages suf- (three times the actual damages suf- (three times the actual damages suf fered) and attorneys’ fees. In some instances, private par- ties may also seek injunctive relief to prevent antitrust

21. 15 U.S.C. Sections 41–58.

violations. A party wishing to sue under the Sherman Act must prove that: 1. The antitrust violation either caused or was a sub-

stantial factor in causing the injury that was suffered. 2. The unlawful actions of the accused party affected

business activities of the plaintiff that were protected by the antitrust laws.

Additionally, the United States Supreme Court has held that to pursue antitrust lawsuits, private parties must present some evidence suggesting that an illegal agree- ment was made.22

A private party can bring an action under Section 2 of the Sherman Act based on the attempted enforcement of a fraudulently obtained patent. This is called a Walker Process claim.Process claim.Process 23 To prevail, the plaintiff must first show that the defendant obtained the patent by fraud on the U.S. Patent and Trademark Office and enforced the pat- ent with knowledge of the fraud. The plaintiff must then establish all the other elements of a Sherman Act monop- olization claim—anticompetitive conduct, an intent to monopolize, and a dangerous probability of achieving monopoly power.

In the following case, a respiratory filter maker was accused of patent infringement. The maker sought a declaratory judgment of non-infringement, assert- ing a Walker Process claim. One of the primary issues Walker Process claim. One of the primary issues Walker Process was whether attorney fees were an appropriate basis for damages.

22. Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007).

23. The name of the claim comes from the title of the case in which the claim originated—Walker Process Equipment v. Food Machine and Chem- ical Corp., 382 U.S. 172, 86 S.Ct. 347, 15 L.Ed.2d 247 (1965).

Background and Facts TransWeb, LLC, makes respirator filters made of nonwoven fibrous mate- rial to be worn by workers at contaminated worksites. At a filtration industry exposition, TransWeb’s founder, Kumar Ogale, handed out samples of TransWeb’s filter material. At the time, 3M Innovative Products Company was experimenting with filter materials. At the expo, 3M employees obtained the TransWeb samples.

TransWeb, LLC v. 3M Innovative Properties Co. United States Court of Appeals, Federal Circuit, 812 F.3d 1295 (2016).

Case 27.3

C H A P T E R 2 7 Antitrust Law 581

More than a year later, 3M obtained patents for its filter products and filed a suit against TransWeb, claiming infringement. 3M asserted that it had not received the TransWeb samples until after its pat- ent application had been filed. The suit was dismissed.

TransWeb then filed a suit in a federal district court, seeking a declaratory judgment of non- infringement and asserting a Walker Process claim. A jury found that 3M had obtained its patents Walker Process claim. A jury found that 3M had obtained its patents Walker Process through fraud, that its assertion of the patents against TransWeb violated antitrust law, and that Trans- Web was entitled to attorney fees as damages. TransWeb had incurred $7.7 million defending against 3M’s infringement suit. The court trebled this to $23 million. 3M appealed.

In the Language of the Court HUGHES, Circuit Judge.

* * * * 3M argues that the district court erred in awarding the $23 million of attorney-fees damages, because

TransWeb failed to show any link between those attorney fees and an impact on competition. 3M argues that those attorney fees had no effect on competition because they did not force TransWeb out of the market or otherwise affect prices in the market.

* * * * 3M’s argument focuses on the fact that the harmful effect on competition proven by TransWeb at

trial never actually came about. TransWeb proved at trial that increased prices for fluorinated filter * * * respirators would have resulted had 3M succeeded in its suit.

* * * * * * * 3M’s unlawful act was * * * aimed at reducing competition and would have done so had the suit

been successful. 3M’s unlawful act was the bringing of suit based on a patent known to be fraudulently obtained. What made this act unlawful under the antitrust laws was its attempt to gain a monopoly based on this fraudulently obtained patent. TransWeb’s attorney fees flow directly from this unlawful aspect of 3M’s act. * * * The attorney fees are precisely the type of loss that the claimed violations would be likely to cause.

* * * * * * * It is the abuse of the legal process by the antitrust-defendant that makes the attorney fees incurred by

the antitrust-plaintiff during that legal process a relevant antitrust injury. [Emphasis added.] No assertion of a patent known to be fraudulently obtained can be a proper use of legal process. No

successful outcome of that litigation, regardless of how much the patentee subjectively desires it, would save that suit from being improper due to its tainted origin.

* * * The antitrust laws exist to protect competition. If we were to hold that TransWeb can seek anti- trust damages only [by] forfeiture of competition, but not [by] defending the anticompetitive suit, then we would be incentivizing the former over the latter. * * * This is not in accord with the purpose of those very same antitrust laws.

Furthermore, it furthers the purpose of the antitrust laws to encourage TransWeb to bring its anti- trust suit * * * instead of waiting to be excluded from the market * * * . If TransWeb proceeds only after being excluded from the market * * * , then the [injury] will no longer be borne by TransWeb alone, but rather would be shared by all consumers in the relevant markets.

Decision and Remedy The U.S. Court of Appeals for the Federal Circuit affirmed the lower court’s judg- ment and award of trebled attorney fees. “TransWeb’s attorney fees appropriately flow from the unlawful aspect of 3M’s antitrust violation and thus are an antitrust injury that can properly serve as the basis for antitrust damages.”

Critical Thinking • Legal Environment How would TransWeb’s injury have been “shared by all consumers in the relevant

markets” if TransWeb had not sued until after it had been driven out of those markets by 3M’s actions? • Ethical What does 3M’s conduct suggest about its corporate ethics?

Case 27.3 Continued

582 U N I T F I V E The Regulatory Environment

27–5c Exemptions from Antitrust Laws There are many legislative and constitutional limita- tions on antitrust enforcement. Most of the statutory and judicially created exemptions to the antitrust laws apply only in certain areas (see Exhibit 27–2). One of the most significant exemptions covers joint efforts by

businesspersons to obtain legislative, judicial, or execu- tive action. Under this exemption, for instance, music producers and record companies can jointly lobby Con- gress to change the copyright laws without being held liable for attempting to restrain trade. Another exemp- tion covers professional baseball teams.

Agricultural Associations

The Clayton Act and the Capper-Volstead Act—Allow agricultural cooperatives to set prices.

Fisheries The Fisheries Cooperative Marketing Act—Allows the fishing industry to set prices.

Insurance Companies

The McCarran-Ferguson Act—Exempts the insurance business in states in which the industry is regulated.

Exporters The Webb-Pomerene Act—Allows U.S. exporters to engage in cooperative activity to compete with similar foreign associations. The Export Trading Company Act—Permits the U.S. Department of Justice to exempt certain exporters.

Professional Baseball

The United States Supreme Court—Has held that professional baseball is exempt because it is not “interstate commerce.”a

Oil Marketing The Interstate Oil Compact—Allows states to set quotas on oil to be marketed in interstate commerce.

Defense Activities The Defense Production Act—Allows the president to approve, and thereby exempt, certain activities to further the military defense of the United States.

Small Businesses’ Cooperative Research

The Small Business Administration Act—Allows small firms to undertake cooperative research.

State Actions The United States Supreme Court—Has held that actions by a state are exempt if the state clearly articulates and actively supervises the policy behind its action.b

Regulated Industries

Federal Agencies—Industries (such as airlines) are exempt when a federal administrative agency (such as the Federal Aviation Administration) has primary regulatory authorityagency (such as the Federal Aviation Administration) has primary regulatory authorityagency (such as the Federal A .

Businesspersons’ Joint Efforts to Seek Government Action

The United States Supreme Court—Cooperative efforts by businesspersons to obtain legislative, jforts by businesspersons to obtain legislative, j judicial, or executive action are exempt unless it is clear that an effort is “objectively baseless” and is an attempt to make anticompetitive use of government processes.c

SOURCE AND SCOPE

The Clayton Act—Permits unions to organize and bargain without violating antitrust laws and specifies that strikes and other labor activities normally do not violate any federal law.

EXEMPTION

Labor

a. Federal Baseball Club of Baltimore, Inc. v. National League of Professional Baseball Clubs,Federal Baseball Club of Baltimore, Inc. v. National League of Professional Baseball Clubs,Federal Baseball Club of Baltimore, Inc. v 259 U.S. 200, 42 S.Ct. 465, 66 L.Ed. 898 (1922). See City of San Jose v. City of San Jose v. City of San Jose v Office of the Commissioner of Baseball, 776 F.3d 686 (9th Cir. 2015). b. See Parker v. BrownParker v. BrownParker v , 317 U.S. 341, 63 S.Ct. 307, 87 L.Ed. 315 (1943). c. Eastern Railroad Presidents Conference v. Noerr Motor Freight, Inc.Eastern Railroad Presidents Conference v. Noerr Motor Freight, Inc.Eastern Railroad Presidents Conference v , 365 U.S. 127, 81 S.Ct. 523, 5 L.Ed.2d 464 (1961); and United Mine Workers of America vUnited Mine Workers of America vUnited Mine W . orkers of America v. orkers of America v

Pennington, 381 U.S. 657, 89 S.Ct. 1585, 14 L.Ed.2d 626 (1965). These two cases established the exception often referred to as the Noerr-Pennington Noerr-Pennington Noerr doctrine.

E X H I B I T 2 7 – 2 Exemptions to Antitrust Enforcement

C H A P T E R 2 7 Antitrust Law 583

27–6 U.S. Antitrust Laws in the Global Context

U.S. antitrust laws have a broad application. Not only may persons in foreign nations be subject to their provi- sions, but the laws may also be applied to protect foreign consumers and competitors from violations committed by U.S. business firms. Consequently, foreign persons, a term that by definition includes foreign governments, may sue under U.S. antitrust laws in U.S. courts.

27–6a The Extraterritorial Application of U.S. Antitrust Laws

Section 1 of the Sherman Act provides for the extrater- ritorial effect of the U.S. antitrust laws. Any conspiracy that has a substantial effect on U.S. commerce is within substantial effect on U.S. commerce is within substantial effect the reach of the Sherman Act. The violation may even occur outside the United States, and foreign govern- ments as well as individuals can be sued for violation of U.S. antitrust laws.

Before U.S. courts will exercise jurisdiction and apply antitrust laws, it must be shown that the alleged violation had a substantial effect on U.S. commerce. U.S. juris- diction is automatically invoked, however, when a per se violation occurs.

If a domestic firm, for instance, joins a foreign cartel to control the production, price, or distribution of goods, and this cartel has a substantial effect on U.S. commerce, a substantial effect on U.S. commerce, a substantial effect per se violation may arise. Hence, both the domestic firm per se violation may arise. Hence, both the domestic firm per se and the foreign cartel could be sued for violation of the U.S. antitrust laws.

Likewise, if a foreign firm doing business in the United States enters into a price-fixing or other anti- competitive agreement to control a portion of U.S. marcompetitive agreement to control a portion of U.S. marcompetitive agreement to control a portion of U.S. marcompetitive agreement to control a portion of U.S. mar- kets, a per se violation may exist. per se violation may exist. per se ■ CASE IN POINT 27.14 Carrier Corporation is a U.S. firm that manufactures air-conditioning and refrigeration (ACR) equipment. To make these products, Carrier uses ACR copper tubing it buys from Outokumpu Oyj, a Finnish company. Carrier is one of the world’s largest purchasers of ACR copper tubing.

After the Commission of the European Communi- ties found that Outokumpu had conspired with other companies to fix ACR tubing prices in Europe, Carrier filed a suit in a U.S. court. Carrier alleged that the car- tel had also conspired to fix prices in the United States by agreeing that only Outokumpu would sell ACR tub- ing in the U.S. market. The district court dismissed the

case for lack of jurisdiction, but a federal appellate court reversed. The reviewing court found that the alleged anti- competitive conspiracy had a substantial effect on U.S. commerce. Therefore, the U.S. courts had jurisdiction over the Finnish defendant.24 ■

27–6b The Application of Foreign Antitrust Laws

Large U.S. companies increasingly must be concerned about the application of foreign antitrust laws. The European Union (EU), in particular, has stepped up its enforcement actions against antitrust violators.

European Union Enforcement The EU’s laws pro- moting competition are stricter in many respects than those of the United States and define more conduct as anticompetitive. The EU actively pursues antitrust viola- tors, especially individual companies and cartels that alleg- edly engage in monopolistic conduct. EU investigations of possible antitrust violations often take years. See this chapter’s Digital Update feature for a discussion of how Digital Update feature for a discussion of how Digital Update the EU is pursuing Google, Inc., for antitrust violations.

Increased Enforcement in Asia and Latin America Many other nations also have laws that pro- mote competition and prohibit trade restraints. Japanese antitrust laws forbid unfair trade practices, monopoliza- tion, and restrictions that unreasonably restrain trade. China’s antitrust rules restrict monopolization and price fixing (except that the Chinese government can set prices on exported goods). Indonesia, Malaysia, South Korea, and Vietnam all have statutes protecting competition. Argentina, Brazil, Chile, Peru, and several other Latin American countries have adopted modern antitrust laws as well.

Most of the antitrust laws apply extraterritorially, as U.S. antitrust laws do. This means that a U.S. company may be subject to another nation’s antitrust laws if the company’s conduct has a substantial effect on that nation’s commerce. For instance, in 2015, China fined the U.S. chipmaker Qualcomm, Inc., $975 million for violating antitrust laws. China has also targeted Microsoft, Inc., in its antitrust investigations and has searched Microsoft’s company servers in China for evidence of violations.

24. Carrier Corp. v. Outokumpu Oyj, 673 F.3d 430 (6th Cir. 2012).

584 U N I T F I V E The Regulatory Environment

Reviewing: Antitrust Law

The Internet Corporation for Assigned Names and Numbers (ICANN) is a nonprofit entity that organizes Internet domain names. It is governed by a board of directors elected by various groups with commercial interests in the Inter- net. One of ICANN’s functions is to authorize an entity to serve as a registry for certain “Top Level Domains” (TLDs). ICANN and VeriSign entered into an agreement that authorized VeriSign to serve as a registry for the “.com” TLD and provide registry services in accordance with ICANN’s specifications. VeriSign complained that ICANN was restricting

Google Faces an Antitrust Complaint from the European Union

“Just google it.” Google’s search engine is so dominant that the company name has become a verb synonymous with conducting an Internet search. According to the European Commissioner for Competition, Margrethe Vestager, Google has become too dominant, at least with respect to comparison shopping and product search. For that reason, the Euro- pean Union (EU) has formally charged Google with an antitrust violation. The charges relate specifically to Google operations in the EU.

The EU’s Antitrust Objections

According to the EU, Google is abusing a dominant position—a breach of EU antitrust rules. The EU has alleged that Google promotes its own comparison shopping service at the expense of competitors. It does this by “positioning and prominently displaying its comparison shopping service in its general search result pages, irrespective of its merits.” As a result, “users do not necessarily see the most relevant results in response to queries—to the detriment of consumers and rival comparison shopping services.” Presumably, this con- duct started in 2008.

What the EU Wants Google to Do and Google’s Response

Now that the EU has established its complaint against Google, here is what it wants Google to do: change the way it displays search results in the EU. When Google shows comparison shopping services in response to a user’s query, the search results should show the most relevant services first.

In response to both the complaint and the sug- gested remedy, Google offered a 130-page rebuttal. It contends that it cannot change its core software. It also claims that the results in its search algorithms are based on relevance. In addition, Google contends that it has actually boosted traffic to its Web competitors. Therein lies the major argument against the EU’s antitrust

complaint. Search engines have proliferated on the Web, suggesting that Google’s success has not eliminated competition.

The Compartmentalization of Search on the Web

More and more frequently, Internet users do not engage in general searches. Rather,

they know exactly where to go to obtain product information. When they want information on movies, for instance, they go to the Internet Movie Data Base (IMDB) rather than Google. When they want informa- tion on music, they go to iTunes. When they want to search for the cheapest airfares, they go to Kayak or similar sites. When they want to find the best rates on hotels, they go to sites such as hotels.com. And when they are interested in buying a product, they frequently go to Amazon or eBay. Amazon, in particular, has fine-tuned its ability to generate advertising revenues through its Amazon-sponsored links.

And, of course, social media must be considered. More people are on social media sites than ever before, particularly on their mobile devices. Users spend four times more time on Facebook than they do on Google. These users often “crowdsource”—that is, look for answers from Facebook friends rather than search on Google. Facebook is also becoming increasingly com- petitive with Google in the services it offers, including mobile payments and the Facebook Messenger instant messaging service.

Whether the European Antitrust Commission accepts Google’s arguments will determine Google’s fate. Will it pay billions of dollars in fines and be forced to make significant changes in how it does business? That probably will not be decided any time soon. Experts estimate that the case could go on for years.

Critical Thinking Which companies in Europe do you think may have pressured the European Union to lodge its antitrust complaint against Google?

DIGITAL UPDATE

C H A P T E R 2 7 Antitrust Law 585

the services that it could make available as a registrar, blocking new services, imposing unnecessary conditions on those services, and setting the prices at which the services were offered. VeriSign claimed that ICANN’s control of the regis- try services for domain names violated Section 1 of the Sherman Act. Using the information presented in the chapter, answer the following questions.

1. Should ICANN’s actions be judged under the rule of reason or be deemed per se violations of Section 1 of the Sherman Act? Why?

2. Should ICANN’s actions be viewed as a horizontal or a vertical restraint of trade? Why? 3. Does it matter that ICANN’s directors are chosen by groups with a commercial interest in the Internet? Explain. 4. If the dispute is judged under the rule of reason, what might be ICANN’s defense for having a standardized set of

registry services that must be used?

Debate This . . . The Internet and the rise of e-commerce have rendered our current antitrust concepts and laws obsolete.

Terms and Concepts antitrust law 568 attempted monopolization 575 concentrated industry 571 divestiture 580 exclusive-dealing contract 578 group boycott 571 horizontal merger 579 horizontal restraint 570 market concentration 579 market power 569

monopolization 572 monopoly 569 monopoly power 569 per se violation 569per se violation 569per se predatory pricing 572 price discrimination 577 price-�xing agreement 570 resale price maintenance

agreement 572

restraint of trade 568 rule of reason 569 treble damages 580 tying arrangement 578 vertical merger 579 vertical restraint 571 vertically integrated �rm 571

Issue Spotters 1. Under what circumstances would Pop’s Market, a small

store in a small, isolated town, be considered a monopo- list? If Pop’s is a monopolist, is it in violation of Section 2 of the Sherman Act? Why or why not? (See Section 2 of the Sherman Act.)

2. Maple Corporation conditions the sale of its syrup on the buyer’s agreement to buy Maple’s pancake mix. What fac- tors would a court consider to decide whether this arrange- ment violates the Clayton Act? (See The Clayton Act.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 27–1. Group Boycott. Jorge’s Appliance Corp. was a new retail seller of appliances in Sunrise City. Because of its inno- vative sales techniques and financing, Jorge’s attracted many customers. As a result, the appliance department of No-Glow Department Store, a large chain store with a great deal of buy- ing power, lost a substantial number of sales. No-Glow told a number of appliance manufacturers from whom it made large-volume purchases that if they continued to sell to Jorge’s, No-Glow would stop buying from them. The manufacturers immediately stopped selling appliances to Jorge’s. Jorge’s filed

a suit against No-Glow and the manufacturers, claiming that their actions constituted an antitrust violation. No-Glow and the manufacturers were able to prove that Jorge’s was a small retailer with a small market share. They claimed that because the relevant market was not substantially affected, they were not guilty of restraint of trade. Discuss fully whether there was an antitrust violation. (See Section 1 of the Sherman Act.)

27–2. Antitrust Laws. Allitron, Inc., and Donovan, Ltd., are interstate competitors selling similar appliances,

586 U N I T F I V E The Regulatory Environment

principally in the states of Illinois, Indiana, Kentucky, and Ohio. Allitron and Donovan agree that Allitron will no longer sell in Indiana and Ohio and that Donovan will no longer sell

in Illinois and Kentucky. Have Allitron and Donovan violated any antitrust laws? If so, which law? Explain. (See Section 1 of The Sherman Act.)

Business Case Problems 27–3. Section 2 of the Sherman Act. While Deer Val- ley Resort Co. (DVRC) was developing its ski resort in the Wasatch Mountains near Park City, Utah, it sold parcels of land in the resort village to third parties. Each sales contract reserved the right of approval over the conduct of certain busi- nesses on the property, including ski rentals. For �fteen years, DVRC permitted Christy Sports, LLC, to rent skis in competi- tion with DVRC’s ski rental outlet. �en DVRC opened a new midmountain ski rental outlet and revoked Christy’s permis- sion to rent skis. �is meant that most skiers who �ew into Salt Lake City and shuttled to Deer Valley had few choices. �ey could carry their ski equipment with them on their �ights, take a shuttle into Park City and look for cheaper ski rentals there, or rent from DVRC. Christy �led a suit in a federal dis- trict court against DVRC. Was DVRC’s action an attempt to monopolize in violation of Section 2 of the Sherman Act? Why or why not? [Christy Sports, LLC v. Deer Valley Resort Co., 555 F.3d 1188 (10th Cir. 2009)] (See Section 2 of the Sherman Act.) 27–4. Price Fixing. Together, EMI, Sony BMG Music Entertainment, Universal Music Group Recordings, Inc., and Warner Music Group Corp. produced, licensed, and distrib- uted 80 percent of the digital music sold in the United States. �e companies formed MusicNet to sell music to online ser- vices that sold the songs to consumers. MusicNet required all of the services to sell the songs at the same price and subject to the same restrictions. Digitization of music became cheaper, but MusicNet did not change its prices. Did MusicNet violate the antitrust laws? Explain. [Starr v. Sony BMG Music Enter- tainment, 592 F.3d 314 (2d Cir. 2010)] (See Section 1 of the Sherman Act.) 27–5. Business Case Problem with Sample Answer— Price Discrimination. Dayton Superior Corp. sells its

products in interstate commerce to several com- panies, including Spa Steel Products, Inc. �e purchasers often compete directly with each other for customers. From 2005 to 2007, one of Spa

Steel’s customers purchased Dayton Superior’s products from two of Spa Steel’s competitors. According to the customer, Spa Steel’s prices were always 10 to 15 percent higher for the same products. As a result, Spa Steel lost sales to at least that cus- tomer and perhaps others. Spa Steel wants to sue Dayton Superior for price discrimination. Which requirements for such a claim under Section 2 of the Clayton Act does Spa Steel satisfy? What additional facts will it need to prove? [Dayton Superior Corp. v. Spa Steel Products, Inc., 2012 WL 113663 (N.D.N.Y. 2012)] (See �e Clayton Act.) • For a sample answer to Problem 27–5, go to Appendix E at

the end of this text.

27–6. Section 1 of the Sherman Act. �e National Collegiate Athletic Association (NCAA) and the National Federation of State High School Associations (NFHS) set a new standard for non-wood baseball bats. �eir goal was to ensure that aluminum and composite bats performed like wood bats in order to enhance player safety and reduce tech- nology-driven home runs and other big hits. Marucci Sports, LLC, makes non-wood bats. Under the new standard, four of Marucci’s eleven products were decerti�ed for use in high school and collegiate games. Marucci �led suit against the NCAA and the NFHS under Section 1 of the Sherman Act. At trial, Marucci’s evidence focused on injury to its own busi- ness. Did the NCAA and NFHS’s standard restrain trade in violation of the Sherman Act? Explain. [Marucci Sports, L.L.C. v. National Collegiate Athletic Association, 751 F.3d 368 (5th Cir. 2014)] (See Section 1 of the Sherman Act.)

27–7. Mergers. St. Luke’s Health Systems, Ltd., operated an emergency clinic in Nampa, Idaho. Saltzer Medical Group, P.A., had thirty-four physicians practicing at its o�ces in Nampa. Saint Alphonsus Medical Center operated the only hospital in Nampa. St. Luke’s acquired Saltzer’s assets and entered into a �ve-year professional service agreement with the Saltzer physicians. �is a�liation resulted in a combined share of two-thirds of the Nampa adult primary care pro- vider market. Together, the two entities could impose a sig- ni�cant increase in the prices charged to patients and insurers, and correspondence between the parties indicated that they would. Saint Alphonsus �led a suit against St. Luke’s to block the merger. Did this a�liation violate antitrust law? Explain. [Saint Alphonsus Medical Center-Nampa, Inc. v. St. Luke’s Health System, Ltd., 778 F.3d 775 (9th Cir. 2015)] (See �e Clayton Act.)

27–8. Section 1 of the Sherman Act. Manitou North America, Inc., makes and distributes telehandlers (forklifts with extendable telescopic booms) to dealers throughout the United States. Manitou agreed to make McCormick International, LLC, its exclusive dealer in the state of Michigan. Later, Mani- tou entered into an agreement with Gehi Company, which also makes and sells telehandlers. �e companies agreed to allocate territories within Michigan among certain dealers for each man- ufacturer, limiting the dealers’ selection of competitive products to certain models. Under this agreement, McCormick was pre- cluded from buying or selling Gehi telehandlers. What type of trade restraint did the agreement between Manitou and Gehi represent? Is this a violation of antitrust law? If so, who was injured, and how were they injured? Explain. [Manitou North injured, and how were they injured? Explain. [Manitou North injured, and how were they injured? Explain. [ America, Inc. v. McCormick International, LLC, __ N.W.2d __, 2016 WL 439354 (2016)] (See Section 1 of the Sherman Act.)Section 1 of the Sherman Act.)Section 1 of the Sherman Act

C H A P T E R 2 7 Antitrust Law 587

27–9. A Question of Ethics—Section 1 of the Sherman Act. In the 1990s, DuCoa, L.P., made choline chloride, a

B-complex vitamin essential for the growth and development of animals. DuCoa, Bioproducts, Inc., and Chinook Group, Ltd., each had one-third of the U.S. market for choline chloride. To stabilize the

market and keep the price of the vitamin higher than it would otherwise have been, the companies took action. �ey agreed to �x the price and allocate market share by deciding which of them would o�er the lowest price to each customer. At times, however, the companies disregarded the agreement.

During an increase in competitive activity in August 1997, Daniel Rose became president of DuCoa. The next month, a sub- ordinate advised him of the conspiracy. By February 1998, Rose had begun to implement a strategy to persuade DuCoa’s competi- tors to rejoin the conspiracy. By April, the three companies had reallocated their market shares and increased their prices. In June,

the U.S. Department of Justice began to investigate allegations of price fixing in the vitamin market. Ultimately, a federal district court convicted Rose of conspiracy to violate Section 1 of the Sher- man Act. [United States v. Rose, man Act. [United States v. Rose, man Act. [ 449 F.3d 627 (5th Cir. 2006)] (See Section 1 of the Sherman Act.)

(a) The court “enhanced” Rose’s sentence to thirty months’ imprisonment, one year of supervised release, and a $20,000 fine. Among other things, the court based this enhancement on Rose’s role as “a manager or supervisor” in the conspiracy. Rose appealed the enhancement to the U.S. Court of Appeals for the Fifth Circuit. Was it fair to increase Rose’s sentence on this ground? Why or why not?

(b) Was Rose’s participation in the conspiracy unethical? If so, how might Rose have behaved ethically instead? If not, could any of the participants’ conduct be considered unethical? Explain.

Legal Reasoning Group Activity 27–10. Antitrust Violations. Residents of the city of Madison, Wisconsin, became concerned about overconsump- tion of liquor near the campus of the University of Wisconsin (UW). �e city initiated a new policy, imposing conditions on area bars to discourage reduced-price “specials” that were believed to encourage high-volume and dangerous drinking. Later, the city began to draft an ordinance to ban all drink specials. Bar owners responded by announcing that they had “voluntarily” agreed to discontinue drink specials on Friday and Saturday nights after 8:00 p.m. �e city put its ordinance on hold. Several UW students �led a lawsuit against the local

bar owners’ association, alleging violations of antitrust law. (See Section 1 of the Sherman Act.)

(a) The first group will identify the grounds on which the plaintiffs might base their claim for relief and formulate an argument on behalf of the plaintiffs.

(b) The second group will determine whether the defendants are exempt from the antitrust laws.

588

C H A P T E R 2 8

to purchase a security or a group of securities on a national security exchange.

3. Notes, instruments, or other evidence of indebted- ness, including certificates of interest in a profit- sharing agreement and certificates of deposit.

4. Any fractional undivided interest in oil, gas, or other mineral rights.

5. Investment contracts, which include interests in lim- ited partnerships and other investment schemes.

The Howey Test In interpreting the act, the United States Supreme Court has held that an investment con- tract is any transaction in which a person (1) invests (2) in tract is any transaction in which a person (1) invests (2) in tract a common enterprise (3) reasonably expecting profits (4) derived primarily or primarily or primarily substantially from others’ managesubstantially from others’ managesubstantially - rial or entrepreneurial efforts. Known as the Howey test, Howey test, Howey this definition continues to guide the determination of what types of contracts can be considered securities.6

■ CASE IN POINT 28.1 James Nistler and his wife bought undeveloped land in Jackson County, Oregon, and created an LLC to develop it. The property, called Tennessee Acres, was divided into six lots. Nistler obtained investors for the development by telling them

6. SEC v. W. J. Howey Co., 328 U.S. 293, 66 S.Ct. 1100, 90 L.Ed. 1244 (1946).

28–1 The Securities Act of 1933 The Securities Act of 1933 governs initial sales of stock by businesses. The act was designed to prohibit various forms of fraud and to stabilize the securities industry by requiring that investors receive financial and other signif-requiring that investors receive financial and other signif-requiring that investors receive financial and other signif icant information concerning the securities being offered for public sale.

Basically, the purpose of this act is to require disclo- sure. The 1933 act provides that all securities transac- tions must be registered with the SEC unless they are specifically exempt from the registration requirements.

28–1a What Is a Security? Section 2(1) of the Securities Act contains a broad defini- tion of securities, which generally include the following:5

1. Instruments and interests commonly known as secu- rities, such as preferred and common stocks, bonds, debentures, and stock warrants.

2. Interests commonly known as securities, such as stock options, puts, and calls, that involve the right

5. 15 U.S.C. Section 77b(1). Amendments in 1982 added stock options.

A fter the stock market crash of October 29, 1929, and the ensuing economic depression,

Congress enacted legislation to regu- late securities markets. The result was the Securities Act of 19331 and the Securities Exchange Act of 1934.2 Both acts were designed to provide inves- tors with more information to help them make buying and selling deci- sions about securities and to prohibit

1. 15 U.S.C. Sections 77a-77aa. 2. 15 U.S.C. Sections 778a-78mm.

deceptive, unfair, and manipulative practices. Securities generally include any instruments evidencing corporate ownership (stock) or debt (bonds).

Today, the sale and transfer of securities are heavily regulated by federal and state statutes and by gov- ernment agencies. The Securities and Exchange Commission (SEC) is the main independent regulatory agency that administers the 1933 and 1934 securities acts. The SEC also plays a key role in interpreting the provisions of these acts (and their amendments)

and in creating regulations governing the purchase and sale of securities. The agency continually updates regu- lations in response to legislation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act,3 and particular challenges, such as climate change.4

3. Pub. L. No. 111-203, July 21, 2010, 124 Stat. 1376; codified at 12 U.S.C. Sections 5301 et seq.

4. The SEC now requires companies to make disclosures about the potential impacts of cli- mate change on their future profitability. See 17 C.F.R. Parts 211, 231, and 241.

Investor Protection and Corporate Governance

C H A P T E R 2 8 Investor Protection and Corporate Governance 589

that they would earn 12 to 15 percent interest on their investment and be repaid in full within a specified time. The property was never developed, the investors were never paid, and a substantial part of the funds provided by investors were used to pay Nistler and his wife.

Nistler was convicted of securities fraud. He appealed, claiming that the investments at issue did not involve “securities,” but a state appellate court affirmed his con- viction. The court found that there had been a pooling of funds from a group of investors whose interests had been secured by the same land. The value of that land had been highly dependent on Nistler’s use of the investors’ funds to develop the land. In other words, the investors had engaged in a common enterprise from which they reasonably expected to profit, and that profit would be derived from the development efforts of Nistler.7 ■

Many Types of Securities For our purposes, it is convenient to think of securities in their most common form—stocks and bonds issued by corporations. Bear in mind, though, that securities can take many forms, including interests in whiskey, cosmetics, worms, bea- vers, boats, vacuum cleaners, muskrats, and cemetery lots. Almost any stake in the ownership or debt of a company can be considered a security. Investment contracts in con- dominiums, franchises, limited partnerships in real estate, and oil or gas or other mineral rights have qualified as securities.

28–1b Registration Statement Section 5 of the Securities Act of 1933 broadly provides that if a security does not qualify for an exemption, that security must be registered before it is offered to the registered before it is offered to the registered public. Issuing corporations must file a registration state- ment with the SEC and must provide all investors with ment with the SEC and must provide all investors with ment a prospectus.

A prospectus is a disclosure document that describes the security being sold, the financial operations of the issuing corporation, and the investment or risk attach- ing to the security. The prospectus also serves as a selling tool for the issuing corporation. The SEC now allows an issuer to deliver its prospectus to investors electronically via the Internet.8

In principle, the registration statement and the pro- spectus supply sufficient information to enable unsophis- ticated investors to evaluate the financial risk involved.

7. State of Oregon v. Nistler, 286 Or.App. 470, 342 P.3d 1035 (2015). 8. Basically, an electronic prospectus must meet the same requirements as a

printed prospectus. The SEC rules address situations in which the graph- ics, images, or audio files in or accompanying a printed prospectus can- not be reproduced in an electronic form. 17 C.F.R. Section 232.304.

Contents of the Registration Statement The registration statement must be written in plain English and fully describe the following: 1. The securities being offered for sale, including their

relationship to the registrant’s other securities. 2. The corporation’s properties and business (includ-

ing a financial statement certified by an independent public accounting firm).

3. The management of the corporation, including man- agerial compensation, stock options, pensions, and other benefits. (See this chapter’s Managerial Strat-Managerial Strat-Managerial Strat egy feature for a discussion of a new SEC rule that egy feature for a discussion of a new SEC rule that egy imposes additional requirements on the disclosure of management compensation.) Any interests of direc- tors or officers in any material transactions with the corporation must also be disclosed.

4. How the corporation intends to use the proceeds of the sale.

5. Any pending lawsuits or special risk factors. All companies, both domestic and foreign, must file

their registration statements electronically so that they can be posted on the SEC’s online EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database. Inves- tors can then access the statements via the Internet. The EDGAR database includes material on initial public offerings (IPOs), proxy statements (concerning voting authority), annual reports, registration statements, and other documents that have been filed with the SEC.

Registration Process The registration statement does not become effective until it has been reviewed and approved by the SEC (unless it is filed by a well-known seasoned issuer, as discussed shortly). The 1933 act restricts the types of activities that an issuer can engage in at each stage of the registration process. If an issuer violates these restrictions, investors can rescind their contracts to pur- chase the securities.

Prefiling Period. During the pre�ling period (before the pre�ling period (before the pre�ling period registration statement is �led), the issuer normally can- not sell or o�er to sell the securities. Once the registration statement has been �led, a waiting period begins while the SEC reviews the registration statement for completeness.9

Waiting Period. During the waiting period, the securi- ties can be o�ered for sale but cannot be sold by the issu- ing corporation. Only certain types of o�ers are allowed at this time. All issuers can distribute a preliminary

9. The waiting period must last at least twenty days but always extends much longer because the SEC inevitably requires numerous changes and additions to the registration statement.

590 U N I T F I V E The Regulatory Environment

prospectus,10 which contains most of the information that will be included in the �nal prospectus but often does not include a price.

Most issuers can use a free-writing prospectus during free-writing prospectus during free-writing prospectus this period (although some inexperienced issuers will need to file a preliminary prospectus first).11 A free- writing prospectus is any type of written, electronic, or graphic offer that describes the issuer or its securities and includes a legend indicating that the investor may obtain the prospectus at the SEC’s Web site.

Posteffective Period. Once the SEC has reviewed and approved the registration statement and the waiting

10. A preliminary prospectus may also be called a red herring prospectus. The name comes from the legend printed in red across the prospectus stating that the registration has been filed but has not become effective.

11. See SEC Rules 164 and 433.

period is over, the registration is e�ective, and the postef-postef-postef fective period begins. �e issuer can now o�er and sell the fective period begins. �e issuer can now o�er and sell the fective period securities without restrictions.

If the company issued a preliminary or free-writing prospectus to investors, it must provide those investors with a final prospectus either before or at the time they purchase the securities. The issuer can make the final pro- spectus available to investors to download from a Web site if it notifies them of the appropriate Internet address.

28–1c Well-Known Seasoned Issuers A well-known seasoned issuer (WKSI) is a firm that has well-known seasoned issuer (WKSI) is a firm that has well-known seasoned issuer issued at least $1 billion in securities in the last three years or has outstanding stock valued at $700 million or more in the hands of the public. WKSIs have greater flexibility than other issuers. They can file registration

The SEC’s New Pay-Ratio Disclosure Rule

After the financial meltdown of recent years, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act.a

One of the goals of the act was to improve accountability and transparency in the finan- cial system. A brief sectionb in the lengthy bill requires a publicly held company to disclose the ratio of the total compensation of its chief executive officer (CEO) to the median compensation of its workers. For instance, if the annual pay of the median employee is $45,790 and the total compensa- tion of the CEO is $12,260,000, then the pay ratio is 1 to 268. Otherwise stated, the CEO makes 268 times more than the median income for employees.

Five Years in the Making

For five years, the Securities and Exchange Commission (SEC) hesitated to adopt a disclosure rule as mandated by the Dodd-Frank act. The SEC received almost 300,000 comments and issued its own comments on the proposed rule.c The commissioners indicated that they were unsure what potential economic benefits, “if any,” would be realized from making this information public. The SEC has estimated that the regulation will cause companies almost 550,000 annual paperwork hours, plus about $75 million per year to hire outside professionals.

Dealing with the New Rule

The new rule is 1,800 words long, and manag- ers initially may find it difficult to implement. Fortunately for them, the SEC realizes that it can only ask for “reasonable estimates” of the CEO-worker pay ratio.

The CEO’s measured compensation includes salary, bonuses, stocks and options, incentive plans, and other compensation. In theory, calculating this amount is fairly straightforward.

Calculating the median income of the company’s labor force is more difficult. Note that the median income is not the average income of employees. Rather, the rule requires the company to identify a “median” employee as the basis for comparison.

The rule does give companies flexibility in determin- ing how to identify this median employee. Statistical sampling can be used, for instance. And the rule states, “Since identifying the median involves finding the employee in the middle, it may not be necessary to determine the exact compensation amounts for every employee paid more or less than that employee in the middle.” The rule also permits companies to make the median employee determination only once every three years.

Business Questions 1. Why might the new SEC pay-ratio disclosure rule cause

certain businesses to eliminate low-wage workers? 2. How might the new SEC pay-ratio disclosure rule help

shareholders?

MANAGERIAL STRATEGY

a. Pub. L. No. 111-203, July 21, 2010, 124 Stat. 1376 (2010); codified at 12 U.S.C. Sections 5301 et seq.

b. Ibid., Section 953(b). c. 2013 WL 6503197 (2013 S.E.C. Release Nos. 33-9452 and

34-70443).

C H A P T E R 2 8 Investor Protection and Corporate Governance 591

statements the day they announce a new offering and are not required to wait for SEC review and approval. They can also use a free-writing prospectus at any time, even during the prefiling period.

28–1d Exempt Securities and Transactions Certain types of securities are exempt from the registra- tion requirements of the Securities Act. These securi- ties—which generally can also be resold without being registered—are summarized under the heading “Exempt Securities” in Exhibit 28–1.12 The exhibit also lists and describes certain transactions that are exempt from regis- tration requirements under various SEC regulations.

The transaction exemptions are important because they are very broad and can enable an issuer to avoid the high cost and complicated procedures associated with registration. Indeed, many sales occur without reg- istration. Even when a transaction is exempt from the registration requirements, however, the offering is still subject to the antifraud provisions of the 1933 act (as well as those of the 1934 act, to be discussed later in this chapter).

Regulation A Offerings An exemption from regis- tration is available for an issuer’s security offerings that do not exceed $50 million during any twelve-month period.13 Under Regulation A,14 the issuer must file with the SEC a notice of the issue and an offering circular, which must also be provided to investors before the sale. Additional review requirements apply to issuers raising between $20 and $50 million. Overall, Regulation A provides a much less expensive process than the procedures associated with full registration.

Note that the cap for Regulation A was $5 million until 2015, when the SEC approved rule changes to make it easier for small and mid-sized businesses to raise capital. These changes were made in connection with the Jumpstart Our Business Startups, or JOBS, Act.15

Expanding the issuers that qualify for exemption under Regulation A will likely decrease the significance of the other exemptions listed in Exhibit 28–1. In addition, the amended Regulation A—popularly known as Reg A+ — has allowed for an increase in online crowdfunding.

Testing the Waters. Before preparing a Regulation A o�ering circular, companies are allowed to “test the waters” for potential interest. To test the waters means to test the waters means to test the waters

12. 15 U.S.C. Section 77c. 13. 15 U.S.C. Section 77c(b). 14. 17 C.F.R. Sections 230.251–230.263. 15. Pub.L.No. 112-106 (June 19, 2012).

determine potential interest without actually selling any securities or requiring any commitment from those who express interest. Small-business issuers can also use an integrated registration and reporting system that requires simpler forms than the full registration system.

Using the Internet. Some companies have sold their securities on the Internet using Regulation A. securities on the Internet using Regulation A. securities on the Internet using Regulation A. ■ EXAM- PLE 28.2 �e Spring Street Brewing Company was the �rst company to sell securities via an online initial pub- lic o�ering (IPO). Spring Street raised about $1.6 mil- lion without incurring high expenses. ■ Online IPOs are particularly attractive to small companies and start-up ventures that may �nd it di�cult to raise capital from institutional investors or through underwriters.

Small Offerings—Regulation D The SEC’s Regu- lation D contains several exemptions from registration requirements (Rules 504, 505, and 506) for offers that either involve a small dollar amount or are made in a lim- ited manner.

Rule 504. Rule 504 is the exemption used by most small businesses. It provides that noninvestment company o�erings up to $1 million in any twelve-month period are exempt.16 Noninvestment companies are �rms that are not engaged primarily in the business of investing or trading in securities. (In contrast, an investment com- pany is a �rm that buys a large portfolio of securities and pany is a �rm that buys a large portfolio of securities and pany professionally manages it on behalf of many smaller share- holders/owners. A mutual fund is a well-known type of mutual fund is a well-known type of mutual fund investment company.)

■ EXAMPLE 28.3 Zeta Enterprises is a limited part- nership that develops commercial property. Zeta intends to offer $600,000 of its limited partnership interests for sale between June 1 and next May 31. The buyers will become limited partners in Zeta. Because an interest in a limited partnership meets the definition of a security (discussed earlier), this offering would be subject to the registration and prospectus requirements of the Securi- ties Act of 1933.

Under Rule 504, however, the sales of Zeta’s interests are exempt from these requirements because Zeta is a noninvestment company making an offering of less than $1 million in a given twelve-month period. Therefore, Zeta can sell its interests without filing a registration statement with the SEC or issuing a prospectus to any investor. ■

16. 17 C.F.R. Section 230.504. Small businesses in California may also be exempt under SEC Rule 1001. California’s rule permits limited offer- ings of up to $5 million per transaction, if they satisfy certain conditions.Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

592 U N I T F I V E The Regulatory Environment

Rule 505. Another exemption is available under Rule 505 for private, noninvestment company o�erings up to $5 million in any twelve-month period. �e o�er may be made to an unlimited number of accredited investors and up to thirty-�ve unaccredited investors. investors and up to thirty-�ve unaccredited investors. investors

Accredited investors include banks, insurance com- panies, investment companies, employee bene�t plans, the issuer’s executive o�cers and directors, and per- sons whose income or net worth exceeds a certain threshold.

Exempt Securities

• Government-issued securities.• Government-issued securities.• • Bank and financial institution• Bank and financial institution•

securities, which are regulated by banking authorities.

• Short-term notes and drafts• Short-term notes and drafts• (negotiable instruments that have a maturity date that does not exceed nine months).

• Securities of nonprofit,• Securities of nonprofit,• educational, and charitable organizations.

• Securities issued by common• Securities issued by common• carriers (railroads and trucking companies).

• Any insurance, endowment, or• Any insurance, endowment, or• annuity contract issued by a state- regulated insurance company.

• Securities issued in a corporate• Securities issued in a corporate• reorganization in which one security is exchanged for another or in a bankruptcy proceeding.

• Securities issued in stock dividends• Securities issued in stock dividends• and stock splits.

Restricted securities must be registered before resale unless they qualify for a safe harbor under Rule 144 or 144A.

Except when the seller is an issuer, underwriter, or dealer, unrestricted securities generally can be resold without first being registered.

Unregistered Unrestricted Securities Unregistered Restricted Securities Registered Unrestricted Securities

Exempt Transactions Regulation A—

Securities issued by an issuer that has offered less than $50 million in securities during any twelve-month period if the issuer meets specific requirements.

Regulation D—

• Rule 504: Noninvestment company offerings up to $1 million in any twelve-month period.

• Rule 505: Private, noninvestment company offerings up to $5 million in any twelve-month period.

• Rule 506: Private, noninvestment company offerings in unlimited amounts that are not generally advertised or solicited.

Nonexempt Securities

All Securities Offerings

Nonexempt Transactions

All nonexempt securities that are not offered in an exempt transaction normally require registration with the SEC.

E X H I B I T 2 8 – 1 Exemptions for Securities Offerings under the 1933 Securities Act

C H A P T E R 2 8 Investor Protection and Corporate Governance 593

The SEC must be notified of the sales, and pre- cautions must be taken, because these restricted secu- rities may be resold only by registration or in an exempt transaction. No general solicitation or adver- tising is allowed. The issuer must provide any unac- credited investors with disclosure documents, which generally are the same as those used in registered offerings.

Rule 506—Private Placement Exemption. Rule 506 exempts private, noninvestment company o�erings in unlimited amounts that are not generally solicited or advertised. �is exemption is often referred to as the private placement exemption because it exempts “trans- actions not involving any public o�ering.”17 �ere can be an unlimited number of accredited investors and up to thirty-�ve unaccredited investors. To qualify for the exemption, the issuer must believe that each unaccredited investor has su�cient knowledge or experience in �nan- cial matters to be capable of evaluating the investment’s merits and risks.18

The private placement exemption is perhaps the most important exemption for firms that want to raise funds through the sale of securities without registering funds through the sale of securities without registering funds through the sale of securities without registering funds through the sale of securities without registering them. ■ EXAMPLE 28.4 Citco Corporation needs to raise capital to expand its operations. Citco decides to make a private $10 million offering of its common stock directly to two hundred accredited investors and a group of thirty highly sophisticated, but unaccredited, inves- tors. Citco provides all of these investors with a prospec- tus and material information about the firm, including its most recent financial statements.

As long as Citco notifies the SEC of the sale, this offering will likely qualify as an exempt transaction under Rule 506. The offering is nonpublic and not generally advertised. There are fewer than thirty-five unaccredited investors, and each of them possesses sufficient knowl- edge and experience to evaluate the risks involved. The issuer has provided all purchasers with the material infor- mation. Thus, Citco will likely not be required to comply not be required to comply not with the registration requirements of the Securities Act of 1933. ■

Resales and Safe Harbor Rules Most securities can be resold without registration. The Securities Act provides exemptions for resales by most persons other than issuers or underwriters. The average investor who sells shares of stock need not file a registration statement with the SEC.

17. 15 U.S.C. Section 77d(2). 18. 17 C.F.R. Section 230.506.

Resales of restricted securities acquired under Rule 505 or Rule 506, however, trigger the registration require- ments unless the party selling them complies with Rule 144 or Rule 144A. These rules are sometimes referred to as safe harbors.

Rule 144. Rule 144 exempts restricted securities from registration on resale if all of the following conditions are met: 1. There is adequate current public information about

the issuer. (“Adequate current public information” refers to the reports that certain companies are required to file under the 1934 Securities Exchange Act.)

2. The person selling the securities has owned them for at least six months if the issuer is subject to the reporting requirements of the 1934 act. If the issuer is not subject to the 1934 act’s reporting require- ments, the seller must have owned the securities for at least one year.

3. The securities are sold in certain limited amounts in unsolicited brokers’ transactions.

4. The SEC is notified of the resale.19

Rule 144A. Securities that at the time of issue were not of the same class as securities listed on a national securities exchange or quoted in a U.S. automated interdealer quota- tion system may be resold under Rule 144A.20 �ey may be sold only to a quali�ed institutional buyer (an institution, such as an insurance company or a bank, that owns and invests at least $100 million in securities). �e seller must take reasonable steps to ensure that the buyer knows that the seller is relying on the exemption under Rule 144A.

28–1e Violations of the 1933 Act It is a violation of the Securities Act to intentionally defraud investors by misrepresenting or omitting facts in a registration statement or prospectus. Liability may also be imposed on those who are negligent with respect to the preparation of these publications. Selling securi- ties before the effective date of the registration statement or under an exemption for which the securities do not qualify also results in liability.

Can the omission of a material fact make a statement of opinion misleading to an ordinary investor? That was the question before the United States Supreme Court in the following case.

19. 17 C.F.R. Section 230.144. 20. 17 C.F.R. Section 230.144A.

594 U N I T F I V E The Regulatory Environment

Background and Facts Omnicare, Inc., a pharmacy services company, filed a registration state- ment in connection with a public offering. The statement expressed the company’s opinion that it was in compliance with federal and state laws. Later, the federal government accused Omnicare of receiving kickbacks from pharmaceutical manufacturers. The Laborers District Council Construction Industry Pension Fund and others, which had bought the stock, filed a suit in a federal district court against Omnicare.

The plaintiffs alleged that Omnicare’s legal-compliance opinion was “untrue” and that Omni- care had, in violation of the Securities Act, “omitted to state [material] facts necessary” to make that opinion not misleading. Omnicare argued that “no reasonable person, in any context, can understand a pure statement of opinion to convey anything more than the speaker’s own mindset.” The district court dismissed the pension funds’ suit, but the U.S. Court of Appeals for the Sixth Circuit reversed the dismissal. Omnicare appealed to the United States Supreme Court.

In the Language of the Court Justice KAGAN delivered the opinion of the Court.

* * * * * * * Whether a statement is “misleading” depends on the perspective of a reasonable investor: The

inquiry * * * is objective. * * * * * * * A reasonable person understands, and takes into account, the difference * * * between a state-

ment of fact and one of opinion. She recognizes the import of words like “I think” or “I believe,” and grasps that they convey some lack of certainty as to the statement’s content.

But Omnicare takes its point too far, because a reasonable investor may, depending on the cir- cumstances, understand an opinion statement to convey facts about how the speaker has formed the opinion—or, otherwise put, about the speaker’s basis for holding that view. And if the real facts are otherwise, but not provided, the opinion statement will mislead its audience. Consider an unadorned statement of opinion about legal compliance: “We believe our conduct is lawful.” * * * If the issuer made the statement in the face of its lawyers’ contrary advice, or with knowledge that the Federal Government was taking the opposite view, the investor * * * has cause to complain: He expects not just that the issuer believes the opinion (however irrationally), but that it fairly aligns with the information in the issuer’s possession at the time. Thus, if a registration statement omits material facts about the issuer’s inquiry into or knowledge concerning a statement of opinion, and if those facts conflict with what a reasonable investor would take from the statement itself, then [the Securities Act] creates liability. [Emphasis added.]

An opinion statement, however, is not necessarily misleading when an issuer knows, but fails to dis- close, some fact cutting the other way. * * * A reasonable investor does not expect that every fact known every fact known every to an issuer supports its opinion statement. [Emphasis in the original.]

Moreover, whether an omission makes an expression of opinion misleading always depends on context. Registration statements as a class are formal documents, filed with the SEC as a legal prerequisite for selling securities to the public. Investors do not, and are right not to, expect opinions contained in those statements to reflect baseless, off-the-cuff judgments, of the kind that an individual might communicate in daily life. At the same time, an investor reads each statement within such a document, whether of fact or opinion, in light of all its surrounding text, including hedges, disclaimers, and apparently conflicting information. And the investor takes into account the customs and practices of the relevant industry. * * * The reasonable investor understands a statement of opinion in its full context, and [the Securities Act] creates liability only for the omission of material facts that cannot be squared with such a fair reading. [Emphasis added.]

Decision and Remedy The United States Supreme Court concluded that “neither [lower court] consid- ered the Funds’ omissions theory with the right standard in mind.” The Court therefore vacated the decision

Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund Supreme Court of the United States, __ U.S. __, 135 S.Ct. 1318, 191 L.Ed.2d 253 (2015).

Case 28.1

C H A P T E R 2 8 Investor Protection and Corporate Governance 595

Remedies Criminal violations are prosecuted by the U.S. Department of Justice. Violators may be fined up to $10,000, imprisoned for up to five years, or both.

The SEC is authorized to impose civil sanctions against those who willfully violate the 1933 act. It can request an injunction to prevent further sales of the secu- rities involved or ask a court to grant other relief, such as ordering a violator to refund profits. Private parties who purchase securities and suffer harm as a result of false or omitted statements or other violations may bring a suit in a federal court to recover their losses and additional damages.

Defenses There are three basic defenses to charges of violations under the 1933 act. A defendant can avoid liability by proving any of the following: 1. The statement or omission was not material. 2. The plaintiff knew about the misrepresentation at

the time the stock was purchased. 3. The defendant exercised due diligence in preparing or due diligence in preparing or due diligence

reviewing the registration and reasonably believed at the time that the statements were true. This impor- tant defense is available to an underwriter or subse- quent seller but not to the issuer. ■ CASE IN POINT 28.5 In preparation for an initial

public offering (IPO), Blackstone Group, LP, filed a regis- tration statement with the SEC. At the time, Blackstone’s corporate private equity investments included FGIC Corporation (which insured investments in subprime mortgages) and Freescale Semiconductor, Inc. Before the IPO, FGIC’s customers began to suffer large losses, and Freescale lost an exclusive contract to make wireless 3G chipsets for Motorola, Inc. (its largest customer). The losses suffered by these two companies would affect Blackstone. Nevertheless, Blackstone’s registration state- ment did not mention the impact on its revenues of the investments in FGIC and Freescale.

Martin Litwin and others who had invested in Black- stone’s IPO filed a suit in a federal district court against Blackstone and its officers, alleging material omissions from the statement. Blackstone argued as a defense that the omissions were not material, and the lower court

dismissed the case. The plaintiffs appealed. A federal appellate court ruled that the alleged omissions were rea- sonably likely to be material, and remanded the case. The plaintiffs were entitled to the opportunity to prove at a trial that Blackstone had omitted material information that it was required to disclose.21 ■

28–2 The Securities Exchange Act of 1934

The 1934 Securities Exchange Act provides for the regu- lation and registration of securities exchanges, brokers, dealers, and national securities associations, such as the National Association of Securities Dealers (NASD). Unlike the 1933 act, which is a one-time disclosure law, the 1934 act provides for continuous periodic disclosures by publicly held corporations to enable the SEC to regu- late subsequent trading.

The Securities Exchange Act applies to companies that have assets in excess of $10 million and five hundred or more shareholders. These corporations are referred to as Section 12 companies because they are required to register their securities under Section 12 of the 1934 act. Section 12 companies are required to file reports with the SEC annually and quarterly, and sometimes even monthly if specified events occur (such as a merger).

The act also authorizes the SEC to engage in market surveillance to deter undesirable market practices such as fraud, market manipulation, and misrepresentation. In addition, the act provides for the SEC’s regulation of proxy solicitations for voting.

28–2a Section 10(b), SEC Rule 10b-5, and Insider Trading

Section 10(b) is one of the more important sections of the Securities Exchange Act. This section prohibits the use of any manipulative or deceptive mechanism in violation of

21. Litwin v. Blackstone Group, LP, 634 F.3d 706 (2d Cir. 2011).

of the lower court and remanded the case “for a determination of whether the Funds have stated a viable omissions claim (or, if not, whether they should have a chance to replead).”

Critical Thinking • Legal Environment Would a reasonable investor have cause to complain if an issuer, without having

consulted a lawyer, states, “We believe our conduct is lawful”? Explain.

Case 28.1 Continued

596 U N I T F I V E The Regulatory Environment

SEC rules and regulations. Among the rules that the SEC has promulgated pursuant to the 1934 act is SEC Rule 10b-5, which prohibits the commission of fraud in con- nection with the purchase or sale of any security.

SEC Rule 10b-5 applies to almost all cases concerning the trading of securities, whether on organized exchanges, in over-the-counter markets, or in private transactions. Generally, the rule covers just about any form of security. The securities need not be registered under the 1933 act for the 1934 act to apply.

Private parties can sue for securities fraud under Rule 10b-5. The basic elements of a securities fraud action are as follows: 1. A material misrepresentation (or omission) in connec-

tion with the purchase and sale of securities. 2. Scienter (a wrongful state of mind).Scienter (a wrongful state of mind).Scienter 3. Reliance by the plaintiff on the material misrep-Reliance by the plaintiff on the material misrep-Reliance

resentation. 4. An economic loss. 5. Causation, meaning that there is a causal connection

between the misrepresentation and the loss.

Insider Trading One of the major goals of Section 10(b) and SEC Rule 10b-5 is to prevent insider trading, which occurs when persons buy or sell securities on the basis of information that is not available to the public. Corporate directors, officers, and majority shareholders, among others, often have advance inside information that can affect the future market value of the corporate stock. Obviously, if they act on this information, their positions give them a trading advantage over the general public and other shareholders.

The 1934 act defines inside information. It also extends liability to those who take advantage of such information in their personal transactions when they know that the information is unavailable to those with whom they are dealing. Section 10(b) of the 1934 act

and SEC Rule 10b-5 apply to anyone who has access to or receives information of a nonpublic nature on which trading is based—not just to corporate “insiders.”

Disclosure under SEC Rule 10b-5 Any material omission or misrepresentation of material facts in con- nection with the purchase or sale of a security may violate Section 10(b) of the 1934 act and SEC Rule 10b-5. The key to liability (which can be civil or criminal) is whether the information omitted or misrepresented is material.

The following are some examples of material facts calling for disclosure under SEC Rule 10b-5: 1. Fraudulent trading in the company stock by a

broker-dealer. 2. A dividend change (whether up or down). 3. A contract for the sale of corporate assets. 4. A new discovery, a new process, or a new product. 5. A significant change in the firm’s financial condition. 6. Potential litigation against the company.

Note that any one of these facts, by itself, is not auto- matically considered material. It will be regarded as a material fact only if it is significant enough that it would likely affect an investor’s decision as to whether to pur- chase or sell the company’s securities.

■ EXAMPLE 28.6 Zilotek, Inc., is the defendant in a class-action product liability suit that its attorney, Paula Frasier, believes the company will lose. Frasier has advised Zilotek’s directors, officers, and accountants that the company will likely have to pay a substantial dam- ages award. Zilotek plans to make a $5 million offer- ing of newly issued stock before the date when the trial is expected to end. Zilotek’s potential liability and the financial consequences to the firm are material facts that must be disclosed, because they are significant enough to affect an investor’s decision to purchase the stock. ■

The case that follows is a Classic Case interpreting Classic Case interpreting Classic Case materiality under SEC Rule 10b-5.

Background and Facts Texas Gulf Sulphur Company (TGS) conducted aerial geophysical surveys over more than 15,000 square miles of eastern Canada. The operations indicated concentrations of commercially exploitable minerals. At one site near Timmins, Ontario, TGS drilled a hole that appeared to yield a core with an exceedingly high mineral content. The company did not disclose the results of the core sample to the public.

After learning of the sample, TGS officers and employees made substantial purchases of TGS’s stock or accepted stock options (rights to purchase stock). On April 11, 1964, an unauthorized report

Classic Case 28.2 SEC v. Texas Gulf Sulphur Co. United States Court of Appeals, Second Circuit, 401 F.2d 833 (1968).

C H A P T E R 2 8 Investor Protection and Corporate Governance 597

Outsiders and SEC Rule 10b-5 The traditional insider-trading case involves true insiders—corporate officers, directors, and majority shareholders who have access to (and trade on) inside information. Increas- ingly, however, liability under Section 10(b) of the 1934 act and SEC Rule 10b-5 has been extended to include certain “outsiders”—those who trade on inside informa- tion acquired indirectly. Two theories have been devel- oped under which outsiders may be held liable for insider

trading: the tipper/tippee theory and the tipper/tippee theory and the tipper/tippee theory misappropriation theory.

Tipper/Tippee Theory. Anyone who acquires inside information as a result of a corporate insider’s breach of his or her �duciary duty can be liable under SEC Rule 10b-5. �is liability extends to tippees (those who receive “tips” from insiders) and even remote tippees (tippees of remote tippees (tippees of remote tippees tippees).

of the mineral find appeared in the newspapers. On the following day, TGS issued a press release that played down the discovery and stated that it was too early to tell whether the ore find would be significant.

Several months later, TGS announced that the strike was expected to yield at least 25 million tons of ore. Subsequently, the price of TGS stock rose substantially. The Securities and Exchange Commis- sion (SEC) brought a suit against the officers and employees of TGS for violating SEC Rule 10b-5. The officers and employees argued that the information on which they had traded had not been material at the time of their trades because the mine had not then been commercially proved. The trial court held that most of the defendants had not violated SEC Rule 10b-5, and the SEC appealed.

In the Language of the Court WATERMAN, Circuit Judge.

* * * * * * * Whether facts are material within Rule 10b-5 when the facts relate to a particular event and are

undisclosed by those persons who are knowledgeable thereof will depend at any given time upon a balanc- ing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity. Here, * * * knowledge of the possibility, which surely was more than marginal, of the existence of a mine of the vast magnitude indicated by the remarkably rich drill core located rather close to the surface (suggesting mineability by the less expensive openpit method) within the confines of a large anomaly (suggesting an extensive region of mineralization) might well have affected the price of TGS stock and would certainly have been an important fact to a reasonable, if speculative, investor in deciding whether he should buy, sell, or hold. [Emphasis added.]

* * * * * * * A major factor in determining whether the * * * discovery was a material fact is the importance

attached to the drilling results by those who knew about it. * * * The timing by those who knew of it of their stock purchases * * *—purchases in some cases by individuals who had never before purchased * * * TGS stock—virtually compels the inference that the insiders were influenced by the drilling results.

Decision and Remedy The appellate court ruled in favor of the SEC. All of the trading by insiders who knew of the mineral find before its true extent had been publicly announced had violated SEC Rule 10b-5.

Impact of This Case on Today’s Law This landmark case affirmed the principle that the test of whether information is “material,” for SEC Rule 10b-5 purposes, is whether it would affect the judgment of reasonable investors. The corporate insiders’ purchases of stock and stock options indicated that they were influenced by the drilling results and that the information about the drilling results was material. The courts continue to cite this case when applying SEC Rule 10b-5 to cases of alleged insider trading.

Critical Thinking • What If the Facts Were Different? Suppose that further drilling had revealed that there was not

enough ore at this site for it to be mined commercially. Would the defendants still have been liable for vio- lating SEC Rule 10b-5? Why or why not?

Case 28.2 Continued

598 U N I T F I V E The Regulatory Environment

The key to liability under this theory is that the inside information must be obtained as a result of someone’s breach of a fiduciary duty to the corporation whose shares are traded. The tippee is liable only if the follow- ing requirements are met: 1. There is a breach of a duty not to disclose inside

information. 2. The disclosure is made in exchange for personal

benefit. 3. The tippee knows (or should know) of this breach

and benefits from it. ■ EXAMPLE 28.7 Eric McPhail was a member of the Eric McPhail was a member of the

same country club as an executive at American Super- conductor. While they were golfing, the executive shared information with McPhail about the company’s expected earnings, contracts, and other major developments, trusting that McPhail would keep the information con- fidential. Instead, McPhail tipped six of his other golfing buddies at the country club, and they all used the non- public information to their advantage in trading. In this situation, the executive breached his duty not to disclose the information, which McPhail knew. McPhail (the tip- pee) is liable under SEC Rule 10b-5, and so are his other golfing buddies (remote tippees). All traded on inside information to their benefit.22 ■

Misappropriation Theory. Liability for insider trading may also be established under the misappropriation the- ory. �is theory holds liable an individual who wrongfully obtains (misappropriates) inside information and trades on it for her or his personal gain. Basically, this individual has stolen information rightfully belonging to another.

The misappropriation theory has been controversial because it significantly extends the reach of SEC Rule 10b-5 to outsiders who ordinarily would not be deemed not be deemed not fiduciaries of the corporations in whose stock they trade. It is not always wrong to disclose material, nonpublic information about a company to a person who would not otherwise be privy to it. Nevertheless, a person who obtains the information and trades securities on it can be held liable.23

Insider Reporting and Trading—Section 16(b) Section 16(b) of the 1934 act provides for the recapture by the corporation of all profits realized by an insider on a purchase and sale, or sale and purchase, of the

22. Three of the defendants in this case agreed to settle with the SEC and return the trading profits. See SEC press release 2014-134 “SEC Charges Group of Amateur Golfers in Insider Trading Ring.”

23. See, for instance, United States v. Gansman, 657 F.3d 85 (2d Cir. 2011).

corporation’s stock within any six-month period.24 It is irrelevant whether the insider actually uses inside infor- mation—all such short-swing profits must be returned to the corporation.

In the context of Section 16(b), insiders means offi- cers, directors, and large stockholders of Section 12 corporations. (Large stockholders are those owning 10 percent of the class of equity securities registered under Section 12 of the 1934 act.) To discourage such insid- ers from using nonpublic information about their com- panies to their personal benefit in the stock market, the SEC requires them to file reports concerning their own- ership and trading of the corporation’s securities.

Section 16(b) applies not only to stock but also to warrants, options, and securities convertible into stock. In addition, the courts have fashioned complex rules for determining profits. Note, though, that the SEC exempts a number of transactions under Rule 16b-3.25

Exhibit 28–2 compares the effects of SEC Rule 10b-5 and Section 16(b). Because of the various ways in which insiders can incur liability under these provisions, corpo- rate insiders should seek the advice of competent counsel before trading in the corporation’s stock.

The Private Securities Litigation Reform Act The disclosure requirements of SEC Rule 10b-5 had the unintended effect of deterring the disclosure of forward- looking information. To understand why, consider the looking information. To understand why, consider the looking information. To understand why, consider the looking information. To understand why, consider the following situation. ■ EXAMPLE 28.8 XT Company announces that its projected earnings for a future time period will be a certain amount, but its forecast turns out to be wrong. The earnings are in fact much lower, and the price of XT’s stock is affected negatively. The shareholders bring a class-action suit against XT, alleging that its directors violated SEC Rule 10b-5 by disclosing misleading financial information. ■

In an attempt to solve the problem and promote full disclosure, Congress passed the Private Securities Litiga- tion Reform Act (PSLRA).26 Among other things, the PSLRA provides a “safe harbor” for publicly held com- panies that make forward-looking statements, such as financial forecasts. Those who make such statements are protected against liability for securities fraud if they include “meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement.”27

24. A person who expects the price of a particular stock to decline can real- ize profits by “selling short”—selling at a high price and repurchasing later at a lower price to cover the “short sale.”

25. 17 C.F.R. Section 240.16b-3. 26. Pub.L.No. 104-67, 109 Stat. 737, codified in various sections of Title

15 of the United States Code. 27. 15 U.S.C. Sections 77z-2, 78u-5.

C H A P T E R 2 8 Investor Protection and Corporate Governance 599

The PSLRA also affected the level of detail required in securities fraud complaints. Plaintiffs must specify each misleading statement and say how it led them to a mis- taken belief.

28–2b Regulation of Proxy Statements Section 14(a) of the Securities Exchange Act regulates the solicitation of proxies from shareholders of Section 12 companies. The SEC regulates the content of proxy statements. Whoever solicits a proxy must fully and accu- rately disclose in the proxy statement all of the facts that are pertinent to the matter on which the shareholders are to vote. SEC Rule 14a-9 is similar to the antifraud provi- sions of SEC Rule 10b-5. Remedies for violations range from injunctions to prevent a vote from being taken to monetary damages.

28–2c Violations of the 1934 Act As mentioned earlier, violations of Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5, includ- ing insider trading, may lead to both criminal and civil liability.

Scienter Requirement For either criminal or civil sanctions to be imposed, scienter must exist—that is, the scienter must exist—that is, the scienter violator must have had an intent to defraud or knowledge of his or her misconduct. Scienter can be proved by showScienter can be proved by showScienter - ing that the defendant made false statements or wrong- fully failed to disclose material facts. In some situations, it can even be proved by showing that the defendant was consciously reckless as to the truth or falsity of his or her statements.

■ CASE IN POINT 28.9 Alvin Gebhart and Jack Archer Alvin Gebhart and Jack Archer started a business venture purchasing mobile home parks (MHPs) from owners and converting them to resident ownership. They formed MHP Conversions, LP, to facilitate the conversion process and issue promissory notes that were sold to investors to raise funds for the purchases. Archer ran the MHP program, and Gebhart sold the promissory notes. Gebhart sold nearly $2.4 mil- lion in MHP promissory notes to clients, who bought the notes based on Gebhart’s positive statements about the investment.

During the time Gebhart was selling the notes, how- ever, he never actually looked into the finances of the MHP program. He relied entirely on information that Archer gave him, some of which was not true. When

AREA OF COMPARISON SEC RULE 10b-5 SECTION 16(b)

What is the subject matter of the transaction?

Any security (does not have to be registered).

What transactions are covered? Purchase or sale. Short-swing purchase and sale or short-swing sale and purchase.

Who is subject to liability? Almost anyone with inside information under a duty to disclose—including officers, directors, controlling shareholders, and tippees.

Officers, directors, and certain shareholders who own 10 percent or more.

Is omission or misrepresentation necessary for liability?

No.

No.Yes.

Are there any exempt transactions?

Yes, there are a number of exemptions.

Who may bring an action? A person transacting with an insider, the SEC, or a purchaser or seller damaged by a wrongful act.

A corporation or a shareholder by derivative action.

E X H I B I T 2 8 – 2 Comparison of Coverage, Application, and Liability under SEC Rule 10b-5 and Section 16(b)

600 U N I T F I V E The Regulatory Environment

Gebhart was later sued for securities fraud, a federal appellate court concluded that there was sufficient evi- dence of scienter. Gebhart knew that he had no knowl- edge of the financial affairs of MHP, and he had been consciously reckless as to the truth or falsity of his state- ments about investing in MHP.28 ■

Complaint Must Raise an Inference of Scienter.Scienter.Scienter In a complaint alleging a violation, the plainti� must state complaint alleging a violation, the plainti� must state complaint alleging a violation, the plainti� must state complaint alleging a violation, the plainti� must state facts giving rise to an inference of facts giving rise to an inference of scienter. ■ CASE IN CASE IN POINT 28.10 Between May 4 and June 22, Boeing Com- pany made announcements that its new plane called the Dreamliner, which had not yet �own, was on track for its �rst �ight on June 30. Meanwhile, however, the plane failed important stress tests before and after redesign. On June 23, Boeing canceled the scheduled debut �ight and warned of a delay in the delivery of the Dreamliner to the commercial airlines. Boeing’s stock price dropped more than 10 percent. 28. Gebhart v. SEC, 595 F.3d 1034 (9th Cir. 2010).

A group of investors filed a suit against Boeing for securities fraud. They claimed that Boeing and its offi- cers had known about the likely postponement of the first flight when they made public statements to the contrary. The plaintiffs argued that Boeing’s “internal e-mails” would confirm this theory but did not identify the source of these messages. A federal court dismissed the suit, and that dismissal was affirmed on appeal. Allegations “merely implying unnamed confidential sources” was not sufficient to give rise to an inference of scienter. Scienter can also be established by showing Scienter can also be established by showing Scienter a defendant’s motive to commit fraud, but Boeing had nothing to gain by delaying the postponement of the first flight.29 ■

Whether the plaintiff alleged sufficient facts to give rise to an inference of scienter was the question in the scienter was the question in the scienter following case.

29. City of Livonia Employees’ Retirement System and Local 295/Local 851 v. Boeing Co., 711 F.3d 754 (7th Cir. 2013).

In the Language of the Court BENTON, Circuit Judge.BENTON, Circuit Judge.BENTON

* * * * I.

[Dolan Company specializes in professional services and business infor- mation from its base in Minneapolis, Minnesota.] DiscoverReady—a subsid- iary of Dolan Company—performed litigation support [discovery manage- ment and document review services, including technology services related to processing and hosting discovery data], working mostly for Bank of America. In May or June 2013, Bank of America met with James Dolan (Chief Executive Officer of Dolan Company) and other DiscoverReady representatives. Bank of America noted concerns about Dolan Company’s finances * * * and indicated it would send no new work to Discover- Ready until the financial concerns were resolved. * * * Dolan reported what transpired at the meeting to Dolan Company’s Board of Directors, which

proceeded to authorize DiscoverReady for sale. Bank of America stopped send- ing new work to DiscoverReady in June.

On August 1, Dolan Company released a Form 10-Q [for the second quarter], which stated:

* * * To operate profitably on a continuous basis in the future, the Company must increase revenue and eliminate costs * * * . These challenges make it probable that the Company will be unable to comply with certain of its financial covenants.

Also on August 1, Dolan spoke with stock analysts. [Dolan made] the [follow- ing] statements during the conference:

For 2013, we expect * * * Discover- Ready * * * to grow at double-digit rates over the prior year * * *. How- ever, we must point out that we expect DiscoverReady’s third quarter rev- enues to be below last year’s all time record revenue quarter. We make this comment not to dampen enthusiasm

about our growth prospects for Dis- coverReady, but to set proper expectations for a business that may experience lumpiness on a quarter-to-quarter basis.

Asked to elaborate about “lumpiness,” Dolan stated:

Well, it’s hard to be very specific about the lumpiness now without getting into details we normally do not dis- close. * * * These things do come and they come sometimes unexpectedly, sometimes quickly. So * * * we have to be cautious in how we describe things.

On November 12, 2013, Dolan * * * filed its Form 10-Q ending September 30. [Form 10-Q is a quarterly report required by the Securities and Exchange Commission.] The 10-Q reported that the decline in revenue “exceeded our expectations,” largely due to “a reduction in new work from DiscoverReady’s largest customer, a reduction that we identified

Case Analysis 28.3 Rand-Heart of New York, Inc. v. Dolan United States Court of Appeals, Eighth Circuit, 812 F.3d 1172 (2016).

C H A P T E R 2 8 Investor Protection and Corporate Governance 601

Scienter Not Required for Section 16(b) Vio- lations Violations of Section 16(b) include the sale by insiders of stock acquired less than six months before the sale (or, for a short sale, less than six months after the sale). (Recall that a short sale involves selling securities that one does not yet own.) These violations are subject to civil sanctions. Liability under Section 16(b) is strict liability. Neither scienter nor negligence is required.scienter nor negligence is required.scienter

Criminal Penalties For violations of Section 10(b) and Rule 10b-5, an individual may be fined up to $5 mil- lion, imprisoned for up to twenty years, or both. A part- nership or a corporation may be fined up to $25 million. Under Section 807 of the Sarbanes-Oxley Act, for a will-will-will ful violation of the 1934 act the violator can be imprisful violation of the 1934 act the violator can be imprisful - oned for up to twenty-five years (in addition to being subject to a fine).

towards the end of the quarter. We believe this reduction resulted from the customer’s evaluation of the Company’s overall financial condition.” The clos- ing price for Dolan Company stock fell to $2.08 on November 11, to $1.05 on November 12, to $0.90 on November 13.

On January 2, 2014, Dolan Company issued a final press release announcing the appointment of a Chief Restructuring Officer * * * . Share prices then fell by $0.14. In March, Dolan Company filed a Chapter 11 bankruptcy.

II. * * * * Rand-Heart [of New York, Inc.]

brought a class action suit [in a federal district court on behalf of purchasers of Dolan Company’s securities between August 1, 2013, and January 2, 2014,] alleging Dolan made material misrepre- sentations and omissions about Discov- erReady’s financial stability [in violation of Section 10(b) and Rule 10b–5]. The district court granted Dolan’s motion to dismiss * * * . It found that Rand-Heart failed to allege scienter.

[Rand-Heart appealed the dismissal to the U.S. Court of Appeals for the Eighth Circuit.]

* * * *

A. Rand-Heart argues the district court

erred in finding inadequate allegations of scienter.

* * * * Rand-Heart maintains it adequately

pled scienter by alleging that Dolan had scienter by alleging that Dolan had scienter been severely reckless. Severe recklessness is defined as highly unreasonable omissions or misrepresentations involving an extreme departure from the standards of ordinary care, and presenting the danger of mislead-care, and presenting the danger of mislead-care, and presenting the danger of mislead ing buyers or sellers which is either known to the defendant or is so obvious that the defendant must have been aware of it. [Emphasis added.]

* * * * Rand-Heart * * * argues that Dolan

was reckless in failing to disclose that Bank of America had stopped sending new work to DiscoverReady in May or June 2013. Bank of America was DiscoverReady’s biggest client, provid- ing over 50% of DiscoverReady’s work. In the second half of 2013, however, Bank of America work sharply declined. The complaint quoted DiscoverReady’s Chief Operating Officer’s acknowledg- ment: “We were, our work, our revenues

were dropping and our case origination had dropped, as I said earlier, to almost nothing from Bank of America.” By May or June 2013, DiscoverReady had “completed a large document review project for Bank of America” imme- diately causing “great concerns.” This decline prompted the Company’s Board in June 2013 to “authorize the market- ing of DiscoverReady for sale.” Taking these allegations as true, DiscoverReady’s financial instability caused by the decline in Bank of America work was, at the least, so obvious that Dolan must have been aware of it. The facts pled are suf-been aware of it. The facts pled are suf-been aware of it. The facts pled are suf ficient to survive a motion to dismiss.

B. * * * * The district court erred in dismissing

the Section 10(b) and Rule 10b–5 claims for failure to state a claim.

III. * * * * The district court’s decision is * * *

reversed * * * and remanded for proceed- ings consistent with this opinion.

Legal Reasoning Questions

1. Scienter can be established by showing a defendant’s motive to commit fraud. In the context of the Scienter can be established by showing a defendant’s motive to commit fraud. In the context of the Scienter Rand-Heart case, what act Rand-Heart case, what act Rand-Heart might have established motive on Dolan’s part?

2. When Bank of America met with Dolan to discuss his company’s financial situation, it demanded that the company be restructured. Dolan did not disclose this fact in the Form 10-Q or in his conference with stock analysts. Was this omission misleading?

3. Suppose that Dolan had disclosed Bank of America’s action with respect to DiscoverReady in the Form 10-Q and the confer- ence. Would the result in this case have been different? Explain.

Case 28.3 Continued

602 U N I T F I V E The Regulatory Environment

For a defendant to be convicted in a criminal prosecu- tion under the securities laws, there can be no reason- able doubt that the defendant knew he or she was acting wrongfully. In other words, a jury is not allowed merely to speculate that the defendant may have acted willfully.

■ CASE IN POINT 28.11 Douglas Newton was the Douglas Newton was the president and sole director of Real American Brands, Inc. (RLAB). RLAB owned the Billy Martin’s USA brand and operated a Billy Martin’s retail boutique at the Trump Plaza in New York City. (Billy Martin’s, a Western wear store, was co-founded by Billy Martin, the one-time manager of the New York Yankees.)

Newton agreed to pay kickbacks to Chris Russo, whom he believed to be the manager of a pension fund, to induce the fund to buy shares of RLAB stock. Newton later arranged for his friend Yan Skwara to pay similar kickbacks for the fund’s purchase of stock in U.S. Farms, Inc. In reality, the pension fund was fictitious, and New- ton and Skwara had been dealing with agents of the Fed- eral Bureau of Investigation (FBI). Newton was charged with securities fraud and convicted by a jury (Skwara pled guilty). Newton appealed, but a federal appellate court upheld his conviction.

According to the court, the evidence established that in each transaction, the amount of the kickback was added to the price of the stock, which artificially increased the stock price. The evidence sufficiently proved that Newton had engaged in a scheme to defraud the supposed pen- sion fund. His words and conduct, which were revealed on video at the trial, showed his intent to defraud the pension fund investors.30 ■

Civil Sanctions The SEC can also bring a civil action against anyone who purchases or sells a security while in possession of material nonpublic information in violation of the 1934 act or SEC rules.31 The violation must occur through the use of a national securities exchange or a bro- ker or dealer.32 A court can assess a penalty amounting to as much as triple the profits gained or the loss avoided by the guilty party.33

The Insider Trading and Securities Fraud Enforce- ment Act enlarged the class of persons who may be sub- ject to civil liability for insider trading. In addition, this

30. United States v. Newton, 559 Fed.Appx. 902 (11th Cir. 2014). 31. 15 U.S.C. Section 78u(d)(2)(A). 32. Transactions pursuant to a public offering by an issuer of securities are

exempted. 33. 15 U.S.C. Section 78u(d)(2)(C).

act gave the SEC authority to offer monetary rewards to informants.34

Private parties may also sue violators of Section 10(b) and Rule 10b-5. A private party can obtain rescission (cancellation) of a contract to buy securities or damages to the extent of the violator’s illegal profits. Those found liable have a right to seek contribution from those who share responsibility for the violations, including accoun- tants, attorneys, and corporations. For violations of Sec- tion 16(b), a corporation can bring an action to recover the short-swing profits.

28–2d Securities Fraud Online and Ponzi Schemes

A problem facing the SEC today is how to enforce the antifraud provisions of the securities laws in the online environment. Internet-related forms of securities fraud include many types of investment scams. Spam, online newsletters and bulletin boards, chat rooms, blogs, social media, and tweets can all be used to spread false infor- mation and perpetrate fraud. For a relatively small cost, fraudsters can even build sophisticated Web pages to facilitate their investment scams.

Investment Newsletters Hundreds of online invest- ment newsletters provide information on stocks. Legiti- mate online newsletters can help investors gather valuable information, but some e-newsletters are used for fraud. The law allows companies to pay these newsletters to tout their securities. The newsletters are required to disclose who paid for the advertising, but many newsletters do not follow that law. Thus, an investor reading an online newsletter may believe that the information is unbiased, when in fact the fraudsters will directly profit by convinc- ing investors to buy or sell particular stocks.

Ponzi Schemes Although much securities fraud occurs online, schemes conducted primarily offline have not dis- appeared. In recent years, the SEC has filed an increasing number of enforcement actions against perpetrators of Ponzi schemes. (Ponzi schemes are fraudulent investment operations that pay returns to investors from new capital paid to the fraudsters rather than from a legitimate invest- ment.) Such schemes sometimes target U.S. residents and convince them to invest in offshore companies or banks.

34. 15 U.S.C. Section 78u-1.

C H A P T E R 2 8 Investor Protection and Corporate Governance 603

28–3 State Securities Laws Today, every state has its own corporate securities laws, or blue sky laws, that regulate the offer and sale of securi- ties within its borders. (The phrase blue sky laws comes blue sky laws comes blue sky laws from a 1917 United States Supreme Court decision. The Court stated that the purpose of such laws was to pre- vent “speculative schemes which have no more basis than so many feet of ‘blue sky.’ ”)35 Article 8 of the Uniform Commercial Code, which has been adopted by all of the states, also imposes various requirements relating to the purchase and sale of securities.

28–3a Requirements under State Securities Laws

State securities laws apply mainly to intrastate transac- tions (transactions within one state). Typically, state laws have disclosure requirements and antifraud provisions, many of which are patterned after Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. State laws also provide for the registration of securities offered or issued for sale within the state and impose dis- closure requirements.

■ CASE IN POINT 28.12 Randall Fincke was the founder, director, and officer of Access Cardiosystems, Inc., a small start-up company that sold portable auto- mated external heart defibrillators. Fincke prepared a business plan stating that Access’s “patent counsel” had advised the firm that “its product does not infringe any patents.” This statement was false—patent coun- sel never offered Access any opinion on the question of infringement.

Fincke gave this plan to potential investors, includ- ing Joseph Zimmel, who bought $1.5 million in Access shares. When the company later filed for Chapter 11 bankruptcy protection, Zimmel filed a complaint with the federal bankruptcy court, alleging that Fincke had violated the Massachusetts blue sky law. The court awarded Zimmel $1.5 million in damages, and the award was affirmed on appeal. Fincke had solicited investors “by means of ” a false statement of material fact, in violation of the fraud provisions in the state’s securities laws.36 ■

35. Hall v. Geiger-Jones Co., 242 U.S. 539, 37 S.Ct. 217, 61 L.Ed. 480 (1917).

36. In re Access Cardiosystems, Inc., 776 F.3d 60 (1st Cir. 2015).

Methods of registration, required disclosures, and exemptions from registration vary among states. Unless an exemption from registration is applicable, issuers must register or qualify their stock with the appropri- ate state official, often called a corporations commissioner. Additionally, most state securities laws regulate securities brokers and dealers.

28–3b Concurrent Regulation Since the adoption of the 1933 and 1934 federal securi- ties acts, the state and federal governments have regulated securities concurrently. Issuers must comply with both federal and state securities laws, and exemptions from federal law are not exemptions from state laws.

The dual federal and state system has not always worked well, particularly during the early 1990s, when the securities markets underwent considerable expan- sion. Today, many of the duplicate regulations have been eliminated, and the SEC has exclusive power to regulate most national securities activities.

The National Conference of Commissioners on Uni- form State Laws has substantially revised the Uniform Securities Act to coordinate state and federal securities regulation and enforcement efforts. Nineteen states have adopted the most recent version of the Uniform Securi- ties Act.37

28–4 Corporate Governance Corporate governance can be narrowly defined as the relationship between a corporation and its sharehold- ers. Some argue for a broader definition—that corpo- rate governance specifies the rights and responsibilities among different participants in the corporation, such as the board of directors, managers, shareholders, and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. Regardless of the way it is defined, effective corporate governance requires more than just compliance with laws and regulations.

Effective corporate governance is essential in large cor- porations because corporate ownership (by shareholders)

37. At the time this book went to press, the Uniform Securities Act had been adopted in Georgia, Hawaii, Idaho, Indiana, Iowa, Kansas, Maine, Michigan, Minnesota, Mississippi, Missouri, New Hampshire, New Mexico, Oklahoma, South Carolina, South Dakota, Vermont, Wiscon- sin, and Wyoming, as well as in the U.S. Virgin Islands.

604 U N I T F I V E The Regulatory Environment

is separated from corporate control (by officers and managers). Under these circumstances, officers and managers may attempt to advance their own interests at the expense of the shareholders. The well-publicized corporate scandals in the early 2000s clearly illustrated how the misconduct of corporate managers can cause harm to companies and to society. Indeed, with the globalization of business, corporate governance has become even more important because a corporation’s bad acts (or lack of control systems) can have far- reaching consequences.

28–4a Aligning the Interests of Officers and Shareholders

Some corporations have sought to align the finan- cial interests of their officers with those of the compa- ny’s shareholders by providing the officers with stock options. These options enable holders to purchase shares of the corporation’s stock at a set price. When the mar- ket price rises above that level, the officers can sell their shares for a profit. Because a stock’s market price gen- erally increases as the corporation prospers, the options give the officers a financial stake in the corporation’s well- being and supposedly encourage them to work hard for the benefit of the shareholders.

Problems with Stock Options Options have turned out to be an imperfect device for encouraging effective governance. Executives in some companies have been tempted to “cook” the company’s books in order to keep share prices higher so that they can sell their stock for a profit. Executives in other corporations have experi- enced no losses when share prices dropped because their options were “repriced” so that they did not suffer from the price decline. Thus, although stock options theoreti- cally can motivate officers to protect shareholder interests, stock option plans have sometimes become a way for offi- cers to take advantage of shareholders.

Outside Directors With stock options generally fail- ing to work as planned, there has been an outcry for more outside directors (those with no formal employment affil- iation with the company). The theory is that independent directors will more closely monitor the actions of corpo- rate officers. Hence, today we see more boards with out- side directors. Note, though, that outside directors may not be truly independent of corporate officers. They may be friends or business associates of the leading officers.

28–4b Promoting Accountability Effective corporate governance standards are designed to address problems such as those briefly discussed earlier and to motivate officers to make decisions that promote the financial interests of the company’s shareholders. Generally, corporate governance entails corporate decision-making structures that monitor employees (particularly officers) to ensure that they are acting for the benefit of the sharehold- ers. Thus, corporate governance involves, at a minimum: 1. The audited reporting of financial conditions at the

corporation so that managers can be evaluated. 2. Legal protections for shareholders so that violators of

the law who attempt to take advantage of sharehold- ers can be punished for misbehavior and victims can recover damages for any associated losses.

Governance and Corporate Law State corpora- tion statutes set up the legal framework for corporate governance. Under the corporate law of Delaware, where most major companies incorporate, all corporations must have certain structures of corporate governance in place. The most important structure, of course, is the board of directors, because the board makes the major decisions about the future of the corporation.

The Board of Directors Under corporate law, a cor- poration must have a board of directors elected by the shareholders. Directors are responsible for ensuring that the corporation’s officers are operating wisely and in the exclusive interest of shareholders. Directors receive reports from the officers and give them managerial direction. In reality, though, corporate directors devote a relatively small amount of time to monitoring officers.

Ideally, shareholders would monitor the directors’ supervision of the officers. In practice, however, it can be difficult for shareholders to monitor directors and hold them responsible for corporate failings. Although the directors can be sued if they fail to do their jobs effec- tively, directors are rarely held personally liable.

The Audit Committee. A crucial committee of the board of directors is the audit committee, which oversees the cor- poration’s accounting and �nancial reporting processes, including both internal and outside auditors. Unless the committee members have su�cient expertise and are willing to spend the time to carefully examine the corpo- ration’s bookkeeping methods, however, the audit com- mittee may be ine�ective.

C H A P T E R 2 8 Investor Protection and Corporate Governance 605

The audit committee also oversees the corporation’s “internal controls.” These controls, carried out largely by the company’s internal auditing staff, are measures taken to ensure that reported results are accurate. For instance, internal controls help to determine whether a corpora- tion’s debts are collectible. If the debts are not collectible, it is up to the audit committee to make sure that the cor- poration’s financial officers do not simply pretend that payment will eventually be made.

The Compensation Committee. Another important committee of the board of directors is the compensation committee, which determines the compensation of the company’s o�cers. As part of this process, the commit- tee must assess the o�cers’ performance and attempt to design a compensation system that will align the o�cers’ interests with those of the shareholders.

28–4c The Sarbanes-Oxley Act In 2002, following a series of corporate scandals, Con- gress passed the Sarbanes-Oxley Act,38 which addresses certain issues relating to corporate governance. Gener- ally, the act attempts to increase corporate accountabil- ity by imposing strict disclosure requirements and harsh penalties for violations of securities laws. Among other things, the act requires chief corporate executives to take personal responsibility for the accuracy of financial state- ments and reports that are filed with the SEC.

Additionally, the act requires that certain financial and stock-transaction reports be filed with the SEC ear- lier than was required under the previous rules. The act also created a new entity, called the Public Company Accounting Oversight Board, to regulate and oversee public accounting firms. Other provisions of the act established private civil actions and expanded the SEC’s remedies in administrative and civil actions.

Because of the importance of this act for corporate leaders and for those dealing with securities transactions, we highlight some of its key provisions relating to corpo- rate accountability in Exhibit 28–3.

More Internal Controls and Accountability The Sarbanes-Oxley Act introduced direct federal corpofederal corpofederal - rate governance requirements for publicly traded compa- nies. The law addressed many of the corporate governance procedures just discussed and created new requirements

38. 15 U.S.C. Sections 7201 et seq.

in an attempt to make the system work more effectively. The requirements deal with independent monitoring of company officers by both the board of directors and auditors.

Sections 302 and 404 of the Sarbanes-Oxley Act require high-level managers (the most senior officers) to establish and maintain an effective system of internal controls. The system must include “disclosure controls and procedures” to ensure that company financial reports are accurate and timely and to document financial results prior to reporting.

Senior management must reassess the system’s effec- tiveness annually. Some companies have had to take expensive steps to bring their internal controls up to the new federal standards. Hundreds of companies have reported that they identified and corrected shortcomings in their internal control systems as a result.

Exemptions for Smaller Companies The act ini- tially required all public companies to have an indepen- dent auditor file a report with the SEC on management’s assessment of internal controls. Congress, however, enacted an exemption for smaller companies in 2010 in an effort to reduce compliance costs. Public companies with a market capitalization, or public float, of less than $75 million no longer need to have an auditor report on management’s assessment of internal controls.

Certification and Monitoring Requirements Section 906 of the Sarbanes-Oxley Act requires that chief executive officers and chief financial officers certify the accuracy of the information in the corporate financial statements. The statements must “fairly represent in all material respects, the financial conditions and results of operations of the issuer.” This requirement makes the offi- cers directly accountable for the accuracy of their finan- cial reporting and precludes any “ignorance defense” if shortcomings are later discovered.

The act also includes requirements to improve direc- tors’ monitoring of officers’ activities. All members of a publicly traded corporation’s audit committee, which oversees the corporation’s accounting and financial reporting processes, must be outside directors. The audit committee must have a written charter that sets out its duties and provides for performance appraisal. At least one “financial expert” must serve on the audit commit- tee, which must hold executive meetings without com- pany officers being present. In addition to reviewing the internal controls, the committee also monitors the actions of the outside auditor.

606 U N I T F I V E The Regulatory Environment

STATUTE OF LIMITATIONS FOR SECURITIES FRAUD

Section 804 provides that a private right of action for securities fraud may be brought no later than two years after the discovery of the violation or five years after the violation, whichever is earlier.

ENHANCED PENALTIES

• Violations of Section 906 Certification Requirements—A CEO or CFO who certifies a financial report or statement filed with the SEC knowing that the report or statement does not fulfill all of the requirements of Section 906 will be subject to criminal penalties of up to $1 million in fines, ten years in prison, or both. Section 906 will be subject to criminal penalties of up to $1 million in fines, ten years in prison, or both. Section 906 Willful violators of the certification requirements may be subject to $5 million in fines, twenty years in prison,Willful violators of the certification requirements may be subject to $5 million in fines, twenty years in prison,Willful or both.

• Violations of the Securities Exchange Act of 1934—Penalties for securities fraud under the 1934 act were also increased. Individual violators may be fined up to $5 million, imprisoned for up to twenty years, or both. Willful violators may be imprisoned for up to twenty-five years in addition to being fined.Willful violators may be imprisoned for up to twenty-five years in addition to being fined.Willful

• Destruction or Alteration of Documents—Anyone who alters, destroys, or conceals documents or otherwise obstructs any official proceeding will be subject to fines, imprisonment for up to twenty years, or both.

• Other Forms of White-Collar Crime—The act stiffened the penalties for certain criminal violations, such as federal mail and wire fraud, and ordered the U.S. Sentencing Commission to revise the sentencing guidelines for white-collar crimes.

Protection for Whistleblowers—Section 806 protects “whistleblowers”—employees who “blow the whistle” on securities violations by their employers—from being fired or in any way discriminated against by their employers.

Blackout Periods—Section 306 prohibits certain6 prohibits certain6 types of securities transactions during “blackout periods”—periods during which the issuer’s ability to purchase, sell, or otherwise transfer funds in individual account plans (such as pension funds) is suspended.

CERTIFICATION REQUIREMENTS

Under Section 906 of the Sarbanes-Oxley Act, Section 906 of the Sarbanes-Oxley Act, Section 906 the chief executive officers (CEOs) and chief financial officers (CFOs) of most major companies listed on public stock exchanges must certify financial statements that are filed with the SEC. CEOs and CFOs have to certify that filed financial reports “fully comply” with SEC requirements and that all of the information reported “fairly represents in all material respects, the financial conditions and results of operations of the issuer.”

Under Section 302 of the act, CEOs and CFOs of reporting companies are required to certify that a signing officer reviewed each quarterly and annual filing with the SEC and that none contained untrue statements of material fact. Also, the signing officer or officers must certify that they have established an internal control system to identify all material information and that any deficiencies in the system were disclosed to the auditors.

INTERNAL CONTROLS

Financial Controls—Section 404(a) requires all public companies to assess the effectiveness of their internal control over financial reporting. Section 404(b) requires independent auditors to report on management’s assessment of internal controls, but certain companies are exempted. Loans to Directors and Officers—Section 402 prohibits any reporting company—as well as any private company that is filing an initial public offering—from making personal loans to directors and executive officers with a few limited exceptions.

E X H I B I T 2 8 – 3 Some Key Provisions of the Sarbanes-Oxley Act Relating to Corporate Accountability

C H A P T E R 2 8 Investor Protection and Corporate Governance 607

Reviewing: Investor Protection and Corporate Governance

Dale Emerson served as the chief financial officer for Reliant Electric Company, a distributor of electricity serving portions of Montana and North Dakota. Reliant was in the final stages of planning a takeover of Dakota Gasworks, Inc., a natural gas distributor that operated solely within North Dakota. Emerson went on a weekend fishing trip with his uncle, Ernest Wallace. Emerson mentioned to Wallace that he had been putting in a lot of extra hours at the office planning a takeover of Dakota Gasworks. When he returned from the fishing trip, Wallace purchased $20,000 worth of Reliant stock. Three weeks later, Reliant made a tender offer to Dakota Gasworks stockholders and purchased 57 percent of Dakota Gasworks stock. Over the next two weeks, the price of Reliant stock rose 72 percent before leveling out. Wallace then sold his Reliant stock for a gross profit of $14,400. Using the information presented in the chapter, answer the following questions. 1. Would registration with the SEC be required for Dakota Gasworks securities? Why or why not? 2. Did Emerson violate Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5? Why or why not? 3. What theory or theories might a court use to hold Wallace liable for insider trading? 4. Under the Sarbanes-Oxley Act, who would be required to certify the accuracy of the financial statements Reliant

filed with the SEC?

Debate This . . . Insider trading should be legalized.

Terms and Concepts accredited investor 592 blue sky laws 603 corporate governance 603 free-writing prospectus 590 insider trading 596

investment company 591 investment contract 588 mutual fund 591 prospectus 589 SEC Rule 10b-5 596

securities 588 short-swing pro�ts 598 stock option 604 tippee 597

Issue Spotters 1. When a corporation wishes to issue certain securities,

it must provide sufficient information for an unsophis- ticated investor to evaluate the financial risk involved. Specifically, the law imposes liability for making a false statement or omission that is “material.” What sort of information would an investor consider material? (See The Securities Exchange Act of 1934.)

2. Lee is an officer of Magma Oil, Inc. Lee knows that a Magma geologist has just discovered a new deposit of oil. Can Lee take advantage of this information to buy and sell Magma stock? Why or why not? (See The Securities Exchange Act of 1934.)

• Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.

Business Scenarios 28–1. Registration Requirements. Estrada Hermanos, Inc., a corporation incorporated and doing business in Florida, decides to sell $1 million worth of its common stock to the public. The stock will be sold only within the state of Florida. José Estrada, the chair of the board, says the offering need not be registered with the Securities and Exchange Commission. His brother, Gustavo, disagrees. Who is right? Explain. (See The Securities Act of 1933.) 28–2. Registration Requirements. Huron Corp. has 300,000 common shares outstanding. The owners of these

outstanding shares live in several different states. Huron has decided to split the 300,000 shares two for one. Will Huron Corp. have to file a registration statement and prospectus on the 300,000 new shares to be issued as a result of the split? Explain. (See The Securities Act of 1933.) 28–3. Insider Trading. David Gain was the chief execu- tive officer (CEO) of Forest Media Corp., which became interested in acquiring RS Communications, Inc. To initiate negotiations, Gain met with RS’s CEO, Gill Raz, on Friday, Copyright 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. WCN 02-200-203

608 U N I T F I V E The Regulatory Environment

July 12. Two days later, Gain phoned his brother Mark, who bought 3,800 shares of RS stock on the following Monday. Mark discussed the deal with their father, Jordan, who bought 20,000 RS shares on Thursday. On July 25, the day before the RS bid was due, Gain phoned his parents’ home, and Mark bought another 3,200 RS shares. The same routine was fol- lowed over the next few days, with Gain periodically phoning Mark or Jordan, both of whom continued to buy RS shares.

Forest’s bid was refused, but on August 5, RS announced its merger with another company. The price of RS stock rose 30 percent, increasing the value of Mark’s and Jordan’s shares by $664,024 and $412,875, respectively. Did Gain engage in insider trading? What is required to impose sanctions for this offense? Could a court hold Gain liable? Why or why not? (See The Securities Exchange Act of 1934.)

Business Case Problems 28–4. Business Case Problem with Sample Answer— Violations of the 1934 Act. Matrixx Initiatives, Inc.,

makes and sells over-the-counter pharmaceutical products. Its core brand is Zicam, which accounts for 70 percent of its sales. Matrixx received reports that some consumers had lost their sense of smell

(a condition called anosmia) after using Zicam Cold Remedy. Four product liability suits were �led against Matrixx, seeking damages for anosmia. In public statements relating to reve- nues and product safety, however, Matrixx did not reveal this information.

James Siracusano and other Matrixx investors filed a suit in a federal district court against the company and its executives under Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, claiming that the statements were mis- leading because they did not disclose information regarding the product liability suits. Matrixx argued that to be material, information must consist of a statistically significant number of adverse events that require disclosure. Because Siracusano’s claim did not allege that Matrixx knew of a statistically signifi- cant number of adverse events, the company contended that the claim should be dismissed. What is the standard for mate- riality in this context? Should Siracusano’s claim be dismissed? Explain. [Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 131 S.Ct. 1309, 179 L.Ed.2d 398 (2011)] (See The Securities Exchange Act of 1934.)Exchange Act of 1934.)Exchange Act of 1934 • For a sample answer to Problem 28–4, go to Appendix E at

the end of this text.

28–5. Disclosure under SEC Rule 10b-5. Dodona I, LLC, invested $4 million in two securities o�erings from Goldman, Sachs & Co. �e investments were in collateral- ized debt obligations (CDOs). �eir value depended on resi- dential mortgage-backed securities (RMBS), whose value in turn depended on the performance of subprime residential mortgages.

Before marketing the CDOs, Goldman had noticed several “red flags” relating to investments in the subprime market, in which it had invested heavily. To limit its risk, Goldman began betting against subprime mortgages, RMBS, and CDOs, including the CDOs it had sold to Dodona. In other words, Goldman made investments based on the assumption that subprime mortgages and the securities instruments built upon them would decrease in value. In an internal e-mail, one

Goldman official commented that the company had managed to “make some lemonade from some big old lemons.” Never- theless, Goldman’s marketing materials provided only boiler- plate statements about the risks of investing in the securities.

The CDOs were later downgraded to junk status, and Dodona suffered a major loss while Goldman profited. Assuming that Goldman did not affirmatively misrepresent any facts about the CDOs, can Dodona still recover under SEC Rule 10b-5? If so, how? [Dodona I, LLC v. Goldman, Sachs & Co., 847 F.Supp.2d 624 (S.D.N.Y. 2012)] (See The Securities Exchange Act of 1934.)Securities Exchange Act of 1934.)Securities Exchange Act of 1934 28–6. Violations of the 1933 Act. �ree shareholders of iStorage sought to sell their stock through World Trade Financial Corp. �e shares were restricted securities—that is, restricted securities—that is, restricted securities securities acquired in an unregistered, private sale. Restricted securities typically bear a “restrictive” legend clearly stating that they cannot be resold in the public marketplace. �is legend had been wrongly removed from the iStorage shares, however.

Information about the company that was publicly available included the fact that, despite a ten-year life, it had no operat- ing history or earnings. In addition, it had net losses of about $200,000, and its stock was thinly traded. Without investigat- ing the company or the status of its stock, World Trade sold more than 2.3 million shares to the public on behalf of the three customers. Did World Trade violate the Securities Act of 1933? Discuss. [World Trade Financial Corp. v. Securities and Exchange Commission, 739 F.3d 1243 (9th Cir. 2014)] (See The Securities Act of 1933.) 28–7. Securities Act of 1933. Big Apple Consulting USA, Inc., provided small publicly traded companies with a variety of services, including marketing, business planning, and Web site development and maintenance. CyberKey Corp. sold cus- tomizable USB drives. CyberKey falsely informed Big Apple that CyberKey had been awarded a $25 million contract with the Department of Homeland Security. Big Apple used this information in aggressively promoting CyberKey’s stock and was compensated for the e�ort in the form of CyberKey shares.

When the Securities and Exchange Commission (SEC) began to investigate, Big Apple sold its shares for $7.8 million. The SEC filed an action in a federal district court against Big Apple, alleging a violation of the Securities Act of 1933. Can

C H A P T E R 2 8 Investor Protection and Corporate Governance 609

liability be imposed on a seller for a false statement that was made by someone else? Explain. [U.S. Securities and Exchange Commission v. Big Apple Consulting USA, Inc., 783 F.3d 786 (11th Cir. 2015)] (See The Securities Act of 1933.) 28–8. The Securities Exchange Act of 1934. Dilean Reyes-Rivera was the president of Global Reach Trading (GRT), a corporation registered in Puerto Rico. His brother Je�rey was the �rm’s accountant. Along with GRT sales agents and other promoters, the brothers solicited funds from indi- viduals by promising to invest the funds in low-risk, short- term, high-yield securities. �e investors were guaranteed a rate of return of up to 20 percent. �rough this arrangement, more than 230 persons provided the brothers with about $22 million. �is money was not actually invested. Instead, the funds received from later investors were used to pay “returns” to earlier investors. �e Reyes-Riveras spent $4.6 million of the proceeds to buy luxury vehicles, houses, furniture, jewelry, and trips for themselves. What is this type of scheme called? What are the potential consequences? Discuss. [United States v. Reyes-Rivera, 812 F.3d 79 (1st Cir. 2016)] (See �e Securities Exchange Act of 1934.)Exchange Act of 1934.)Exchange Act of 1934 28–9. A Question of Ethics—Violations of the 1934 Act. Melvin Lyttle told John Montana and Paul Knight about a

“Trading Program” that purportedly would buy and sell securities. Lyttle said the securities deals were fully insured, as well as monitored and controlled by the Federal Reserve. Without checking the details or even

verifying whether the Program existed, Montana and Knight, with Lyttle’s help, began to sell interests in the Program to

investors. For a minimum investment of $1 million, the investors were promised extraordinary rates of return—from 10 percent to as much as 100 percent per week—without risk. �ey were told, among other things, that the Program would “utilize banks that can ensure full bank integrity of �e Transaction whose undertaking[s] are in complete harmony with international banking rules and protocol and who guarantee maximum security of a Funder’s Capital Placement Amount.” Nothing was required but the investors’ funds and their silence—the Program was to be kept secret. Over a four-month period in 1999, Montana raised approximately $23 million from twenty-two investors. �e prom- ised gains did not accrue, however. Instead, Montana, Lyttle, and Knight depleted investors’ funds in high-risk trades or spent the funds on themselves. [SEC v. Montana,funds on themselves. [SEC v. Montana,funds on themselves. [ 464 F.Supp.2d 772 (S.D.Ind. 2006)] (See �e Securities Exchange Act of 1934.)�e Securities Exchange Act of 1934.)�e Securities Exchange Act of 1934 (a) The Securities and Exchange Commission (SEC) filed

a suit in a federal district court against Montana and the others, seeking an injunction, civil penalties, and refund of profits with interest. The SEC alleged, among other things, violations of Section 10(b) of the Securi- ties Exchange Act of 1934 and SEC Rule 10b-5. What is required to establish such violations? Describe how and why the facts in this case meet, or fail to meet, these requirements.

(b) It is often remarked, “There’s a sucker born every minute!” Does that phrase describe the Program’s investors? Ulti- mately, about half of the investors recouped the amount they invested. Should the others be considered at least partly responsible for their own losses? Why or why not?

Legal Reasoning Group Activity 28–10. Violations of Securities Laws. Karel Svoboda, a credit o�cer for Rogue Bank, evaluated and approved his employer’s extensions of credit to clients. �ese responsibili- ties gave Svoboda access to nonpublic information about the clients’ earnings, performance, acquisitions, and business plans from con�dential memos, e-mail, and other sources. Svoboda devised a scheme with Alena Robles, an independent accountant, to use this information to trade securities. Pursu- ant to their scheme, Robles traded in the securities of more than twenty di�erent companies and pro�ted by more than $2 million. Svoboda also executed trades for his own pro�t of more than $800,000, despite their agreement that Robles would do all of the trading. Aware that their scheme violated

Rogue Bank’s policy, they attempted to conduct their trades in such a way as to avoid suspicion. When the bank questioned Svoboda about his actions, he lied, refused to cooperate, and was �red. (See �e Securities Exchange Act of 1934.)�e Securities Exchange Act of 1934.)�e Securities Exchange Act of 1934 (a) The first group will determine whether Svoboda or Robles

committed any crimes. (b) The second group will decide whether Svoboda or Robles

is subject to civil liability. If so, who could file a suit, and on what ground? What are the possible sanctions?

(c) A third group will identify any defenses that Svoboda or Robles could raise and determine their likelihood of success.

610

U N I T F I V E Application and Ethics

Our planet’s average temperature has risen by 1.5 degrees Fahrenheit over the last hundred years. It is predicted that it will rise another 0.5 to 4.5 degrees over the next century. These seemingly small increases in the average temperature can result in significant change to our climate.

What Are the Causes? Over the last century, our atmosphere experienced a large increase in carbon dioxide and other greenhouse gases (GHGs). GHGs act like a blanket around our planet, absorbing radiation from the surface, trapping it as heat in the atmosphere, and reflecting it back to the surface.

This process, known as the greenhouse effect, is necessary to support life. The recent increase greenhouse effect, is necessary to support life. The recent increase greenhouse effect in GHGs, however, may be changing our climate. Deforestation, industrial processes, and agri- cultural practices emit these gases, but the majority of GHGs come from burning fossil fuels to produce energy.1

What Are the Effects? The warmer it gets, the greater the risk for more change to the climate. Ultimately, the climate that we are used to may no longer be a guide for what to expect in the future.

Changes in Weather Rising global temperatures have sometimes coincided with changes in weather. Some locations have seen altered rainfall, resulting in heavier rains and more floods, or more frequent and intense heat waves and droughts. The rising temperatures may also be mak- ing our planet’s oceans warmer and more acidic. Some glaciers and ice caps are melting, which may cause sea levels to rise.

Impacts on Society The warmer temperatures and changes in weather can affect society in many ways. Agricultural yields, human health, and the supply of energy are affected. More severe weather can lead to higher food and energy prices and increasing insurance costs. (Note, though, that higher average temperatures could lead to more agricultural output and hence lower food prices.) Of course, any impact in one area of human activity can have widespread and unforeseen effects throughout society.

What Can We Do about It? The effects of climate change may be lessened by choices that reduce GHGs. About half of the states have set statewide GHG emission goals.2 In the areas of transportation and power genera- tion, two of the options for reducing emissions are the use of low-emission fuels and increased energy efficiency.

Reduce Emissions at the Pump and the Plant Motor vehicles and transportation fuels are sources for nearly a third of U.S. GHG emissions. To reduce these emissions, the federal

1. Fossil fuel-burning power plants are the largest single source of U.S. GHG emissions—33 percent. 2. California established the first statewide goals in 2006 in the Global Warming Solutions Act.

Climate Change

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U N I T F I V E Application and Ethics

government and the states impose emission standards on cars and trucks, and encourage the use of fuel-efficient vehicles and alternative fuels.

The federal Environmental Protection Agency (EPA) and National Highway Transportation Safety Administration have established standards for GHG emissions and fuel economy for new light-duty cars and trucks through the model year 2025.3 The standards are projected to save about 4 billion barrels of oil and avoid 2 billion metric tons of GHG emissions per year.

Some states have set low-emission fuel standards. More than a dozen states have set renew- able fuel standards to encourage the use of low-emission fuels. Incentives to use alternative fuels include tax exemptions, tax credits, and grants.

To reduce GHG emissions from coal- and gas-fired power plants, the EPA issued the Clean Power Plan (CPP).4 It is projected that, when the CPP is fully in place in 2030, carbon pollu- tion from the power sector will be 32 percent below 2005 levels. Emissions of sulfur dioxide from power plants will be 90 percent lower than 2005 levels, and emissions of nitrogen oxides will be 72 percent lower.

About two-thirds of the states will require power companies to generate a certain percentage or amount of power from renewable energy sources by a specific date, which varies by state. These targets aim to reduce emissions and to improve air quality, diversify energy sources, and create jobs in the renewable energy industry.

Become More Energy Efficient More than half of the states have set standards requiring power companies to save specified amounts of energy. To attain these goals, the utilities must adopt more efficient technology in their operations and encourage their customers to become more energy efficient.

About half of the states dedicate funds to the support of renewable energy projects. More than a dozen of these states formed the Clean Energy States Alliance to coordinate their investments.

Nearly all states permit utility customers to sell electricity back to the grid. In most states, utilities offer their customers the opportunity to have a portion of their power provided from renewable sources.

Many states participate in regional climate initiatives. For example, nine states in the north- eastern United States formed the Regional Greenhouse Gas Initiative to implement a market- based program to reduce GHG emissions from power plants. The initiative sets an emissions budget, or cap, for each member state. Credits that exceed the actual emissions can be sold. The proceeds are generally invested in energy-efficient renewable energy programs.

Adapt to the Changes The EPA’s State and Local Climate and Energy Program provides technical assistance, analytical tools, and outreach support on climate change issues to state, local, and tribal governments.5 The program directs resource managers to set priorities and to design and implement climate and energy policies tailored to the particular circumstances of their locations.

Part of the process is to assess an area’s vulnerability to the effects of climate change and to consider approaches for adapting to the effects. For example, a coastal estuary that is subject to

3. 40 C.F.R. Parts 85, 86, and 600, and 49 C.F.R. Parts 523, 531, 533, 600 et al. The United States Supreme Court has made et al. The United States Supreme Court has made et al clear that the Environmental Protection Agency can regulate GHGs under the Clean Air Act. See Massachusetts v. E.P.A., 549 U.S. 497, 127 S.Ct. 1438, 167 L.Ed.2d 248 (2007).

4. 40 C.F.R. Part 60. This act is being challenged in court. 5. See Environmental Protection Agency, State and Local Climate and Energy Program (December 28, 2015) available at http://

www3.epa.gov/statelocalclimate/index.html. Continues

612

salt-water inundation as a consequence of rising sea levels might benefit from a coastal restora- tion project.

The U.S. Interagency Climate Change Adaptation Task Force coordinates the efforts for adaptation across government agencies.6 The task force recommends actions that the federal government can take to respond to the needs of states and local communities. The top priority is to enhance the resilience of natural resources to absorb the impacts of climate change.

Agree to More Limits on Emissions The European Union and 195 nations, including the United States, participated in the 2015 United Nations Climate Change Conference in Paris, France. The parties negotiated the Paris Agreement to encourage the reduction of GHG emissions.7 The agreement sets a goal of limiting the global temperature increase to less than 2 degrees Celsius. The parties agreed to make “nationally determined contributions” (NDCs) to this goal and to pursue domestic measures designed to achieve the NDCs.8 None of these agree- ments are binding, however, and therefore rely on voluntary actions by governments throughout the world.

Ethical Connection Have all these efforts had an effect? It seems that they have. The transition to clean energy is happening faster than anticipated, and GHG emissions and air pollution have decreased somewhat.

Furthermore, climate change could have some positive effects. For example, the goals to lessen the impact and adapt to the changes create economic opportunities. There are new mar- kets for alternative sources of power and sales of GHG emission credits, for instance. Climate change also represents a political opportunity to improve air quality and develop domestic sources of clean energy.

A business that takes advantage of these opportunities is not acting unethically. Such a busi- ness is, in fact, acting in the best interest of all of us.

Ethics Question Is it ethical to continue to use fossil fuels? Explain.

Critical Thinking What are the advantages of fossil fuels? What are the disadvantages? Discuss.

6. Executive Order, Preparing the United States for the Impacts of Climate Change (November 11, 2013) available at https:// Preparing the United States for the Impacts of Climate Change (November 11, 2013) available at https:// Preparing the United States for the Impacts of Climate Change www.whitehouse.gov/the-press-office/2013/11/01/executive-order-preparing-united-states-impacts-climate-change.

7. United Nations Framework Convention on Climate Change, Conference of the Parties, Adoption of the Paris Agreement. Proposal by the President, FCCC/CP/2015/L.9/Rev. 1 (December 12, 2015) available at http://unfccc.int/resource/docs/2015/Proposal by the President, FCCC/CP/2015/L.9/Rev. 1 (December 12, 2015) available at http://unfccc.int/resource/docs/2015/Proposal by the President cop21/eng/l09r01.pdf.

8. There are, however, no binding emission targets or financial commitments. And the agreement itself will not become binding until fifty-five of the participants who produce more than 55 percent of global GHGs have ratified it.

U N I T F I V E Application and Ethics

A P P E N D I X A How to Brief Cases and Analyze Case Problems A-1

A P P E N D I X A

How to Brief Cases To fully understand the law with respect to business, you need to be able to read and understand court decisions. To make this task easier, you can use a method of case analysis that is called briefing. There is a fairly standard procedure that you can follow when you “brief ” any court case. You must first read the case opinion carefully. When you feel you understand the case, you can prepare a brief of it.

Although the format of the brief may vary, typically it will present the essentials of the case under headings such as the following:

1. Citation. Give the full citation for the case, including the name of the case, the date it was decided, and the court that decided it.

2. Facts. Briefly indicate (a) the reasons for the lawsuit; (b) the identity and arguments of the plaintiff(s) and defendant(s), respectively; and (c) the lower court’s decision—if appropriate.

3. Issue. Concisely phrase, in the form of a question, the essential issue before the court. (If more than one issue is involved, you may have two—or even more—questions here.)

4. Decision. Indicate here—with a “yes” or “no,” if possible—the court’s answer to the question (or questions) in the Issue section Issue section Issue above.

5. Reason. Summarize as briefly as possible the reasons given by the court for its decision (or decisions) and the case or statutory law relied on by the court in arriving at its decision.

An Example of a Briefed Sample Court Case As an example of the format used in briefing cases, we present here a briefed version of the sample court case that was presented in Chapter 1 in Exhibit 1–6.

ROSA AND RAYMOND PARKS INSTITUTE FOR SELF DEVELOPMENT v. TARGET CORPORATION United States Court of Appeals, Eleventh Circuit, 812 F.3d 824 (2016).

FACTS In December 1955, on a bus in Montgomery, Alabama, Rosa Parks refused to give up her seat to a white man in viola- tion of the city’s segregation law. This “courageous act” sparked the modern civil rights movement. Parks’s role in “the most sig- nificant social movement in the history of the United States” has been chronicled in books and movies, and featured on

mementoes, some of which are offered for sale by Target Corp. The Rosa and Raymond Parks Institute for Self Development is a Michigan firm that owns Parks’s name and likeness. The Insti- tute filed a suit in a federal district court against Target, alleging misappropriation in violation of the Institute’s right of publicity. The court dismissed the complaint. The Institute appealed to the U.S. Court of Appeals for the Eleventh Circuit.

ISSUE Are Target’s sales of books, movies, and other items that depict or discuss Rosa Parks and the modern civil rights move- ment protected by Michigan’s common-law qualified privilege?

DECISION Yes. The U.S. Court of Appeals for the Eleventh Circuit affirmed the lower court’s decision to dismiss the Insti- tute’s complaint. The items offered for sale by Target that fea- ture or discuss Rosa Parks and her role in history are protected by Michigan’s qualified privilege protecting matters of public interest.

REASON Michigan’s common-law right of publicity prohibits the commercial use of a person’s name or likeness without his or her consent. But this privacy right has limits. It “must yield to the qualified privilege to communicate on matters of pub- lic interest.” The court recognized that “Rosa Parks is a figure of great historical significance and the civil rights movement a matter of legitimate and important public interest.” The items identified by the Institute and sold by Target are “bona fide works” discussing Parks and her role in the modern civil rights movement. The items “communicate information, express opin- ions, recite grievances, and protest claimed abuses on behalf of a movement whose existence and objectives continue to be of the highest public interest and concern.” Therefore, they fall within Michigan’s qualified privilege.

A Review of the Briefed Sample Court Case Here, we provide a review of the briefed case to indicate the kind of information that is contained in each section.

CITATION The name of the case is Rosa and Raymond Parks Institute for Self Development v. Target Corporation. The Rosa and Raymond Parks Institute for Self Development is the plaintiff. Target is the defendant. The U.S. Court of Appeals for the Elev- enth Circuit decided this case in 2016. The citation states that this case can be found in Volume 812 of the Federal Reporter, Third Series, on page 824.

How to Brief Cases and Analyze Case Problems

A-2 A P P E N D I X A How to Brief Cases and Analyze Case Problems

FACTS The Facts section identifies the plaintiff and the defenFacts section identifies the plaintiff and the defenFacts - dant. It also describes the events leading up to this suit and the allegations made by the plaintiff in the suit. Because this case is a decision of one of the U.S. courts of appeals, the lower court’s ruling, the party appealing, and sometimes the appellant’s con- tention on appeal are included here.

ISSUE The Issue section presents the central issue (or issues) Issue section presents the central issue (or issues) Issue decided by the court. In this case, the court considers whether the sales of books and other items that depict or discuss Rosa Parks and the modern civil rights movement are protected by Michigan’s common-law qualified privilege.

DECISION The Decision section includes the court’s decision on the issues before it. The decision reflects the opinion of the judge or justice hearing the case. In this case, the court decided that the items offered for sale focusing on or featuring Rosa Parks and her role in history fall within Michigan’s qualified privilege, which protects depictions and discussions of matters of public interest. Decisions by appellate courts are frequently phrased in reference to the lower court’s decision. That is, the appellate court may “affirm” the lower court’s ruling or “reverse” it. A case may also be remanded, or sent back to the lower court, for fur- ther proceedings.

REASON The Reason section includes references to the relevant laws and legal principles that the court applied in coming to the conclusion arrived at in the case. The relevant law here includes Michigan’s common-law qualified privilege protecting the use of others’ names and likenesses in depictions and discussions of matters in the pubic interest. This section also explains the court’s application of the law to the facts in this case.

Analyzing Case Problems In addition to learning how to brief cases, students also find it helpful to know how to analyze case problems. Part of the study of business law and the legal environment usually involves ana- lyzing case problems, such as those included in this text at the end of each chapter.

For each case problem in this book, we provide the rele- vant background and facts of the lawsuit and the issue before the court. When you are assigned one of these problems, your job will be to determine how the court should decide the issue, and why. In other words, you will need to engage in legal analy- sis and reasoning. Here, we offer some suggestions on how to make this task less daunting. We begin by presenting a SAMPLE PROBLEM:

While Janet Lawson, a famous pianist, was shopping in Quality Market, she slipped and fell on a wet floor in one of the aisles. The floor had recently been mopped by one of the store’s employees, but there were no signs

warning customers that the floor in that area was wet. As a result of the fall, Lawson injured her right arm and was unable to perform piano concerts for the next six months. Had she been able to perform the scheduled concerts, she would have earned approximately $60,000 over that period of time. Lawson sued Quality Mar- ket for this amount, plus another $10,000 in medical expenses. She claimed that the store’s failure to warn customers of the wet floor constituted negligence and therefore the market was liable for her injuries. Will the court agree with Lawson? Discuss.

Understand the Facts This may sound obvious, but before you can analyze or apply the relevant law to a specific set of facts, you must clearly understand those facts. In other words, you should read through the case problem carefully—more than once, if necessary—to make sure you understand the identity of the plaintiff(s) and defendant(s) in the case and the progression of events that led to the lawsuit.

In the sample case problem just given, the identity of the parties is fairly obvious. Janet Lawson is the one bringing the suit; therefore, she is the plaintiff. Quality Market, against whom she is bringing the suit, is the defendant. Some of the case problems you may work on have multiple plaintiffs or defendants. Often, it is helpful to use abbreviations for the parties. To indicate a reference to a plaintiff, for example, the pi symbol—π—is often pi symbol—π—is often pi used, and a defendant is denoted by a delta—∆—a triangle.delta—∆—a triangle.delta

The events leading to the lawsuit are also fairly straightfor- ward. Lawson slipped and fell on a wet floor, and she contends that Quality Market should be liable for her injuries because it was negligent in not posting a sign warning customers of the wet floor.

When you are working on case problems, realize that the facts should be accepted as they are given. For example, in our sample problem, it should be accepted that the floor was wet and that there was no sign. In other words, avoid making con- jectures, such as “Maybe the floor wasn’t too wet,” or “Maybe an employee was getting a sign to put up,” or “Maybe someone stole the sign.” Questioning the facts as they are presented only adds confusion to your analysis.

Legal Analysis and Reasoning Once you understand the facts given in the case problem, you can begin to analyze the case. The IRAC method is a helpful tool to use in the legal analysis and reasoning process. IRAC is an acronym for Issue, Rule, Application, Conclusion. Applying this method to our sample problem would involve the following steps:

1. First, you need to decide what legal issue is involved in the case. In our sample case, the basic issue is whether Quality Market’s

A P P E N D I X A How to Brief Cases and Analyze Case Problems A-3

failure to warn customers of the wet floor constituted neg- ligence. As discussed in the text, negligence is a tort—a civil tort—a civil tort wrong. In a tort lawsuit, the plaintiff seeks to be compensated for another’s wrongful act. A defendant will be deemed negli- gent if he or she breached a duty of care owed to the plaintiff and the breach of that duty caused the plaintiff to suffer harm.

2. Once you have identified the issue, the next step is to determine what rule of law applies to the issue. To make this determinarule of law applies to the issue. To make this determinarule of law - tion, you will want to review carefully the text of the chapter in which the relevant rule of law for the problem appears. Our sample case problem involves the tort of negligence. The appli- cable rule of law is the tort law principle that business owners owe a duty to exercise reasonable care to protect their customers (“business invitees”). Reasonable care, in this context, includes either removing—or warning customers of—foreseeableeither removing—or warning customers of—foreseeableeither removing—or warning customers of— risks foreseeable risks foreseeable about which the owner knew or knew or knew should have known. Business owners need not warn customers of “open and obvious” risks, however. If a business owner breaches this duty of care (fails to exercise the appropriate degree of care toward customers), and the breach of duty causes a customer to be injured, the business owner will be liable to the customer for the customer’s injuries.

3. The next—and usually the most difficult—step in analyzing case problems is the application of the relevant rule of law to the specific facts of the case you are studying. In the sample problem, applying the tort law principle just discussed presents

few difficulties. An employee of the store had mopped the floor in the aisle where Lawson slipped and fell, but no sign was pres- ent indicating that the floor was wet. That a customer might fall on a wet floor is clearly a foreseeable risk. Therefore, the failure to warn customers about the wet floor was a breach of the duty of care owed by the business owner to the store’s customers.

4. Once you have completed Step 3 in the IRAC method, you should be ready to draw your conclusion. In our sample prob- lem, Quality Market is liable to Lawson for her injuries, because the market’s breach of its duty of care caused Lawson’s injuries.

The fact patterns in the business scenarios and case problems presented in this text are not always as simple as those presented in our sample problem. Often, for example, a case has more than one plaintiff or defendant. A case may also involve more than one issue and have more than one applicable rule of law. Fur- thermore, in some case problems the facts may indicate that the general rule of law should not apply.

For example, suppose that a store employee advised Law- son not to walk on the floor in the aisle because it was wet, but Lawson decided to walk on it anyway. This fact could alter the outcome of the case because the store could then raise the defense of assumption of risk. Nonetheless, a careful review of the chapter text should always provide you with the knowledge you need to analyze the problem thoroughly and arrive at accu- rate conclusions.

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A P P E N D I X B

Preamble We the People of the United States, in Order to form a more

perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.

Article I Section 1. All legislative Powers herein granted shall be

vested in a Congress of the United States, which shall consist of a Senate and House of Representatives.

Section 2. The House of Representatives shall be composed of Members chosen every second Year by the People of the sev- eral States, and the Electors in each State shall have the Quali- fications requisite for Electors of the most numerous Branch of the State Legislature.

No Person shall be a Representative who shall not have attained to the Age of twenty five Years, and been seven Years a Citizen of the United States, and who shall not, when elected, be an Inhabitant of that State in which he shall be chosen.

Representatives and direct Taxes shall be apportioned among the several States which may be included within this Union, according to their respective Numbers, which shall be deter- mined by adding to the whole Number of free Persons, includ- ing those bound to Service for a Term of Years, and excluding Indians not taxed, three fifths of all other Persons. The actual Enumeration shall be made within three Years after the first Meeting of the Congress of the United States, and within every subsequent Term of ten Years, in such Manner as they shall by Law direct. The Number of Representatives shall not exceed one for every thirty Thousand, but each State shall have at Least one Representative; and until such enumeration shall be made, the State of New Hampshire shall be entitled to chuse three, Mas- sachusetts eight, Rhode Island and Providence Plantations one, Connecticut five, New York six, New Jersey four, Pennsylvania eight, Delaware one, Maryland six, Virginia ten, North Carolina five, South Carolina five, and Georgia three.

When vacancies happen in the Representation from any State, the Executive Authority thereof shall issue Writs of Elec- tion to fill such Vacancies.

The House of Representatives shall chuse their Speaker and other Officers; and shall have the sole Power of Impeachment.

Section 3. The Senate of the United States shall be com- posed of two Senators from each State, chosen by the Legislature thereof, for six Years; and each Senator shall have one Vote.

Immediately after they shall be assembled in Consequence of the first Election, they shall be divided as equally as may be

into three Classes. The Seats of the Senators of the first Class shall be vacated at the Expiration of the second Year, of the sec- ond Class at the Expiration of the fourth Year, and of the third Class at the Expiration of the sixth Year, so that one third may be chosen every second Year; and if Vacancies happen by Resigna- tion, or otherwise, during the Recess of the Legislature of any State, the Executive thereof may make temporary Appointments until the next Meeting of the Legislature, which shall then fill such Vacancies.

No Person shall be a Senator who shall not have attained to the Age of thirty Years, and been nine Years a Citizen of the United States, and who shall not, when elected, be an Inhabitant of that State for which he shall be chosen.

The Vice President of the United States shall be President of the Senate, but shall have no Vote, unless they be equally divided.

The Senate shall chuse their other Officers, and also a Presi- dent pro tempore, in the Absence of the Vice President, or when he shall exercise the Office of President of the United States.

The Senate shall have the sole Power to try all Impeach- ments. When sitting for that Purpose, they shall be on Oath or Affirmation. When the President of the United States is tried, the Chief Justice shall preside: And no Person shall be convicted without the Concurrence of two thirds of the Members present.

Judgment in Cases of Impeachment shall not extend fur- ther than to removal from Office, and disqualification to hold and enjoy any Office of honor, Trust, or Profit under the United States: but the Party convicted shall nevertheless be liable and subject to Indictment, Trial, Judgment, and Punishment, accord- ing to Law.

Section 4. The Times, Places and Manner of holding Elec- tions for Senators and Representatives, shall be prescribed in each State by the Legislature thereof; but the Congress may at any time by Law make or alter such Regulations, except as to the Places of chusing Senators.

The Congress shall assemble at least once in every Year, and such Meeting shall be on the first Monday in December, unless they shall by Law appoint a different Day.

Section 5. Each House shall be the Judge of the Elections, Returns, and Qualifications of its own Members, and a Majority of each shall constitute a Quorum to do Business; but a smaller Number may adjourn from day to day, and may be authorized to compel the Attendance of absent Members, in such Manner, and under such Penalties as each House may provide.

Each House may determine the Rules of its Proceedings, punish its Members for disorderly Behavior, and, with the Con- currence of two thirds, expel a Member.

Each House shall keep a Journal of its Proceedings, and from time to time publish the same, excepting such Parts as may in their Judgment require Secrecy; and the Yeas and Nays of the

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Members of either House on any question shall, at the Desire of one fifth of those Present, be entered on the Journal.

Neither House, during the Session of Congress, shall, with- out the Consent of the other, adjourn for more than three days, nor to any other Place than that in which the two Houses shall be sitting.

Section 6. The Senators and Representatives shall receive a Compensation for their Services, to be ascertained by Law, and paid out of the Treasury of the United States. They shall in all Cases, except Treason, Felony and Breach of the Peace, be privi- leged from Arrest during their Attendance at the Session of their respective Houses, and in going to and returning from the same; and for any Speech or Debate in either House, they shall not be questioned in any other Place.

No Senator or Representative shall, during the Time for which he was elected, be appointed to any civil Office under the Authority of the United States, which shall have been created, or the Emoluments whereof shall have been increased during such time; and no Person holding any Office under the United States, shall be a Member of either House during his Continuance in Office.

Section 7. All Bills for raising Revenue shall originate in the House of Representatives; but the Senate may propose or concur with Amendments as on other Bills.

Every Bill which shall have passed the House of Representa- tives and the Senate, shall, before it become a Law, be presented to the President of the United States; If he approve he shall sign it, but if not he shall return it, with his Objections to the House in which it shall have originated, who shall enter the Objections at large on their Journal, and proceed to reconsider it. If after such Reconsideration two thirds of that House shall agree to pass the Bill, it shall be sent together with the Objections, to the other House, by which it shall likewise be reconsidered, and if approved by two thirds of that House, it shall become a Law. But in all such Cases the Votes of both Houses shall be determined by Yeas and Nays, and the Names of the Persons voting for and against the Bill shall be entered on the Journal of each House respectively. If any Bill shall not be returned by the President within ten Days (Sundays excepted) after it shall have been pre- sented to him, the Same shall be a Law, in like Manner as if he had signed it, unless the Congress by their Adjournment prevent its Return in which Case it shall not be a Law.

Every Order, Resolution, or Vote, to which the Concurrence of the Senate and House of Representatives may be necessary (except on a question of Adjournment) shall be presented to the President of the United States; and before the Same shall take Effect, shall be approved by him, or being disapproved by him, shall be repassed by two thirds of the Senate and House of Rep- resentatives, according to the Rules and Limitations prescribed in the Case of a Bill.

Section 8. The Congress shall have Power To lay and col- lect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uni- form throughout the United States;

To borrow Money on the credit of the United States;

To regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes;

To establish an uniform Rule of Naturalization, and uni- form Laws on the subject of Bankruptcies throughout the United States;

To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures;

To provide for the Punishment of counterfeiting the Securi- ties and current Coin of the United States;

To establish Post Offices and post Roads; To promote the Progress of Science and useful Arts, by

securing for limited Times to Authors and Inventors the exclu- sive Right to their respective Writings and Discoveries;

To constitute Tribunals inferior to the supreme Court; To define and punish Piracies and Felonies committed on

the high Seas, and Offenses against the Law of Nations; To declare War, grant Letters of Marque and Reprisal, and

make Rules concerning Captures on Land and Water; To raise and support Armies, but no Appropriation of

Money to that Use shall be for a longer Term than two Years; To provide and maintain a Navy; To make Rules for the Government and Regulation of the

land and naval Forces; To provide for calling forth the Militia to execute the Laws

of the Union, suppress Insurrections and repel Invasions; To provide for organizing, arming, and disciplining, the Mili-

tia, and for governing such Part of them as may be employed in the Service of the United States, reserving to the States respectively, the Appointment of the Officers, and the Authority of training the Militia according to the discipline prescribed by Congress;

To exercise exclusive Legislation in all Cases whatsoever, over such District (not exceeding ten Miles square) as may, by Cession of particular States, and the Acceptance of Congress, become the Seat of the Government of the United States, and to exercise like Authority over all Places purchased by the Consent of the Legislature of the State in which the Same shall be, for the Erection of Forts, Magazines, Arsenals, dock-Yards, and other needful Buildings;—And

To make all Laws which shall be necessary and proper for carrying into Execution the foregoing Powers, and all other Pow- ers vested by this Constitution in the Government of the United States, or in any Department or Officer thereof.

Section 9. The Migration or Importation of such Persons as any of the States now existing shall think proper to admit, shall not be prohibited by the Congress prior to the Year one thousand eight hundred and eight, but a Tax or duty may be imposed on such Importation, not exceeding ten dollars for each Person.

The privilege of the Writ of Habeas Corpus shall not be sus- pended, unless when in Cases of Rebellion or Invasion the public Safety may require it.

No Bill of Attainder or ex post facto Law shall be passed. No Capitation, or other direct, Tax shall be laid, unless in

Proportion to the Census or Enumeration herein before directed to be taken.

No Tax or Duty shall be laid on Articles exported from any State.

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No Preference shall be given by any Regulation of Com- merce or Revenue to the Ports of one State over those of another: nor shall Vessels bound to, or from, one State be obliged to enter, clear, or pay Duties in another.

No Money shall be drawn from the Treasury, but in Con- sequence of Appropriations made by Law; and a regular State- ment and Account of the Receipts and Expenditures of all public Money shall be published from time to time.

No Title of Nobility shall be granted by the United States: And no Person holding any Office of Profit or Trust under them, shall, without the Consent of the Congress, accept of any pres- ent, Emolument, Office, or Title, of any kind whatever, from any King, Prince, or foreign State.

Section 10. No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts; pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts, or grant any Title of Nobility.

No State shall, without the Consent of the Congress, lay any Imposts or Duties on Imports or Exports, except what may be absolutely necessary for executing its inspection Laws: and the net Produce of all Duties and Imposts, laid by any State on Imports or Exports, shall be for the Use of the Treasury of the United States; and all such Laws shall be subject to the Revision and Controul of the Congress.

No State shall, without the Consent of Congress, lay any Duty of Tonnage, keep Troops, or Ships of War in time of Peace, enter into any Agreement or Compact with another State, or with a foreign Power, or engage in War, unless actually invaded, or in such imminent Danger as will not admit of delay.

Article II Section 1. The executive Power shall be vested in a Presi-

dent of the United States of America. He shall hold his Office during the Term of four Years, and, together with the Vice Presi- dent, chosen for the same Term, be elected, as follows:

Each State shall appoint, in such Manner as the Legislature thereof may direct, a Number of Electors, equal to the whole Number of Senators and Representatives to which the State may be entitled in the Congress; but no Senator or Representative, or Person holding an Office of Trust or Profit under the United States, shall be appointed an Elector.

The Electors shall meet in their respective States, and vote by Ballot for two Persons, of whom one at least shall not be an Inhabitant of the same State with themselves. And they shall make a List of all the Persons voted for, and of the Number of Votes for each; which List they shall sign and certify, and trans- mit sealed to the Seat of the Government of the United States, directed to the President of the Senate. The President of the Senate shall, in the Presence of the Senate and House of Repre- sentatives, open all the Certificates, and the Votes shall then be counted. The Person having the greatest Number of Votes shall be the President, if such Number be a Majority of the whole Number of Electors appointed; and if there be more than one

who have such Majority, and have an equal Number of Votes, then the House of Representatives shall immediately chuse by Ballot one of them for President; and if no Person have a Major- ity, then from the five highest on the List the said House shall in like Manner chuse the President. But in chusing the President, the Votes shall be taken by States, the Representation from each State having one Vote; A quorum for this Purpose shall consist of a Member or Members from two thirds of the States, and a Majority of all the States shall be necessary to a Choice. In every Case, after the Choice of the President, the Person having the greater Number of Votes of the Electors shall be the Vice President. But if there should remain two or more who have equal Votes, the Senate shall chuse from them by Ballot the Vice President.

The Congress may determine the Time of chusing the Elec- tors, and the Day on which they shall give their Votes; which Day shall be the same throughout the United States.

No person except a natural born Citizen, or a Citizen of the United States, at the time of the Adoption of this Constitu- tion, shall be eligible to the Office of President; neither shall any Person be eligible to that Office who shall not have attained to the Age of thirty five Years, and been fourteen Years a Resident within the United States.

In Case of the Removal of the President from Office, or of his Death, Resignation or Inability to discharge the Powers and Duties of the said Office, the same shall devolve on the Vice President, and the Congress may by Law provide for the Case of Removal, Death, Resignation or Inability, both of the President and Vice President, declaring what Officer shall then act as Presi- dent, and such Officer shall act accordingly, until the Disability be removed, or a President shall be elected.

The President shall, at stated Times, receive for his Services, a Compensation, which shall neither be increased nor dimin- ished during the Period for which he shall have been elected, and he shall not receive within that Period any other Emolument from the United States, or any of them.

Before he enter on the Execution of his Office, he shall take the following Oath or Affirmation: “I do solemnly swear (or affirm) that I will faithfully execute the Office of President of the United States, and will to the best of my Ability, preserve, protect and defend the Constitution of the United States.’’

Section 2. The President shall be Commander in Chief of the Army and Navy of the United States, and of the Mili- tia of the several States, when called into the actual Service of the United States; he may require the Opinion, in writing, of the principal Officer in each of the executive Departments, upon any Subject relating to the Duties of their respective Offices, and he shall have Power to grant Reprieves and Par- dons for Offenses against the United States, except in Cases of Impeachment.

He shall have Power, by and with the Advice and Consent of the Senate to make Treaties, provided two thirds of the Sena- tors present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassa- dors, other public Ministers and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose

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Appointments are not herein otherwise provided for, and which shall be established by Law; but the Congress may by Law vest the Appointment of such inferior Officers, as they think proper, in the President alone, in the Courts of Law, or in the Heads of Departments.

The President shall have Power to fill up all Vacancies that may happen during the Recess of the Senate, by granting Com- missions which shall expire at the End of their next Session.

Section 3. He shall from time to time give to the Con- gress Information of the State of the Union, and recommend to their Consideration such Measures as he shall judge necessary and expedient; he may, on extraordinary Occasions, convene both Houses, or either of them, and in Case of Disagreement between them, with Respect to the Time of Adjournment, he may adjourn them to such Time as he shall think proper; he shall receive Ambassadors and other public Ministers; he shall take Care that the Laws be faithfully executed, and shall Commission all the Officers of the United States.

Section 4. The President, Vice President and all civil Officers of the United States, shall be removed from Office on Impeachment for, and Conviction of, Treason, Bribery, or other high Crimes and Misdemeanors.

Article III Section 1. The judicial Power of the United States, shall

be vested in one supreme Court, and in such inferior Courts as the Congress may from time to time ordain and establish. The Judges, both of the supreme and inferior Courts, shall hold their Offices during good Behaviour, and shall, at stated Times, receive for their Services a Compensation, which shall not be diminished during their Continuance in Office.

Section 2. The judicial Power shall extend to all Cases, in Law and Equity, arising under this Constitution, the Laws of the United States, and Treaties made, or which shall be made, under their Authority;—to all Cases affecting Ambassadors, other public Ministers and Consuls;—to all Cases of admi- ralty and maritime Jurisdiction;—to Controversies to which the United States shall be a Party;—to Controversies between two or more States;—between a State and Citizens of another State;—between Citizens of different States;—between Citi- zens of the same State claiming Lands under Grants of differ- ent States, and between a State, or the Citizens thereof, and foreign States, Citizens or Subjects.

In all Cases affecting Ambassadors, other public Minis- ters and Consuls, and those in which a State shall be a Party, the supreme Court shall have original Jurisdiction. In all the other Cases before mentioned, the supreme Court shall have appellate Jurisdiction, both as to Law and Fact, with such Exceptions, and under such Regulations as the Congress shall make.

The Trial of all Crimes, except in Cases of Impeachment, shall be by Jury; and such Trial shall be held in the State where the said Crimes shall have been committed; but when not com- mitted within any State, the Trial shall be at such Place or Places as the Congress may by Law have directed.

Section 3. Treason against the United States, shall consist only in levying War against them, or, in adhering to their Ene- mies, giving them Aid and Comfort. No Person shall be con- victed of Treason unless on the Testimony of two Witnesses to the same overt Act, or on Confession in open Court.

The Congress shall have Power to declare the Punishment of Treason, but no Attainder of Treason shall work Corruption of Blood, or Forfeiture except during the Life of the Person attainted.

Article IV Section 1. Full Faith and Credit shall be given in each State

to the public Acts, Records, and judicial Proceedings of every other State. And the Congress may by general Laws prescribe the Manner in which such Acts, Records and Proceedings shall be proved, and the Effect thereof.

Section 2. The Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States.

A Person charged in any State with Treason, Felony, or other Crime, who shall flee from Justice, and be found in another State, shall on Demand of the executive Authority of the State from which he fled, be delivered up, to be removed to the State having Jurisdiction of the Crime.

No Person held to Service or Labour in one State, under the Laws thereof, escaping into another, shall, in Consequence of any Law or Regulation therein, be discharged from such Service or Labour, but shall be delivered up on Claim of the Party to whom such Service or Labour may be due.

Section 3. New States may be admitted by the Congress into this Union; but no new State shall be formed or erected within the Jurisdiction of any other State; nor any State be formed by the Junction of two or more States, or Parts of States, without the Consent of the Legislatures of the States concerned as well as of the Congress.

The Congress shall have Power to dispose of and make all needful Rules and Regulations respecting the Territory or other Property belonging to the United States; and nothing in this Constitution shall be so construed as to Prejudice any Claims of the United States, or of any particular State.

Section 4. The United States shall guarantee to every State in this Union a Republican Form of Government, and shall pro- tect each of them against Invasion; and on Application of the Legislature, or of the Executive (when the Legislature cannot be convened) against domestic Violence.

Article V The Congress, whenever two thirds of both Houses shall

deem it necessary, shall propose Amendments to this Constitu- tion, or, on the Application of the Legislatures of two thirds of the several States, shall call a Convention for proposing Amend- ments, which, in either Case, shall be valid to all Intents and Purposes, as part of this Constitution, when ratified by the Leg- islatures of three fourths of the several States, or by Conven- tions in three fourths thereof, as the one or the other Mode of Ratification may be proposed by the Congress; Provided that no

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Amendment which may be made prior to the Year One thousand eight hundred and eight shall in any Manner affect the first and fourth Clauses in the Ninth Section of the first Article; and that no State, without its Consent, shall be deprived of its equal Suf-no State, without its Consent, shall be deprived of its equal Suf-no State, without its Consent, shall be deprived of its equal Suf frage in the Senate.

Article VI All Debts contracted and Engagements entered into,

before the Adoption of this Constitution shall be as valid against the United States under this Constitution, as under the Confederation.

This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.

The Senators and Representatives before mentioned, and the Members of the several State Legislatures, and all executive and judicial Officers, both of the United States and of the several States, shall be bound by Oath or Affirmation, to support this Constitution; but no religious Test shall ever be required as a Qualification to any Office or public Trust under the United States.

Article VII The Ratification of the Conventions of nine States shall be

sufficient for the Establishment of this Constitution between the States so ratifying the Same.

Amendment I [1791] Congress shall make no law respecting an establishment of

religion, or prohibiting the free exercise thereof; or abridging the freedom of speech, or of the press; or the right of the people peaceably to assembly, and to petition the Government for a redress of grievances.

Amendment II [1791] A well regulated Militia, being necessary to the security of

a free State, the right of the people to keep and bear Arms, shall not be infringed.

Amendment III [1791] No Soldier shall, in time of peace be quartered in any house,

without the consent of the Owner, nor in time of war, but in a manner to be prescribed by law.

Amendment IV [1791] The right of the people to be secure in their persons, houses,

papers, and effects, against unreasonable searches and seizures, shall not be violated, and no Warrants shall issue, but upon prob- able cause, supported by Oath or affirmation, and particularly describing the place to be searched, and the persons or things to be seized.

Amendment V [1791] No person shall be held to answer for a capital, or other-

wise infamous crime, unless on a presentment or indictment of a Grand Jury, except in cases arising in the land or naval forces, or in the Militia, when in actual service in time of War or pub- lic danger; nor shall any person be subject for the same offence to be twice put in jeopardy of life or limb; nor shall be com- pelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation.

Amendment VI [1791] In all criminal prosecutions, the accused shall enjoy the

right to a speedy and public trial, by an impartial jury of the State and district wherein the crime shall have been committed, which district shall have been previously ascertained by law, and to be informed of the nature and cause of the accusation; to be confronted with the witnesses against him; to have compulsory process for obtaining witnesses in his favor, and to have the Assis- tance of Counsel for his defence.

Amendment VII [1791] In Suits at common law, where the value in controversy shall

exceed twenty dollars, the right of trial by jury shall be preserved, and no fact tried by jury, shall be otherwise re-examined in any Court of the United States, than according to the rules of the common law.

Amendment VIII [1791] Excessive bail shall not be required, nor excessive fines

imposed, nor cruel and unusual punishments inflicted.

Amendment IX [1791] The enumeration in the Constitution, of certain rights, shall

not be construed to deny or disparage others retained by the people.

Amendment X [1791] The powers not delegated to the United States by the Con-

stitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.

Amendment XI [1795] The Judicial power of the United States shall not be con-

strued to extend to any suit in law or equity, commenced or pros- ecuted against one of the United States by Citizens of another State, or by Citizens or Subjects of any Foreign State.

Amendment XII [1804] The Electors shall meet in their respective states, and vote

by ballot for President and Vice-President, one of whom, at least, shall not be an inhabitant of the same state with them- selves; they shall name in their ballots the person voted for as

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President, and in distinct ballots the person voted for as Vice- President, and they shall make distinct lists of all persons voted for as President, and of all persons voted for as Vice-President, and of the number of votes for each, which lists they shall sign and certify, and transmit sealed to the seat of the govern- ment of the United States, directed to the President of the Senate;—The President of the Senate shall, in the presence of the Senate and House of Representatives, open all the certificates and the votes shall then be counted;—The person having the greatest number of votes for President, shall be the President, if such number be a majority of the whole number of Electors appointed; and if no person have such majority, then from the persons having the highest numbers not exceeding three on the list of those voted for as President, the House of Representatives shall choose immediately, by ballot, the President. But in choos- ing the President, the votes shall be taken by states, the repre- sentation from each state having one vote; a quorum for this purpose shall consist of a member or members from two-thirds of the states, and a majority of all states shall be necessary to a choice. And if the House of Representatives shall not choose a President whenever the right of choice shall devolve upon them, before the fourth day of March next following, then the Vice- President shall act as President, as in the case of the death or other constitutional disability of the President.—The person having the greatest number of votes as Vice-President, shall be the Vice-President, if such number be a majority of the whole number of Electors appointed, and if no person have a major- ity, then from the two highest numbers on the list, the Senate shall choose the Vice-President; a quorum for the purpose shall consist of two-thirds of the whole number of Senators, and a majority of the whole number shall be necessary to a choice. But no person constitutionally ineligible to the office of President shall be eligible to that of Vice-President of the United States.

Amendment XIII [1865] Section 1. Neither slavery nor involuntary servitude, except

as a punishment for crime whereof the party shall have been duly convicted, shall exist within the United States, or any place sub- ject to their jurisdiction.

Section 2. Congress shall have power to enforce this article by appropriate legislation.

Amendment XIV [1868] Section 1. All persons born or naturalized in the United

States, and subject to the jurisdiction thereof, are citizens of the United States and of the State wherein they reside. No State shall make or enforce any law which shall abridge the privileges or immunities of citizens of the United States; nor shall any State deprive any person of life, liberty, or property, without due process of law; nor deny to any person within its jurisdic- tion the equal protection of the laws.

Section 2. Representatives shall be apportioned among the several States according to their respective numbers, counting the whole number of persons in each State, excluding Indians not taxed. But when the right to vote at any election for the choice

of electors for President and Vice President of the United States, Representatives in Congress, the Executive and Judicial officers of a State, or the members of the Legislature thereof, is denied to any of the male inhabitants of such State, being twenty-one years of age, and citizens of the United States, or in any way abridged, except for participation in rebellion, or other crime, the basis of representation therein shall be reduced in the proportion which the number of such male citizens shall bear to the whole number of male citizens twenty-one years of age in such State.

Section 3. No person shall be a Senator or Representative in Congress, or elector of President and Vice President, or hold any office, civil or military, under the United States, or under any State, who having previously taken an oath, as a member of Congress, or as an officer of the United States, or as a member of any State legislature, or as an executive or judicial officer of any State, to support the Constitution of the United States, shall have engaged in insurrection or rebellion against the same, or given aid or comfort to the enemies thereof. But Congress may by a vote of two-thirds of each House, remove such disability.

Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.

Section 5. The Congress shall have power to enforce, by appropriate legislation, the provisions of this article.

Amendment XV [1870] Section 1. The right of citizens of the United States to

vote shall not be denied or abridged by the United States or by any State on account of race, color, or previous condition of servitude.

Section 2. The Congress shall have power to enforce this article by appropriate legislation.

Amendment XVI [1913] The Congress shall have power to lay and collect taxes on

incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

Amendment XVII [1913] Section 1. The Senate of the United States shall be com-

posed of two Senators from each State, elected by the people thereof, for six years; and each Senator shall have one vote. The electors in each State shall have the qualifications requisite for electors of the most numerous branch of the State legislatures.

Section 2. When vacancies happen in the representation of any State in the Senate, the executive authority of such State shall issue writs of election to fill such vacancies: Provided, That the Provided, That the Provided legislature of any State may empower the executive thereof to

A P P E N D I X B The Constitution of the United States A-11

make temporary appointments until the people fill the vacancies by election as the legislature may direct.

Section 3. This amendment shall not be so construed as to affect the election or term of any Senator chosen before it becomes valid as part of the Constitution.

Amendment XVIII [1919] Section 1. After one year from the ratification of this article

the manufacture, sale, or transportation of intoxicating liquors within, the importation thereof into, or the exportation thereof from the United States and all territory subject to the jurisdic- tion thereof for beverage purposes is hereby prohibited.

Section 2. The Congress and the several States shall have concurrent power to enforce this article by appropriate legislation.

Section 3. This article shall be inoperative unless it shall have been ratified as an amendment to the Constitution by the legislatures of the several States, as provided in the Constitution, within seven years from the date of the submission hereof to the States by the Congress.

Amendment XIX [1920] Section 1. The right of citizens of the United States to vote

shall not be denied or abridged by the United States or by any State on account of sex.

Section 2. Congress shall have power to enforce this article by appropriate legislation.

Amendment XX [1933] Section 1. The terms of the President and Vice President

shall end at noon on the 20th day of January, and the terms of Senators and Representatives at noon on the 3d day of January, of the years in which such terms would have ended if this article had not been ratified; and the terms of their successors shall then begin.

Section 2. The Congress shall assemble at least once in every year, and such meeting shall begin at noon on the 3d day of January, unless they shall by law appoint a different day.

Section 3. If, at the time fixed for the beginning of the term of the President, the President elect shall have died, the Vice President elect shall become President. If the President shall not have been chosen before the time fixed for the beginning of his term, or if the President elect shall have failed to qualify, then the Vice President elect shall act as President until a President shall have qualified; and the Congress may by law provide for the case wherein neither a President elect nor a Vice President elect shall have qualified, declaring who shall then act as President, or the manner in which one who is to act shall be selected, and such person shall act accordingly until a President or Vice President shall have qualified.

Section 4. The Congress may by law provide for the case of the death of any of the persons from whom the House of Representatives may choose a President whenever the right of choice shall have devolved upon them, and for the case of the death of any of the persons from whom the Senate may choose a

Vice President whenever the right of choice shall have devolved upon them.

Section 5. Sections 1 and 2 shall take effect on the 15th day of October following the ratification of this article.

Section 6. This article shall be inoperative unless it shall have been ratified as an amendment to the Constitution by the legislatures of three-fourths of the several States within seven years from the date of its submission.

Amendment XXI [1933] Section 1. The eighteenth article of amendment to the

Constitution of the United States is hereby repealed. Section 2. The transportation or importation into any

State, Territory, or possession of the United States for delivery or use therein of intoxicating liquors, in violation of the laws thereof, is hereby prohibited.

Section 3. This article shall be inoperative unless it shall have been ratified as an amendment to the Constitution by con- ventions in the several States, as provided in the Constitution, within seven years from the date of the submission hereof to the States by the Congress.

Amendment XXII [1951] Section 1. No person shall be elected to the office of the

President more than twice, and no person who has held the office of President, or acted as President, for more than two years of a term to which some other person was elected President shall be elected to the office of President more than once. But this Article shall not apply to any person holding the office of Presi- dent when this Article was proposed by the Congress, and shall not prevent any person who may be holding the office of Presi- dent, or acting as President, during the term within which this Article becomes operative from holding the office of President or acting as President during the remainder of such term.

Section 2. This article shall be inoperative unless it shall have been ratified as an amendment to the Constitution by the legislatures of three-fourths of the several States within seven years from the date of its submission to the States by the Congress.

Amendment XXIII [1961] Section 1. The District constituting the seat of Govern-

ment of the United States shall appoint in such manner as the Congress may direct:

A number of electors of President and Vice President equal to the whole number of Senators and Representatives in Con- gress to which the District would be entitled if it were a State, but in no event more than the least populous state; they shall be in addition to those appointed by the states, but they shall be considered, for the purposes of the election of President and Vice President, to be electors appointed by a state; and they shall meet in the District and perform such duties as provided by the twelfth article of amendment.

Section 2. The Congress shall have power to enforce this article by appropriate legislation.

A-12 A P P E N D I X B The Constitution of the United States

Amendment XXIV [1964] Section 1. The right of citizens of the United States to vote in

any primary or other election for President or Vice President, for elec- tors for President or Vice President, or for Senator or Representative in Congress, shall not be denied or abridged by the United States, or any State by reason of failure to pay any poll tax or other tax.

Section 2. The Congress shall have power to enforce this article by appropriate legislation.

Amendment XXV [1967] Section 1. In case of the removal of the President from

office or of his death or resignation, the Vice President shall become President.

Section 2. Whenever there is a vacancy in the office of the Vice President, the President shall nominate a Vice President who shall take office upon confirmation by a majority vote of both Houses of Congress.

Section 3. Whenever the President transmits to the President pro tempore of the Senate and the Speaker of the House of Repre- sentatives his written declaration that he is unable to discharge the powers and duties of his office, and until he transmits to them a written declaration to the contrary, such powers and duties shall be discharged by the Vice President as Acting President.

Section 4. Whenever the Vice President and a majority of either the principal officers of the executive departments or of such other body as Congress may by law provide, transmit to the President pro tempore of the Senate and the Speaker of the House of Representatives their written declaration that the Presi- dent is unable to discharge the powers and duties of his office, the Vice President shall immediately assume the powers and duties of the office as Acting President.

Thereafter, when the President transmits to the President pro tempore of the Senate and the Speaker of the House of Rep- resentatives his written declaration that no inability exists, he shall resume the powers and duties of his office unless the Vice President and a majority of either the principal officers of the executive department or of such other body as Congress may by law provide, transmit within four days to the President pro tempore of the Senate and the Speaker of the House of Repre- sentatives their written declaration that the President is unable to discharge the powers and duties of his office. Thereupon Congress shall decide the issue, assembling within forty-eight hours for that purpose if not in session. If the Congress, within twenty-one days after receipt of the latter written declaration, or, if Congress is not in session, within twenty-one days after Congress is required to assemble, determines by two-thirds vote of both Houses that the President is unable to discharge the pow- ers and duties of his office, the Vice President shall continue to discharge the same as Acting President; otherwise, the President shall resume the powers and duties of his office.

Amendment XXVI [1971] Section 1. The right of citizens of the United States, who

are eighteen years of age or older, to vote shall not be denied or abridged by the United States or by any State on account of age.

Section 2. The Congress shall have power to enforce this article by appropriate legislation.

Amendment XXVII [1992] No law, varying the compensation for the services of the

Senators and Representatives, shall take effect, until an election of Representatives shall have intervened.

A P P E N D I X C Articles 2 and 2A of the Uniform Commercial Code A-13

(Adopted in fifty-two jurisdictions—all fifty States, although Loui- siana has adopted only Articles 1, 3, 4, 7, 8, and 9; the District of Columbia; and the Virgin Islands.)

The Code consists of the following articles: Article 1. General Provisions 2. Sales 2A. Leases 3. Negotiable Instruments 4. Bank Deposits and Collections 4A. Funds Transfers 5. Letters of Credit 6. Repealer of U.C.C.—Article 6: Bulk Transfers and Repealer of U.C.C.—Article 6: Bulk Transfers and R

[Revised] Article 6: Bulk Sales 7. Warehouse Receipts, Bills of Lading and Other Documents Warehouse Receipts, Bills of Lading and Other Documents W

of Title 8. Investment Securities 9. Secured Transactions

ARTICLE 2: SALES

Part 1—Short Title, General Construction and Subject Matter

§ 2–101. Short Title. This Article shall be known and may be cited as Uniform Com- mercial Code—Sales.

§ 2–102. Scope; Certain Security and Other Transactions Excluded From This Article. Unless the context otherwise requires, this Article applies to transac- tions in goods; it does not apply to any transaction which although in the form of an unconditional contract to sell or present sale is intended to operate only as a security transaction nor does this Arti- cle impair or repeal any statute regulating sales to consumers, farm- ers or other specified classes of buyers.

§ 2–103. Definitions and Index of Definitions. (1) In this Article unless the context otherwise requires

(a) “Buyer” means a person who buys or contracts to buy goods. (b) “Good faith” in the case of a merchant means honesty in fact and the observance of reasonable commercial standards of fair dealing in the trade. (c) “Receipt” of goods means taking physical possession of them. (d) “Seller” means a person who sells or contracts to sell goods.

(2) Other definitions applying to this Article or to specified Parts thereof, and the sections in which they appear are: “Acceptance”. Section 2–606. “Banker’s credit”. Section 2–325. “Between merchants”. Section 2–104. “Cancellation”. Section 2–106(4). “Commercial unit”. Section 2–105. “Confirmed credit”. Section 2–325. “Conforming to contract”. Section 2–106. “Contract for sale”. Section 2–106. “Cover”. Section 2–712. “Entrusting”. Section 2–403. “Financing agency”. Section 2–104. “Future goods”. Section 2–105. “Goods”. Section 2–105. “Identification”. Section 2–501. “Installment contract”. Section 2–612. “Letter of Credit”. Section 2–325. “Lot”. Section 2–105. “Merchant”. Section 2–104. “Overseas”. Section 2–323. “Person in position of seller”. Section 2–707. “Present sale”. Section 2–106. “Sale”. Section 2–106. “Sale on approval”. Section 2–326. “Sale or return”. Section 2–326. “Termination”. Section 2–106. (3) The following definitions in other Articles apply to this Article: “Check”. Section 3–104. “Consignee”. Section 7–102. “Consignor”. Section 7–102. “Consumer goods”. Section 9–109. “Dishonor”. Section 3–507. “Draft”. Section 3–104. (4) In addition Article 1 contains general definitions and prin- ciples of construction and interpretation applicable throughout this Article. As amended in 1994 and 1999.

A-13

Copyright 2016 by the American Law Institute and the National Conference of Com- missioners on Uniform State Laws. Reproduced with the permission of the Permanent Editorial Board for the Uniform Commercial Code. All rights reserved.

A P P E N D I X C

Articles 2 and 2A of the Uniform Commercial Code

A-14 A P P E N D I X C Articles 2 and 2A of the Uniform Commercial Code

§ 2–104. Definitions: “Merchant”; “Between Merchants”; “Financing Agency”. (1) “Merchant” means a person who deals in goods of the kind or otherwise by his occupation holds himself out as having knowl- edge or skill peculiar to the practices or goods involved in the transaction or to whom such knowledge or skill may be attrib- uted by his employment of an agent or broker or other interme- diary who by his occupation holds himself out as having such knowledge or skill. (2) “Financing agency” means a bank, finance company or other person who in the ordinary course of business makes advances against goods or documents of title or who by arrangement with either the seller or the buyer intervenes in ordinary course to make or collect payment due or claimed under the contract for sale, as by purchasing or paying the seller’s draft or making advances against it or by merely taking it for collection whether or not documents of title accompany the draft. “Financing agency” includes also a bank or other person who similarly inter- venes between persons who are in the position of seller and buyer in respect to the goods (Section 2–707). (3) “Between merchants” means in any transaction with respect to which both parties are chargeable with the knowledge or skill of merchants.

§ 2–105. Definitions: Transferability; “Goods”; “Future” Goods; “Lot”; “Commercial Unit”. (1) “Goods” means all things (including specially manufactured goods) which are movable at the time of identification to the contract for sale other than the money in which the price is to be paid, investment securities (Article 8) and things in action. “Goods” also includes the unborn young of animals and growing crops and other identified things attached to realty as described in the section on goods to be severed from realty (Section 2–107). (2) Goods must be both existing and identified before any inter- est in them can pass. Goods which are not both existing and identified are “future” goods. A purported present sale of future goods or of any interest therein operates as a contract to sell. (3) There may be a sale of a part interest in existing identified goods. (4) An undivided share in an identified bulk of fungible goods is sufficiently identified to be sold although the quantity of the bulk is not determined. Any agreed proportion of such a bulk or any quantity thereof agreed upon by number, weight or other measure may to the extent of the seller’s interest in the bulk be sold to the buyer who then becomes an owner in common. (5) “Lot” means a parcel or a single article which is the subject matter of a separate sale or delivery, whether or not it is sufficient to perform the contract. (6) “Commercial unit” means such a unit of goods as by com- mercial usage is a single whole for purposes of sale and division of which materially impairs its character or value on the market or in use. A commercial unit may be a single article (as a machine) or a set of articles (as a suite of furniture or an assortment of sizes) or a quantity (as a bale, gross, or carload) or any other unit treated in use or in the relevant market as a single whole.

§ 2–106. Definitions: “Contract”; “Agreement”; “Contract for Sale”; “Sale”; “Present Sale”; “Conforming” to Contract; “Termination”; “Cancellation”.

(1) In this Article unless the context otherwise requires “con- tract” and “agreement” are limited to those relating to the pres- ent or future sale of goods. “Contract for sale” includes both a present sale of goods and a contract to sell goods at a future time. A “sale” consists in the passing of title from the seller to the buyer for a price (Section 2–401). A “present sale” means a sale which is accomplished by the making of the contract.

(2) Goods or conduct including any part of a performance are “conforming” or conform to the contract when they are in accor- dance with the obligations under the contract.

(3) “Termination” occurs when either party pursuant to a power created by agreement or law puts an end to the contract other- wise than for its breach. On “termination” all obligations which are still executory on both sides are discharged but any right based on prior breach or performance survives.

(4) “Cancellation” occurs when either party puts an end to the contract for breach by the other and its effect is the same as that of “termination” except that the cancelling party also retains any remedy for breach of the whole contract or any unperformed balance.

§ 2–107. Goods to Be Severed From Realty: Recording.

(1) A contract for the sale of minerals or the like (including oil and gas) or a structure or its materials to be removed from realty is a contract for the sale of goods within this Article if they are to be severed by the seller but until severance a purported present sale thereof which is not effective as a transfer of an interest in land is effective only as a contract to sell.

(2) A contract for the sale apart from the land of growing crops or other things attached to realty and capable of severance without material harm thereto but not described in subsection (1) or of timber to be cut is a contract for the sale of goods within this Article whether the subject matter is to be severed by the buyer or by the seller even though it forms part of the realty at the time of contracting, and the parties can by identification effect a present sale before severance.

(3) The provisions of this section are subject to any third party rights provided by the law relating to realty records, and the contract for sale may be executed and recorded as a document transferring an interest in land and shall then constitute notice to third parties of the buyer’s rights under the contract for sale.

A P P E N D I X C Articles 2 and 2A of the Uniform Commercial Code A-15

Part 2—Form, Formation and Readjustment of Contract

§ 2–201. Formal Requirements; Statute of Frauds. (1) Except as otherwise provided in this section a contract for the sale of goods for the price of $500 or more is not enforceable by way of action or defense unless there is some writing sufficient to indicate that a contract for sale has been made between the par- ties and signed by the party against whom enforcement is sought or by his authorized agent or broker. A writing is not insufficient because it omits or incorrectly states a term agreed upon but the contract is not enforceable under this paragraph beyond the quantity of goods shown in such writing. (2) Between merchants if within a reasonable time a writing in confirmation of the contract and sufficient against the sender is received and the party receiving it has reason to know its contents, its satisfies the requirements of subsection (1) against such party unless written notice of objection to its contents is given within ten days after it is received. (3) A contract which does not satisfy the requirements of subsec- tion (1) but which is valid in other respects is enforceable

(a) if the goods are to be specially manufactured for the buyer and are not suitable for sale to others in the ordinary course of the seller’s business and the seller, before notice of repudiation is received and under circumstances which rea- sonably indicate that the goods are for the buyer, has made either a substantial beginning of their manufacture or com- mitments for their procurement; or (b) if the party against whom enforcement is sought admits in his pleading, testimony or otherwise in court that a con- tract for sale was made, but the contract is not enforceable under this provision beyond the quantity of goods admitted; or (c) with respect to goods for which payment has been made and accepted or which have been received and accepted (Sec. 2–606).

§ 2–202. Final Written Expression: Parol or Extrinsic Evidence. Terms with respect to which the confirmatory memoranda of the parties agree or which are otherwise set forth in a writing intended by the parties as a final expression of their agreement with respect to such terms as are included therein may not be contradicted by evidence of any prior agreement or of a contemporaneous oral agree- ment but may be explained or supplemented

(a) by course of dealing or usage of trade (Section 1–205) or by course of performance (Section 2–208); and (b) by evidence of consistent additional terms unless the court finds the writing to have been intended also as a com- plete and exclusive statement of the terms of the agreement.

§ 2–203. Seals Inoperative. The affixing of a seal to a writing evidencing a contract for sale or an offer to buy or sell goods does not constitute the writing a sealed

instrument and the law with respect to sealed instruments does not apply to such a contract or offer.

§ 2–204. Formation in General. (1) A contract for sale of goods may be made in any manner sufficient to show agreement, including conduct by both parties which recognizes the existence of such a contract. (2) An agreement sufficient to constitute a contract for sale may be found even though the moment of its making is undetermined. (3) Even though one or more terms are left open a contract for sale does not fail for indefiniteness if the parties have intended to make a contract and there is a reasonably certain basis for giving an appropriate remedy.

§ 2–205. Firm Offers. An offer by a merchant to buy or sell goods in a signed writing which by its terms gives assurance that it will be held open is not revocable, for lack of consideration, during the time stated or if no time is stated for a reasonable time, but in no event may such period of irre- vocability exceed three months; but any such term of assurance on a form supplied by the offeree must be separately signed by the offeror.

§ 2–206. Offer and Acceptance in Formation of Contract. (1) Unless other unambiguously indicated by the language or circumstances

(a) an offer to make a contract shall be construed as inviting acceptance in any manner and by any medium reasonable in the circumstances; (b) an order or other offer to buy goods for prompt or cur- rent shipment shall be construed as inviting acceptance either by a prompt promise to ship or by the prompt or cur- rent shipment of conforming or nonconforming goods, but such a shipment of non-conforming goods does not consti- tute an acceptance if the seller seasonably notifies the buyer that the shipment is offered only as an accommodation to the buyer.

(2) Where the beginning of a requested performance is a reasonable mode of acceptance an offeror who is not notified of acceptance within a reasonable time may treat the offer as having lapsed before acceptance.

§ 2–207. Additional Terms in Acceptance or Confirmation. (1) A definite and seasonable expression of acceptance or a writ- ten confirmation which is sent within a reasonable time oper- ates as an acceptance even though it states terms additional to or different from those offered or agreed upon, unless acceptance is expressly made conditional on assent to the additional or dif-is expressly made conditional on assent to the additional or dif-is expressly made conditional on assent to the additional or dif ferent terms. (2) The additional terms are to be construed as proposals for addition to the contract. Between merchants such terms become part of the contract unless:

(a) the offer expressly limits acceptance to the terms of the offer;

A-16 A P P E N D I X C Articles 2 and 2A of the Uniform Commercial Code

(b) they materially alter it; or (c) notification of objection to them has already been given or is given within a reasonable time after notice of them is received.

(3) Conduct by both parties which recognizes the existence of a contract is sufficient to establish a contract for sale although the writings of the parties do not otherwise establish a contract. In such case the terms of the particular contract consist of those terms on which the writings of the parties agree, together with any supplementary terms incorporated under any other provi- sions of this Act.

§ 2–208. Course of Performance or Practical Construction. (1) Where the contract for sale involves repeated occasions for performance by either party with knowledge of the nature of the performance and opportunity for objection to it by the other, any course of performance accepted or acquiesced in without objection shall be relevant to determine the meaning of the agreement. (2) The express terms of the agreement and any such course of performance, as well as any course of dealing and usage of trade, shall be construed whenever reasonable as consistent with each other; but when such construction is unreasonable, express terms shall control course of performance and course of performance shall control both course of dealing and usage of trade (Section 1–205). (3) Subject to the provisions of the next section on modifica- tion and waiver, such course of performance shall be relevant to show a waiver or modification of any term inconsistent with such course of performance.

§ 2–209. Modification, Rescission and Waiver. (1) An agreement modifying a contract within this Article needs no consideration to be binding. (2) A signed agreement which excludes modification or rescis- sion except by a signed writing cannot be otherwise modified or rescinded, but except as between merchants such a requirement on a form supplied by the merchant must be separately signed by the other party. (3) The requirements of the statute of frauds section of this Arti- cle (Section 2–201) must be satisfied if the contract as modified is within its provisions. (4) Although an attempt at modification or rescission does not satisfy the requirements of subsection (2) or (3) it can operate as a waiver. (5) A party who has made a waiver affecting an executory por- tion of the contract may retract the waiver by reasonable noti- fication received by the other party that strict performance will be required of any term waived, unless the retraction would be unjust in view of a material change of position in reliance on the waiver.

§ 2–210. Delegation of Performance; Assignment of Rights.

(1) A party may perform his duty through a delegate unless oth- erwise agreed or unless the other party has a substantial inter- est in having his original promisor perform or control the acts required by the contract. No delegation of performance relieves the party delegating of any duty to perform or any liability for breach.

(2) Except as otherwise provided in Section 9–406, unless oth- erwise agreed, all rights of either seller or buyer can be assigned except where the assignment would materially change the duty of the other party, or increase materially the burden or risk imposed on him by his contract, or impair materially his chance of obtaining return performance. A right to damages for breach of the whole contract or a right arising out of the assignor’s due performance of his entire obligation can be assigned despite agreement otherwise.

(3) The creation, attachment, perfection, or enforcement of a security interest in the seller’s interest under a contract is not a transfer that materially changes the duty of or increases materially the burden or risk imposed on the buyer or impairs materially the buyer’s chance of obtaining return performance within the purview of subsection (2) unless, and then only to the extent that, enforcement actually results in a delegation of material performance of the seller. Even in that event, the cre- ation, attachment, perfection, and enforcement of the security interest remain effective, but (i) the seller is liable to the buyer for damages caused by the delegation to the extent that the dam- ages could not reasonably by prevented by the buyer, and (ii) a court having jurisdiction may grant other appropriate relief, including cancellation of the contract for sale or an injunction against enforcement of the security interest or consummation of the enforcement.

(4) Unless the circumstances indicate the contrary a prohibition of assignment of “the contract” is to be construed as barring only the delegation to the assignee of the assignor’s performance.

(5) An assignment of “the contract” or of “all my rights under the contract” or an assignment in similar general terms is an assign- ment of rights and unless the language or the circumstances (as in an assignment for security) indicate the contrary, it is a delega- tion of performance of the duties of the assignor and its accep- tance by the assignee constitutes a promise by him to perform those duties. This promise is enforceable by either the assignor or the other party to the original contract.

(6) The other party may treat any assignment which delegates performance as creating reasonable grounds for insecurity and may without prejudice to his rights against the assignor demand assurances from the assignee (Section 2–609).

A P P E N D I X C Articles 2 and 2A of the Uniform Commercial Code A-17

Part 3—General Obligation and Construction of Contract

§ 2–301. General Obligations of Parties. The obligation of the seller is to transfer and deliver and that of the buyer is to accept and pay in accordance with the contract.

§ 2–302. Unconscionable Contract or Clause. (1) If the court as a matter of law finds the contract or any clause of the contract to have been unconscionable at the time it was made the court may refuse to enforce the contract, or it may enforce the remainder of the contract without the unconscio- nable clause, or it may so limit the application of any unconscio- nable clause as to avoid any unconscionable result. (2) When it is claimed or appears to the court that the contract or any clause thereof may be unconscionable the parties shall be afforded a reasonable opportunity to present evidence as to its commercial setting, purpose and effect to aid the court in mak- ing the determination.

§ 2–303. Allocations or Division of Risks. Where this Article allocates a risk or a burden as between the par- ties “unless otherwise agreed”, the agreement may not only shift the allocation but may also divide the risk or burden.

§ 2–304. Price Payable in Money, Goods, Realty, or Otherwise. (1) The price can be made payable in money or otherwise. If it is payable in whole or in part in goods each party is a seller of the goods which he is to transfer. (2) Even though all or part of the price is payable in an interest in realty the transfer of the goods and the seller’s obligations with reference to them are subject to this Article, but not the transfer of the interest in realty or the transferor’s obligations in connection therewith.

§ 2–305. Open Price Term. (1) The parties if they so intend can conclude a contract for sale even though the price is not settled. In such a case the price is a reasonable price at the time for delivery if

(a) nothing is said as to price; or (b) the price is left to be agreed by the parties and they fail to agree; or (c) the price is to be fixed in terms of some agreed market or other standard as set or recorded by a third person or agency and it is not so set or recorded.

(2) A price to be fixed by the seller or by the buyer means a price for him to fix in good faith. (3) When a price left to be fixed otherwise than by agreement of the parties fails to be fixed through fault of one party the other may at his option treat the contract as cancelled or himself fix a reasonable price. (4) Where, however, the parties intend not to be bound unless the price be fixed or agreed and it is not fixed or agreed there is no contract. In such a case the buyer must return any goods

already received or if unable so to do must pay their reasonable value at the time of delivery and the seller must return any por- tion of the price paid on account.

§ 2–306. Output, Requirements and Exclusive Dealings. (1) A term which measures the quantity by the output of the seller or the requirements of the buyer means such actual out- put or requirements as may occur in good faith, except that no quantity unreasonably disproportionate to any stated estimate or in the absence of a stated estimate to any normal or otherwise comparable prior output or requirements may be tendered or demanded. (2) A lawful agreement by either the seller or the buyer for exclu- sive dealing in the kind of goods concerned imposes unless oth- erwise agreed an obligation by the seller to use best efforts to supply the goods and by the buyer to use best efforts to promote their sale.

§ 2–307. Delivery in Single Lot or Several Lots. Unless otherwise agreed all goods called for by a contract for sale must be tendered in a single delivery and payment is due only on such tender but where the circumstances give either party the right to make or demand delivery in lots the price if it can be apportioned may be demanded for each lot.

§ 2–308. Absence of Specified Place for Delivery. Unless otherwise agreed

(a) the place for delivery of goods is the seller’s place of busi- ness or if he has none his residence; but (b) in a contract for sale of identified goods which to the knowledge of the parties at the time of contracting are in some other place, that place is the place for their delivery; and (c) documents of title may be delivered through customary banking channels.

§ 2–309. Absence of Specific Time Provisions; Notice of Termination. (1) The time for shipment or delivery or any other action under a contract if not provided in this Article or agreed upon shall be a reasonable time. (2) Where the contract provides for successive performances but is indefinite in duration it is valid for a reasonable time but unless otherwise agreed may be terminated at any time by either party. (3) Termination of a contract by one party except on the hap- pening of an agreed event requires that reasonable notification be received by the other party and an agreement dispensing with notification is invalid if its operation would be unconscionable.

§ 2–310. Open Time for Payment or Running of Credit; Authority to Ship Under Reservation. Unless otherwise agreed

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(a) payment is due at the time and place at which the buyer is to receive the goods even though the place of shipment is the place of delivery; and (b) if the seller is authorized to send the goods he may ship them under reservation, and may tender the documents of title, but the buyer may inspect the goods after their arrival before payment is due unless such inspection is inconsistent with the terms of the contract (Section 2–513); and (c) if delivery is authorized and made by way of documents of title otherwise than by subsection (b) then payment is due at the time and place at which the buyer is to receive the documents regardless of where the goods are to be received; and (d) where the seller is required or authorized to ship the goods on credit the credit period runs from the time of ship- ment but post-dating the invoice or delaying its dispatch will correspondingly delay the starting of the credit period.

§ 2–311. Options and Cooperation Respecting Performance. (1) An agreement for sale which is otherwise sufficiently definite (subsection (3) of Section 2–204) to be a contract is not made invalid by the fact that it leaves particulars of performance to be specified by one of the parties. Any such specification must be made in good faith and within limits set by commercial reasonableness. (2) Unless otherwise agreed specifications relating to assortment of the goods are at the buyer’s option and except as otherwise provided in subsections (1)(c) and (3) of Section 2–319 speci- fications or arrangements relating to shipment are at the seller’s option. (3) Where such specification would materially affect the other party’s performance but is not seasonably made or where one party’s cooperation is necessary to the agreed performance of the other but is not seasonably forthcoming, the other party in addi- tion to all other remedies

(a) is excused for any resulting delay in his own perfor- mance; and (b) may also either proceed to perform in any reasonable manner or after the time for a material part of his own per- formance treat the failure to specify or to cooperate as a breach by failure to deliver or accept the goods.

§ 2–312. Warranty of Title and Against Infringement; Buyer’s Obligation Against Infringement. (1) Subject to subsection (2) there is in a contract for sale a war- ranty by the seller that

(a) the title conveyed shall be good, and its transfer right- ful; and (b) the goods shall be delivered free from any security inter- est or other lien or encumbrance of which the buyer at the time of contracting has no knowledge.

(2) A warranty under subsection (1) will be excluded or modi- fied only by specific language or by circumstances which give the

buyer reason to know that the person selling does not claim title in himself or that he is purporting to sell only such right or title as he or a third person may have. (3) Unless otherwise agreed a seller who is a merchant regularly dealing in goods of the kind warrants that the goods shall be delivered free of the rightful claim of any third person by way of infringement or the like but a buyer who furnishes specifications to the seller must hold the seller harmless against any such claim which arises out of compliance with the specifications.

§ 2–313. Express Warranties by Affirmation, Promise, Description, Sample. (1) Express warranties by the seller are created as follows:

(a) Any affirmation of fact or promise made by the seller to the buyer which relates to the goods and becomes part of the basis of the bargain creates an express warranty that the goods shall conform to the affirmation or promise. (b) Any description of the goods which is made part of the basis of the bargain creates an express warranty that the goods shall conform to the description. (c) Any sample or model which is made part of the basis of the bargain creates an express warranty that the whole of the goods shall conform to the sample or model.

(2) It is not necessary to the creation of an express warranty that the seller use formal words such as “warrant” or “guarantee” or that he have a specific intention to make a warranty, but an affir- mation merely of the value of the goods or a statement purport- ing to be merely the seller’s opinion or commendation of the goods does not create a warranty.

§ 2–314. Implied Warranty: Merchantability; Usage of Trade. (1) Unless excluded or modified (Section 2–316), a warranty that the goods shall be merchantable is implied in a contract for their sale if the seller is a merchant with respect to goods of that kind. Under this section the serving for value of food or drink to be consumed either on the premises or elsewhere is a sale. (2) Goods to be merchantable must be at least such as

(a) pass without objection in the trade under the contract description; and (b) in the case of fungible goods, are of fair average quality within the description; and (c) are fit for the ordinary purposes for which such goods are used; and (d) run, within the variations permitted by the agreement, of even kind, quality and quantity within each unit and among all units involved; and (e) are adequately contained, packaged, and labeled as the agreement may require; and (f) conform to the promises or affirmations of fact made on the container or label if any.

(3) Unless excluded or modified (Section 2–316) other implied warranties may arise from course of dealing or usage of trade.

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§ 2–315. Implied Warranty: Fitness for Particular Purpose. Where the seller at the time of contracting has reason to know any particular purpose for which the goods are required and that the buyer is relying on the seller’s skill or judgment to select or furnish suitable goods, there is unless excluded or modified under the next section an implied warranty that the goods shall be fit for such purpose.

§ 2–316. Exclusion or Modification of Warranties. (1) Words or conduct relevant to the creation of an express war- ranty and words or conduct tending to negate or limit warranty shall be construed wherever reasonable as consistent with each other; but subject to the provisions of this Article on parol or extrinsic evidence (Section 2–202) negation or limitation is inoperative to the extent that such construction is unreasonable. (2) Subject to subsection (3), to exclude or modify the implied warranty of merchantability or any part of it the language must mention merchantability and in case of a writing must be con- spicuous, and to exclude or modify any implied warranty of fitness the exclusion must be by a writing and conspicuous. Language to exclude all implied warranties of fitness is sufficient if it states, for example, that “There are no warranties which extend beyond the description on the face hereof.” (3) Notwithstanding subsection (2)

(a) unless the circumstances indicate otherwise, all implied warranties are excluded by expressions like “as is”, “with all faults” or other language which in common understanding calls the buyer’s attention to the exclusion of warranties and makes plain that there is no implied warranty; and (b) when the buyer before entering into the contract has examined the goods or the sample or model as fully as he desired or has refused to examine the goods there is no implied warranty with regard to defects which an examina- tion ought in the circumstances to have revealed to him; and (c) an implied warranty can also be excluded or modified by course of dealing or course of performance or usage of trade.

(4) Remedies for breach of warranty can be limited in accordance with the provisions of this Article on liquidation or limitation of damages and on contractual modification of remedy (Sections 2–718 and 2–719).

§ 2–317. Cumulation and Conflict of Warranties Express or Implied. Warranties whether express or implied shall be construed as con- sistent with each other and as cumulative, but if such construction is unreasonable the intention of the parties shall determine which warranty is dominant. In ascertaining that intention the following rules apply:

(c) Express warranties displace inconsistent implied warran- ties other than an implied warranty of fitness for a particular purpose.

§ 2–318. Third Party Beneficiaries of Warranties Express or Implied. Note: If this Act is introduced in the Congress of the United States this section should be omitted. (States to select one alternative.)

Alternative A A seller’s warranty whether express or implied extends to any natural person who is in the family or household of his buyer or who is a guest in his home if it is reasonable to expect that such person may use, consume or be affected by the goods and who is injured in per- son by breach of the warranty. A seller may not exclude or limit the operation of this section.

Alternative B A seller’s warranty whether express or implied extends to any natu- ral person who may reasonably be expected to use, consume or be affected by the goods and who is injured in person by breach of the warranty. A seller may not exclude or limit the operation of this section.

Alternative C A seller’s warranty whether express or implied extends to any person who may reasonably be expected to use, consume or be affected by the goods and who is injured by breach of the warranty. A seller may not exclude or limit the operation of this section with respect to injury to the person of an individual to whom the warranty extends. As amended 1966.

§ 2–319. F.O.B. and F.A.S. Terms. (1) Unless otherwise agreed the term F.O.B. (which means “free on board”) at a named place, even though used only in connec- tion with the stated price, is a delivery term under which

(a) when the term is F.O.B. the place of shipment, the seller must at that place ship the goods in the manner provided in this Article (Section 2–504) and bear the expense and risk of putting them into the possession of the carrier; or (b) when the term is F.O.B. the place of destination, the seller must at his own expense and risk transport the goods to that place and there tender delivery of them in the man- ner provided in this Article (Section 2–503); (c) when under either (a) or (b) the term is also F.O.B. ves- sel, car or other vehicle, the seller must in addition at his own expense and risk load the goods on board. If the term is F.O.B. vessel the buyer must name the vessel and in an appropriate case the seller must comply with the provisions of this Article on the form of bill of lading (Section 2–323).

(2) Unless otherwise agreed the term F.A.S. vessel (which means “free alongside”) at a named port, even though used only in con- nection with the stated price, is a delivery term under which the seller must

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§ 2–321. C.I.F. or C. & F.: “Net Landed Weights”; “Payment on Arrival”; Warranty of Condition on Arrival. Under a contract containing a term C.I.F. or C. & F. (1) Where the price is based on or is to be adjusted according to “net landed weights”, “delivered weights”, “out turn” quantity or quality or the like, unless otherwise agreed the seller must reasonably estimate the price. The payment due on tender of the documents called for by the contract is the amount so estimated, but after final adjustment of the price a settlement must be made with commercial promptness. (2) An agreement described in subsection (1) or any warranty of quality or condition of the goods on arrival places upon the seller the risk of ordinary deterioration, shrinkage and the like in transportation but has no effect on the place or time of identi- fication to the contract for sale or delivery or on the passing of the risk of loss. (3) Unless otherwise agreed where the contract provides for pay- ment on or after arrival of the goods the seller must before pay- ment allow such preliminary inspection as is feasible; but if the goods are lost delivery of the documents and payment are due when the goods should have arrived.

§ 2–322. Delivery “Ex-Ship”. (1) Unless otherwise agreed a term for delivery of goods “ex-ship” (which means from the carrying vessel) or in equivalent language is not restricted to a particular ship and requires delivery from a ship which has reached a place at the named port of destination where goods of the kind are usually discharged. (2) Under such a term unless otherwise agreed

(a) the seller must discharge all liens arising out of the car- riage and furnish the buyer with a direction which puts the carrier under a duty to deliver the goods; and (b) the risk of loss does not pass to the buyer until the goods leave the ship’s tackle or are otherwise properly unloaded.

§ 2–323. Form of Bill of Lading Required in Overseas Shipment; “Overseas”. (1) Where the contract contemplates overseas shipment and con- tains a term C.I.F. or C. & F. or F.O.B. vessel, the seller unless otherwise agreed must obtain a negotiable bill of lading stating that the goods have been loaded on board or, in the case of a term C.I.F. or C. & F., received for shipment. (2) Where in a case within subsection (1) a bill of lading has been issued in a set of parts, unless otherwise agreed if the documents are not to be sent from abroad the buyer may demand tender of the full set; otherwise only one part of the bill of lading need be tendered. Even if the agreement expressly requires a full set

(a) due tender of a single part is acceptable within the provi- sions of this Article on cure of improper delivery (subsection (1) of Section 2–508); and (b) even though the full set is demanded, if the documents are sent from abroad the person tendering an incomplete set may nevertheless require payment upon furnishing an indemnity which the buyer in good faith deems adequate.

(a) at his own expense and risk deliver the goods alongside the vessel in the manner usual in that port or on a dock designated and provided by the buyer; and (b) obtain and tender a receipt for the goods in exchange for which the carrier is under a duty to issue a bill of lading.

(3) Unless otherwise agreed in any case falling within subsection (1)(a) or (c) or subsection (2) the buyer must seasonably give any needed instructions for making delivery, including when the term is F.A.S. or F.O.B. the loading berth of the vessel and in an appropriate case its name and sailing date. The seller may treat the failure of needed instructions as a failure of cooperation under this Article (Section 2–311). He may also at his option move the goods in any reasonable manner preparatory to deliv- ery or shipment. (4) Under the term F.O.B. vessel or F.A.S. unless otherwise agreed the buyer must make payment against tender of the required documents and the seller may not tender nor the buyer demand delivery of the goods in substitution for the documents.

§ 2–320. C.I.F. and C. & F. Terms. (1) The term C.I.F. means that the price includes in a lump sum the cost of the goods and the insurance and freight to the named destination. The term C. & F. or C.F. means that the price so includes cost and freight to the named destination. (2) Unless otherwise agreed and even though used only in con- nection with the stated price and destination, the term C.I.F. destination or its equivalent requires the seller at his own expense and risk to

(a) put the goods into the possession of a carrier at the port for shipment and obtain a negotiable bill or bills of lading covering the entire transportation to the named destination; and (b) load the goods and obtain a receipt from the carrier (which may be contained in the bill of lading) showing that the freight has been paid or provided for; and (c) obtain a policy or certificate of insurance, including any war risk insurance, of a kind and on terms then current at the port of shipment in the usual amount, in the currency of the contract, shown to cover the same goods covered by the bill of lading and providing for payment of loss to the order of the buyer or for the account of whom it may concern; but the seller may add to the price the amount of the premium for any such war risk insurance; and (d) prepare an invoice of the goods and procure any other documents required to effect shipment or to comply with the contract; and (e) forward and tender with commercial promptness all the documents in due form and with any indorsement necessary to perfect the buyer’s rights.

(3) Unless otherwise agreed the term C. & F. or its equivalent has the same effect and imposes upon the seller the same obligations and risks as a C.I.F. term except the obligation as to insurance. (4) Under the term C.I.F. or C. & F. unless otherwise agreed the buyer must make payment against tender of the required documents and the seller may not tender nor the buyer demand delivery of the goods in substitution for the documents.

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§ 2–327. Special Incidents of Sale on Approval and Sale or Return. (1) Under a sale on approval unless otherwise agreed

(a) although the goods are identified to the contract the risk of loss and the title do not pass to the buyer until accep- tance; and (b) use of the goods consistent with the purpose of trial is not acceptance but failure seasonably to notify the seller of election to return the goods is acceptance, and if the goods conform to the contract acceptance of any part is acceptance of the whole; and (c) after due notification of election to return, the return is at the seller’s risk and expense but a merchant buyer must follow any reasonable instructions.

(2) Under a sale or return unless otherwise agreed (a) the option to return extends to the whole or any com- mercial unit of the goods while in substantially their original condition, but must be exercised seasonably; and (b) the return is at the buyer’s risk and expense.

§ 2–328. Sale by Auction. (1) In a sale by auction if goods are put up in lots each lot is the subject of a separate sale. (2) A sale by auction is complete when the auctioneer so announces by the fall of the hammer or in other customary man- ner. Where a bid is made while the hammer is falling in accep- tance of a prior bid the auctioneer may in his discretion reopen the bidding or declare the goods sold under the bid on which the hammer was falling. (3) Such a sale is with reserve unless the goods are in explicit terms put up without reserve. In an auction with reserve the auc- tioneer may withdraw the goods at any time until he announces completion of the sale. In an auction without reserve, after the auctioneer calls for bids on an article or lot, that article or lot cannot be withdrawn unless no bid is made within a reasonable time. In either case a bidder may retract his bid until the auc- tioneer’s announcement of completion of the sale, but a bidder’s retraction does not revive any previous bid. (4) If the auctioneer knowingly receives a bid on the seller’s behalf or the seller makes or procures such as bid, and notice has not been given that liberty for such bidding is reserved, the buyer may at his option avoid the sale or take the goods at the price of the last good faith bid prior to the completion of the sale. This subsection shall not apply to any bid at a forced sale.

Part 4—Title, Creditors and Good Faith Purchasers

§ 2–401. Passing of Title; Reservation for Security; Limited Application of This Section. Each provision of this Article with regard to the rights, obligations and remedies of the seller, the buyer, purchasers or other third parties applies irrespective of title to the goods except where the provision refers to such title. Insofar as situations are not covered by the other

(3) A shipment by water or by air or a contract contemplating such shipment is “overseas” insofar as by usage of trade or agree- ment it is subject to the commercial, financing or shipping prac- tices characteristic of international deep water commerce.

§ 2–324. “No Arrival, No Sale” Term. Under a term “no arrival, no sale” or terms of like meaning, unless otherwise agreed,

(a) the seller must properly ship conforming goods and if they arrive by any means he must tender them on arrival but he assumes no obligation that the goods will arrive unless he has caused the non-arrival; and (b) where without fault of the seller the goods are in part lost or have so deteriorated as no longer to conform to the con- tract or arrive after the contract time, the buyer may proceed as if there had been casualty to identified goods (Section 2–613).

§ 2–325. “Letter of Credit” Term; “Confirmed Credit”. (1) Failure of the buyer seasonably to furnish an agreed letter of credit is a breach of the contract for sale. (2) The delivery to seller of a proper letter of credit suspends the buyer’s obligation to pay. If the letter of credit is dishonored, the seller may on seasonable notification to the buyer require pay- ment directly from him. (3) Unless otherwise agreed the term “letter of credit” or “bank- er’s credit” in a contract for sale means an irrevocable credit issued by a financing agency of good repute and, where the ship- ment is overseas, of good international repute. The term “con- firmed credit” means that the credit must also carry the direct obligation of such an agency which does business in the seller’s financial market.

§ 2–326. Sale on Approval and Sale or Return; Rights of Creditors. (1) Unless otherwise agreed, if delivered goods may be returned by the buyer even though they conform to the contract, the transac- tion is

(a) a “sale on approval” if the goods are delivered primarily for use, and (b) a “sale or return” if the goods are delivered primarily for resale.

(2) Goods held on approval are not subject to the claims of the buyer’s creditors until acceptance; goods held on sale or return are subject to such claims while in the buyer’s possession. (3) Any “or return” term of a contract for sale is to be treated as a separate contract for sale within the statute of frauds section of this Article (Section 2–201) and as contradicting the sale aspect of the contract within the provisions of this Article or on parol or extrinsic evidence (Section 2–202). As amended in 1999.

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(b) where identification to the contract or delivery is made not in current course of trade but in satisfaction of or as security for a pre-existing claim for money, security or the like and is made under circumstances which under any rule of law of the state where the goods are situated would apart from this Article constitute the transaction a fraudulent transfer or voidable preference.

§ 2–403. Power to Transfer; Good Faith Purchase of Goods; “Entrusting”. (1) A purchaser of goods acquires all title which his transferor had or had power to transfer except that a purchaser of a limited interest acquires rights only to the extent of the interest pur- chased. A person with voidable title has power to transfer a good title to a good faith purchaser for value. When goods have been delivered under a transaction of purchase the purchaser has such power even though

(a) the transferor was deceived as to the identity of the pur- chaser, or (b) the delivery was in exchange for a check which is later dishonored, or (c) it was agreed that the transaction was to be a “cash sale”, or (d) the delivery was procured through fraud punishable as larcenous under the criminal law.

(2) Any entrusting of possession of goods to a merchant who deals in goods of that kind gives him power to transfer all rights of the entruster to a buyer in ordinary course of business. (3) “Entrusting” includes any delivery and any acquiescence in retention of possession regardless of any condition expressed between the parties to the delivery or acquiescence and regardless of whether the procurement of the entrusting or the possessor’s disposition of the goods have been such as to be larcenous under the criminal law. (4) The rights of other purchasers of goods and of lien creditors are governed by the Articles on Secured Transactions (Article 9), Bulk Transfers (Article 6) and Documents of Title (Article 7). As amended in 1988.

Part 5—Performance

§ 2–501. Insurable Interest in Goods; Manner of Identification of Goods. (1) The buyer obtains a special property and an insurable interest in goods by identification of existing goods as goods to which the contract refers even though the goods so identified are non- conforming and he has an option to return or reject them. Such identification can be made at any time and in any manner explic- itly agreed to by the parties. In the absence of explicit agreement identification occurs

(a) when the contract is made if it is for the sale of goods already existing and identified; (b) if the contract is for the sale of future goods other than those described in paragraph (c), when goods are shipped,

provisions of this Article and matters concerning title became mate- rial the following rules apply: (1) Title to goods cannot pass under a contract for sale prior to their identification to the contract (Section 2–501), and unless otherwise explicitly agreed the buyer acquires by their identifica- tion a special property as limited by this Act. Any retention or reservation by the seller of the title (property) in goods shipped or delivered to the buyer is limited in effect to a reservation of a security interest. Subject to these provisions and to the provi- sions of the Article on Secured Transactions (Article 9), title to goods passes from the seller to the buyer in any manner and on any conditions explicitly agreed on by the parties. (2) Unless otherwise explicitly agreed title passes to the buyer at the time and place at which the seller completes his performance with reference to the physical delivery of the goods, despite any reservation of a security interest and even though a document of title is to be delivered at a different time or place; and in par- ticular and despite any reservation of a security interest by the bill of lading

(a) if the contract requires or authorizes the seller to send the goods to the buyer but does not require him to deliver them at destination, title passes to the buyer at the time and place of shipment; but (b) if the contract requires delivery at destination, title passes on tender there.

(3) Unless otherwise explicitly agreed where delivery is to be made without moving the goods,

(a) if the seller is to deliver a document of title, title passes at the time when and the place where he delivers such docu- ments; or (b) if the goods are at the time of contracting already identi- fied and no documents are to be delivered, title passes at the time and place of contracting.

(4) A rejection or other refusal by the buyer to receive or retain the goods, whether or not justified, or a justified revocation of acceptance revests title to the goods in the seller. Such revesting occurs by operation of law and is not a “sale”.

§ 2–402. Rights of Seller’s Creditors Against Sold Goods. (1) Except as provided in subsections (2) and (3), rights of unse- cured creditors of the seller with respect to goods which have been identified to a contract for sale are subject to the buyer’s rights to recover the goods under this Article (Sections 2–502 and 2–716). (2) A creditor of the seller may treat a sale or an identification of goods to a contract for sale as void if as against him a reten- tion of possession by the seller is fraudulent under any rule of law of the state where the goods are situated, except that reten- tion of possession in good faith and current course of trade by a merchant-seller for a commercially reasonable time after a sale or identification is not fraudulent. (3) Nothing in this Article shall be deemed to impair the rights of creditors of the seller

(a) under the provisions of the Article on Secured Transac- tions (Article 9); or

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(4) Where goods are in the possession of a bailee and are to be delivered without being moved

(a) tender requires that the seller either tender a negotiable document of title covering such goods or procure acknowl- edgment by the bailee of the buyer’s right to possession of the goods; but (b) tender to the buyer of a non-negotiable document of title or of a written direction to the bailee to deliver is suffi- cient tender unless the buyer seasonably objects, and receipt by the bailee of notification of the buyer’s rights fixes those rights as against the bailee and all third persons; but risk of loss of the goods and of any failure by the bailee to honor the non-negotiable document of title or to obey the direction remains on the seller until the buyer has had a reasonable time to present the document or direction, and a refusal by the bailee to honor the document or to obey the direction defeats the tender.

(5) Where the contract requires the seller to deliver documents (a) he must tender all such documents in correct form, except as provided in this Article with respect to bills of lad- ing in a set (subsection (2) of Section 2–323); and (b) tender through customary banking channels is sufficient and dishonor of a draft accompanying the documents con- stitutes non-acceptance or rejection.

§ 2–504. Shipment by Seller. Where the seller is required or authorized to send the goods to the buyer and the contract does not require him to deliver them at a particular destination, then unless otherwise agreed he must

(a) put the goods in the possession of such a carrier and make such a contract for their transportation as may be rea- sonable having regard to the nature of the goods and other circumstances of the case; and (b) obtain and promptly deliver or tender in due form any document necessary to enable the buyer to obtain possession of the goods or otherwise required by the agreement or by usage of trade; and (c) promptly notify the buyer of the shipment.

Failure to notify the buyer under paragraph (c) or to make a proper contract under paragraph (a) is a ground for rejection only if mate- rial delay or loss ensues.

§ 2–505. Seller’s Shipment under Reservation. (1) Where the seller has identified goods to the contract by or before shipment:

(a) his procurement of a negotiable bill of lading to his own order or otherwise reserves in him a security interest in the goods. His procurement of the bill to the order of a financ- ing agency or of the buyer indicates in addition only the seller’s expectation of transferring that interest to the person named. (b) a non-negotiable bill of lading to himself or his nomi- nee reserves possession of the goods as security but except in a case of conditional delivery (subsection (2) of Section 2–507) a non-negotiable bill of lading naming the buyer as

marked or otherwise designated by the seller as goods to which the contract refers; (c) when the crops are planted or otherwise become growing crops or the young are conceived if the contract is for the sale of unborn young to be born within twelve months after con- tracting or for the sale of crops to be harvested within twelve months or the next normal harvest season after contracting whichever is longer.

(2) The seller retains an insurable interest in goods so long as title to or any security interest in the goods remains in him and where the identification is by the seller alone he may until default or insolvency or notification to the buyer that the identification is final substitute other goods for those identified. (3) Nothing in this section impairs any insurable interest recog- nized under any other statute or rule of law.

§ 2–502. Buyer’s Right to Goods on Seller’s Insolvency. (1) Subject to subsections (2) and (3) and even though the goods have not been shipped a buyer who has paid a part or all of the price of goods in which he has a special property under the provisions of the immediately preceding section may on making and keeping good a tender of any unpaid portion of their price recover them from the seller if:

(a) in the case of goods bought for personal, family, or household purposes, the seller repudiates or fails to deliver as required by the contract; or (b) in all cases, the seller becomes insolvent within ten days after receipt of the first installment on their price.

(2) The buyer’s right to recover the goods under subsection (1) (a) vests upon acquisition of a special property, even if the seller had not then repudiated or failed to deliver. (3) If the identification creating his special property has been made by the buyer he acquires the right to recover the goods only if they conform to the contract for sale. As amended in 1999.

§ 2–503. Manner of Seller’s Tender of Delivery. (1) Tender of delivery requires that the seller put and hold con- forming goods at the buyer’s disposition and give the buyer any notification reasonably necessary to enable him to take delivery. The manner, time and place for tender are determined by the agreement and this Article, and in particular

(a) tender must be at a reasonable hour, and if it is of goods they must be kept available for the period reasonably neces- sary to enable the buyer to take possession; but (b) unless otherwise agreed the buyer must furnish facilities reasonably suited to the receipt of the goods.

(2) Where the case is within the next section respecting shipment tender requires that the seller comply with its provisions. (3) Where the seller is required to deliver at a particular destina- tion tender requires that he comply with subsection (1) and also in any appropriate case tender documents as described in subsec- tions (4) and (5) of this section.

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possession of the carrier, the risk of loss passes to the buyer when the goods are there duly so tendered as to enable the buyer to take delivery.

(2) Where the goods are held by a bailee to be delivered without being moved, the risk of loss passes to the buyer

(a) on his receipt of a negotiable document of title covering the goods; or (b) on acknowledgment by the bailee of the buyer’s right to possession of the goods; or (c) after his receipt of a non-negotiable document of title or other written direction to deliver, as provided in subsection (4)(b) of Section 2–503.

(3) In any case not within subsection (1) or (2), the risk of loss passes to the buyer on his receipt of the goods if the seller is a merchant; otherwise the risk passes to the buyer on tender of delivery. (4) The provisions of this section are subject to contrary agree- ment of the parties and to the provisions of this Article on sale on approval (Section 2–327) and on effect of breach on risk of loss (Section 2–510).

§ 2–510. Effect of Breach on Risk of Loss. (1) Where a tender or delivery of goods so fails to conform to the contract as to give a right of rejection the risk of their loss remains on the seller until cure or acceptance. (2) Where the buyer rightfully revokes acceptance he may to the extent of any deficiency in his effective insurance coverage treat the risk of loss as having rested on the seller from the beginning. (3) Where the buyer as to conforming goods already identified to the contract for sale repudiates or is otherwise in breach before risk of their loss has passed to him, the seller may to the extent of any deficiency in his effective insurance coverage treat the risk of loss as resting on the buyer for a commercially reasonable time.

§ 2–511. Tender of Payment by Buyer; Payment by Check. (1) Unless otherwise agreed tender of payment is a condition to the seller’s duty to tender and complete any delivery. (2) Tender of payment is sufficient when made by any means or in any manner current in the ordinary course of business unless the seller demands payment in legal tender and gives any exten- sion of time reasonably necessary to procure it. (3) Subject to the provisions of this Act on the effect of an instru- ment on an obligation (Section 3–310), payment by check is conditional and is defeated as between the parties by dishonor of the check on due presentment. As amended in 1994.

§ 2–512. Payment by Buyer Before Inspection. (1) Where the contract requires payment before inspection non- conformity of the goods does not excuse the buyer from so mak- ing payment unless

(a) the non-conformity appears without inspection; or

consignee reserves no security interest even though the seller retains possession of the bill of lading.

(2) When shipment by the seller with reservation of a security interest is in violation of the contract for sale it constitutes an improper contract for transportation within the preceding sec- tion but impairs neither the rights given to the buyer by ship- ment and identification of the goods to the contract nor the seller’s powers as a holder of a negotiable document.

§ 2–506. Rights of Financing Agency. (1) A financing agency by paying or purchasing for value a draft which relates to a shipment of goods acquires to the extent of the payment or purchase and in addition to its own rights under the draft and any document of title securing it any rights of the shipper in the goods including the right to stop delivery and the shipper’s right to have the draft honored by the buyer. (2) The right to reimbursement of a financing agency which has in good faith honored or purchased the draft under commitment to or authority from the buyer is not impaired by subsequent dis- covery of defects with reference to any relevant document which was apparently regular on its face.

§ 2–507. Effect of Seller’s Tender; Delivery on Condition. (1) Tender of delivery is a condition to the buyer’s duty to accept the goods and, unless otherwise agreed, to his duty to pay for them. Tender entitles the seller to acceptance of the goods and to payment according to the contract. (2) Where payment is due and demanded on the delivery to the buyer of goods or documents of title, his right as against the seller to retain or dispose of them is conditional upon his making the payment due.

§ 2–508. Cure by Seller of Improper Tender or Delivery; Replacement. (1) Where any tender or delivery by the seller is rejected because non-conforming and the time for performance has not yet expired, the seller may seasonably notify the buyer of his inten- tion to cure and may then within the contract time make a con- forming delivery. (2) Where the buyer rejects a non-conforming tender which the seller had reasonable grounds to believe would be acceptable with or without money allowance the seller may if he seasonably noti- fies the buyer have a further reasonable time to substitute a con- forming tender.

§ 2–509. Risk of Loss in the Absence of Breach. (1) Where the contract requires or authorizes the seller to ship the goods by carrier

(a) if it does not require him to deliver them at a particular destination, the risk of loss passes to the buyer when the goods are duly delivered to the carrier even though the ship- ment is under reservation (Section 2–505); but (b) if it does require him to deliver them at a particular des- tination and the goods are there duly tendered while in the

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Part 6—Breach, Repudiation and Excuse

§ 2–601. Buyer’s Rights on Improper Delivery. Subject to the provisions of this Article on breach in installment contracts (Section 2–612) and unless otherwise agreed under the sections on contractual limitations of remedy (Sections 2–718 and 2–719), if the goods or the tender of delivery fail in any respect to conform to the contract, the buyer may

(a) reject the whole; or (b) accept the whole; or (c) accept any commercial unit or units and reject the rest.

§ 2–602. Manner and Effect of Rightful Rejection. (1) Rejection of goods must be within a reasonable time after their delivery or tender. It is ineffective unless the buyer season- ably notifies the seller. (2) Subject to the provisions of the two following sections on rejected goods (Sections 2–603 and 2–604),

(a) after rejection any exercise of ownership by the buyer with respect to any commercial unit is wrongful as against the seller; and (b) if the buyer has before rejection taken physical posses- sion of goods in which he does not have a security interest under the provisions of this Article (subsection (3) of Sec- tion 2–711), he is under a duty after rejection to hold them with reasonable care at the seller’s disposition for a time suf-with reasonable care at the seller’s disposition for a time suf-with reasonable care at the seller’s disposition for a time suf ficient to permit the seller to remove them; but (c) the buyer has no further obligations with regard to goods rightfully rejected.

(3) The seller’s rights with respect to goods wrongfully rejected are governed by the provisions of this Article on Seller’s remedies in general (Section 2–703).

§ 2–603. Merchant Buyer’s Duties as to Rightfully Rejected Goods. (1) Subject to any security interest in the buyer (subsection (3) of Section 2–711), when the seller has no agent or place of business at the market of rejection a merchant buyer is under a duty after rejection of goods in his possession or control to follow any rea- sonable instructions received from the seller with respect to the goods and in the absence of such instructions to make reasonable efforts to sell them for the seller’s account if they are perishable or threaten to decline in value speedily. Instructions are not reason- able if on demand indemnity for expenses is not forthcoming. (2) When the buyer sells goods under subsection (1), he is enti- tled to reimbursement from the seller or out of the proceeds for reasonable expenses of caring for and selling them, and if the expenses include no selling commission then to such commis- sion as is usual in the trade or if there is none to a reasonable sum not exceeding ten per cent on the gross proceeds. (3) In complying with this section the buyer is held only to good faith and good faith conduct hereunder is neither acceptance nor conversion nor the basis of an action for damages.

(b) despite tender of the required documents the circum- stances would justify injunction against honor under this Act (Section 5–109(b)).

(2) Payment pursuant to subsection (1) does not constitute an acceptance of goods or impair the buyer’s right to inspect or any of his remedies. As amended in 1995.

§ 2–513. Buyer’s Right to Inspection of Goods. (1) Unless otherwise agreed and subject to subsection (3), where goods are tendered or delivered or identified to the contract for sale, the buyer has a right before payment or acceptance to inspect them at any reasonable place and time and in any reason- able manner. When the seller is required or authorized to send the goods to the buyer, the inspection may be after their arrival. (2) Expenses of inspection must be borne by the buyer but may be recovered from the seller if the goods do not conform and are rejected. (3) Unless otherwise agreed and subject to the provisions of this Article on C.I.F. contracts (subsection (3) of Section 2–321), the buyer is not entitled to inspect the goods before payment of the price when the contract provides

(a) for delivery “C.O.D.” or on other like terms; or (b) for payment against documents of title, except where such payment is due only after the goods are to become available for inspection.

(4) A place or method of inspection fixed by the parties is pre- sumed to be exclusive but unless otherwise expressly agreed it does not postpone identification or shift the place for delivery or for passing the risk of loss. If compliance becomes impossible, inspection shall be as provided in this section unless the place or method fixed was clearly intended as an indispensable condition failure of which avoids the contract.

§ 2–514. When Documents Deliverable on Acceptance; When on Payment. Unless otherwise agreed documents against which a draft is drawn are to be delivered to the drawee on acceptance of the draft if it is payable more than three days after presentment; otherwise, only on payment.

§ 2–515. Preserving Evidence of Goods in Dispute. In furtherance of the adjustment of any claim or dispute

(a) either party on reasonable notification to the other and for the purpose of ascertaining the facts and preserving evi- dence has the right to inspect, test and sample the goods including such of them as may be in the possession or con- trol of the other; and (b) the parties may agree to a third party inspection or sur- vey to determine the conformity or condition of the goods and may agree that the findings shall be binding upon them in any subsequent litigation or adjustment.

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(b) if the claim is one for infringement or the like (subsec- tion (3) of Section 2–312) and the buyer is sued as a result of such a breach he must so notify the seller within a rea- sonable time after he receives notice of the litigation or be barred from any remedy over for liability established by the litigation.

(4) The burden is on the buyer to establish any breach with respect to the goods accepted. (5) Where the buyer is sued for breach of a warranty or other obligation for which his seller is answerable over

(a) he may give his seller written notice of the litigation. If the notice states that the seller may come in and defend and that if the seller does not do so he will be bound in any action against him by his buyer by any determination of fact common to the two litigations, then unless the seller after seasonable receipt of the notice does come in and defend he is so bound. (b) if the claim is one for infringement or the like (subsec- tion (3) of Section 2–312) the original seller may demand in writing that his buyer turn over to him control of the litigation including settlement or else be barred from any remedy over and if he also agrees to bear all expense and to satisfy any adverse judgment, then unless the buyer after seasonable receipt of the demand does turn over control the buyer is so barred.

(6) The provisions of subsections (3), (4) and (5) apply to any obligation of a buyer to hold the seller harmless against infringe- ment or the like (subsection (3) of Section 2–312).

§ 2–608. Revocation of Acceptance in Whole or in Part. (1) The buyer may revoke his acceptance of a lot or commercial unit whose non-conformity substantially impairs its value to him if he has accepted it

(a) on the reasonable assumption that its nonconformity would be cured and it has not been seasonably cured; or (b) without discovery of such non-conformity if his accep- tance was reasonably induced either by the difficulty of dis- covery before acceptance or by the seller’s assurances.

(2) Revocation of acceptance must occur within a reasonable time after the buyer discovers or should have discovered the ground for it and before any substantial change in condition of the goods which is not caused by their own defects. It is not effective until the buyer notifies the seller of it. (3) A buyer who so revokes has the same rights and duties with regard to the goods involved as if he had rejected them.

§ 2–609. Right to Adequate Assurance of Performance. (1) A contract for sale imposes an obligation on each party that the other’s expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable

§ 2–604. Buyer’s Options as to Salvage of Rightfully Rejected Goods. Subject to the provisions of the immediately preceding section on perishables if the seller gives no instructions within a reasonable time after notification of rejection the buyer may store the rejected goods for the seller’s account or reship them to him or resell them for the seller’s account with reimbursement as provided in the preceding section. Such action is not acceptance or conversion.

§ 2–605. Waiver of Buyer’s Objections by Failure to Particularize. (1) The buyer’s failure to state in connection with rejection a particular defect which is ascertainable by reasonable inspec- tion precludes him from relying on the unstated defect to justify rejection or to establish breach

(a) where the seller could have cured it if stated seasonably; or (b) between merchants when the seller has after rejection made a request in writing for a full and final written state- ment of all defects on which the buyer proposes to rely.

(2) Payment against documents made without reservation of rights precludes recovery of the payment for defects apparent on the face of the documents.

§ 2–606. What Constitutes Acceptance of Goods. (1) Acceptance of goods occurs when the buyer

(a) after a reasonable opportunity to inspect the goods signi- fies to the seller that the goods are conforming or that he will take or retain them in spite of their nonconformity; or (b) fails to make an effective rejection (subsection (1) of Sec- tion 2–602), but such acceptance does not occur until the buyer has had a reasonable opportunity to inspect them; or (c) does any act inconsistent with the seller’s ownership; but if such act is wrongful as against the seller it is an acceptance only if ratified by him.

(2) Acceptance of a part of any commercial unit is acceptance of that entire unit.

§ 2–607. Effect of Acceptance; Notice of Breach; Burden of Establishing Breach After Acceptance; Notice of Claim or Litigation to Person Answerable Over. (1) The buyer must pay at the contract rate for any goods accepted. (2) Acceptance of goods by the buyer precludes rejection of the goods accepted and if made with knowledge of a non-confor- mity cannot be revoked because of it unless the acceptance was on the reasonable assumption that the non-conformity would be seasonably cured but acceptance does not of itself impair any other remedy provided by this Article for non-conformity. (3) Where a tender has been accepted

(a) the buyer must within a reasonable time after he discov- ers or should have discovered any breach notify the seller of breach or be barred from any remedy; and

A P P E N D I X C Articles 2 and 2A of the Uniform Commercial Code A-27

without seasonably notifying of cancellation or if he brings an action with respect only to past installments or demands perfor- mance as to future installments.

§ 2–613. Casualty to Identified Goods. Where the contract requires for its performance goods identified when the contract is made, and the goods suffer casualty without fault of either party before the risk of loss passes to the buyer, or in a proper case under a “no arrival, no sale” term (Section 2–324) then

(a) if the loss is total the contract is avoided; and (b) if the loss is partial or the goods have so deteriorated as no longer to conform to the contract the buyer may nev- ertheless demand inspection and at his option either treat the contract as voided or accept the goods with due allow- ance from the contract price for the deterioration or the deficiency in quantity but without further right against the seller.

§ 2–614. Substituted Performance. (1) Where without fault of either party the agreed berthing, loading, or unloading facilities fail or an agreed type of carrier becomes unavailable or the agreed manner of delivery otherwise becomes commercially impracticable but a commercially reason- able substitute is available, such substitute performance must be tendered and accepted. (2) If the agreed means or manner of payment fails because of domestic or foreign governmental regulation, the seller may withhold or stop delivery unless the buyer provides a means or manner of payment which is commercially a substantial equiva- lent. If delivery has already been taken, payment by the means or in the manner provided by the regulation discharges the buyer’s obligation unless the regulation is discriminatory, oppressive or predatory.

§ 2–615. Excuse by Failure of Presupposed Conditions. Except so far as a seller may have assumed a greater obligation and subject to the preceding section on substituted performance:

(a) Delay in delivery or non-delivery in whole or in part by a seller who complies with paragraphs (b) and (c) is not a breach of his duty under a contract for sale if performance as agreed has been made impracticable by the occurrence of a contingency the nonoccurrence of which was a basic assumption on which the contract was made or by compli- ance in good faith with any applicable foreign or domestic governmental regulation or order whether or not it later proves to be invalid. (b) Where the causes mentioned in paragraph (a) affect only a part of the seller’s capacity to perform, he must allocate production and deliveries among his customers but may at his option include regular customers not then under con- tract as well as his own requirements for further manufac- ture. He may so allocate in any manner which is fair and reasonable.

suspend any performance for which he has not already received the agreed return. (2) Between merchants the reasonableness of grounds for inse- curity and the adequacy of any assurance offered shall be deter- mined according to commercial standards. (3) Acceptance of any improper delivery or payment does not prejudice the party’s right to demand adequate assurance of future performance. (4) After receipt of a justified demand failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract.

§ 2–610. Anticipatory Repudiation. When either party repudiates the contract with respect to a perfor- mance not yet due the loss of which will substantially impair the value of the contract to the other, the aggrieved party may

(a) for a commercially reasonable time await performance by the repudiating party; or (b) resort to any remedy for breach (Section 2–703 or Sec- tion 2–711), even though he has notified the repudiating party that he would await the latter’s performance and has urged retraction; and (c) in either case suspend his own performance or proceed in accordance with the provisions of this Article on the sell- er’s right to identify goods to the contract notwithstanding breach or to salvage unfinished goods (Section 2–704).

§ 2–611. Retraction of Anticipatory Repudiation. (1) Until the repudiating party’s next performance is due he can retract his repudiation unless the aggrieved party has since the repudiation cancelled or materially changed his position or oth- erwise indicated that he considers the repudiation final. (2) Retraction may be by any method which clearly indicates to the aggrieved party that the repudiating party intends to perform, but must include any assurance justifiably demanded under the provisions of this Article (Section 2–609). (3) Retraction reinstates the repudiating party’s rights under the contract with due excuse and allowance to the aggrieved party for any delay occasioned by the repudiation.

§ 2–612. “Installment Contract”; Breach. (1) An “installment contract” is one which requires or authorizes the delivery of goods in separate lots to be separately accepted, even though the contract contains a clause “each delivery is a separate contract” or its equivalent. (2) The buyer may reject any installment which is non- conforming if the non-conformity substantially impairs the value of that installment and cannot be cured or if the non-conformity is a defect in the required documents; but if the non-conformity does not fall within subsection (3) and the seller gives adequate assurance of its cure the buyer must accept that installment. (3) Whenever non-conformity or default with respect to one or more installments substantially impairs the value of the whole contract there is a breach of the whole. But the aggrieved party reinstates the contract if he accepts a non-conforming installment

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with respect to a part or the whole, then with respect to any goods directly affected and, if the breach is of the whole contract (Section 2–612), then also with respect to the whole undelivered balance, the aggrieved seller may (a) withhold delivery of such goods; (b) stop delivery by any bailee as hereafter provided (Section 2–705); (c) proceed under the next section respecting goods still uniden- tified to the contract; (d) resell and recover damages as hereafter provided (Section 2–706); (e) recover damages for non-acceptance (Section 2–708) or in a proper case the price (Section 2–709); (f) cancel.

§ 2–704. Seller’s Right to Identify Goods to the Contract Notwithstanding Breach or to Salvage Unfinished Goods. (1) An aggrieved seller under the preceding section may

(a) identify to the contract conforming goods not already identified if at the time he learned of the breach they are in his possession or control; (b) treat as the subject of resale goods which have demon- strably been intended for the particular contract even though those goods are unfinished.

(2) Where the goods are unfinished an aggrieved seller may in the exercise of reasonable commercial judgment for the purposes of avoiding loss and of effective realization either complete the manufacture and wholly identify the goods to the contract or cease manufacture and resell for scrap or salvage value or proceed in any other reasonable manner.

§ 2–705. Seller’s Stoppage of Delivery in Transit or Otherwise. (1) The seller may stop delivery of goods in the possession of a carrier or other bailee when he discovers the buyer to be insol- vent (Section 2–702) and may stop delivery of carload, truck- load, planeload or larger shipments of express or freight when the buyer repudiates or fails to make a payment due before deliv- ery or if for any other reason the seller has a right to withhold or reclaim the goods. (2) As against such buyer the seller may stop delivery until

(a) receipt of the goods by the buyer; or (b) acknowledgment to the buyer by any bailee of the goods except a carrier that the bailee holds the goods for the buy er; or (c) such acknowledgment to the buyer by a carrier by reship- ment or as warehouseman; or (d) negotiation to the buyer of any negotiable document of title covering the goods.

(3) (a) To stop delivery the seller must so notify as to enable the bailee by reasonable diligence to prevent delivery of the goods.

(b) After such notification the bailee must hold and deliver the goods according to the directions of the seller but

(c) The seller must notify the buyer seasonably that there will be delay or non-delivery and, when allocation is required under paragraph (b), of the estimated quota thus made available for the buyer.

§ 2–616. Procedure on Notice Claiming Excuse. (1) Where the buyer receives notification of a material or indefi- nite delay or an allocation justified under the preceding section he may by written notification to the seller as to any delivery concerned, and where the prospective deficiency substantially impairs the value of the whole contract under the provisions of this Article relating to breach of installment contracts (Section 2–612), then also as to the whole,

(a) terminate and thereby discharge any unexecuted portion of the contract; or (b) modify the contract by agreeing to take his available quota in substitution.

(2) If after receipt of such notification from the seller the buyer fails so to modify the contract within a reasonable time not exceeding thirty days the contract lapses with respect to any deliveries affected. (3) The provisions of this section may not be negated by agree- ment except in so far as the seller has assumed a greater obliga- tion under the preceding section.

Part 7—Remedies

§ 2–701. Remedies for Breach of Collateral Contracts Not Impaired. Remedies for breach of any obligation or promise collateral or ancil- lary to a contract for sale are not impaired by the provisions of this Article.

§ 2–702. Seller’s Remedies on Discovery of Buyer’s Insolvency. (1) Where the seller discovers the buyer to be insolvent he may refuse delivery except for cash including payment for all goods theretofore delivered under the contract, and stop delivery under this Article (Section 2–705). (2) Where the seller discovers that the buyer has received goods on credit while insolvent he may reclaim the goods upon demand made within ten days after the receipt, but if misrepresentation of solvency has been made to the particular seller in writing within three months before delivery the ten day limitation does not apply. Except as provided in this subsection the seller may not base a right to reclaim goods on the buyer’s fraudulent or innocent misrepresentation of solvency or of intent to pay. (3) The seller’s right to reclaim under subsection (2) is subject to the rights of a buyer in ordinary course or other good faith pur- chaser under this Article (Section 2–403). Successful reclamation of goods excludes all other remedies with respect to them.

§ 2–703. Seller’s Remedies in General. Where the buyer wrongfully rejects or revokes acceptance of goods or fails to make a payment due on or before delivery or repudiates

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§ 2–707. “Person in the Position of a Seller”. (1) A “person in the position of a seller” includes as against a principal an agent who has paid or become responsible for the price of goods on behalf of his principal or anyone who other- wise holds a security interest or other right in goods similar to that of a seller. (2) A person in the position of a seller may as provided in this Article withhold or stop delivery (Section 2–705) and resell (Sec- tion 2–706) and recover incidental damages (Section 2–710).

§ 2–708. Seller’s Damages for Non- Acceptance or Repudiation. (1) Subject to subsection (2) and to the provisions of this Article with respect to proof of market price (Section 2–723), the mea- sure of damages for non-acceptance or repudiation by the buyer is the difference between the market price at the time and place for tender and the unpaid contract price together with any inci- dental damages provided in this Article (Section 2–710), but less expenses saved in consequence of the buyer’s breach. (2) If the measure of damages provided in subsection (1) is inadequate to put the seller in as good a position as perform- ance would have done then the measure of damages is the profit (including reasonable overhead) which the seller would have made from full performance by the buyer, together with any incidental damages provided in this Article (Section 2–710), due allowance for costs reasonably incurred and due credit for pay- ments or proceeds of resale.

§ 2–709. Action for the Price. (1) When the buyer fails to pay the price as it becomes due the seller may recover, together with any incidental damages under the next section, the price

(a) of goods accepted or of conforming goods lost or dam- aged within a commercially reasonable time after risk of their loss has passed to the buyer; and (b) of goods identified to the contract if the seller is unable after reasonable effort to resell them at a reasonable price or the circumstances reasonably indicate that such effort will be unavailing.

(2) Where the seller sues for the price he must hold for the buyer any goods which have been identified to the contract and are still in his control except that if resale becomes possible he may resell them at any time prior to the collection of the judgment. The net proceeds of any such resale must be credited to the buyer and payment of the judgment entitles him to any goods not resold. (3) After the buyer has wrongfully rejected or revoked acceptance of the goods or has failed to make a payment due or has repudi- ated (Section 2–610), a seller who is held not entitled to the price under this section shall nevertheless be awarded damages for non-acceptance under the preceding section.

§ 2–710. Seller’s Incidental Damages. Incidental damages to an aggrieved seller include any commercially reasonable charges, expenses or commissions incurred in stopping delivery, in the transportation, care and custody of goods after the

the seller is liable to the bailee for any ensuing charges or damages. (c) If a negotiable document of title has been issued for goods the bailee is not obliged to obey a notification to stop until surrender of the document. (d) A carrier who has issued a non-negotiable bill of lading is not obliged to obey a notification to stop received from a person other than the consignor.

§ 2–706. Seller’s Resale Including Contract for Resale. (1) Under the conditions stated in Section 2–703 on seller’s remedies, the seller may resell the goods concerned or the unde- livered balance thereof. Where the resale is made in good faith and in a commercially reasonable manner the seller may recover the difference between the resale price and the contract price together with any incidental damages allowed under the provi- sions of this Article (Section 2–710), but less expenses saved in consequence of the buyer’s breach. (2) Except as otherwise provided in subsection (3) or unless oth- erwise agreed resale may be at public or private sale including sale by way of one or more contracts to sell or of identification to an existing contract of the seller. Sale may be as a unit or in parcels and at any time and place and on any terms but every aspect of the sale including the method, manner, time, place and terms must be commercially reasonable. The resale must be reasonably identified as referring to the broken contract, but it is not neces- sary that the goods be in existence or that any or all of them have been identified to the contract before the breach. (3) Where the resale is at private sale the seller must give the buyer reasonable notification of his intention to resell. (4) Where the resale is at public sale

(a) only identified goods can be sold except where there is a recognized market for a public sale of futures in goods of the kind; and (b) it must be made at a usual place or market for public sale if one is reasonably available and except in the case of goods which are perishable or threaten to decline in value speedily the seller must give the buyer reasonable notice of the time and place of the resale; and (c) if the goods are not to be within the view of those attend- ing the sale the notification of sale must state the place where the goods are located and provide for their reasonable inspection by prospective bidders; and (d) the seller may buy.

(5) A purchaser who buys in good faith at a resale takes the goods free of any rights of the original buyer even though the seller fails to comply with one or more of the requirements of this section. (6) The seller is not accountable to the buyer for any profit made on any resale. A person in the position of a seller (Sec- tion 2–707) or a buyer who has rightfully rejected or justifiably revoked acceptance must account for any excess over the amount of his security interest, as hereinafter defined (subsection (3) of Section 2–711).

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(2) Market price is to be determined as of the place for tender or, in cases of rejection after arrival or revocation of acceptance, as of the place of arrival.

§ 2–714. Buyer’s Damages for Breach in Regard to Accepted Goods. (1) Where the buyer has accepted goods and given notification (sub- section (3) of Section 2–607) he may recover as damages for any non-conformity of tender the loss resulting in the ordinary course of events from the seller’s breach as determined in any manner which is reasonable. (2) The measure of damages for breach of warranty is the differ- ence at the time and place of acceptance between the value of the goods accepted and the value they would have had if they had been as warranted, unless special circumstances show proximate damages of a different amount. (3) In a proper case any incidental and consequential damages under the next section may also be recovered.

§ 2–715. Buyer’s Incidental and Consequential Damages. (1) Incidental damages resulting from the seller’s breach include expenses reasonably incurred in inspection, receipt, transpor- tation and care and custody of goods rightfully rejected, any commercially reasonable charges, expenses or commissions in connection with effecting cover and any other reasonable expense incident to the delay or other breach. (2) Consequential damages resulting from the seller’s breach include

(a) any loss resulting from general or particular requirements and needs of which the seller at the time of contracting had reason to know and which could not reasonably be pre- vented by cover or otherwise; and (b) injury to person or property proximately resulting from any breach of warranty.

§ 2–716. Buyer’s Right to Specific Performance or Replevin. (1) Specific performance may be decreed where the goods are unique or in other proper circumstances. (2) The decree for specific performance may include such terms and conditions as to payment of the price, damages, or other relief as the court may deem just. (3) The buyer has a right of replevin for goods identified to the contract if after reasonable effort he is unable to effect cover for such goods or the circumstances reasonably indicate that such effort will be unavailing or if the goods have been shipped under reservation and satisfaction of the security interest in them has been made or tendered. In the case of goods bought for personal, family, or household purposes, the buyer’s right of replevin vests upon acquisition of a special property, even if the seller had not then repudiated or failed to deliver. As amended in 1999.

buyer’s breach, in connection with return or resale of the goods or otherwise resulting from the breach.

§ 2–711. Buyer’s Remedies in General; Buyer’s Security Interest in Rejected Goods. (1) Where the seller fails to make delivery or repudiates or the buyer rightfully rejects or justifiably revokes acceptance then with respect to any goods involved, and with respect to the whole if the breach goes to the whole contract (Section 2–612), the buyer may cancel and whether or not he has done so may in addition to recovering so much of the price as has been paid

(a) “cover” and have damages under the next section as to all the goods affected whether or not they have been identified to the contract; or (b) recover damages for non-delivery as pro-vided in this Article (Section 2–713).

(2) Where the seller fails to deliver or repudiates the buyer may also

(a) if the goods have been identified recover them as pro- vided in this Article (Section 2–502); or (b) in a proper case obtain specific performance or replevy the goods as provided in this Article (Section 2–716).

(3) On rightful rejection or justifiable revocation of acceptance a buyer has a security interest in goods in his possession or control for any payments made on their price and any expenses reason- ably incurred in their inspection, receipt, transportation, care and custody and may hold such goods and resell them in like manner as an aggrieved seller (Section 2–706).

§ 2–712. “Cover”; Buyer’s Procurement of Substitute Goods. (1) After a breach within the preceding section the buyer may “cover” by making in good faith and without unreasonable delay any reasonable purchase of or contract to purchase goods in sub- stitution for those due from the seller. (2) The buyer may recover from the seller as damages the differ- ence between the cost of cover and the contract price together with any incidental or consequential damages as hereinafter defined (Section 2–715), but less expenses saved in consequence of the seller’s breach. (3) Failure of the buyer to effect cover within this section does not bar him from any other remedy.

§ 2–713. Buyer’s Damages for Non-Delivery or Repudiation. (1) Subject to the provisions of this Article with respect to proof of market price (Section 2–723), the measure of damages for non- delivery or repudiation by the seller is the difference between the market price at the time when the buyer learned of the breach and the contract price together with any incidental and conse- quential damages provided in this Article (Section 2–715), but less expenses saved in consequence of the seller’s breach.

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(3) Consequential damages may be limited or excluded unless the limitation or exclusion is unconscionable. Limitation of consequential damages for injury to the person in the case of consumer goods is prima facie unconscionable but limitation of damages where the loss is commercial is not.

§ 2–720. Effect of “Cancellation” or “Rescission” on Claims for Antecedent Breach. Unless the contrary intention clearly appears, expressions of “cancel- lation” or “rescission” of the contract or the like shall not be con- strued as a renunciation or discharge of any claim in damages for an antecedent breach.

§ 2–721. Remedies for Fraud. Remedies for material misrepresentation or fraud include all rem- edies available under this Article for non-fraudulent breach. Neither rescission or a claim for rescission of the contract for sale nor rejec- tion or return of the goods shall bar or be deemed inconsistent with a claim for damages or other remedy.

§ 2–722. Who Can Sue Third Parties for Injury to Goods. Where a third party so deals with goods which have been identified to a contract for sale as to cause actionable injury to a party to that contract (a) a right of action against the third party is in either party to the contract for sale who has title to or a security interest or a special property or an insurable interest in the goods; and if the goods have been destroyed or converted a right of action is also in the party who either bore the risk of loss under the contract for sale or has since the injury assumed that risk as against the other; (b) if at the time of the injury the party plaintiff did not bear the risk of loss as against the other party to the contract for sale and there is no arrangement between them for disposition of the recovery, his suit or settlement is, subject to his own interest, as a fiduciary for the other party to the contract; (c) either party may with the consent of the other sue for the benefit of whom it may concern.

§ 2–723. Proof of Market Price: Time and Place. (1) If an action based on anticipatory repudiation comes to trial before the time for performance with respect to some or all of the goods, any damages based on market price (Section 2–708 or Section 2–713) shall be determined according to the price of such goods prevailing at the time when the aggrieved party learned of the repudiation. (2) If evidence of a price prevailing at the times or places described in this Article is not readily available the price prevail- ing within any reasonable time before or after the time described or at any other place which in commercial judgment or under usage of trade would serve as a reasonable substitute for the one described may be used, making any proper allowance for the cost of transporting the goods to or from such other place.

§ 2–717. Deduction of Damages From the Price. The buyer on notifying the seller of his intention to do so may deduct all or any part of the damages resulting from any breach of the contract from any part of the price still due under the same contract.

§ 2–718. Liquidation or Limitation of Damages; Deposits. (1) Damages for breach by either party may be liquidated in the agreement but only at an amount which is reasonable in the light of the anticipated or actual harm caused by the breach, the dif-of the anticipated or actual harm caused by the breach, the dif-of the anticipated or actual harm caused by the breach, the dif ficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing unrea- sonably large liquidated damages is void as a penalty. (2) Where the seller justifiably withholds delivery of goods because of the buyer’s breach, the buyer is entitled to restitution of any amount by which the sum of his payments exceeds

(a) the amount to which the seller is entitled by virtue of terms liquidating the seller’s damages in accordance with subsection (1), or (b) in the absence of such terms, twenty per cent of the value of the total performance for which the buyer is obligated under the contract or $500, whichever is smaller.

(3) The buyer’s right to restitution under subsection (2) is sub- ject to offset to the extent that the seller establishes

(a) a right to recover damages under the provisions of this Article other than subsection (1), and (b) the amount or value of any benefits received by the buyer directly or indirectly by reason of the contract.

(4) Where a seller has received payment in goods their reasonable value or the proceeds of their resale shall be treated as payments for the purposes of subsection (2); but if the seller has notice of the buyer’s breach before reselling goods received in part perfor- mance, his resale is subject to the conditions laid down in this Article on resale by an aggrieved seller (Section 2–706).

§ 2–719. Contractual Modification or Limitation of Remedy. (1) Subject to the provisions of subsections (2) and (3) of this section and of the preceding section on liquidation and limita- tion of damages,

(a) the agreement may provide for remedies in addition to or in substitution for those provided in this Article and may limit or alter the measure of damages recoverable under this Article, as by limiting the buyer’s remedies to return of the goods and repayment of the price or to repair and replace- ment of nonconforming goods or parts; and (b) resort to a remedy as provided is optional unless the rem- edy is expressly agreed to be exclusive, in which case it is the sole remedy.

(2) Where circumstances cause an exclusive or limited remedy to fail of its essential purpose, remedy may be had as provided in this Act.

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security interest or leasehold interest of a third party in the goods buys in ordinary course from a person in the business of selling goods of that kind but does not include a pawn- broker. “Buying” may be for cash or by exchange of other property or on secured or unsecured credit and includes receiving goods or documents of title under a pre-existing contract for sale but does not include a transfer in bulk or as security for or in total or partial satisfaction of a money debt. (b) “Cancellation” occurs when either party puts an end to the lease contract for default by the other party. (c) “Commercial unit” means such a unit of goods as by commercial usage is a single whole for purposes of lease and division of which materially impairs its character or value on the market or in use. A commercial unit may be a single article, as a machine, or a set of articles, as a suite of furniture or a line of machinery, or a quantity, as a gross or carload, or any other unit treated in use or in the relevant market as a single whole. (d) “Conforming” goods or performance under a lease con- tract means goods or performance that are in accordance with the obligations under the lease contract. (e) “Consumer lease” means a lease that a lessor regularly engaged in the business of leasing or selling makes to a les- see who is an individual and who takes under the lease pri- marily for a personal, family, or household purpose [, if the total payments to be made under the lease contract, exclud- ing payments for options to renew or buy, do not exceed $______]. (f) “Fault” means wrongful act, omission, breach, or default. (g) “Finance lease” means a lease with respect to which:

(i) the lessor does not select, manufacture or supply the goods; (ii) the lessor acquires the goods or the right to posses- sion and use of the goods in connection with the lease; and (iii) one of the following occurs:

(A) the lessee receives a copy of the contract by which the lessor acquired the goods or the right to possession and use of the goods before signing the lease contract; (B) the lessee’s approval of the contract by which the lessor acquired the goods or the right to possession and use of the goods is a condition to effectiveness of the lease contract; (C) the lessee, before signing the lease contract, receives an accurate and complete statement desig- nating the promises and warranties, and any dis- claimers of warranties, limitations or modifications of remedies, or liquidated damages, including those of a third party, such as the manufacturer of the goods, provided to the lessor by the person supply- ing the goods in connection with or as part of the contract by which the lessor acquired the goods or the right to possession and use of the goods; or (D) if the lease is not a consumer lease, the lessor, before the lessee signs the lease contract, informs the

(3) Evidence of a relevant price prevailing at a time or place other than the one described in this Article offered by one party is not admissible unless and until he has given the other party such notice as the court finds sufficient to prevent unfair surprise.

§ 2–724. Admissibility of Market Quotations. Whenever the prevailing price or value of any goods regularly bought and sold in any established commodity market is in issue, reports in official publications or trade journals or in newspapers or periodicals of general circulation published as the reports of such market shall be admissible in evidence. The circumstances of the preparation of such a report may be shown to affect its weight but not its admissibility.

§ 2–725. Statute of Limitations in Contracts for Sale. (1) An action for breach of any contract for sale must be com- menced within four years after the cause of action has accrued. By the original agreement the parties may reduce the period of limitation to not less than one year but may not extend it. (2) A cause of action accrues when the breach occurs, regardless of the aggrieved party’s lack of knowledge of the breach. A breach of warranty occurs when tender of delivery is made, except that where a warranty explicitly extends to future performance of the goods and discovery of the breach must await the time of such per- formance the cause of action accrues when the breach is or should have been discovered. (3) Where an action commenced within the time limited by sub- section (1) is so terminated as to leave available a remedy by another action for the same breach such other action may be commenced after the expiration of the time limited and within six months after the termination of the first action unless the termination resulted from voluntary discontinuance or from dismissal for failure or neglect to prosecute. (4) This section does not alter the law on tolling of the statute of limitations nor does it apply to causes of action which have accrued before this Act becomes effective.

ARTICLE 2A: LEASES Part 1—General Provisions

§ 2A–101. Short Title. This Article shall be known and may be cited as the Uniform Com- mercial Code—Leases.

§ 2A–102. Scope. This Article applies to any transaction, regardless of form, that cre- ates a lease.

§ 2A–103. Definitions and Index of Definitions. (1) In this Article unless the context otherwise requires:

(a) “Buyer in ordinary course of business” means a person who in good faith and without knowledge that the sale to him [or her] is in violation of the ownership rights or

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documents of title under a pre-existing lease contract but does not include a transfer in bulk or as security for or in total or partial satisfaction of a money debt. (p) “Lessor” means a person who transfers the right to pos- session and use of goods under a lease. Unless the context clearly indicates otherwise, the term includes a sublessor. (q) “Lessor’s residual interest” means the lessor’s interest in the goods after expiration, termination, or cancellation of the lease contract. (r) “Lien” means a charge against or interest in goods to secure payment of a debt or performance of an obligation, but the term does not include a security interest. (s) “Lot” means a parcel or a single article that is the subject matter of a separate lease or delivery, whether or not it is suf-matter of a separate lease or delivery, whether or not it is suf-matter of a separate lease or delivery, whether or not it is suf ficient to perform the lease contract. (t) “Merchant lessee” means a lessee that is a merchant with respect to goods of the kind subject to the lease. (u) “Present value” means the amount as of a date certain of one or more sums payable in the future, discounted to the date certain. The discount is determined by the interest rate specified by the parties if the rate was not manifestly unreasonable at the time the transaction was entered into; otherwise, the discount is determined by a commercially reasonable rate that takes into account the facts and circumstances of each case at the time the transaction was entered into. (v) “Purchase” includes taking by sale, lease, mortgage, security interest, pledge, gift, or any other voluntary transaction creating an interest in goods. (w) “Sublease” means a lease of goods the right to possession and use of which was acquired by the lessor as a lessee under an existing lease. (x) “Supplier” means a person from whom a lessor buys or leases goods to be leased under a finance lease. (y) “Supply contract” means a contract under which a lessor buys or leases goods to be leased. (z) “Termination” occurs when either party pursuant to a power created by agreement or law puts an end to the lease contract otherwise than for default.

(2) Other definitions applying to this Article and the sections in which they appear are: “Accessions”. Section 2A–310(1). “Construction mortgage”. Section 2A–309(1)(d). “Encumbrance”. Section 2A–309(1)(e). “Fixtures”. Section 2A–309(1)(a). “Fixture filing”. Section 2A–309(1)(b). “Purchase money lease”. Section 2A–309(1)(c). (3) The following definitions in other Articles apply to this Article: “Accounts”. Section 9–106. “Between merchants”. Section 2–104(3). “Buyer”. Section 2–103(1)(a). “Chattel paper”. Section 9–105(1)(b). “Consumer goods”. Section 9–109(1). “Document”. Section 9–105(1)(f ). “Entrusting”. Section 2–403(3). “General intangibles”. Section 9–106.

lessee in writing (a) of the identity of the person sup- plying the goods to the lessor, unless the lessee has selected that person and directed the lessor to acquire the goods or the right to possession and use of the goods from that person, (b) that the lessee is entitled under this Article to any promises and warranties, including those of any third party, provided to the lessor by the person supplying the goods in connec- tion with or as part of the contract by which the les- sor acquired the goods or the right to possession and use of the goods, and (c) that the lessee may commu- nicate with the person supplying the goods to the les- sor and receive an accurate and complete statement of those promises and warranties, including any dis- claimers and limitations of them or of remedies.

(h) “Goods” means all things that are movable at the time of identification to the lease contract, or are fixtures (Section 2A–309), but the term does not include money, documents, instruments, accounts, chattel paper, general intangibles, or minerals or the like, including oil and gas, before extraction. The term also includes the unborn young of animals. (i) “Installment lease contract” means a lease contract that authorizes or requires the delivery of goods in separate lots to be separately accepted, even though the lease contract contains a clause “each delivery is a separate lease” or its equivalent. (j) “Lease” means a transfer of the right to possession and use of goods for a term in return for consideration, but a sale, including a sale on approval or a sale or return, or reten- tion or creation of a security interest is not a lease. Unless the context clearly indicates otherwise, the term includes a sublease. (k) “Lease agreement” means the bargain, with respect to the lease, of the lessor and the lessee in fact as found in their lan- guage or by implication from other circumstances including course of dealing or usage of trade or course of performance as provided in this Article. Unless the context clearly indi- cates otherwise, the term includes a sublease agreement. (l) “Lease contract” means the total legal obligation that results from the lease agreement as affected by this Article and any other applicable rules of law. Unless the context clearly indicates otherwise, the term includes a sublease contract. (m) “Leasehold interest” means the interest of the lessor or the lessee under a lease contract. (n) “Lessee” means a person who acquires the right to pos- session and use of goods under a lease. Unless the context clearly indicates otherwise, the term includes a sublessee. (o) “Lessee in ordinary course of business” means a person who in good faith and without knowledge that the lease to him [or her] is in violation of the ownership rights or security inter- est or leasehold interest of a third party in the goods, leases in ordinary course from a person in the business of selling or leasing goods of that kind but does not include a pawnbroker. “Leasing” may be for cash or by exchange of other property or on secured or unsecured credit and includes receiving goods or

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(2) If the judicial forum chosen by the parties to a consumer lease is a forum that would not otherwise have jurisdiction over the lessee, the choice is not enforceable.

§ 2A–107. Waiver or Renunciation of Claim or Right After Default. Any claim or right arising out of an alleged default or breach of warranty may be discharged in whole or in part without consider- ation by a written waiver or renunciation signed and delivered by the aggrieved party.

§ 2A–108. Unconscionability. (1) If the court as a matter of law finds a lease contract or any clause of a lease contract to have been unconscionable at the time it was made the court may refuse to enforce the lease contract, or it may enforce the remainder of the lease contract without the unconscionable clause, or it may so limit the application of any unconscionable clause as to avoid any unconscionable result. (2) With respect to a consumer lease, if the court as a matter of law finds that a lease contract or any clause of a lease contract has been induced by unconscionable conduct or that unconscio- nable conduct has occurred in the collection of a claim arising from a lease contract, the court may grant appropriate relief. (3) Before making a finding of unconscionability under subsec- tion (1) or (2), the court, on its own motion or that of a party, shall afford the parties a reasonable opportunity to present evi- dence as to the setting, purpose, and effect of the lease contract or clause thereof, or of the conduct. (4) In an action in which the lessee claims unconscionability with respect to a consumer lease:

(a) If the court finds unconscionability under subsection (1) or (2), the court shall award reasonable attorney’s fees to the lessee. (b) If the court does not find unconscionability and the les- see claiming unconscionability has brought or maintained an action he [or she] knew to be groundless, the court shall award reasonable attorney’s fees to the party against whom the claim is made. (c) In determining attorney’s fees, the amount of the recov- ery on behalf of the claimant under subsections (1) and (2) is not controlling.

§ 2A–109. Option to Accelerate at Will. (1) A term providing that one party or his [or her] successor in interest may accelerate payment or performance or require collat- eral or additional collateral “at will” or “when he [or she] deems himself [or herself ] insecure” or in words of similar import must be construed to mean that he [or she] has power to do so only if he [or she] in good faith believes that the prospect of payment or performance is impaired. (2) With respect to a consumer lease, the burden of establishing good faith under subsection (1) is on the party who exercised the

“Good faith”. Section 2–103(1)(b). “Instrument”. Section 9–105(1)(i). “Merchant”. Section 2–104(1). “Mortgage”. Section 9–105(1)(j). “Pursuant to commitment”. Section 9–105(1)(k). “Receipt”. Section 2–103(1)(c). “Sale”. Section 2–106(1). “Sale on approval”. Section 2–326. “Sale or return”. Section 2–326. “Seller”. Section 2–103(1)(d). (4) In addition Article 1 contains general definitions and prin- ciples of construction and interpretation applicable throughout this Article. As amended in 1990 and 1999.

§ 2A–104. Leases Subject to Other Law. (1) A lease, although subject to this Article, is also subject to any applicable:

(a) certificate of title statute of this State: (list any certifi- cate of title statutes covering automobiles, trailers, mobile homes, boats, farm tractors, and the like); (b) certificate of title statute of another jurisdiction (Section 2A–105); or (c) consumer protection statute of this State, or final con- sumer protection decision of a court of this State existing on the effective date of this Article.

(2) In case of conflict between this Article, other than Sections 2A–105, 2A–304(3), and 2A–305(3), and a statute or decision referred to in subsection (1), the statute or decision controls. (3) Failure to comply with an applicable law has only the effect specified therein. As amended in 1990.

§ 2A–105. Territorial Application of Article to Goods Covered by Certificate of Title. Subject to the provisions of Sections 2A–304(3) and 2A–305(3), with respect to goods covered by a certificate of title issued under a statute of this State or of another jurisdiction, compliance and the effect of compliance or noncompliance with a certificate of title stat- ute are governed by the law (including the conflict of laws rules) of the jurisdiction issuing the certificate until the earlier of (a) surren- der of the certificate, or (b) four months after the goods are removed from that jurisdiction and thereafter until a new certificate of title is issued by another jurisdiction.

§ 2A–106. Limitation on Power of Parties to Consumer Lease to Choose Applicable Law and Judicial Forum. (1) If the law chosen by the parties to a consumer lease is that of a jurisdiction other than a jurisdiction in which the lessee resides at the time the lease agreement becomes enforceable or within 30 days thereafter or in which the goods are to be used, the choice is not enforceable.

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§ 2A–202. Final Written Expression: Parol or Extrinsic Evidence. Terms with respect to which the confirmatory memoranda of the parties agree or which are otherwise set forth in a writing intended by the parties as a final expression of their agreement with respect to such terms as are included therein may not be contradicted by evidence of any prior agreement or of a contemporaneous oral agree- ment but may be explained or supplemented: (a) by course of dealing or usage of trade or by course of perfor- mance; and (b) by evidence of consistent additional terms unless the court finds the writing to have been intended also as a complete and exclusive statement of the terms of the agreement.

§ 2A–203. Seals Inoperative. The affixing of a seal to a writing evidencing a lease contract or an offer to enter into a lease contract does not render the writing a sealed instrument and the law with respect to sealed instruments does not apply to the lease contract or offer.

§ 2A–204. Formation in General. (1) A lease contract may be made in any manner sufficient to show agreement, including conduct by both parties which rec- ognizes the existence of a lease contract. (2) An agreement sufficient to constitute a lease contract may be found although the moment of its making is undetermined. (3) Although one or more terms are left open, a lease contract does not fail for indefiniteness if the parties have intended to make a lease contract and there is a reasonably certain basis for giving an appropriate remedy.

§ 2A–205. Firm Offers. An offer by a merchant to lease goods to or from another person in a signed writing that by its terms gives assurance it will be held open is not revocable, for lack of consideration, during the time stated or, if no time is stated, for a reasonable time, but in no event may the period of irrevocability exceed 3 months. Any such term of assurance on a form supplied by the offeree must be separately signed by the offeror.

§ 2A–206. Offer and Acceptance in Formation of Lease Contract. (1) Unless otherwise unambiguously indicated by the language or circumstances, an offer to make a lease contract must be con- strued as inviting acceptance in any manner and by any medium reasonable in the circumstances. (2) If the beginning of a requested performance is a reasonable mode of acceptance, an offeror who is not notified of acceptance within a reasonable time may treat the offer as having lapsed before acceptance.

power; otherwise the burden of establishing lack of good faith is on the party against whom the power has been exercised.

Part 2—Formation and Construction of Lease Contract

§ 2A–201. Statute of Frauds. (1) A lease contract is not enforceable by way of action or defense unless:

(a) the total payments to be made under the lease contract, excluding payments for options to renew or buy, are less than $1,000; or (b) there is a writing, signed by the party against whom enforcement is sought or by that party’s authorized agent, sufficient to indicate that a lease contract has been made between the parties and to describe the goods leased and the lease term.

(2) Any description of leased goods or of the lease term is suffi- cient and satisfies subsection (1)(b), whether or not it is specific, if it reasonably identifies what is described. (3) A writing is not insufficient because it omits or incorrectly states a term agreed upon, but the lease contract is not enforce- able under subsection (1)(b) beyond the lease term and the quantity of goods shown in the writing. (4) A lease contract that does not satisfy the requirements of sub- section (1), but which is valid in other respects, is enforceable:

(a) if the goods are to be specially manufactured or obtained for the lessee and are not suitable for lease or sale to others in the ordinary course of the lessor’s business, and the les- sor, before notice of repudiation is received and under cir- cumstances that reasonably indicate that the goods are for the lessee, has made either a substantial beginning of their manufacture or commitments for their procurement; (b) if the party against whom enforcement is sought admits in that party’s pleading, testimony or otherwise in court that a lease contract was made, but the lease contract is not enforceable under this provision beyond the quantity of goods admitted; or (c) with respect to goods that have been received and accepted by the lessee.

(5) The lease term under a lease contract referred to in subsec- tion (4) is:

(a) if there is a writing signed by the party against whom enforcement is sought or by that party’s authorized agent specifying the lease term, the term so specified; (b) if the party against whom enforcement is sought admits in that party’s pleading, testimony, or otherwise in court a lease term, the term so admitted; or (c) a reasonable lease term.

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has received notice that the lessee has entered into a finance lease related to the supply contract. If the modification or rescission is effective between the supplier and the lessee, the lessor is deemed to have assumed, in addition to the obligations of the lessor to the lessee under the lease contract, promises of the supplier to the lessor and warranties that were so modified or rescinded as they existed and were available to the lessee before modification or rescission. (4) In addition to the extension of the benefit of the supplier’s promises and of warranties to the lessee under subsection (1), the lessee retains all rights that the lessee may have against the sup- plier which arise from an agreement between the lessee and the supplier or under other law. As amended in 1990.

§ 2A–210. Express Warranties. (1) Express warranties by the lessor are created as follows:

(a) Any affirmation of fact or promise made by the lessor to the lessee which relates to the goods and becomes part of the basis of the bargain creates an express warranty that the goods will conform to the affirmation or promise. (b) Any description of the goods which is made part of the basis of the bargain creates an express warranty that the goods will conform to the description. (c) Any sample or model that is made part of the basis of the bargain creates an express warranty that the whole of the goods will conform to the sample or model.

(2) It is not necessary to the creation of an express warranty that the lessor use formal words, such as “warrant” or “guarantee,” or that the lessor have a specific intention to make a warranty, but an affirma- tion merely of the value of the goods or a statement purporting to be merely the lessor’s opinion or commendation of the goods does not create a warranty.

§ 2A–211. Warranties Against Interference and Against Infringement; Lessee’s Obligation Against Infringement. (1) There is in a lease contract a warranty that for the lease term no person holds a claim to or interest in the goods that arose from an act or omission of the lessor, other than a claim by way of infringement or the like, which will interfere with the lessee’s enjoyment of its leasehold interest. (2) Except in a finance lease there is in a lease contract by a lessor who is a merchant regularly dealing in goods of the kind a war- ranty that the goods are delivered free of the rightful claim of any person by way of infringement or the like. (3) A lessee who furnishes specifications to a lessor or a supplier shall hold the lessor and the supplier harmless against any claim by way of infringement or the like that arises out of compliance with the specifications.

§ 2A–212. Implied Warranty of Merchantability. (1) Except in a finance lease, a warranty that the goods will be merchantable is implied in a lease contract if the lessor is a mer- chant with respect to goods of that kind.

§ 2A–207. Course of Performance or Practical Construction. (1) If a lease contract involves repeated occasions for performance by either party with knowledge of the nature of the performance and opportunity for objection to it by the other, any course of performance accepted or acquiesced in without objection is rel- evant to determine the meaning of the lease agreement. (2) The express terms of a lease agreement and any course of performance, as well as any course of dealing and usage of trade, must be construed whenever reasonable as consistent with each other; but if that construction is unreasonable, express terms control course of performance, course of performance controls both course of dealing and usage of trade, and course of dealing controls usage of trade. (3) Subject to the provisions of Section 2A–208 on modification and waiver, course of performance is relevant to show a waiver or modification of any term inconsistent with the course of performance.

§ 2A–208. Modification, Rescission and Waiver. (1) An agreement modifying a lease contract needs no consider- ation to be binding. (2) A signed lease agreement that excludes modification or rescis- sion except by a signed writing may not be otherwise modified or rescinded, but, except as between merchants, such a requirement on a form supplied by a merchant must be separately signed by the other party. (3) Although an attempt at modification or rescission does not satisfy the requirements of subsection (2), it may operate as a waiver. (4) A party who has made a waiver affecting an executory portion of a lease contract may retract the waiver by reasonable notifi- cation received by the other party that strict performance will be required of any term waived, unless the retraction would be unjust in view of a material change of position in reliance on the waiver.

§ 2A–209. Lessee under Finance Lease as Beneficiary of Supply Contract. (1) The benefit of the supplier’s promises to the lessor under the supply contract and of all warranties, whether express or implied, including those of any third party provided in connection with or as part of the supply contract, extends to the lessee to the extent of the lessee’s leasehold interest under a finance lease related to the supply contract, but is subject to the terms warranty and of the supply contract and all defenses or claims arising therefrom. (2) The extension of the benefit of supplier’s promises and of warranties to the lessee (Section 2A–209(1)) does not: (i) modify the rights and obligations of the parties to the supply contract, whether arising therefrom or otherwise, or (ii) impose any duty or liability under the supply contract on the lessee. (3) Any modification or rescission of the supply contract by the supplier and the lessor is effective between the supplier and the lessee unless, before the modification or rescission, the supplier

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(4) To exclude or modify a warranty against interference or against infringement (Section 2A–211) or any part of it, the language must be specific, be by a writing, and be conspicu- ous, unless the circumstances, including course of performance, course of dealing, or usage of trade, give the lessee reason to know that the goods are being leased subject to a claim or inter- est of any person.

§ 2A–215. Cumulation and Conflict of Warranties Express or Implied. Warranties, whether express or implied, must be construed as con- sistent with each other and as cumulative, but if that construction is unreasonable, the intention of the parties determines which war- ranty is dominant. In ascertaining that intention the following rules apply:

(a) Exact or technical specifications displace an inconsistent sample or model or general language of description. (b) A sample from an existing bulk displaces inconsistent general language of description. (c) Express warranties displace inconsistent implied warran- ties other than an implied warranty of fitness for a particular purpose.

§ 2A–216. Third-Party Beneficiaries of Express and Implied Warranties.

Alternative A A warranty to or for the benefit of a lessee under this Article, whether express or implied, extends to any natural person who is in the family or household of the lessee or who is a guest in the lessee’s home if it is reasonable to expect that such person may use, consume, or be affected by the goods and who is injured in person by breach of the warranty. This section does not displace principles of law and equity that extend a warranty to or for the benefit of a lessee to other persons. The opera- tion of this section may not be excluded, modified, or limited, but an exclusion, modification, or limitation of the warranty, including any with respect to rights and remedies, effective against the lessee is also effective against any beneficiary designated under this section.

Alternative B A warranty to or for the benefit of a lessee under this Article, whether express or implied, extends to any natural person who may reason- ably be expected to use, consume, or be affected by the goods and who is injured in person by breach of the warranty. This section does not displace principles of law and equity that extend a war- ranty to or for the benefit of a lessee to other persons. The operation of this section may not be excluded, modified, or limited, but an exclusion, modification, or limitation of the warranty, including any with respect to rights and remedies, effective against the lessee is also effective against the beneficiary designated under this section.

Alternative C A warranty to or for the benefit of a lessee under this Article, whether express or implied, extends to any person who may reasonably be

(2) Goods to be merchantable must be at least such as (a) pass without objection in the trade under the description in the lease agreement; (b) in the case of fungible goods, are of fair average quality within the description; (c) are fit for the ordinary purposes for which goods of that type are used; (d) run, within the variation permitted by the lease agree- ment, of even kind, quality, and quantity within each unit and among all units involved; (e) are adequately contained, packaged, and labeled as the lease agreement may require; and (f) conform to any promises or affirmations of fact made on the container or label.

(3) Other implied warranties may arise from course of dealing or usage of trade.

§ 2A–213. Implied Warranty of Fitness for Particular Purpose. Except in a finance of lease, if the lessor at the time the lease contract is made has reason to know of any particular purpose for which the goods are required and that the lessee is relying on the lessor’s skill or judgment to select or furnish suitable goods, there is in the lease con- tract an implied warranty that the goods will be fit for that purpose.

§ 2A–214. Exclusion or Modification of Warranties. (1) Words or conduct relevant to the creation of an express war- ranty and words or conduct tending to negate or limit a warranty must be construed wherever reasonable as consistent with each other; but, subject to the provisions of Section 2A–202 on parol or extrinsic evidence, negation or limitation is inoperative to the extent that the construction is unreasonable. (2) Subject to subsection (3), to exclude or modify the implied warranty of merchantability or any part of it the language must mention “merchantability”, be by a writing, and be conspicu- ous. Subject to subsection (3), to exclude or modify any implied warranty of fitness the exclusion must be by a writing and be conspicuous. Language to exclude all implied warranties of fit- ness is sufficient if it is in writing, is conspicuous and states, for example, “There is no warranty that the goods will be fit for a particular purpose”. (3) Notwithstanding subsection (2), but subject to subsection (4),

(a) unless the circumstances indicate otherwise, all implied warranties are excluded by expressions like “as is” or “with all faults” or by other language that in common understanding calls the lessee’s attention to the exclusion of warranties and makes plain that there is no implied warranty, if in writing and conspicuous; (b) if the lessee before entering into the lease contract has examined the goods or the sample or model as fully as desired or has refused to examine the goods, there is no implied warranty with regard to defects that an examination ought in the circumstances to have revealed; and

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(ii) if it does require delivery at a particular destination and the goods are there duly tendered while in the possession of the carrier, the risk of loss passes to the lessee when the goods are there duly so tendered as to enable the lessee to take delivery.

(b) If the goods are held by a bailee to be delivered without being moved, the risk of loss passes to the lessee on acknowl- edgment by the bailee of the lessee’s right to possession of the goods.

(c) In any case not within subsection (a) or (b), the risk of loss passes to the lessee on the lessee’s receipt of the goods if the lessor, or, in the case of a finance lease, the supplier, is a merchant; otherwise the risk passes to the lessee on tender of delivery.

§ 2A–220. Effect of Default on Risk of Loss. (1) Where risk of loss is to pass to the lessee and the time of pas- sage is not stated:

(a) If a tender or delivery of goods so fails to conform to the lease contract as to give a right of rejection, the risk of their loss remains with the lessor, or, in the case of a finance lease, the supplier, until cure or acceptance.

(b) If the lessee rightfully revokes acceptance, he [or she], to the extent of any deficiency in his [or her] effective insur- ance coverage, may treat the risk of loss as having remained with the lessor from the beginning.

(2) Whether or not risk of loss is to pass to the lessee, if the les- see as to conforming goods already identified to a lease contract repudiates or is otherwise in default under the lease contract, the lessor, or, in the case of a finance lease, the supplier, to the extent of any deficiency in his [or her] effective insurance coverage may treat the risk of loss as resting on the lessee for a commercially reasonable time.

§ 2A–221. Casualty to Identified Goods. If a lease contract requires goods identified when the lease contract is made, and the goods suffer casualty without fault of the lessee, the lessor or the supplier before delivery, or the goods suffer casualty before risk of loss passes to the lessee pursuant to the lease agreement or Section 2A–219, then:

(a) if the loss is total, the lease contract is avoided; and

(b) if the loss is partial or the goods have so deteriorated as to no longer conform to the lease contract, the lessee may nev- ertheless demand inspection and at his [or her] option either treat the lease contract as avoided or, except in a finance lease that is not a consumer lease, accept the goods with due allow- ance from the rent payable for the balance of the lease term for the deterioration or the deficiency in quantity but without further right against the lessor.

expected to use, consume, or be affected by the goods and who is injured by breach of the warranty. The operation of this section may not be excluded, modified, or limited with respect to injury to the person of an individual to whom the warranty extends, but an exclusion, modification, or limitation of the warranty, including any with respect to rights and remedies, effective against the lessee is also effective against the beneficiary designated under this section.

§ 2A–217. Identification. Identification of goods as goods to which a lease contract refers may be made at any time and in any manner explicitly agreed to by the parties. In the absence of explicit agreement, identification occurs: (a) when the lease contract is made if the lease contract is for a lease of goods that are existing and identified; (b) when the goods are shipped, marked, or otherwise designated by the lessor as goods to which the lease contract refers, if the lease contract is for a lease of goods that are not existing and identified; or (c) when the young are conceived, if the lease contract is for a lease of unborn young of animals.

§ 2A–218. Insurance and Proceeds. (1) A lessee obtains an insurable interest when existing goods are identified to the lease contract even though the goods identified are nonconforming and the lessee has an option to reject them. (2) If a lessee has an insurable interest only by reason of the les- sor’s identification of the goods, the lessor, until default or insol- vency or notification to the lessee that identification is final, may substitute other goods for those identified. (3) Notwithstanding a lessee’s insurable interest under subsections (1) and (2), the lessor retains an insurable interest until an option to buy has been exercised by the lessee and risk of loss has passed to the lessee. (4) Nothing in this section impairs any insurable interest recog- nized under any other statute or rule of law. (5) The parties by agreement may determine that one or more parties have an obligation to obtain and pay for insurance cover- ing the goods and by agreement may determine the beneficiary of the proceeds of the insurance.

§ 2A–219. Risk of Loss. (1) Except in the case of a finance lease, risk of loss is retained by the lessor and does not pass to the lessee. In the case of a finance lease, risk of loss passes to the lessee. (2) Subject to the provisions of this Article on the effect of default on risk of loss (Section 2A–220), if risk of loss is to pass to the lessee and the time of passage is not stated, the following rules apply:

(a) If the lease contract requires or authorizes the goods to be shipped by carrier

(i) and it does not require delivery at a particular des- tination, the risk of loss passes to the lessee when the goods are duly delivered to the carrier; but

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contract, unless the party not making the transfer agrees at any time to the transfer in the lease contract or otherwise, then, except as limited by contract, (i) the transferor is liable to the party not making the transfer for damages caused by the transfer to the extent that the damages could not reason- ably be prevented by the party not making the transfer and (ii) a court having jurisdiction may grant other appropri- ate relief, including cancellation of the lease contract or an injunction against the transfer.

(5) A transfer of “the lease” or of “all my rights under the lease”, or a transfer in similar general terms, is a transfer of rights and, unless the language or the circumstances, as in a transfer for secu- rity, indicate the contrary, the transfer is a delegation of duties by the transferor to the transferee. Acceptance by the transferee constitutes a promise by the transferee to perform those duties. The promise is enforceable by either the transferor or the other party to the lease contract. (6) Unless otherwise agreed by the lessor and the lessee, a delega- tion of performance does not relieve the transferor as against the other party of any duty to perform or of any liability for default. (7) In a consumer lease, to prohibit the transfer of an inter- est of a party under the lease contract or to make a transfer an event of default, the language must be specific, by a writing, and conspicuous. As amended in 1990 and 1999.

§ 2A–304. Subsequent Lease of Goods by Lessor. (1) Subject to Section 2A–303, a subsequent lessee from a lessor of goods under an existing lease contract obtains, to the extent of the leasehold interest transferred, the leasehold interest in the goods that the lessor had or had power to transfer, and except as provided in subsection (2) and Section 2A–527(4), takes subject to the exist- ing lease contract. A lessor with voidable title has power to transfer a good leasehold interest to a good faith subsequent lessee for value, but only to the extent set forth in the preceding sentence. If goods have been delivered under a transaction of purchase the lessor has that power even though:

(a) the lessor’s transferor was deceived as to the identity of the lessor; (b) the delivery was in exchange for a check which is later dishonored; (c) it was agreed that the transaction was to be a “cash sale”; or (d) the delivery was procured through fraud punishable as larcenous under the criminal law.

(2) A subsequent lessee in the ordinary course of business from a lessor who is a merchant dealing in goods of that kind to whom the goods were entrusted by the existing lessee of that lessor before the interest of the subsequent lessee became enforceable against that lessor obtains, to the extent of the leasehold interest transferred, all of that lessor’s and the existing lessee’s rights to the goods, and takes free of the existing lease contract.

Part 3—Effect of Lease Contract

§ 2A–301. Enforceability of Lease Contract. Except as otherwise provided in this Article, a lease contract is effec- tive and enforceable according to its terms between the parties, against purchasers of the goods and against creditors of the parties.

§ 2A–302. Title to and Possession of Goods. Except as otherwise provided in this Article, each provision of this Article applies whether the lessor or a third party has title to the goods, and whether the lessor, the lessee, or a third party has pos- session of the goods, notwithstanding any statute or rule of law that possession or the absence of possession is fraudulent.

§ 2A–303. Alienability of Party’s Interest Under Lease Contract or of Lessor’s Residual Interest in Goods; Delegation of Performance; Transfer of Rights. (1) As used in this section, “creation of a security interest” includes the sale of a lease contract that is subject to Article 9, Secured Transactions, by reason of Section 9–109(a)(3). (2) Except as provided in subsections (3) and Section 9–407, a provision in a lease agreement which (i) prohibits the voluntary or involuntary transfer, including a transfer by sale, sublease, cre- ation or enforcement of a security interest, or attachment, levy, or other judicial process, of an interest of a party under the lease contract or of the lessor’s residual interest in the goods, or (ii) makes such a transfer an event of default, gives rise to the rights and remedies provided in subsection (4), but a transfer that is prohibited or is an event of default under the lease agreement is otherwise effective. (3) A provision in a lease agreement which (i) prohibits a trans- fer of a right to damages for default with respect to the whole lease contract or of a right to payment arising out of the trans- feror’s due performance of the transferor’s entire obligation, or (ii) makes such a transfer an event of default, is not enforceable, and such a transfer is not a transfer that materially impairs the propsect of obtaining return performance by, materially changes the duty of, or materially increases the burden or risk imposed on, the other party to the lease contract within the purview of subsection (4). (4) Subject to subsection (3) and Section 9–407:

(a) if a transfer is made which is made an event of default under a lease agreement, the party to the lease contract not making the transfer, unless that party waives the default or otherwise agrees, has the rights and remedies described in Section 2A–501(2); (b) if paragraph (a) is not applicable and if a transfer is made that (i) is prohibited under a lease agreement or (ii) materi- ally impairs the prospect of obtaining return performance by, materially changes the duty of, or materially increases the burden or risk imposed on, the other party to the lease

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(2) Except as otherwise provided in subsection (3) and in Sec- tions 2A–306 and 2A–308, a creditor of a lessor takes subject to the lease contract unless the creditor holds a lien that attached to the goods before the lease contract became enforceable. (3) Except as otherwise provided in Sections 9–317, 9–321, and 9–323, a lessee takes a leasehold interest subject to a security interest held by a creditor of the lessor. As amended in 1990 and 1999.

§ 2A–308. Special Rights of Creditors. (1) A creditor of a lessor in possession of goods subject to a lease contract may treat the lease contract as void if as against the creditor retention of possession by the lessor is fraudulent under any statute or rule of law, but retention of possession in good faith and current course of trade by the lessor for a commercially reasonable time after the lease contract becomes enforceable is not fraudulent. (2) Nothing in this Article impairs the rights of creditors of a les- sor if the lease contract (a) becomes enforceable, not in current course of trade but in satisfaction of or as security for a pre-exist- ing claim for money, security, or the like, and (b) is made under circumstances which under any statute or rule of law apart from this Article would constitute the transaction a fraudulent transfer or voidable preference. (3) A creditor of a seller may treat a sale or an identification of goods to a contract for sale as void if as against the creditor reten- tion of possession by the seller is fraudulent under any statute or rule of law, but retention of possession of the goods pursuant to a lease contract entered into by the seller as lessee and the buyer as lessor in connection with the sale or identification of the goods is not fraudulent if the buyer bought for value and in good faith.

§ 2A–309. Lessor’s and Lessee’s Rights When Goods Become Fixtures. (1) In this section:

(a) goods are “fixtures” when they become so related to par- ticular real estate that an interest in them arises under real estate law; (b) a “fixture filing” is the filing, in the office where a mortgage on the real estate would be filed or recorded, of a financing statement covering goods that are or are to become fixtures and conforming to the requirements of Sec- tion 9–502(a) and (b); (c) a lease is a “purchase money lease” unless the lessee has possession or use of the goods or the right to possession or use of the goods before the lease agreement is enforceable; (d) a mortgage is a “construction mortgage” to the extent it secures an obligation incurred for the construction of an improvement on land including the acquisition cost of the land, if the recorded writing so indicates; and (e) “encumbrance” includes real estate mortgages and other liens on real estate and all other rights in real estate that are not ownership interests.

(3) A subsequent lessee from the lessor of goods that are subject to an existing lease contract and are covered by a certificate of title issued under a statute of this State or of another jurisdiction takes no greater rights than those provided both by this section and by the certificate of title statute. As amended in 1990.

§ 2A–305. Sale or Sublease of Goods by Lessee. (1) Subject to the provisions of Section 2A–303, a buyer or sublessee from the lessee of goods under an existing lease con- tract obtains, to the extent of the interest transferred, the lease- hold interest in the goods that the lessee had or had power to transfer, and except as provided in subsection (2) and Section 2A–511(4), takes subject to the existing lease contract. A les- see with a voidable leasehold interest has power to transfer a good leasehold interest to a good faith buyer for value or a good faith sublessee for value, but only to the extent set forth in the preceding sentence. When goods have been delivered under a transaction of lease the lessee has that power even though:

(a) the lessor was deceived as to the identity of the lessee; (b) the delivery was in exchange for a check which is later dishonored; or (c) the delivery was procured through fraud punishable as larcenous under the criminal law.

(2) A buyer in the ordinary course of business or a sublessee in the ordinary course of business from a lessee who is a merchant dealing in goods of that kind to whom the goods were entrusted by the lessor obtains, to the extent of the interest transferred, all of the lessor’s and lessee’s rights to the goods, and takes free of the existing lease contract. (3) A buyer or sublessee from the lessee of goods that are subject to an existing lease contract and are covered by a certificate of title issued under a statute of this State or of another jurisdiction takes no greater rights than those provided both by this section and by the certificate of title statute.

§ 2A–306. Priority of Certain Liens Arising by Operation of Law. If a person in the ordinary course of his [or her] business furnishes services or materials with respect to goods subject to a lease contract, a lien upon those goods in the possession of that person given by statute or rule of law for those materials or services takes priority over any interest of the lessor or lessee under the lease contract or this Article unless the lien is created by statute and the statute provides otherwise or unless the lien is created by rule of law and the rule of law provides otherwise.

§ 2A–307. Priority of Liens Arising by Attachment or Levy on, Security Interests in, and Other Claims to Goods. (1) Except as otherwise provided in Section 2A–306, a creditor of a lessee takes subject to the lease contract.

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or owner of the real estate who is not the lessee is determined by the priority rules governing conflicting interests in real estate. (8) If the interest of a lessor of fixtures, including the lessor’s resid- ual interest, has priority over all conflicting interests of all owners and encumbrancers of the real estate, the lessor or the lessee may (i) on default, expiration, termination, or cancellation of the lease agreement but subject to the agreement and this Article, or (ii) if necessary to enforce other rights and remedies of the lessor or lessee under this Article, remove the goods from the real estate, free and clear of all conflicting interests of all owners and encum- brancers of the real estate, but the lessor or lessee must reimburse any encumbrancer or owner of the real estate who is not the lessee and who has not otherwise agreed for the cost of repair of any physical injury, but not for any diminution in value of the real estate caused by the absence of the goods removed or by any neces- sity of replacing them. A person entitled to reimbursement may refuse permission to remove until the party seeking removal gives adequate security for the performance of this obligation. (9) Even though the lease agreement does not create a security interest, the interest of a lessor of fixtures, including the lessor’s residual interest, is perfected by filing a financing statement as a fixture filing for leased goods that are or are to become fixtures in accordance with the relevant provisions of the Article on Secured Transactions (Article 9). As amended in 1990 and 1999.

§ 2A–310. Lessor’s and Lessee’s Rights When Goods Become Accessions. (1) Goods are “accessions” when they are installed in or affixed to other goods. (2) The interest of a lessor or a lessee under a lease contract entered into before the goods became accessions is superior to all interests in the whole except as stated in subsection (4). (3) The interest of a lessor or a lessee under a lease contract entered into at the time or after the goods became accessions is superior to all subsequently acquired interests in the whole except as stated in subsection (4) but is subordinate to interests in the whole existing at the time the lease contract was made unless the holders of such interests in the whole have in writing consented to the lease or disclaimed an interest in the goods as part of the whole. (4) The interest of a lessor or a lessee under a lease contract described in subsection (2) or (3) is subordinate to the interest of

(a) a buyer in the ordinary course of business or a lessee in the ordinary course of business of any interest in the whole acquired after the goods became accessions; or (b) a creditor with a security interest in the whole perfected before the lease contract was made to the extent that the creditor makes subsequent advances without knowledge of the lease contract.

(5) When under subsections (2) or (3) and (4) a lessor or a lessee of accessions holds an interest that is superior to all interests in the whole, the lessor or the lessee may (a) on default, expiration, ter- mination, or cancellation of the lease contract by the other party

(2) Under this Article a lease may be of goods that are fixtures or may continue in goods that become fixtures, but no lease exists under this Article of ordinary building materials incorporated into an improvement on land. (3) This Article does not prevent creation of a lease of fixtures pursuant to real estate law. (4) The perfected interest of a lessor of fixtures has priority over a conflicting interest of an encumbrancer or owner of the real estate if:

(a) the lease is a purchase money lease, the conflicting inter- est of the encumbrancer or owner arises before the goods become fixtures, the interest of the lessor is perfected by a fixture filing before the goods become fixtures or within ten days thereafter, and the lessee has an interest of record in the real estate or is in possession of the real estate; or (b) the interest of the lessor is perfected by a fixture fil- ing before the interest of the encumbrancer or owner is of record, the lessor’s interest has priority over any conflict- ing interest of a predecessor in title of the encumbrancer or owner, and the lessee has an interest of record in the real estate or is in possession of the real estate.

(5) The interest of a lessor of fixtures, whether or not perfected, has priority over the conflicting interest of an encumbrancer or owner of the real estate if:

(a) the fixtures are readily removable factory or office machines, readily removable equipment that is not primar- ily used or leased for use in the operation of the real estate, or readily removable replacements of domestic appliances that are goods subject to a consumer lease, and before the goods become fixtures the lease contract is enforceable; or (b) the conflicting interest is a lien on the real estate obtained by legal or equitable proceedings after the lease contract is enforceable; or (c) the encumbrancer or owner has consented in writing to the lease or has disclaimed an interest in the goods as fix- tures; or (d) the lessee has a right to remove the goods as against the encumbrancer or owner. If the lessee’s right to remove ter- minates, the priority of the interest of the lessor continues for a reasonable time.

(6) Notwithstanding paragraph (4)(a) but otherwise subject to subsections (4) and (5), the interest of a lessor of fixtures, includ- ing the lessor’s residual interest, is subordinate to the conflicting interest of an encumbrancer of the real estate under a construc- tion mortgage recorded before the goods become fixtures if the goods become fixtures before the completion of the construction. To the extent given to refinance a construction mortgage, the conflicting interest of an encumbrancer of the real estate under a mortgage has this priority to the same extent as the encum- brancer of the real estate under the construction mortgage. (7) In cases not within the preceding subsections, priority between the interest of a lessor of fixtures, including the lessor’s residual interest, and the conflicting interest of an encumbrancer

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await the repudiating party’s performance and assurance and has urged retraction. In addition, whether or not the aggrieved party is pursuing one of the foregoing remedies, the aggrieved party may suspend performance or, if the aggrieved party is the lessor, proceed in accordance with the provisions of this Article on the lessor’s right to identify goods to the lease contract notwithstand- ing default or to salvage unfinished goods (Section 2A–524).

§ 2A–403. Retraction of Anticipatory Repudiation. (1) Until the repudiating party’s next performance is due, the repudiating party can retract the repudiation unless, since the repudiation, the aggrieved party has cancelled the lease contract or materially changed the aggrieved party’s position or otherwise indicated that the aggrieved party considers the repudiation final. (2) Retraction may be by any method that clearly indicates to the aggrieved party that the repudiating party intends to perform under the lease contract and includes any assurance demanded under Section 2A–401. (3) Retraction reinstates a repudiating party’s rights under a lease contract with due excuse and allowance to the aggrieved party for any delay occasioned by the repudiation.

§ 2A–404. Substituted Performance. (1) If without fault of the lessee, the lessor and the supplier, the agreed berthing, loading, or unloading facilities fail or the agreed type of carrier becomes unavailable or the agreed manner of delivery otherwise becomes commercially impracticable, but a commercially reasonable substitute is available, the substitute performance must be tendered and accepted. (2) If the agreed means or manner of payment fails because of domestic or foreign governmental regulation:

(a) the lessor may withhold or stop delivery or cause the supplier to withhold or stop delivery unless the lessee pro- vides a means or manner of payment that is commercially a substantial equivalent; and (b) if delivery has already been taken, payment by the means or in the manner provided by the regulation discharges the lessee’s obligation unless the regulation is discriminatory, oppressive, or predatory.

§ 2A–405. Excused Performance. Subject to Section 2A–404 on substituted performance, the follow- ing rules apply: (a) Delay in delivery or nondelivery in whole or in part by a les- sor or a supplier who complies with paragraphs (b) and (c) is not a default under the lease contract if performance as agreed has been made impracticable by the occurrence of a contingency the nonoccurrence of which was a basic assumption on which the lease contract was made or by compliance in good faith with any applicable foreign or domestic governmental regulation or order, whether or not the regulation or order later proves to be invalid. (b) If the causes mentioned in paragraph (a) affect only part of the lessor’s or the supplier’s capacity to perform, he [or she] shall allo- cate production and deliveries among his [or her] customers but at his [or her] option may include regular customers not then under

but subject to the provisions of the lease contract and this Article, or (b) if necessary to enforce his [or her] other rights and remedies under this Article, remove the goods from the whole, free and clear of all interests in the whole, but he [or she] must reimburse any holder of an interest in the whole who is not the lessee and who has not otherwise agreed for the cost of repair of any physical injury but not for any diminution in value of the whole caused by the absence of the goods removed or by any necessity for replacing them. A person entitled to reimbursement may refuse permission to remove until the party seeking removal gives adequate security for the performance of this obligation.

§ 2A–311. Priority Subject to Subordination. Nothing in this Article prevents subordination by agreement by any person entitled to priority. As added in 1990.

Part 4—Performance of Lease Contract: Repudiated, Substituted and Excused

§ 2A–401. Insecurity: Adequate Assurance of Performance. (1) A lease contract imposes an obligation on each party that the other’s expectation of receiving due performance will not be impaired. (2) If reasonable grounds for insecurity arise with respect to the performance of either party, the insecure party may demand in writing adequate assurance of due performance. Until the inse- cure party receives that assurance, if commercially reasonable the insecure party may suspend any performance for which he [or she] has not already received the agreed return. (3) A repudiation of the lease contract occurs if assurance of due performance adequate under the circumstances of the particular case is not provided to the insecure party within a reasonable time, not to exceed 30 days after receipt of a demand by the other party. (4) Between merchants, the reasonableness of grounds for inse- curity and the adequacy of any assurance offered must be deter- mined according to commercial standards. (5) Acceptance of any nonconforming delivery or payment does not prejudice the aggrieved party’s right to demand adequate assurance of future performance.

§ 2A–402. Anticipatory Repudiation. If either party repudiates a lease contract with respect to a perfor- mance not yet due under the lease contract, the loss of which perfor- mance will substantially impair the value of the lease contract to the other, the aggrieved party may: (a) for a commercially reasonable time, await retraction of repu- diation and performance by the repudiating party; (b) make demand pursuant to Section 2A–401 and await assur- ance of future performance adequate under the circumstances of the particular case; or (c) resort to any right or remedy upon default under the lease contract or this Article, even though the aggrieved party has notified the repudiating party that the aggrieved party would

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(3) If the lessor or the lessee is in default under the lease contract, the party seeking enforcement may reduce the party’s claim to judgment, or otherwise enforce the lease contract by self-help or any available judicial procedure or nonjudicial procedure, includ- ing administrative proceeding, arbitration, or the like, in accor- dance with this Article. (4) Except as otherwise provided in Section 1–106(1) or this Article or the lease agreement, the rights and remedies referred to in subsections (2) and (3) are cumulative. (5) If the lease agreement covers both real property and goods, the party seeking enforcement may proceed under this Part as to the goods, or under other applicable law as to both the real property and the goods in accordance with that party’s rights and remedies in respect of the real property, in which case this Part does not apply. As amended in 1990.

§ 2A–502. Notice After Default. Except as otherwise provided in this Article or the lease agreement, the lessor or lessee in default under the lease contract is not entitled to notice of default or notice of enforcement from the other party to the lease agreement.

§ 2A–503. Modification or Impairment of Rights and Remedies. (1) Except as otherwise provided in this Article, the lease agree- ment may include rights and remedies for default in addition to or in substitution for those provided in this Article and may limit or alter the measure of damages recoverable under this Article. (2) Resort to a remedy provided under this Article or in the lease agreement is optional unless the remedy is expressly agreed to be exclusive. If circumstances cause an exclusive or limited rem- edy to fail of its essential purpose, or provision for an exclusive remedy is unconscionable, remedy may be had as provided in this Article. (3) Consequential damages may be liquidated under Section 2A–504, or may otherwise be limited, altered, or excluded unless the limitation, alteration, or exclusion is unconscionable. Limita- tion, alteration, or exclusion of consequential damages for injury to the person in the case of consumer goods is prima facie uncon- scionable but limitation, alteration, or exclusion of damages where the loss is commercial is not prima facie unconscionable. (4) Rights and remedies on default by the lessor or the lessee with respect to any obligation or promise collateral or ancillary to the lease contract are not impaired by this Article. As amended in 1990.

§ 2A–504. Liquidation of Damages. (1) Damages payable by either party for default, or any other act or omission, including indemnity for loss or diminution of anticipated tax benefits or loss or damage to lessor’s residual interest, may be liquidated in the lease agreement but only at an amount or by a formula that is reasonable in light of the then anticipated harm caused by the default or other act or omission.

contract for sale or lease as well as his [or her] own requirements for further manufacture. He [or she] may so allocate in any manner that is fair and reasonable. (c) The lessor seasonably shall notify the lessee and in the case of a finance lease the supplier seasonably shall notify the lessor and the lessee, if known, that there will be delay or nondelivery and, if allocation is required under paragraph (b), of the estimated quota thus made available for the lessee.

§ 2A–406. Procedure on Excused Performance. (1) If the lessee receives notification of a material or indefinite delay or an allocation justified under Section 2A–405, the lessee may by written notification to the lessor as to any goods involved, and with respect to all of the goods if under an installment lease contract the value of the whole lease contract is substantially impaired (Section 2A–510):

(a) terminate the lease contract (Section 2A–505(2)); or (b) except in a finance lease that is not a consumer lease, modify the lease contract by accepting the available quota in substitution, with due allowance from the rent payable for the balance of the lease term for the deficiency but without further right against the lessor.

(2) If, after receipt of a notification from the lessor under Section 2A–405, the lessee fails so to modify the lease agreement within a reasonable time not exceeding 30 days, the lease contract lapses with respect to any deliveries affected.

§ 2A–407. Irrevocable Promises: Finance Leases. (1) In the case of a finance lease that is not a consumer lease the lessee’s promises under the lease contract become irrevocable and independent upon the lessee’s acceptance of the goods. (2) A promise that has become irrevocable and independent under subsection (1):

(a) is effective and enforceable between the parties, and by or against third parties including assignees of the parties, and (b) is not subject to cancellation, termination, modification, repudiation, excuse, or substitution without the consent of the party to whom the promise runs.

(3) This section does not affect the validity under any other law of a covenant in any lease contract making the lessee’s promises irrevocable and independent upon the lessee’s acceptance of the goods. As amended in 1990.

Part 5—Default

A. In General

§ 2A–501. Default: Procedure. (1) Whether the lessor or the lessee is in default under a lease contract is determined by the lease agreement and this Article. (2) If the lessor or the lessee is in default under the lease con- tract, the party seeking enforcement has rights and remedies as provided in this Article and, except as limited by this Article, as provided in the lease agreement.

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default occurs, whichever is later. A cause of action for indemnity accrues when the act or omission on which the claim for indem- nity is based is or should have been discovered by the indemni- fied party, whichever is later. (3) If an action commenced within the time limited by subsec- tion (1) is so terminated as to leave available a remedy by another action for the same default or breach of warranty or indemnity, the other action may be commenced after the expiration of the time limited and within 6 months after the termination of the first action unless the termination resulted from voluntary dis- continuance or from dismissal for failure or neglect to prosecute. (4) This section does not alter the law on tolling of the statute of limitations nor does it apply to causes of action that have accrued before this Article becomes effective.

§ 2A–507. Proof of Market Rent: Time and Place. (1) Damages based on market rent (Section 2A–519 or 2A–528) are determined according to the rent for the use of the goods concerned for a lease term identical to the remaining lease term of the original lease agreement and prevailing at the times speci- fied in Sections 2A–519 and 2A–528. (2) If evidence of rent for the use of the goods concerned for a lease term identical to the remaining lease term of the original lease agreement and prevailing at the times or places described in this Article is not readily available, the rent prevailing within any reasonable time before or after the time described or at any other place or for a different lease term which in commercial judgment or under usage of trade would serve as a reasonable substitute for the one described may be used, making any proper allowance for the difference, including the cost of transporting the goods to or from the other place. (3) Evidence of a relevant rent prevailing at a time or place or for a lease term other than the one described in this Article offered by one party is not admissible unless and until he [or she] has given the other party notice the court finds sufficient to prevent unfair surprise. (4) If the prevailing rent or value of any goods regularly leased in any established market is in issue, reports in official publica- tions or trade journals or in newspapers or periodicals of general circulation published as the reports of that market are admissible in evidence. The circumstances of the preparation of the report may be shown to affect its weight but not its admissibility. As amended in 1990.

B. Default by Lessor

§ 2A–508. Lessee’s Remedies. (1) If a lessor fails to deliver the goods in conformity to the lease contract (Section 2A–509) or repudiates the lease contract (Section 2A–402), or a lessee rightfully rejects the goods (Section 2A–509) or justifiably revokes acceptance of the goods (Section 2A–517), then with respect to any goods involved, and with respect to all of the goods if under an installment lease contract the value of the whole lease contract

(2) If the lease agreement provides for liquidation of damages, and such provision does not comply with subsection (1), or such provision is an exclusive or limited remedy that circumstances cause to fail of its essential purpose, remedy may be had as pro- vided in this Article. (3) If the lessor justifiably withholds or stops delivery of goods because of the lessee’s default or insolvency (Section 2A–525 or 2A–526), the lessee is entitled to restitution of any amount by which the sum of his [or her] payments exceeds:

(a) the amount to which the lessor is entitled by virtue of terms liquidating the lessor’s damages in accordance with subsection (1); or (b) in the absence of those terms, 20 percent of the then present value of the total rent the lessee was obligated to pay for the balance of the lease term, or, in the case of a con- sumer lease, the lesser of such amount or $500.

(4) A lessee’s right to restitution under subsection (3) is subject to offset to the extent the lessor establishes:

(a) a right to recover damages under the provisions of this Article other than subsection (1); and (b) the amount or value of any benefits received by the lessee directly or indirectly by reason of the lease contract.

§ 2A–505. Cancellation and Termination and Effect of Cancellation, Termination, Rescission, or Fraud on Rights and Remedies. (1) On cancellation of the lease contract, all obligations that are still executory on both sides are discharged, but any right based on prior default or performance survives, and the cancel- ling party also retains any remedy for default of the whole lease contract or any unperformed balance. (2) On termination of the lease contract, all obligations that are still executory on both sides are discharged but any right based on prior default or performance survives. (3) Unless the contrary intention clearly appears, expressions of “cancellation,” “rescission,” or the like of the lease contract may not be construed as a renunciation or discharge of any claim in damages for an antecedent default. (4) Rights and remedies for material misrepresentation or fraud include all rights and remedies available under this Article for default. (5) Neither rescission nor a claim for rescission of the lease con- tract nor rejection or return of the goods may bar or be deemed inconsistent with a claim for damages or other right or remedy.

§ 2A–506. Statute of Limitations. (1) An action for default under a lease contract, including breach of warranty or indemnity, must be commenced within 4 years after the cause of action accrued. By the original lease contract the parties may reduce the period of limitation to not less than one year. (2) A cause of action for default accrues when the act or omis- sion on which the default or breach of warranty is based is or should have been discovered by the aggrieved party, or when the

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the nonconformity does not fall within subsection (2) and the lessor or the supplier gives adequate assurance of its cure, the lessee must accept that delivery. (2) Whenever nonconformity or default with respect to one or more deliveries substantially impairs the value of the installment lease contract as a whole there is a default with respect to the whole. But, the aggrieved party reinstates the installment lease contract as a whole if the aggrieved party accepts a nonconform- ing delivery without seasonably notifying of cancellation or brings an action with respect only to past deliveries or demands performance as to future deliveries.

§ 2A–511. Merchant Lessee’s Duties as to Rightfully Rejected Goods. (1) Subject to any security interest of a lessee (Section 2A–508(5)), if a lessor or a supplier has no agent or place of business at the market of rejection, a merchant lessee, after rejection of goods in his [or her] possession or control, shall follow any reasonable instructions received from the lessor or the supplier with respect to the goods. In the absence of those instructions, a merchant lessee shall make reasonable efforts to sell, lease, or otherwise dispose of the goods for the lessor’s account if they threaten to decline in value speedily. Instructions are not reasonable if on demand indemnity for expenses is not forthcoming. (2) If a merchant lessee (subsection (1)) or any other lessee (Sec- tion 2A–512) disposes of goods, he [or she] is entitled to reim- bursement either from the lessor or the supplier or out of the proceeds for reasonable expenses of caring for and disposing of the goods and, if the expenses include no disposition commis- sion, to such commission as is usual in the trade, or if there is none, to a reasonable sum not exceeding 10 percent of the gross proceeds. (3) In complying with this section or Section 2A–512, the les- see is held only to good faith. Good faith conduct hereunder is neither acceptance or conversion nor the basis of an action for damages. (4) A purchaser who purchases in good faith from a lessee pursu- ant to this section or Section 2A–512 takes the goods free of any rights of the lessor and the supplier even though the lessee fails to comply with one or more of the requirements of this Article.

§ 2A–512. Lessee’s Duties as to Rightfully Rejected Goods. (1) Except as otherwise provided with respect to goods that threaten to decline in value speedily (Section 2A–511) and sub- ject to any security interest of a lessee (Section 2A–508(5)):

(a) the lessee, after rejection of goods in the lessee’s posses- sion, shall hold them with reasonable care at the lessor’s or the supplier’s disposition for a reasonable time after the les- see’s seasonable notification of rejection; (b) if the lessor or the supplier gives no instructions within a reasonable time after notification of rejection, the lessee may store the rejected goods for the lessor’s or the supplier’s account or ship them to the lessor or the supplier or dispose

is substantially impaired (Section 2A–510), the lessor is in default under the lease contract and the lessee may:

(a) cancel the lease contract (Section 2A–505(1)); (b) recover so much of the rent and security as has been paid and is just under the circumstances; (c) cover and recover damages as to all goods affected whether or not they have been identified to the lease con- tract (Sections 2A–518 and 2A–520), or recover damages for nondelivery (Sections 2A–519 and 2A–520); (d) exercise any other rights or pursue any other remedies provided in the lease contract.

(2) If a lessor fails to deliver the goods in conformity to the lease contract or repudiates the lease contract, the lessee may also:

(a) if the goods have been identified, recover them (Section 2A–522); or (b) in a proper case, obtain specific performance or replevy the goods (Section 2A–521).

(3) If a lessor is otherwise in default under a lease contract, the lessee may exercise the rights and pursue the remedies provided in the lease contract, which may include a right to cancel the lease, and in Section 2A–519(3). (4) If a lessor has breached a warranty, whether express or implied, the lessee may recover damages (Section 2A–519(4)). (5) On rightful rejection or justifiable revocation of acceptance, a lessee has a security interest in goods in the lessee’s possession or control for any rent and security that has been paid and any expenses reasonably incurred in their inspection, receipt, trans- portation, and care and custody and may hold those goods and dispose of them in good faith and in a commercially reasonable manner, subject to Section 2A–527(5). (6) Subject to the provisions of Section 2A–407, a lessee, on notifying the lessor of the lessee’s intention to do so, may deduct all or any part of the damages resulting from any default under the lease contract from any part of the rent still due under the same lease contract. As amended in 1990.

§ 2A–509. Lessee’s Rights on Improper Delivery; Rightful Rejection. (1) Subject to the provisions of Section 2A–510 on default in installment lease contracts, if the goods or the tender or delivery fail in any respect to conform to the lease contract, the lessee may reject or accept the goods or accept any commercial unit or units and reject the rest of the goods. (2) Rejection of goods is ineffective unless it is within a reason- able time after tender or delivery of the goods and the lessee seasonably notifies the lessor.

§ 2A–510. Installment Lease Contracts: Rejection and Default. (1) Under an installment lease contract a lessee may reject any delivery that is nonconforming if the nonconformity substan- tially impairs the value of that delivery and cannot be cured or the nonconformity is a defect in the required documents; but if

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Default after Acceptance; Notice of Claim or Litigation to Person Answerable Over. (1) A lessee must pay rent for any goods accepted in accordance with the lease contract, with due allowance for goods rightfully rejected or not delivered. (2) A lessee’s acceptance of goods precludes rejection of the goods accepted. In the case of a finance lease, if made with knowledge of a nonconformity, acceptance cannot be revoked because of it. In any other case, if made with knowledge of a nonconformity, acceptance cannot be revoked because of it unless the acceptance was on the reasonable assumption that the nonconformity would be seasonably cured. Acceptance does not of itself impair any other remedy provided by this Article or the lease agreement for nonconformity. (3) If a tender has been accepted:

(a) within a reasonable time after the lessee discovers or should have discovered any default, the lessee shall notify the lessor and the supplier, if any, or be barred from any remedy against the party notified; (b) except in the case of a consumer lease, within a reason- able time after the lessee receives notice of litigation for infringement or the like (Section 2A–211) the lessee shall notify the lessor or be barred from any remedy over for lia- bility established by the litigation; and (c) the burden is on the lessee to establish any default.

(4) If a lessee is sued for breach of a warranty or other obligation for which a lessor or a supplier is answerable over the following apply:

(a) The lessee may give the lessor or the supplier, or both, written notice of the litigation. If the notice states that the person notified may come in and defend and that if the per- son notified does not do so that person will be bound in any action against that person by the lessee by any determination of fact common to the two litigations, then unless the per- son notified after seasonable receipt of the notice does come in and defend that person is so bound. (b) The lessor or the supplier may demand in writing that the lessee turn over control of the litigation including settle- ment if the claim is one for infringement or the like (Sec- tion 2A–211) or else be barred from any remedy over. If the demand states that the lessor or the supplier agrees to bear all expense and to satisfy any adverse judgment, then unless the lessee after seasonable receipt of the demand does turn over control the lessee is so barred.

(5) Subsections (3) and (4) apply to any obligation of a lessee to hold the lessor or the supplier harmless against infringement or the like (Section 2A–211). As amended in 1990.

§ 2A–517. Revocation of Acceptance of Goods. (1) A lessee may revoke acceptance of a lot or commercial unit whose nonconformity substantially impairs its value to the lessee if the lessee has accepted it:

of them for the lessor’s or the supplier’s account with reim- bursement in the manner provided in Section 2A–511; but (c) the lessee has no further obligations with regard to goods rightfully rejected.

(2) Action by the lessee pursuant to subsection (1) is not accep- tance or conversion.

§ 2A–513. Cure by Lessor of Improper Tender or Delivery; Replacement. (1) If any tender or delivery by the lessor or the supplier is rejected because nonconforming and the time for performance has not yet expired, the lessor or the supplier may seasonably notify the lessee of the lessor’s or the supplier’s intention to cure and may then make a conforming delivery within the time provided in the lease contract. (2) If the lessee rejects a nonconforming tender that the lessor or the supplier had reasonable grounds to believe would be accept- able with or without money allowance, the lessor or the supplier may have a further reasonable time to substitute a conforming tender if he [or she] seasonably notifies the lessee.

§ 2A–514. Waiver of Lessee’s Objections. (1) In rejecting goods, a lessee’s failure to state a particular defect that is ascertainable by reasonable inspection precludes the lessee from relying on the defect to justify rejection or to establish default:

(a) if, stated seasonably, the lessor or the supplier could have cured it (Section 2A–513); or (b) between merchants if the lessor or the supplier after rejection has made a request in writing for a full and final written statement of all defects on which the lessee proposes to rely.

(2) A lessee’s failure to reserve rights when paying rent or other consideration against documents precludes recovery of the pay- ment for defects apparent on the face of the documents.

§ 2A–515. Acceptance of Goods. (1) Acceptance of goods occurs after the lessee has had a reason- able opportunity to inspect the goods and

(a) the lessee signifies or acts with respect to the goods in a manner that signifies to the lessor or the supplier that the goods are conforming or that the lessee will take or retain them in spite of their nonconformity; or (b) the lessee fails to make an effective rejection of the goods (Section 2A–509(2)).

(2) Acceptance of a part of any commercial unit is acceptance of that entire unit.

§ 2A–516. Effect of Acceptance of Goods; Notice of Default; Burden of Establishing

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§ 2A–519. Lessee’s Damages for Non- Delivery, Repudiation, Default, and Breach of Warranty in Regard to Accepted Goods. (1) Except as otherwise provided with respect to damages liq- uidated in the lease agreement (Section 2A–504) or otherwise determined pursuant to agreement of the parties (Sections 1–102(3) and 2A–503), if a lessee elects not to cover or a lessee elects to cover and the cover is by lease agreement that for any reason does not qualify for treatment under Section 2A–518(2), or is by purchase or otherwise, the measure of damages for non- delivery or repudiation by the lessor or for rejection or revoca- tion of acceptance by the lessee is the present value, as of the date of the default, of the then market rent minus the present value as of the same date of the original rent, computed for the remaining lease term of the original lease agreement, together with incidental and consequential damages, less expenses saved in consequence of the lessor’s default. (2) Market rent is to be determined as of the place for tender or, in cases of rejection after arrival or revocation of acceptance, as of the place of arrival. (3) Except as otherwise agreed, if the lessee has accepted goods and given notification (Section 2A–516(3)), the measure of damages for non-conforming tender or delivery or other default by a lessor is the loss resulting in the ordinary course of events from the lessor’s default as determined in any manner that is rea- sonable together with incidental and consequential damages, less expenses saved in consequence of the lessor’s default. (4) Except as otherwise agreed, the measure of damages for breach of warranty is the present value at the time and place of acceptance of the difference between the value of the use of the goods accepted and the value if they had been as warranted for the lease term, unless special circumstances show proximate damages of a different amount, together with incidental and consequential damages, less expenses saved in consequence of the lessor’s default or breach of warranty. As amended in 1990.

§ 2A–520. Lessee’s Incidental and Consequential Damages. (1) Incidental damages resulting from a lessor’s default include expenses reasonably incurred in inspection, receipt, transporta- tion, and care and custody of goods rightfully rejected or goods the acceptance of which is justifiably revoked, any commercially reasonable charges, expenses or commissions in connection with effecting cover, and any other reasonable expense incident to the default. (2) Consequential damages resulting from a lessor’s default include:

(a) any loss resulting from general or particular requirements and needs of which the lessor at the time of contracting had reason to know and which could not reasonably be pre- vented by cover or otherwise; and

(a) except in the case of a finance lease, on the reasonable assumption that its nonconformity would be cured and it has not been seasonably cured; or (b) without discovery of the nonconformity if the lessee’s acceptance was reasonably induced either by the lessor’s assurances or, except in the case of a finance lease, by the difficulty of discovery before acceptance.

(2) Except in the case of a finance lease that is not a consumer lease, a lessee may revoke acceptance of a lot or commercial unit if the lessor defaults under the lease contract and the default sub- stantially impairs the value of that lot or commercial unit to the lessee. (3) If the lease agreement so provides, the lessee may revoke acceptance of a lot or commercial unit because of other defaults by the lessor. (4) Revocation of acceptance must occur within a reasonable time after the lessee discovers or should have discovered the ground for it and before any substantial change in condition of the goods which is not caused by the nonconformity. Revocation is not effective until the lessee notifies the lessor. (5) A lessee who so revokes has the same rights and duties with regard to the goods involved as if the lessee had rejected them. As amended in 1990.

§ 2A–518. Cover; Substitute Goods. (1) After a default by a lessor under the lease contract of the type described in Section 2A–508(1), or, if agreed, after other default by the lessor, the lessee may cover by making any purchase or lease of or contract to purchase or lease goods in substitution for those due from the lessor. (2) Except as otherwise provided with respect to damages liq- uidated in the lease agreement (Section 2A–504) or otherwise determined pursuant to agreement of the parties (Sections 1–102(3) and 2A–503), if a lessee’s cover is by lease agreement substantially similar to the original lease agreement and the new lease agreement is made in good faith and in a commercially reasonable manner, the lessee may recover from the lessor as damages (i) the present value, as of the date of the commence- ment of the term of the new lease agreement, of the rent under the new lease agreement applicable to that period of the new lease term which is comparable to the then remaining term of the original lease agreement minus the present value as of the same date of the total rent for the then remaining lease term of the original lease agreement, and (ii) any incidental or con- sequential damages, less expenses saved in consequence of the lessor’s default. (3) If a lessee’s cover is by lease agreement that for any reason does not qualify for treatment under subsection (2), or is by pur- chase or otherwise, the lessee may recover from the lessor as if the lessee had elected not to cover and Section 2A–519 governs. As amended in 1990.

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together with incidental damages, less expenses saved in conse- quence of the lessee’s default. (3) If a lessee is otherwise in default under a lease contract, the lessor may exercise the rights and pursue the remedies provided in the lease contract, which may include a right to cancel the lease. In addition, unless otherwise provided in the lease contract:

(a) if the default substantially impairs the value of the lease contract to the lessor, the lessor may exercise the rights and pursue the remedies provided in subsections (1) or (2); or (b) if the default does not substantially impair the value of the lease contract to the lessor, the lessor may recover as pro- vided in subsection (2).

As amended in 1990.

§ 2A–524. Lessor’s Right to Identify Goods to Lease Contract. (1) After default by the lessee under the lease contract of the type described in Section 2A–523(1) or 2A–523(3)(a) or, if agreed, after other default by the lessee, the lessor may:

(a) identify to the lease contract conforming goods not already identified if at the time the lessor learned of the default they were in the lessor’s or the supplier’s possession or control; and (b) dispose of goods (Section 2A–527(1)) that demonstra- bly have been intended for the particular lease contract even though those goods are unfinished.

(2) If the goods are unfinished, in the exercise of reasonable com- mercial judgment for the purposes of avoiding loss and of effec- tive realization, an aggrieved lessor or the supplier may either complete manufacture and wholly identify the goods to the lease contract or cease manufacture and lease, sell, or otherwise dis- pose of the goods for scrap or salvage value or proceed in any other reasonable manner. As amended in 1990.

§ 2A–525. Lessor’s Right to Possession of Goods. (1) If a lessor discovers the lessee to be insolvent, the lessor may refuse to deliver the goods. (2) After a default by the lessee under the lease contract of the type described in Section 2A–523(1) or 2A–523(3)(a) or, if agreed, after other default by the lessee, the lessor has the right to take possession of the goods. If the lease contract so provides, the lessor may require the lessee to assemble the goods and make them available to the lessor at a place to be designated by the lessor which is reasonably convenient to both parties. Without removal, the lessor may render unusable any goods employed in trade or business, and may dispose of goods on the lessee’s prem- ises (Section 2A–527). (3) The lessor may proceed under subsection (2) without judicial process if that can be done without breach of the peace or the lessor may proceed by action. As amended in 1990.

(b) injury to person or property proximately resulting from any breach of warranty.

§ 2A–521. Lessee’s Right to Specific Performance or Replevin. (1) Specific performance may be decreed if the goods are unique or in other proper circumstances. (2) A decree for specific performance may include any terms and conditions as to payment of the rent, damages, or other relief that the court deems just. (3) A lessee has a right of replevin, detinue, sequestration, claim and delivery, or the like for goods identified to the lease contract if after reasonable effort the lessee is unable to effect cover for those goods or the circumstances reasonably indicate that the effort will be unavailing.

§ 2A–522. Lessee’s Right to Goods on Lessor’s Insolvency. (1) Subject to subsection (2) and even though the goods have not been shipped, a lessee who has paid a part or all of the rent and security for goods identified to a lease contract (Section 2A–217) on making and keeping good a tender of any unpaid portion of the rent and security due under the lease contract may recover the goods identified from the lessor if the lessor becomes insol- vent within 10 days after receipt of the first installment of rent and security. (2) A lessee acquires the right to recover goods identified to a lease contract only if they conform to the lease contract.

C. Default by Lessee

§ 2A–523. Lessor’s Remedies. (1) If a lessee wrongfully rejects or revokes acceptance of goods or fails to make a payment when due or repudiates with respect to a part or the whole, then, with respect to any goods involved, and with respect to all of the goods if under an installment lease contract the value of the whole lease contract is substantially impaired (Section 2A–510), the lessee is in default under the lease contract and the lessor may:

(a) cancel the lease contract (Section 2A–505(1)); (b) proceed respecting goods not identified to the lease con- tract (Section 2A–524); (c) withhold delivery of the goods and take possession of goods previously delivered (Section 2A–525); (d) stop delivery of the goods by any bailee (Section 2A–526); (e) dispose of the goods and recover damages (Section 2A–527), or retain the goods and recover damages (Section 2A–528), or in a proper case recover rent (Section 2A–529) (f) exercise any other rights or pursue any other remedies provided in the lease contract.

(2) If a lessor does not fully exercise a right or obtain a remedy to which the lessor is entitled under subsection (1), the lessor may recover the loss resulting in the ordinary course of events from the lessee’s default as determined in any reasonable manner,

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§ 2A–526. Lessor’s Stoppage of Delivery in Transit or Otherwise. (1) A lessor may stop delivery of goods in the possession of a car- rier or other bailee if the lessor discovers the lessee to be insolvent and may stop delivery of carload, truckload, planeload, or larger shipments of express or freight if the lessee repudiates or fails to make a payment due before delivery, whether for rent, security or otherwise under the lease contract, or for any other reason the lessor has a right to withhold or take possession of the goods. (2) In pursuing its remedies under subsection (1), the lessor may stop delivery until

(a) receipt of the goods by the lessee; (b) acknowledgment to the lessee by any bailee of the goods, except a carrier, that the bailee holds the goods for the les- see; or (c) such an acknowledgment to the lessee by a carrier via reshipment or as warehouseman.

(3) (a) To stop delivery, a lessor shall so notify as to enable the bailee by reasonable diligence to prevent delivery of the goods. (b) After notification, the bailee shall hold and deliver the goods according to the directions of the lessor, but the lessor is liable to the bailee for any ensuing charges or damages. (c) A carrier who has issued a nonnegotiable bill of lading is not obliged to obey a notification to stop received from a person other than the consignor.

§ 2A–527. Lessor’s Rights to Dispose of Goods. (1) After a default by a lessee under the lease contract of the type described in Section 2A–523(1) or 2A–523(3)(a) or after the lessor refuses to deliver or takes possession of goods (Section 2A–525 or 2A–526), or, if agreed, after other default by a lessee, the lessor may dispose of the goods concerned or the undelivered balance thereof by lease, sale, or otherwise. (2) Except as otherwise provided with respect to damages liq- uidated in the lease agreement (Section 2A–504) or otherwise determined pursuant to agreement of the parties (Sections 1–102(3) and 2A–503), if the disposition is by lease agreement substantially similar to the original lease agreement and the new lease agreement is made in good faith and in a commer- cially reasonable manner, the lessor may recover from the lessee as damages (i) accrued and unpaid rent as of the date of the commencement of the term of the new lease agreement, (ii) the present value, as of the same date, of the total rent for the then remaining lease term of the original lease agreement minus the present value, as of the same date, of the rent under the new lease agreement applicable to that period of the new lease term which is comparable to the then remaining term of the original lease agreement, and (iii) any incidental damages allowed under Section 2A–530, less expenses saved in consequence of the les- see’s default. (3) If the lessor’s disposition is by lease agreement that for any reason does not qualify for treatment under subsection (2), or is by sale or otherwise, the lessor may recover from the lessee as if the lessor had elected not to dispose of the goods and Section 2A–528 governs.

(4) A subsequent buyer or lessee who buys or leases from the les- sor in good faith for value as a result of a disposition under this section takes the goods free of the original lease contract and any rights of the original lessee even though the lessor fails to comply with one or more of the requirements of this Article. (5) The lessor is not accountable to the lessee for any profit made on any disposition. A lessee who has rightfully rejected or jus- tifiably revoked acceptance shall account to the lessor for any excess over the amount of the lessee’s security interest (Section 2A–508(5)). As amended in 1990.

§ 2A–528. Lessor’s Damages for Non-acceptance, Failure to Pay, Repudiation, or Other Default. (1) Except as otherwise provided with respect to damages liq- uidated in the lease agreement (Section 2A–504) or otherwise determined pursuant to agreement of the parties (Section 1–102(3) and 2A–503), if a lessor elects to retain the goods or a lessor elects to dispose of the goods and the disposition is by lease agreement that for any reason does not qualify for treat- ment under Section 2A–527(2), or is by sale or otherwise, the lessor may recover from the lessee as damages for a default of the type described in Section 2A–523(1) or 2A–523(3)(a), or if agreed, for other default of the lessee, (i) accrued and unpaid rent as of the date of the default if the lessee has never taken possession of the goods, or, if the lessee has taken possession of the goods, as of the date the lessor repossesses the goods or an earlier date on which the lessee makes a tender of the goods to the lessor, (ii) the present value as of the date determined under clause (i) of the total rent for the then remaining lease term of the original lease agreement minus the present value as of the same date of the market rent as the place where the goods are located computed for the same lease term, and (iii) any inciden- tal damages allowed under Section 2A–530, less expenses saved in consequence of the lessee’s default. (2) If the measure of damages provided in subsection (1) is inad- equate to put a lessor in as good a position as performance would have, the measure of damages is the present value of the profit, including reasonable overhead, the lessor would have made from full performance by the lessee, together with any incidental damages allowed under Section 2A–530, due allowance for costs reasonably incurred and due credit for payments or proceeds of disposition. As amended in 1990.

§ 2A–529. Lessor’s Action for the Rent. (1) After default by the lessee under the lease contract of the type described in Section 2A–523(1) or 2A–523(3)(a) or, if agreed, after other default by the lessee, if the lessor complies with sub- section (2), the lessor may recover from the lessee as damages:

(a) for goods accepted by the lessee and not repossessed by or tendered to the lessor, and for conforming goods lost or damaged within a commercially reasonable time after risk of loss passes to the lessee (Section 2A–219), (i) accrued and unpaid rent as of the date of entry of judgment in favor of the lessor (ii) the present value as of the same date of the rent

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for the then remaining lease term of the lease agreement, and (iii) any incidental damages allowed under Section 2A–530, less expenses saved in consequence of the lessee’s default; and (b) for goods identified to the lease contract if the lessor is unable after reasonable effort to dispose of them at a reason- able price or the circumstances reasonably indicate that effort will be unavailing, (i) accrued and unpaid rent as of the date of entry of judgment in favor of the lessor, (ii) the present value as of the same date of the rent for the then remaining lease term of the lease agreement, and (iii) any incidental damages allowed under Section 2A–530, less expenses saved in conse- quence of the lessee’s default.

(2) Except as provided in subsection (3), the lessor shall hold for the lessee for the remaining lease term of the lease agreement any goods that have been identified to the lease contract and are in the lessor’s control. (3) The lessor may dispose of the goods at any time before col- lection of the judgment for damages obtained pursuant to sub- section (1). If the disposition is before the end of the remaining lease term of the lease agreement, the lessor’s recovery against the lessee for damages is governed by Section 2A–527 or Section 2A–528, and the lessor will cause an appropriate credit to be provided against a judgment for damages to the extent that the amount of the judgment exceeds the recovery available pursuant to Section 2A–527 or 2A–528. (4) Payment of the judgment for damages obtained pursuant to subsection (1) entitles the lessee to the use and possession of the goods not then disposed of for the remaining lease term of and in accordance with the lease agreement. (5) After default by the lessee under the lease contract of the type described in Section 2A–523(1) or Section 2A–523(3)(a) or, if agreed, after other default by the lessee, a lessor who is held not entitled to rent under this section must nevertheless be awarded damages for non-acceptance under Sections 2A–527 and 2A–528. As amended in 1990.

§ 2A–530. Lessor’s Incidental Damages. Incidental damages to an aggrieved lessor include any commercially reasonable charges, expenses, or commissions incurred in stopping delivery, in the transportation, care and custody of goods after the lessee’s default, in connection with return or disposition of the goods, or otherwise resulting from the default.

§ 2A–531. Standing to Sue Third Parties for Injury to Goods. (1) If a third party so deals with goods that have been identified to a lease contract as to cause actionable injury to a party to the lease contract (a) the lessor has a right of action against the third party, and (b) the lessee also has a right of action against the third party if the lessee:

(i) has a security interest in the goods; (ii) has an insurable interest in the goods; or (iii) bears the risk of loss under the lease contract or has since the injury assumed that risk as against the lessor and the goods have been converted or destroyed.

(2) If at the time of the injury the party plaintiff did not bear the risk of loss as against the other party to the lease contract and there is no arrangement between them for disposition of the recovery, his [or her] suit or settlement, subject to his [or her] own interest, is as a fiduciary for the other party to the lease contract. (3) Either party with the consent of the other may sue for the benefit of whom it may concern.

§ 2A–532. Lessor’s Rights to Residual Interest. In addition to any other recovery permitted by this Article or other law, the lessor may recover from the lessee an amount that will fully compensate the lessor for any loss of or damage to the lessor’s resid- ual interest in the goods caused by the default of the lessee. As added in 1990.

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CHAPTER 1

1. Under what circumstances might a judge rely on case law to determine the intent and purpose of a statute? Case law includes courts’ interpretations of statutes, as well as constitu- tional provisions and administrative rules. Statutes often codify common law rules. For these reasons, a judge might rely on the common law as a guide to the intent and purpose of a statute.

2. Assuming that these convicted war criminals had not dis- obeyed any law of their country and had merely been follow- ing their government’s orders, what law had they violated? Explain. At the time of the Nuremberg trials, “crimes against humanity” were new international crimes. The laws criminalized such acts as murder, extermination, enslavement, deportation, and other inhumane acts committed against any civilian popu- lation. These international laws derived their legitimacy from “natural law.”

Natural law, which is the oldest and one of the most sig- nificant schools of jurisprudence, holds that governments and legal systems should reflect the moral and ethical ideals that are inherent in human nature. Because natural law is universal and discoverable by reason, its adherents believe that all other law is derived from natural law. Natural law therefore supersedes laws created by humans (national, or “positive,” law), and in a conflict between the two, national or positive law loses its legitimacy.

The Nuremberg defendants asserted that they had been acting in accordance with German law. The judges dismissed these claims, reasoning that the defendants’ acts were com- monly regarded as crimes and that the accused must have known that the acts would be considered criminal. The judges clearly believed the tenets of natural law and expected that the defen- dants, too, should have been able to realize that their acts ran afoul of it. The fact that the “positivist law” of Germany at the time required them to commit these acts is irrelevant. Under natural law theory, the international court was justified in find- ing the defendants guilty of crimes against humanity.

CHAPTER 2

1. Does the court in Sue’s state have jurisdiction over Tipton? What factors will the court consider in determining jurisdic- tion? Yes, the court in Sue’s state has jurisdiction over Tipton on the basis of the company’s minimum contacts with the state.

Courts look at the following factors in determining whether minimum contacts exist: the quantity of the contacts, the nature and quality of the contacts, the source and connection of the cause of action to the contacts, the interest of the forum state, and the convenience of the parties. Attempting to exercise juris- diction without sufficient minimum contacts would violate the

due process clause. Generally, courts have found that jurisdiction is proper when there is substantial business conducted online (with contracts, sales, and so on). Even when there is only some interactivity through a Web site, courts have sometimes held that jurisdiction is proper. Jurisdiction is not proper when there is merely passive advertising.

Here, all of these factors suggest that the defendant had suf-Here, all of these factors suggest that the defendant had suf-Here, all of these factors suggest that the defendant had suf ficient minimum contacts with the state to justify the exercise of jurisdiction over the defendant. Two especially important factors were that the plaintiff sold the security system to a resident of the state and that litigating in the defendant’s state would be relatively inconvenient for the plaintiff.

2. If the dispute is not resolved, or if either party disagrees with the decision of the mediator or arbitrator, will a court hear the case? Explain. Yes, if the dispute is not resolved, or if either party disagrees with the decision of the mediator or arbi- trator, a court will hear the case. It is required that the dispute be submitted to mediation or arbitration, but this outcome is not binding.

CHAPTER 3

1. Tom can call his first witness. What else might he do? Tom Tom can call his first witness. What else might he do? Tom Tom can call his first witness. What else might he do? could file a motion for a directed verdict. This motion asks the judge to direct a verdict for Tom on the ground that Sue pre- sented no evidence that would justify granting Sue relief. The judge grants the motion if there is insufficient evidence to raise an issue of fact.

2. Who can appeal to a higher court? Either a plaintiff or a defendant, or both, can appeal a judgment to a higher court. An appellate court can affirm, reverse, or remand a case, or take any of these actions in combination. To appeal successfully, it is best to appeal on the basis of an error of law, because appellate courts do not usually reverse on findings of fact.

CHAPTER 4

1. Can a state, in the interest of energy conservation, ban all advertising by power utilities if conservation could be accom- plished by less restrictive means? Why or why not? No. Even if commercial speech is neither related to illegal activities nor misleading, it may be restricted if a state has a substantial interest that cannot be achieved by less restrictive means. In this case, the interest in energy conservation is substantial, but it could be achieved by less restrictive means. That would be the utilities’ defense against the enforcement of this state law.

2. Is this a violation of equal protection if the only reason for the tax is to protect the local firms from out-of-state com- petition? Explain. Yes. The tax would limit the liberty of some

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persons (out-of-state businesses), so it is subject to a review under the equal protection clause. Protecting local businesses from out- of-state competition is not a legitimate government objective. Thus, such a tax would violate the equal protection clause.

CHAPTER 5

1. Does this raise an ethical conflict between Acme’s employ- ees? Between Acme and its employees? Between Acme and its shareholders? Explain your answers. When a corporation decides to respond to what it sees as a moral obligation to cor- rect for past discrimination by adjusting pay differences among its employees, an ethical conflict is raised between the firm and its employees and between the firm and its shareholders. This dilemma arises directly out of the effect such a decision has on the firm’s profits. If satisfying this obligation increases profitabil- ity, then the dilemma is easily resolved in favor of “doing the right thing.”

2. Does Delta have an ethical duty to remove this product from the market, even if the injuries result only from misuse? Why or why not? Maybe. On the one hand, it is not the com- pany’s “fault” when a product is misused. Also, keeping the prod- uct on the market is not a violation of the law, and stopping sales would hurt profits. On the other hand, suspending sales could reduce suffering and could stop potential negative publicity.

CHAPTER 6

1. Can Lou recover from Jana? Why or why not? Probably. To recover on the basis of negligence, the injured party as a plaintiff must show that the truck’s owner owed the plaintiff a duty of care, that the owner breached that duty, that the plaintiff was injured, and that the breach caused the injury.

In this situation, the owner’s actions breached the duty of reasonable care. The billboard falling on the plaintiff was the direct cause of the injury, not the plaintiff ’s own negligence. Thus, liability turns on whether the plaintiff can connect the breach of duty to the injury. This involves the test of proximate cause—the question of foreseeability. The consequences to the injured party must have been a foreseeable result of the owner’s carelessness.

2. What might the firm successfully claim in defense? The company might defend against this electrician’s claim by assert- ing that the electrician should have known of the risk and, therefore, the company had no duty to warn. According to the problem, the danger is common knowledge in the electrician’s field and should have been apparent to this electrician, given his years of training and experience. In other words, the company most likely had no need to warn the electrician of the risk.

The firm could also raise comparative negligence. Both parties’ negligence, if any, could be weighed and the liability distributed proportionately. The defendant could also assert assumption of risk, claiming that the electrician voluntarily entered into a dangerous situation, knowing the risk involved.

CHAPTER 7

1. Is Superior Vehicles liable? Explain your answer. Yes. The manufacturer is liable for the injuries to the user of the product. A manufacturer is liable for its failure to exercise due care to any person who sustains an injury proximately caused by a negli- gently made (defective) product.

2. What defense might Bensing assert to avoid liability under state law? Bensing can assert the defense of preemption. An injured party may not be able to sue the manufacturer of defec- tive products that are subject to comprehensive federal regula- tory schemes. If the federal government has a comprehensive regulatory scheme (such as it does with medical devices and vac- cines), then it is assumed that the rules were designed to ensure a product’s safety, and the federal rules will preempt any state regu- lations. Therefore, Bensing could not be held liable under state law if it complied with the federal drug-labeling requirements.

CHAPTER 8

1. Has Roslyn violated any of the intellectual property rights discussed in this chapter? Explain. Yes, Roslyn has committed theft of trade secrets. Lists of suppliers and customers cannot be patented, copyrighted, or trademarked, but the information they contain is protected against appropriation by others as trade secrets. And most likely, Roslyn signed a contract agreeing not to use this information outside her employment by Organic. But even without this contract, Organic could make a convincing case against its ex-employee for a theft of trade secrets.

2. Is this patent infringement? If so, how might Global save the cost of suing World for infringement and at the same time profit from World’s sales? This is patent infringement. A soft- ware maker in this situation might best protect its product, save litigation costs, and profit from its patent by the use of a license. In the context of this problem, a license would grant permission to sell a patented item. (A license can be limited to certain pur- poses and to the licensee only.)

CHAPTER 9

1. Has Karl done anything wrong? Explain. Karl may have committed trademark infringement. A site that appropriates the key words of other sites with more frequent hits will appear in the same search engine results as the more popular sites. But using another’s trademark as a key word without the owner’s permission normally constitutes trademark infringement. Of course, some uses of another’s trademark as a meta tag may be permissible if the use is reasonably necessary and does not sug- gest that the owner authorized or sponsored the use.

2. Can Eagle Corporation stop this use of eagle? If so, what must the company show? Yes. This may be an instance of trade- mark dilution. Dilution occurs when a trademark is used, with- out permission, in a way that diminishes the distinctive quality of the mark. Dilution does not require proof that consumers

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are likely to be confused by the use of the unauthorized mark. The products involved do not have to be similar. Dilution does require, however, that a mark be famous when the dilution occurs.

CHAPTER 10

1. With respect to the gas station, has she committed a crime? If so, what is it? Yes. With respect to the gas station, she has obtained goods by false pretenses. She might also be charged with larceny and forgery, and most states have special statutes covering illegal use of credit cards.

2. Has Ben committed a crime? If so, what is it? Yes. The Counterfeit Access Device and Computer Fraud and Abuse Act provides that a person who accesses a computer online, without permission, to obtain classified data—such as consumer credit files in a credit agency’s database—is subject to criminal prosecu- tion. The crime has two elements: accessing the computer with- out permission and taking data. It is a felony if done for private financial gain. Penalties include fines and imprisonment for up to twenty years. The victim of the theft can also bring a civil suit against the criminal to obtain damages and other relief.

CHAPTER 11

1. Under what circumstances would a U.S. court enforce the judgment of the Ecuadoran court? Under the principle of comity, a U.S. court would defer and give effect to foreign laws and judicial decrees that are consistent with U.S. law and public policy.

2. How can this attempt to undersell U.S. businesses be defeated? The practice described in this problem is known as dumping, which is regarded as an unfair international trade practice. Dumping is the sale of imported goods at “less than fair value.” Based on the price of those goods in the exporting country, an extra tariff—known as an antidumping duty—can be imposed on the imports.

CHAPTER 12

1. Under the Uniform Electronic Transactions Act, what determines the effect of the electronic documents evidencing the parties’ deal? Is a party’s “signature” necessary? Explain. First, it might be noted that the UETA does not apply unless the parties to a contract agree to use e-commerce in their transac- tion. In this deal, of course, the parties used e-commerce. The UETA removes barriers to e-commerce by giving the same legal effect to e-records and e-signatures as to paper documents and signatures. The UETA does not include rules for those transac- tions, however.

2. Can Kenwood enforce the lease against Joan? Why or why not? No. Joan is a minor and may disaffirm this contract. Because the apartment was a necessary, however, she remains lia- ble for the reasonable value of her occupancy of the apartment.

CHAPTER 13

1. Before Ready or Stealth starts performing, can the parties call off the deal? What if Stealth has already shipped the piz- zas? Explain your answers. Contracts that are executory on both sides—contracts on which neither party has performed—can be rescinded solely by agreement. Contracts that are executed on one side—contracts on which one party has performed—can be rescinded only if the party who has performed receives consider- ation for the promise to call off the deal.

2. If Haney sues Greg, what will be the measure of recovery? A nonbreaching party is entitled to his or her benefit of the bargain under the contract. Here, the innocent party is entitled to be put in the position she would have been in if the con- tract had been fully performed. The measure of the benefit is the cost to complete the work ($500). These are compensatory damages.

CHAPTER 14

1. Is this an acceptance of the offer or a counteroffer? If it is an acceptance, is it a breach of the contract? Why or why not? What if Fav-O-Rite told E-Design it was sending the printer stands as “an accommodation”? A shipment of non- conforming goods constitutes an acceptance of the offer and a breach, unless the seller seasonably notifies the buyer that the nonconforming shipment does not constitute an acceptance and is offered only as an accommodation. Thus, since there was no notification here, the shipment was both an acceptance and a breach. If, however, Fav-O-Rite had notified E-Design that it was sending the printer stands as an accommodation, the shipment would not constitute an acceptance, and Fav-O-Rite would not be in breach.

2. Can Poster Planet sue Brite without waiting until May 1? Why or why not? Yes. When anticipatory repudiation occurs, a Why or why not? Yes. When anticipatory repudiation occurs, a Why or why not? buyer (or lessee) can resort to any remedy for breach even if the buyer tells the seller (the repudiating party in this problem) that the buyer will wait for the seller’s performance.

CHAPTER 15

1. What can Larry and Midwest do? Each of the parties can place a mechanic’s lien on the debtor’s property. If the debtor does not pay what is owed, the property can be sold to satisfy the debt. The only requirements are that the lien be filed within a specific time from the time of the work, depending on the state statute, and that notice of the foreclosure and sale be given to the debtor in advance.

2. Are these debts dischargeable in bankruptcy? Explain. No. Besides the claims listed in this problem, the debts that can- not be discharged in bankruptcy include amounts borrowed to pay back taxes, goods obtained by fraud, debts that were not listed in the petition, domestic support obligations, certain cash advances, and others.

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CHAPTER 16

1. Would a sole proprietorship be an appropriate form for Frank’s business? Why or why not? Yes. When a business is relaFrank’s business? Why or why not? Yes. When a business is relaFrank’s business? Why or why not? - tively small and is not diversified, employs relatively few people, has modest profits, and is not likely to expand significantly or require extensive financing in the immediate future, the most appropriate form for doing business may be a sole proprietorship.

2. When Darnell dies, his widow claims that as Darnell’s heir, she is entitled to take his place as Eliana’s partner or to receive a share of the firm’s assets. Is she right? Why or why not? No. A widow (or widower) has no right to take a dead part- ner’s place. A partner’s death causes dissociation, after which the partnership must purchase the dissociated partner’s partnership interest. Therefore, the surviving partners must pay the dece- dent’s estate (for his widow) the value of the deceased partner’s interest in the partnership.

CHAPTER 17

1. What are their options with respect to the management of their firm? The members of a limited liability company (LLC) may designate a group to run their firm, in which situation the firm would be considered a manager-managed LLC. The group may include only members, only nonmembers, or members and nonmembers. If, instead, all members participate in man- agement, the firm would be a member-managed LLC. In fact, unless the members agree otherwise, all members are considered to participate in the management of the firm.

2. If Elizabeth is petitioned into involuntary bankruptcy, does that constitute a dissolution of the limited partnership? Bank- ruptcy of the limited partnership itself causes dissolution, but bankruptcy of one of the limited partners does not dissolve the partnership unless it causes the bankruptcy of the firm. Therefore, Elizabeth’s involuntary bankruptcy would not dissolve the firm.

CHAPTER 18

1. Is there a way for Northwest Brands to avoid this double taxation? Explain your answer. Yes. Small businesses that meet certain requirements can qualify as S corporations, created spe- cifically to permit small businesses to avoid double taxation. The six requirements of an S corporation are (1) the firm must be a domestic corporation, (2) the firm must not be a member of an affiliated group of corporations, (3) the firm must have less than a certain number of shareholders, (4) the shareholders must be individuals, estates, or qualified trusts (or corporations in some cases), (5) there can be only one class of stock, and (6) no share- holder can be a nonresident alien.

2. Discuss whether Nico owes a duty to Omega or the minority shareholders in selling his shares. Yes. A single shareholder—or a few shareholders acting together—who owns enough stock to exercise de facto control over a corporation owes the corporation and minority shareholders a fiduciary duty when transferring those shares.

CHAPTER 19

1. Was Winona an independent contractor? Yes. An indepen- dent contractor is a person who contracts with another—the principal—to do something but who is neither controlled by the other nor subject to the other’s right to control with respect to the performance. Independent contractors are not employees, because those who hire them have no control over the details of their performance.

2. Can Davis hold Estee liable for whatever damages he has to pay? Why or why not? Yes. A principal has a duty to indemnify an agent for liabilities incurred because of authorized and lawful acts and transactions and for losses suffered because of the prin- cipal’s failure to perform his or her duties.

CHAPTER 20

1. Can AMC be held liable for breach of contract? If so, why? If not, why not? Yes. Some courts have held that an implied employment contract exists between employer and employee when an employee handbook states that employees will be dis- missed only for good cause. An employer who fires a worker contrary to this promise can be held liable for breach of contract.

2. For Erin to obtain workers’ compensation, must her injury have been caused by Fine Print’s negligence? Does it matter whether the action causing the injury was inten- tional? Explain. Workers’ compensation laws establish a pro- cedure for compensating workers who are injured on the job. Instead of suing to collect benefits, an injured worker notifies the employer of an injury and files a claim with the appropriate state agency.

The right to recover is normally determined without regard to negligence or fault, but intentionally inflicted injuries are not covered. Unlike the potential for recovery in a lawsuit based on negligence or fault, recovery under a workers’ compensation stat- ute is limited to the specific amount designated in the statute for the employee’s injury.

CHAPTER 21

1. Is this sexual harassment? Why or why not? Yes. One type of sexual harassment occurs when a request for sexual favors is a condition of employment, and the person making the request is a supervisor or acts with the authority of the employer. A tan- gible employment action, such as continued employment, may also lead to the employer’s liability for the supervisor’s conduct. That the injured employee is a male and the supervisor a female, instead of the other way around, would not affect the outcome. Same-gender harassment is also actionable.

2. Could Koko succeed in a suit against Lively for discrimina- tion? Explain. Yes, if she can show that Lively failed to hire her solely because of her disability. The other elements for a discrimi- nation suit based on a disability are that the plaintiff (1) has a disability and (2) is otherwise qualified for the job. Both of these elements appear to be satisfied in this problem.

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CHAPTER 22

1. What must Gara do under the Immigration Act to hire for-What must Gara do under the Immigration Act to hire for-What must Gara do under the Immigration Act to hire for eign employees for Skytech? To hire a foreign individual to work in the U.S., an employer must submit a petition to U.S. Citizen- ship and Immigration Services, which determines whether the job candidate meets the legal standards. Each visa is for a specific job. In this situation, because Gara is looking for persons with specialized skills, he needs to show the individual qualifies for an H-1B visa. To qualify, the person must have highly specialized knowledge and a bachelor’s degree or higher. Because only sixty- five thousand H-1B visas are set aside each year for immigrants, Gara must be prepared and file the application within the first few weeks of the year.

2. Are these conditions legal? Why or why not? No. A closed shop (a company that requires union membership as a condi- tion of employment) is illegal. A union shop (a company that does not require union membership as a condition of employ- ment but requires workers to join the union after a certain time on the job) is illegal in a state with a right-to-work law, which makes it illegal to require union membership for continued employment.

CHAPTER 23

1. What safeguards promote the ALJ’s fairness? Under the Administrative Procedure Act (APA), the administrative law judge (ALJ) must be separate from the agency’s investigative and prosecutorial staff. Ex parte communications between the ALJ and a party to a proceeding are prohibited. Under the APA, an ALJ is exempt from agency discipline except on a showing of good cause.

2. Does the firm have any opportunity to express its opinion about the pending rule? Explain. Yes. Administrative rulemak- ing starts with the publication of a notice of the rulemaking in the Federal Register. A public hearing is held at which proponents and opponents can offer evidence and question witnesses. After the hearing, the agency considers what was presented at the hear- ing and drafts the final rule.

CHAPTER 24

1. To market the drug, what must United prove to the U.S. Food and Drug Administration? Under an extensive set of pro- cedures established by the U.S. Food and Drug Administration, which administers the federal Food, Drug, and Cosmetic Act, drugs must be shown to be effective as well as safe before they may be marketed to the public. In general, manufacturers are responsible for ensuring that the drugs they offer for sale are free of any substances that could injure consumers.

2. What can Gert do? Under the Truth-in-Lending Act, a buyer who wishes to withhold payment for a faulty product purchased with a credit card must follow specific procedures to settle the dispute. The credit card issuer then must intervene and attempt to settle the dispute.

CHAPTER 25

1. Are there any reasons that the court might refuse to issue an injunction against Resource’s operation? Explain. Yes. On the ground that the hardships that would be imposed on the polluter and on the community are greater than the hardships suffered by the residents, the court might deny an injunction. If the plant is the core of the local economy, for instance, the residents may be awarded only damages.

2. If the Environmental Protection Agency cleans up the site, from whom can it recover the cost? The Comprehensive Envi- ronmental Response, Compensation, and Liability Act of 1980 regulates the clean-up of hazardous waste disposal sites. Any potentially responsible party can be charged with the entire cost of cleaning up a site. Potentially responsible parties include the per- son that generated the waste (ChemCorp) the person that trans- ported the waste to the site (Disposal), the person that owned or operated the site at the time of the disposal (Eliminators), and the current owner or operator of the site (Fluid). A party held responsible for the entire cost may be able to recoup some of it in a lawsuit against other potentially responsible parties.

CHAPTER 26

1. Delmira wants to have Consuela evicted from the property. What can Consuela do? This is a breach of the warranty deed’s covenant of quiet enjoyment. The buyer can sue the seller and recover the purchase price of the house, plus any damages.

2. Can Haven transfer possession for even less time to Idyll Company? Explain. Yes. An owner of a fee simple has the most rights possible—he or she can give the property away, sell it, transfer it by will, use it for almost any purpose, possess it to the exclusion of all the world, or as in this case, transfer possession for any period of time. The party to whom possession is trans- ferred can also transfer his or her interest (usually only with the owner’s permission) for any lesser period of time.

CHAPTER 27

1. Under what circumstances would Pop’s Market, a small store in a small, isolated town, be considered a monopolist? If Pop’s is a monopolist, is it in violation of Section 2 of the Sherman Act? Why or why not? Size alone does not determine whether a firm is a monopoly—size in relation to the market is what matters. A small store in a small, isolated town is a monop- olist if it is the only store serving that market. Monopoly involves the power to affect prices and output. If a firm has sufficient market power to control prices and exclude competition, that firm has monopoly power. Monopoly power in itself is not a vio- lation of Section 2 of the Sherman Act. The offense also requires that the defendant intended to acquire or maintain that power through anticompetitive means.

2. What factors would a court consider to decide whether this arrangement violates the Clayton Act? This agreement is a tying arrangement. The legality of a tying arrangement depends

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on the purpose of the agreement, the agreement’s likely effect on competition in the relevant markets (the market for the tying product and the market for the tied product), and other fac- tors. Tying arrangements for commodities are subject to Section 3 of the Clayton Act. Tying arrangements for services can be agreements in restraint of trade in violation of Section 1 of the Sherman Act.

CHAPTER 28

1. What sort of information would an investor consider material? The average investor is not concerned with minor

inaccuracies but with facts that if disclosed would tend to deter him or her from buying the securities. This would include facts that have an important bearing on the condition of the issuer and its business—liabilities, loans to officers and directors, cus- tomer delinquencies, and pending lawsuits.

2. Can Lee take advantage of this information to buy and sell Magma stock? Why or why not? No. The Securities Exchange Act of 1934 extends liability to officers and directors in their personal transactions for taking advantage of inside information when they know it is unavailable to the persons with whom they are dealing.

Problem 1–5. Reading Citations. The court’s opinion in this case—Equal Employment Opportunity Commission v. Autozone, Inc., 809 F.3d 916 (7th Cir. 2016)—can be found in Volume 809 of Federal Reporter, Third Series on page 916. The U.S. Court of Appeals for the Seventh Circuit issued this opinion in 2016.

Problem 2–7. Corporate Contacts. No, the defendants’ motion to dismiss the suit for lack of personal jurisdiction should not be granted. A corporation normally is subject to jurisdiction in a state in which it is doing business. A court applies the minimum- contacts test to determine whether it can exercise jurisdiction over an out-of-state corporation. This requirement is met if the corporation sells its products within the state or places its goods in the “stream of commerce” with the intent that the goods be sold in the state.

In this problem, the state of Washington filed a suit in a Washington state court against LG Electronics, Inc., and nine- teen other foreign companies that participated in the global mar- ket for cathode ray tube (CRT) products. The state alleged a conspiracy to raise prices and set production levels in the market for CRTs in violation of a state consumer protection statute. The defendants filed a motion to dismiss the suit for lack of personal jurisdiction. These goods were sold for many years in high vol- ume in the United States, including the state of Washington. In other words, the corporations purposefully established mini- mum contacts in the state of Washington. This is a sufficient basis for a Washington state court to assert personal jurisdiction over the defendants.

In the actual case on which this problem is based, the court dismissed the suit for lack of personal jurisdiction. On appeal, a state intermediate appellate court reversed on the reasoning stated above.

Problem 3–7. Discovery. Yes. The items that were deleted from a Facebook page can be recovered. Normally, a party must hire an expert to recover material in an electronic format, and this can be time consuming and expensive.

Electronic evidence, or e-evidence, consists of all computer- generated or electronically recorded information, such as posts on Facebook and other social media sites. The effect that e-evi- dence can have in a case depends on its relevance and what it reveals. In the facts presented in this problem, Isaiah should be sanctioned—he should be required to cover Allied’s cost to hire the recovery expert and attorney’s fees to confront the mis- conduct. In a jury trial, the court might also instruct the jury to presume that any missing items are harmful to Isaiah’s case. If all of the material is retrieved and presented at the trial, any

prejudice to Allied’s case might thereby be mitigated. If not, the court might go so far as to order a new trial.

In the actual case on which this problem is based, Allied hired an expert, who determined that Isaiah had in fact removed some photos and other items from his Facebook page. After the expert testified about the missing material, Isaiah provided Allied with all of it, including the photos that he had deleted. Allied sought a retrial, but the court instead reduced the amount of Isaiah’s damages by the amount that it cost Allied to address his “misconduct.”

Problem 4–4. The Dormant Commerce Clause. The court ruled that, like a state, Puerto Rico generally may not enact poli- cies that discriminate against out-of-state commerce. The law requiring companies that sell cement in Puerto Rico to place certain labels on their products is clearly an attempt to regulate the cement market. The law imposed labeling regulations that affect transactions between the citizens of Puerto Rico and pri- vate companies. State laws that on their face discriminate against foreign commerce are almost always invalid, and this Puerto Rican law is such a law. The discriminatory labeling requirement placed sellers of cement manufactured outside Puerto Rico at a competitive disadvantage. This law therefore contravenes the dormant commerce clause.

Problem 5–3. Online Privacy. Facebook created a program that makes decisions for users. Using duty-based ethics, many believe that privacy is an extremely important right that should be fiercely protected. Accordingly, any program that has a default of giving out information is unethical. Facebook should create the program as an opt-in program. In addition, under the Kan- tian categorical imperative, if every company created opt-out programs that disclosed potentially personal information, the concept of privacy may be reduced to a theoretical concept only. One could argue that this reduction or elimination of privacy would not make the world a better place. From a utilitarian or outcome-based approach, the benefits of an opt-out program might be in ease of creation and start up, as well as ease of recruiting partner programs. The detriment is the elimination of choice on the part of users to disclose information about them- selves. An opt-in program maintains that user control but may be harder to start, as it requires more marketing up front in order to convince users to opt in.

Problem 6–5. Negligence. Negligence requires proof that (1) the defendant owed a duty of care to the plaintiff, (2) the defendant breached that duty, (3) the defendant’s breach caused

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the plaintiff ’s injury, and (4) the plaintiff suffered a legally rec- ognizable injury. With respect to the duty of care, a business owner has a duty to use reasonable care to protect business invi- tees. This duty includes an obligation to discover and correct or warn of unreasonably dangerous conditions that the owner of the premises should reasonably foresee might endanger an invi- tee. Some risks are so obvious that an owner need not warn of them. But even if a risk is obvious, a business owner may not be excused from the duty to protect its customers from foreseeable harm.

Because Lucario was the Weatherford’s business invitee, the hotel owed her a duty of reasonable care to make its premises safe for her use. The balcony ran nearly the entire width of the window in Lucario’s room. She could have reasonably believed that the window was a means of access to the balcony. The win- dow/balcony configuration was dangerous, however, because the window opened wide enough for an adult to climb out, but the twelve-inch gap between one side of the window and the balcony was unprotected. This unprotected gap opened to a drop of more than three stories to a concrete surface below.

Should the hotel have anticipated the potential harm to a guest who opened the window in Room 59 and attempted to access the balcony? The hotel encouraged guests to “step out onto the balcony” to smoke. The dangerous condition of the window/balcony configuration could have been remedied at a minimal cost. These circumstances could be perceived as creat- ing an “unreasonably dangerous” condition. And it could be con- cluded that the hotel created or knew of the condition and failed to take reasonable steps to warn of it or correct it. Of course, the Weatherford might argue that the window/ balcony configura- tion was so obvious that the hotel was not liable for Lucario’s fall.

In the actual case on which this problem is based, the court concluded that the Weatherford did not breach its duty of care to Lucario. On McMurtry’s appeal, a state intermediate appel- late court held that this conclusion was in error, vacated the lower court’s judgment in favor of the hotel on this issue, and remanded the case.

Problem 7–6. Product Liability. Here, the accident was caused by Jett’s inattention, not by the texting device in the cab of his truck. In a product liability case based on a design defect, the plaintiff has to prove that the product was defective at the time it left the hands of the seller or lessor. The plaintiff must also show that this defective condition made it “unreasonably dangerous” to the user or consumer. If the product was delivered in a safe condi- tion and subsequent mishandling made it harmful to the user, the seller or lessor normally is not liable. To successfully assert a design defect, a plaintiff has to show that a reasonable alternative design was available and that the defendant failed to use it.

The plaintiffs could contend that the defendant manufac- turer of the texting device owed them a duty of care because injuries to vehicle drivers and passengers, and others on the roads, were reasonably foreseeable due to the product’s design, which (1) required the driver to divert his eyes from the road to view an incoming text from the dispatcher, and (2) permitted the receipt of texts while the vehicle was moving. But manufacturers

are not required to design a product incapable of distracting a driver. The duty owed by a manufacturer to the user or consumer of a product does not require guarding against hazards that are commonly known or obvious or protecting against injuries that result from a user’s careless conduct. That is what happened here.

In the actual case on which this problem is based, the court reached the same conclusion, based on the reasoning stated above, and an intermediate appellate court affirmed the judgment.

Problem 8–6. Patents. One ground on which the denial of the patent application in this problem could be reversed on appeal is that the design of Raymond Gianelli’s “Rowing Machine” is not obvious in light of the design of the “Chest Press Apparatus for obvious in light of the design of the “Chest Press Apparatus for obvious Exercising Regions of the Upper Body.”

To obtain a patent, an applicant must demonstrate to the satisfaction of the U.S. Patent and Trademark Office (PTO) that the invention, discovery, process, or design is novel, useful, and not obvious in light of current technology. In this problem, the PTO denied Gianelli’s application for a patent for his “Rowing Machine”—an exercise machine on which a user pulls on hanpulls on hanpulls - dles to perform a rowing motion against a selected resistance to strengthen the back muscles. The PTO considered the device obvious in light of a patented “Chest Press Apparatus for Exercis- ing Regions of the Upper Body”—a chest press exercise machine on which a user pushes on handles to overcome a selected resispushes on handles to overcome a selected resispushes - tance. But it can be easily argued that it is not obvious to modify not obvious to modify not a machine with handles designed to be pushed into one with hanpushed into one with hanpushed - dles designed to be pulled. In fact, anyone who has used exercise pulled. In fact, anyone who has used exercise pulled machines knows that a way to cause injury is to use a machine in a manner not intended by the manufacturer.

In the actual case on which this problem is based, the U.S. Court of Appeals for the Federal Circuit reversed the PTO’s denial of Gianelli’s application for a patent, based on the reason- ing stated above.

Problem 9–3. Privacy. No, Rolfe did not have a privacy inter- est in the information obtained by the subpoenas issued to Mid- continent Communications. The right to privacy is guaranteed by at least one interpretation of the U.S. Constitution’s Bill of Rights and by some state constitutions. A person must have a reasonable expectation of privacy, though, to maintain a suit or to assert a successful defense for an invasion of privacy. People clearly have a reasonable expectation of privacy when they enter their personal banking or credit card information online. They also have a reasonable expectation that online companies will follow their own privacy policies. But people do not have a rea- sonable expectation of privacy in statements made on Twitter and other data that they publicly disseminate. In other words, there is no violation of a subscriber’s right to privacy when a third-party Internet provider receives a subpoena and discloses the subscriber’s information.

Here, Rolfe supplied his e-mail address and other personal information, including his Internet protocol address, to Mid- continent. In other words, Rolfe publicly disseminated this information. Law enforcement officers obtained this informa- tion from Midcontinent through the subpoenas issued by the

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South Dakota state court. Rolfe provided his information to Midcontinent—he had no legitimate expectation of privacy in that information.

In the actual case on which this problem is based, Rolfe was charged with, and convicted of, possessing, manufacturing, and distributing child pornography, as well as other crimes. As part of the proceedings, the court found that Rolfe had no expectation of privacy in the information that he made available to Midcon- tinent. On appeal, the South Dakota Supreme Court upheld the conviction.

Problem 10–4. Criminal Liability. Yes, Green exhibited the required mental state to establish criminal liability. A wrongful mental state (mens rea) is one of the elements typically required to establish criminal liability. The required mental state, or intent, is indicated in an applicable statute or law. For example, for mur- der, the required mental state is the intent to take another’s life. A court can also find that the required mental state is present when a defendant’s acts are reckless or criminally negligent. A defen- dant is criminally reckless if he or she consciously disregards a substantial and unjustifiable risk.

In this problem, Green was clearly aware of the danger to which he was exposing people on the street below. Although he did not indicate that he specifically intended to harm anyone, the risk of death created by his conduct was obvious. He must have known what was likely to happen if a bottle or plate thrown from the height of twenty-six stories hit a pedestrian or the wind- shield of an occupied motor vehicle on the street below. Despite his claim that he was intoxicated, he was sufficiently aware to stop throwing things from the balcony when he saw police in the area, and he later recalled what he had done and what had happened.

In the actual case on which this problem is based, after a jury trial, Green was convicted of reckless endangerment. On appeal, a state intermediate appellate court affirmed the convic- tion, based in part on the reasoning stated above.

Problem 11–6. Import Controls. Yes, an antidumping duty can be assessed retrospectively (retroactively). But it does not seem likely that such a duty should be assessed here.

In this problem, the Wind Tower Trade Coalition (an asso- ciation of domestic manufacturers of utility-scale wind towers) filed a suit in the U.S. Court of International Trade against the U.S. Department of Commerce, challenging its decision to impose only prospective antidumping duties on imports of prospective antidumping duties on imports of prospective utility-scale wind towers from China and Vietnam. The Com- merce Department had found that the domestic industry had not suffered any “material injury” or “threat of material injury,” and that it would be protected by a prospective assessment. Without a previously cognizable injury—and given the fact that any retrospective duties collected would not be payable to the members of the domestic industry in any event—it does not seem likely that retroactive duties should be imposed.

In the actual case on which this problem is based, the court denied the plaintiff ’s request for an injunction. On appeal, the U.S. Court of Appeals for the Federal Circuit affirmed the

denial, holding that the lower court acted within its discretion in determining that retrospective duties were not appropriate.

Problem 12–3. Online Acceptances. No. A shrink-wrap agree- ment is an agreement whose terms are expressed inside the box in which the goods are packaged. The party who opens the box may be informed that he or she agrees to the terms by keeping what- ever is in the box. In many cases, the courts have enforced the terms of shrink-wrap agreements just as they enforce the terms of other contracts. But not all of the terms presented in shrink-wrap agreements have been enforced by the courts. One important consideration is whether the buyer had adequate notice of the terms.

A click-on agreement is formed when a buyer, completing a transaction on a computer, is required to indicate his or her assent to be bound by the terms of an offer by clicking on a button that says, for example, “I agree.” In Reasonover’s situa- tion, no such agreement was formed with respect to Clearwire’s “Terms of Service” (TOS). The e-mail did not give adequate notice of the TOS. It did not contain a direct link to the terms— accessing them required clicks on further links through the firm’s homepage. The written, shrink-wrap materials accompanying the modem did not provide adequate notice of the TOS. There was only a reference to Clearwire’s Web site in small print at the bottom of one page. Similarly, Reasonover’s access to an “I accept terms” box did not establish notice of the terms. She did not click on the box but quit the page. Even if any of these references was sufficient notice, Reasonover kept the modem only because Clearwire told her that she could not return it.

In the actual case on which this problem is based, the court refused to compel arbitration on the basis of the clause in Clear- wire’s TOS.

Problem 13–4. Discharge by Operation of Law. Lambert’s best defense to Baptist’s allegation of breach of contract is the doctrine of impossibility. Under this doctrine, if, after a con- tract has been made, a supervening event makes performance impossible in an objective sense, the contract is discharged. The doctrine applies only when the parties could not have reasonably foreseen the event that renders the performance impossible. One of the situations in which this doctrine applies occurs when a party whose personal performance is essential to the completion of the contract becomes incapacitated prior to performance.

In the facts of this problem, Baptist hired Lambert to provide certain surgical services to Baptist Memorial Hospital–North Mississippi. When complaints about his behavior arose, a team of doctors and psychologists conducted an evaluation, diagnosed him as suffering from obsessive-compulsive personality disorder, and concluded that he was unfit to practice medicine. The hospi- tal suspended his staff privileges. Baptist terminated his employ- ment and filed a suit against him for breach. The doctrine of impossibility discharges Lambert from the performance of his contract—his performance was made impossible through no fault of his own.

In the actual case on which this problem is based, in Bap- tist’s suit against Lambert, the court issued a judgment in the

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defendant’s favor. A state intermediate appellate court applied the doctrine of impossibility to affirm this judgment.

Problem 14–5. Goods and Services Combined. A court applies common law principles to a dispute over contract that involves both goods and services when the court finds the services to be the dominant feature of the agreement. An appellate court, or any court, would rule that the UCC should be applied instead of the common law when the court finds the goods to be the dominant aspect of the deal. In either situation, the applicable law covers both the goods and services parts of the contract.

In this problem, because the court applied common law contract principles to rule in National’s favor on both parties’ claims, the court must have concluded that the services part of the contract was the dominant aspect. The court would likely have come to this conclusion because the contract predomi- nantly involved the installation of a series of shelving racks cus- tomized especially for National. In other words, the contract was more about the service of installing the shelf system rather than the sale of the shelves.

In the actual case on which this problem is based, a state intermediate appellate court affirmed the lower court’s ruling in National’s favor. The appellate court recognized that the contract was a hybrid involving goods ands services and reasoned that the lower court must have determined the services portion of the agreement to be the dominant factor. Because the parties did not provide a trial transcript or a copy of the contract, the appellate court could only affirm the lower court’s order.

Problem 15–6. Liens. Among the liens discussed in this chap- ter, a mechanic’s lien would likely be most effective to Jirak in its attempt to collect the unpaid cost of its work for the Balks. A creditor can place a mechanic’s lien on the real property of a debtor who has contracted for improvements to the property and has not paid the price. When a creditor obtains a mechanic’s lien, the debtor’s real estate becomes security for the debt. If the debtor does not pay, the creditor can foreclose on the property and sell it to collect the amount due.

In this problem, the Balks contracted with Jirak for the remodel of their farmhouse. Due to the Balks’ changes to the project during the course of the work, the costs exceeded the amount of Jirak’s original estimate. Although Jirak regularly advised the Balks about the increasing costs and provided an itemized breakdown at their request, they refused to pay the price. The use of a mechanic’s lien is likely the best way for Jirak to collect the unpaid amount.

In the actual case on which this problem is based, Jirak filed a suit in an Iowa state court against the Balks to foreclose on their property by way of a mechanic’s lien and collect the unpaid amount. The court entered a judgment in Jirak’s favor and enforced the lien. A state intermediate appellate court affirmed the judgment.

Problem 16–4. Partnerships. Yes, Sacco is entitled to 50 per- cent of the profits of Pierce Paxton Collections. The require- ments for establishing a partnership are (1) a sharing of profits

and losses, (2) a joint ownership of the business, and (3) an equal right to be involved in the management of the business.

The effort and time that Sacco expended in the business constituted a sharing of losses, and his proprietary interest in the assets of the partnership consisted of his share of the profits, which he had expressly left in the business to “grow the com- pany” and “build sweat equity” for the future. He was involved in every aspect of the business. Although he was not paid a salary, he was reimbursed for business expenses charged to his personal credit card, which Paxton also used. These facts arguably meet the requirements for establishing a partnership.

In the actual case on which this problem is based, Sacco filed a suit in a Louisiana state court against Paxton, and the court awarded Sacco 50 percent of the profits. A state intermediate appellate court affirmed, based generally on the reasoning stated above.

Problem 17–5. LLC Operation. Part of the attractiveness of an LLC as a form of business enterprise is its flexibility. The mem- bers can decide how to operate the business through an operating agreement. For example, the agreement can set forth procedures for choosing or removing members or managers.

Here, the Bluewater operating agreement provided for a “super majority” vote to remove a member under circumstances that would jeopardize the firm’s contractor status. Thus, one Bluewater member could not unilaterally “fire” another member without providing a reason. In fact, a majority of the members could not terminate the other’s interest in the firm without pro- viding a reason. Moreover, the only acceptable reason would be a circumstance that undercut the firm’s status as a contractor.

The flexibility of the LLC business form relates to its frame- work, not to its members’ capacity to violate its operating agree- ment. In the actual case on which this problem is based, Smith attempted to “fire” Williford without providing a reason. In Wil- liford’s suit, the court issued a judgment in his favor.

Problem 18–5. Piercing the Corporate Veil. Yes, there are suf-Yes, there are suf-Yes, there are suf ficient grounds in the facts of this problem to support pierc- ing the corporate veil and holding Kappeler personally liable to Snapp. First, in a case in which a plaintiff seeks to pierce a corpo- rate veil, there must be a fraud or other injustice to be remedied. In that situation, the factors that a court will consider in deter- mining whether to pierce the corporate veil include (1) a party is tricked or misled into dealing with the corporation rather than the individual, (2) the corporation has insufficient capital to meet its prospective debts or other potential liabilities, (3) cor- porate formalities, such as holding required corporate meetings, are not followed, and (4) personal and corporate interests are commingled.

In this problem, the amount that Snapp ultimately paid the builder exceeded the original estimate by nearly $1 million—and the project was still unfinished. Kappeler could not provide an accounting for the Snapp project—he could not explain double and triple charges nor whether the amount that Snapp paid had actually been spent on the project. These facts support a

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conclusion of fraud. And they also indicate that Kappeler may have tricked or misled Snapp into dealing with the corporation rather than with Kappeler as an individual. Castlebrook had issued no shares of stock, which indicates insufficient capitaliza- tion. The minutes of the corporate meetings “all looked exactly the same,” indicating that in fact the required corporate meetings had not been held. And Kappeler had commingled personal and corporate funds.

In the actual case on which this problem is based, in Snapp’s suit against the builder, the court pierced the corporate veil and held Kappeler personally liable. A state intermediate appellate court affirmed.

Problem 19–5. Determining Employee Status. No, Cox is not liable to Cayer for any injuries or damage that she sustained in the accident with Ovalles. Generally, an employer is not liable for physical harm caused to a third person by the negligent act of an independent contractor in the performance of a contract. This is be cause the employer does not have the right to control the details of the performance. In determining whether a worker has the sta- tus of an independent contractor, how much control the employer can exercise over the details of the work is the most important factor weighed by the courts.

In this problem, Ovalles worked as a cable installer for Cox under an agreement with M&M. The agreement disavowed any employer-employee relationship between Cox and M&M’s installers. Ovalles was required to designate his affiliation with Cox on his van, clothing, and an ID badge. But Cox had minimal contact with Ovalles and limited power to control the manner in which he performed his work. Cox supplied cable wire and other equipment, but these items were delivered to M&M, not Ovalles. These facts indicate that Ovalles was an independent contractor, not an employee. Thus, Cox was not liable to Cayer for the harm caused to her by Ovalles when his van rear-ended Cayer’s car.

In the actual case on which this problem is based, the court issued a judgment in Cox’s favor. The Rhode Island Supreme Court affirmed, applying the principles stated above to arrive at the same conclusion.

Problem 20–6. Unemployment Compensation. Yes, Ramirez qualifies for unemployment compensation. Generally, to be eli- gible for unemployment compensation, a worker must be willing and able to work. Workers who have been fired for misconduct or who have voluntarily left their jobs are not eligible for ben- efits. In the facts of this problem, the applicable state statute disqualifies an employee from receiving benefits if he or she vol- untarily leaves work without “good cause.”

The issue is whether Ramirez left her job for “good cause.” When her father in the Dominican Republic had a stroke, she asked her employer for time off to be with him. Her employer refused the request. But Ramirez left to be with her father and called to inform her employer. It seems likely that this family emergency would constitute “good cause,” and Ramirez’s call and return to work after her father’s death indicated that she did not disregard her employer’s interests.

In the actual case on which this problem is based, the state of Florida denied Ramirez unemployment compensation. On Ramirez’s appeal, a state intermediate appellate court reversed, on the reasoning stated above.

Problem 21–5. Age Discrimination. No, sanofi-aventis U.S. LLC (S-A) does not appear to have engaged in age discrimi- nation. The Age Discrimination in Employment Act (ADEA) prohibits employment discrimination on the basis of age against individuals forty years of age or older. For the act to apply, an employer must have twenty or more employees, and the employ- er’s business activities must affect interstate commerce. To estab- lish a prima facie case, a plaintiff must show that he or she was prima facie case, a plaintiff must show that he or she was prima facie (1) a member of the protected age group, (2) qualified for the position from which he or she was discharged, and (3) discharged because of age discrimination. If the employer offers a legitimate reason for its action, the plaintiff must show that the stated rea- son is only a pretext.

In this problem, Rangel was over forty years old. But he also had negative sales performance reviews for more than two years before he was terminated as part of S-A’s nationwide reduction in force of all sales professionals who had not met the “Expecta- tions” guidelines, including younger workers. The facts do not indicate that a person younger than Rangel replaced him or that S-A intended to discriminate against him on the basis of age. Based on these facts, Rangel could not establish a prima facie case of age prima facie case of age prima facie discrimination on the part of S-A.

In the actual case on which this problem is based, in Ran- gel’s suit against S-A alleging age discrimination, a federal district court issued a judgment in S-A’s favor. On Rangel’s appeal, the U.S. Court of Appeals for the Tenth Circuit affirmed, according to the reasoning stated above.

Problem 22-4. Unfair Labor Practices. Before invoking a union-security clause against an employee, the union’s obliga- tion, under the NLRA, is to deal fairly with employees. The union has a fiduciary duty to (1) provide the employee with actual notice of the precise amount due, including the months for which dues are owed; (2) explain how it computed the amount due; (3) give the employee a reasonable deadline for payment; and, (4) explain to the employee that failure to pay will result in discharge.

In this case, the union arranged to have Lopez fired because of outstanding union dues under a union-security agreement without first having discharged its fiduciary duties. Thus, the union violated the NLRA’s prohibition against coercing employ- ees, which constitutes an unfair labor practice.

The union’s conduct also violated the prohibition against causing an employer to fire an employee. The record indicated that union had not explained to Lopez how it calculated his dues, or provided him a reasonable time period in which to make pay- ment. In fact, there was evidence suggesting that union did just the opposite. It first agreed to a payment schedule with Lopez and then had him fired the next day, before he could complete the schedule and while he was on track to do so.

A-62 A P P E N D I X E Sample Answers for Business Case Problems with Sample Answer

In the actual case on which this problem is based, a fed- eral appellate court found that substantial evidence supported the NLRB’s decision that the union had engaged in unfair labor practices.

Problem 23–4. Agency Powers. The United States Supreme Court held that greenhouse gases fit within the Clean Air Act’s (CAA’s) definition of “air pollutant.” Thus, the Environmental Protection Agency (EPA) has the authority under that statute to regulate the emission of such gases from new motor vehicles. According to the Court, the definition, which includes “any” air pollutant, embraces all airborne compounds “of whatever stripe.” The EPA’s focus on Congress’s 1990 amendments (or their lack) indicates nothing about the original intent behind the statute (and its amendments before 1990). Nothing in the statute suggests that Congress meant to curtail the agency’s power to treat greenhouse gases as air pol- lutants. In other words, the agency has a preexisting mandate to regulate “any air pollutant” that may endanger the public welfare.

The EPA also argued that, even if it had the authority to regulate greenhouse gases, the agency would not exercise that authority because any regulation would conflict with other administration priorities. The Court acknowledged that the CAA conditions EPA action on the agency’s formation of a “judgment,” but explained that judgment must relate to whether a pollutant “cause[s], or contribute[s] to, air pollution which may reasonably be anticipated to endanger public health or wel- fare.” Thus, the EPA can avoid issuing regulations only if the agency determines that greenhouse gases do not contribute to climate change (or if the agency reasonably explains why it can- not or will not determine whether they do). The EPA’s refusal to regulate was thus “arbitrary, capricious, or otherwise not in accordance with law,” The Court remanded the case for the EPA to “ground its reasons for action or inaction in the statute.”

Problem 24–5. Fair Debt-Collection Practices. Engler may recover under the Fair Debt Collection Practices Act (FDCPA). Atlantic is subject to the FDCPA because it is a debt-collection agency and was attempting to collect a debt on behalf of Bank of America. Atlantic used offensive tactics to collect from Engler. After all, Atlantic gave Engler’s employer the false impression that Engler was a criminal, had a pending case, and was about to be arrested. Finally, Engler suffered harm because he experienced discomfort, embarrassment, and distress as a result of Atlantic’s abusive conduct. Engler may recover actual damages, statutory damages, and attorneys’ fees from Atlantic.

Problem 25–5. Environmental Impact Statements. Yes, an environmental impact statement (EIS) is required before the U.S. Forest Service (USFS) implements its proposed travel man- agement plan (TMP). An EIS must be prepared for every major federal action that significantly affects the quality of the environ- ment. An action is “major” if it involves a substantial commit- ment of resources. An action is “federal” if a federal agency has the power to control it. An EIS must analyze (1) the impact on the environment that the action will have, (2) any adverse effects on

the environment and alternative actions that might be taken, and (3) irreversible effects that the action might generate.

Here, the resources committed to the implementation of the USFS’s TMP could include the resources within the wilderness and the time and effort dedicated by the agency. The wilder- ness resources would include the soil, the vegetation, the wildlife, the wildlife habitat, any threatened or endangered species, and other natural assets impacted by the TMP. The agency’s resources would include its funds and its staff—to design, map, maintain, and enforce the TMP. These resources seem substantial. Of course, the implementation of the TMP is federal because the USFS has the power to control it.

As for the aspects of the environment that the agency might consider in preparing the EIS, some of the important factors are listed above—the soil, vegetation, wildlife, wildlife habitat, and threatened or endangered species. Other aspects of the environ- ment impacted by the TMP might include cultural resources, historical resources, wilderness suitability, and other authorized uses of the wilderness. There is a potential for impact by every route that is designed to be part of the system, as well as the “dis- persed vehicle camping” to be permitted on the terrain.

In the actual case on which this problem is based, the USFS considered all of the factors listed above. The agency then issued an EIS and a decision implementing the TMP. On a challenge to the EIS, a federal district court issued a judgment in the USFS’s favor. The U.S. Court of Appeals for the Ninth Circuit affirmed. “The Forest Service took the requisite hard look at the environ- mental impacts.”

Problem 26–5. Adverse Possession. The McKeags satisfied the first three requirements for adverse possession:

1. Their possession was actual and exclusive because they used the beach and prevented others from doing so, including the Finleys.

2. Their possession was open, visible, and notorious because they made improvements to the beach and regularly kept their belongings there.

3. Their possession was continuous and peaceable for the required ten years. They possessed the property for more than four decades, and they even kept a large float there during the winter months.

Nevertheless, the McKeags’ possession was not hostile and not hostile and not adverse, which is the fourth requirement. The Finleys had sub- stantial evidence that they gave the McKeags permission to use the beach. Rather than reject the Finleys’ permission as unneces- sary, the McKeags sometimes said nothing and other times seem- ingly affirmed that the property belonged to the Finleys. Thus, because the McKeags did not satisfy all four requirements, they cannot establish adverse possession.

Problem 27–5. Price Discrimination. Spa Steel satisfies most of the requirements for a price discrimination claim under Sec- tion 2 of the Clayton Act. Dayton Superior is engaged in inter- state commerce, and it sells goods of like grade and quality to

A P P E N D I X E Sample Answers for Business Case Problems with Sample AnswerSample Answers for Business Case Problems with Sample AnswerSample Answers for A-63

at least three purchasers. Moreover, Spa Steel can show that, because it sells Dayton Superior’s products at a higher price, it lost business and thus suffered an injury. To recover, however, Spa Steel will also need to prove that Dayton Superior charged Spa Steel’s competitors a lower price for the same product. Spa Steel cannot recover if its prices were higher for reasons related to its own business, such as having higher overhead expenses or seeking a larger profit.

Problem 28–4. Violations of the 1934 Act. An omission or misrepresentation of a material fact in connection with the purchase or sale of a security may violate Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The key question is whether the omitted or misrepresented information is material. A fact, by itself, is not automatically material. A fact will be regarded as material only if it is significant enough that it would likely affect an investor’s decision as to whether to buy or sell the company’s securities. For example, a company’s potential liability in a product liability suit and the financial consequences to the firm are material facts that must be disclosed because they are significant enough to affect an investor’s decision as to whether to buy stock in the company.

In this case, the plaintiffs’ claim should not be dismissed. To prevail on their claim that the defendants made material omissions in violation of Section 10(b) and SEC Rule 10b-5, the plaintiffs must prove that the omission was material. Their complaint alleged the omission of information linking Zicam and anosmia (a loss of the sense of smell) and plausibly suggested that reasonable investors would have viewed this information as material. Zicam products account for 70 percent of Matrixx’s sales. Matrixx received reports of consumers who suffered anos- mia after using Zicam Cold Remedy.

In public statements discussing revenues and product safety, Matrixx did not disclose this information. But the information was significant enough to likely affect a consumer’s decision to use the product, and this would affect revenue and ultimately the commercial viability of the product. The information was therefore significant enough to likely affect an investor’s deci- sion whether to buy or sell Matrixx’s stock, and this would affect the stock price. Thus, the plaintiffs’ allegations were sufficient. Contrary to the defendants’ assertion, statistical sampling is not required to show materiality—reasonable investors could view reports of adverse events as material even if the reports did not provide statistically significant evidence.

G L O S S A R Y G-1

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A acceptance (1) In contract law, the offeree’s notification to the offeror that the offeree agrees to be bound by the terms of the offeror’s proposal. (2) In negotiable instruments law, the drawee’s signed agreement to pay a draft when presented.

acceptor The person (the drawee) who accepts a draft and who agrees to be primarily responsible for its payment.

accord and satisfaction An agreement for payment (or other performance) between two parties, one of whom has a right of action against the other. After the payment has been accepted or other performance has been made, the “accord and satisfac- tion” is complete, and the obligation is discharged.

accredited investor In the context of securities offerings, sophis- ticated investors, such as banks, insurance companies, investment companies, the issuer’s executive officers and directors, and persons whose income or net worth exceeds certain limits.

actionable Capable of serving as the basis of a lawsuit.

act of state doctrine A doctrine that provides that the judi- cial branch of one country will not examine the validity of public acts committed by a recognized foreign government within its own territory.

actual malice A condition that exists when a person makes a statement with either knowledge of its falsity or reckless disregard for the truth. In a defamation suit, a statement made about a public figure normally must be made with actual malice for liability to be incurred.

actus reus (pronounced ak-tus ray-uhs) A guilty (prohibited) act. The commission of a prohibited act and the intent to commit a crime are the two essential elements required for criminal liability.

adequate protection doctrine In bankruptcy law, a doc- trine that protects secured creditors from losing their security as a result of an automatic stay. In certain circumstances, the bankruptcy court may provide adequate protection by requiring the debtor or trustee to pay the creditor or provide additional guaranties to protect the creditor against the losses suffered by the creditor as a result of the stay.

adhesion contract A “standard-form” contract, such as that between a large retailer and a consumer, in which the stronger party dictates the terms.

adjudication The process of resolving a dispute by presenting evidence and arguments before a neutral third party decision maker in a court or an administrative law proceeding.

administrative agency A federal or state government agency created by the legislature to perform a specific function, such as to make and enforce rules pertaining to the environment.

administrative law The body of law created by admin- istrative agencies in order to carry out their duties and responsibilities.

administrative law judge (ALJ) One who presides over an administrative agency hearing and has the power to adminis- ter oaths, take testimony, rule on questions of evidence, and make determinations of fact.

administrative process The procedure used by administra- tive agencies in fulfilling their three basic functions: rulemak-tive agencies in fulfilling their three basic functions: rulemak-tive agencies in fulfilling their three basic functions: rulemak ing, enforcement, and adjudication.

adverse possession The acquisition of title to real property through open occupation, without the consent of the owner, for a period of time specified by a state statute. The occupa- tion must be actual, exclusive, open, continuous, and in opposition to all others, including the owner.

affidavit A written voluntary statement of facts, confirmed by the oath or affirmation of the party making it and made before a person having the authority to administer the oath or affirmation.

affirmative action Job-hiring policies that give special consideration to members of protected classes in an effort to overcome present effects of past discrimination.

affirmative defense A response to a plaintiff ’s claim that does not deny the plaintiff ’s facts but attacks the plaintiff ’s legal right to bring an action. An example is the running of the statute of limitations.

agency A relationship between two parties in which one party (the agent) agrees to represent or act for the other (the principal).

agreement A meeting of two or more minds in regard to the terms of a contract; usually broken down into two events—an offer by one party to form a contract, and an acceptance of the offer by the person to whom the offer is made.

alien corporation A corporation formed in another country but doing business in the United States.

Glossary

G-2 G L O S S A R Y

allege To state, recite, assert, or charge.

alternative dispute resolution (ADR) The resolution of disputes in ways other than those involved in the traditional judicial process. Negotiation, mediation, and arbitration are forms of ADR.

answer Procedurally, a defendant’s response to the plaintiff ’s complaint.

anticipatory repudiation An assertion or action by a party indicating that he or she will not perform an obligation that he or she is contractually obligated to perform at a future time.

antitrust law Laws protecting commerce from unlawful restraints and anticompetitive practices.

apparent authority Authority that is only apparent, not real. An agent’s apparent authority arises when the principal causes a third party to believe that the agent has authority, even though she or he does not.

appellant The party who takes an appeal from one court to another.

appellee The party against whom an appeal is taken—that is, the party who opposes setting aside or reversing the judgment.

arbitration clause A clause in a contract that provides that, in the event of a dispute, the parties will submit the dispute to arbitration rather than litigate the dispute in court.

arbitration The settling of a dispute by submitting it to a disinterested third party (other than a court), who renders a decision. The decision may or may not be legally binding.

arson The malicious burning of another’s dwelling. Some statutes have expanded arson to include any real property, regardless of ownership, and the destruction of property by other means—for example, by explosion.

articles of incorporation The document that is filed with the appropriate state official, usually the secretary of state, when a business is incorporated and that contains basic infor- mation about the corporation.

articles of partnership A written agreement that sets forth each partner’s rights and obligations with respect to the partnership.

artisan’s lien A possessory lien given to a person who has made improvements and added value to another person’s per- sonal property as security for payment for services performed.

assault Any word or action intended to make another person fearful of immediate physical harm; a reasonably believable threat.

assignment The act of transferring to another all or part of one’s rights arising under a contract.

assumption of risk A defense against negligence that can be used when the plaintiff was aware of a danger and voluntarily assumed the risk of injury from that danger.

attachment In the context of judicial liens, a court-ordered seizure and taking into custody of property prior to the secur- ing of a judgment for a past-due debt.

attempted monopolization An action by a firm that involves anticompetitive conduct, the intent to gain monopoly power, and a “dangerous probability” of success in achieving monop- oly power.

authorization card A card signed by an employee that gives a union permission to act on his or her behalf in negotiations with management.

automatic stay In bankruptcy proceedings, the suspension of almost all litigation and other action by creditors against the debtor or the debtor’s property. The stay is effective the moment the debtor files a petition in bankruptcy.

award In the context of litigation, the amount of money awarded to a plaintiff in a civil lawsuit as damages. In the context of arbitration, the arbitrator’s decision.

B bailment A situation in which the personal property of one person (a bailor) is entrusted to another (a bailee), who is obli- gated to return the bailed property to the bailor or dispose of it as directed.

bait-and-switch advertising Advertising a product at an attractive price and then telling the consumer that the adver- tised product is not available or is of poor quality and encour- aging her or him to purchase a more expensive item.

bankruptcy court A federal court of limited jurisdiction that handles only bankruptcy proceedings.

bankruptcy trustee A person appointed by the court to man- age the debtor’s funds in a bankruptcy proceeding.

battery The unprivileged, intentional touching of another.

benefit corporation A type of for-profit corporation, avail- able by statute in a number of states, that seeks to have a mate- rial positive impact on society and the environment.

G L O S S A R Y G-3

beyond a reasonable doubt The standard used to determine the guilt or innocence of a person criminally charged. To be guilty of a crime, one must be proved guilty “beyond and to the exclusion of every reasonable doubt.” A reasonable doubt is one that would cause a prudent person to hesitate before act- ing in matters important to him or her.

bilateral contract A type of contract that arises when a promise is given in exchange for a promise.

bilateral mistake A mistake that occurs when both parties to a contract are mistaken about the same material fact.

Bill of Rights The first ten amendments to the U.S. Constitution.

binding authority Any source of law that a court must fol- low when deciding a case.

blue sky laws State laws that regulate the offer and sale of securities.

bona fide occupational qualification (BFOQ ) An identifi- able characteristic reasonably necessary to the normal opera- tion of a particular business. Such characteristics can include gender, national origin, and religion, but not race.

bond A security that evidences a corporate (or government) debt.

botnet Short for robot network—a group of computers that run an application controlled and manipulated only by the software source. Usually, the term is reserved for computers that have been infected by malicious robot software.

breach of contract The failure, without legal excuse, of a promisor to perform the obligations of a contract.

breach To violate a law, by an act or an omission, or to break a legal obligation that one owes to another person or to society.

brief A formal legal document submitted by the attorney for the appellant—or the appellee (in answer to the appellant’s brief )—to an appellate court when a case is appealed. The appellant’s brief outlines the facts and issues of the case, the judge’s rulings or jury’s findings that should be reversed or modified, the applicable law, and the arguments on the client’s behalf.

browse-wrap terms Terms and conditions of use that are presented to an Internet user at the time a product, such as software, is downloaded but that need not be agreed to before the product is installed or used.

bureaucracy A large organization that is structured hierar- chically to carry out specific functions.

burglary The unlawful entry into a building with the intent to commit a felony. Some state statutes have expanded bur- glary to include the intent to commit any crime.

business ethics Ethics in a business context; a consensus of what constitutes right or wrong behavior in the world of busi- ness and the application of moral principles to situations that arise in a business setting.

business invitees Those people, such as customers or clients, who are invited onto business premises by the owner of those premises for business purposes.

business judgment rule A rule under which courts will not hold corporate officers and directors liable for honest mistakes of judgment and bad business decisions that were made in good faith.

business necessity A defense to an allegation of employment discrimination in which the employer demonstrates that an employment practice that discriminates against members of a protected class is related to job performance.

buyout price The amount payable to a partner on his or her dissociation from a partnership, based on the amount distrib- utable to that partner if the firm were wound up on that date, and offset by any damages for wrongful dissociation.

buy-sell agreement In the context of partnerships, an express agreement made at the time of partnership formation for one or more of the partners to buy out the other or others should the situation warrant.

bylaws The internal rules of management adopted by a cor- poration at its first organizational meeting.

C case law The rules of law announced in court decisions. Case law interprets statutes, regulations, constitutional provisions, and other case law.

case on point A previous case involving factual circum- stances and issues that are similar to those in the case before the court.

categorical imperative A concept developed by the philoso- pher Immanuel Kant as an ethical guideline for behavior. In deciding whether an action is right or wrong, or desirable or undesirable, a person should evaluate the action in terms of what would happen if everybody else in the same situation, or category, acted the same way.

causation in fact An act or omission without (“but for”) which an event would not have occurred.

G-4 G L O S S A R Y

cease-and-desist order An administrative or judicial order prohibiting a person or business firm from conducting activi- ties that an agency or court has deemed illegal.

certification mark A mark used by one or more persons, other than the owner, to certify the region, materials, mode of manufacture, quality, or accuracy of the owner’s goods or services. Examples of certification marks include the “Good Housekeeping Seal of Approval” and “UL Tested.”

certificate of limited partnership The document that must be filed with a designated state official to form a limited partnership.

checks and balances The system by which each of the three branches of the national government (executive, legislative, and judicial) exercises checks on the powers of the other branches.

citation A reference to a publication in which a legal authority— such as a statute or a court decision—or other source can be found.

civil law The branch of law dealing with the definition and enforcement of all private or public rights, as opposed to criminal matters.

civil law system A system of law derived from that of the Roman Empire and based on a code rather than case law; the predominant system of law in the nations of continental Europe and the nations that were once their colonies. In the United States, Louisiana is the only state that has a civil law system.

click-on agreement An agreement that arises when a buyer, engaging in a transaction on a computer, indicates his or her assent to be bound by the terms of an offer by clicking on a button that says, for example, “I agree”; sometimes referred to as a click-on license or a click-wrap agreement.

close corporation A corporation whose shareholders are lim- ited to a small group of persons, often family members.

closed shop A firm that requires union membership on the part of its workers as a condition of employment.

closing The final step in the sale of real estate, in which own- ership is transferred to the buyer in exchange for payment of the purchase price.

closing argument An argument made at a trial after the plaintiff and defendant have rested their cases. Closing argu- ments are made prior to the jury charges.

cloud computing The delivery to users of on-demand ser- vices from third-party servers over a network.

collective bargaining The process by which labor and man- agement negotiate the terms and conditions of employment, including working hours and workplace conditions.

collective mark A mark used by members of a cooperative, association, or other organization to certify the region, materi- als, mode of manufacture, quality, or accuracy of the specific goods or services. Examples of collective marks include the labor union marks found on tags of certain products and the credits of movies, which indicate the various associations and organizations that participated in the making of the movies.

comity A deference by which one nation gives effect to the laws and judicial decrees of another nation.

commerce clause The provision in Article I, Section 8, of the U.S. Constitution that gives Congress the power to regulate interstate commerce.

commercial impracticability A doctrine under which a seller may be excused from performing a contract when (1) a contingency occurs, (2) the contingency’s occurrence makes performance impracticable, and (3) the nonoccurrence of the contingency was a basic assumption on which the contract was made.

commercial use Use of land for business activities only; sometimes called business use.

commingle To put funds or goods together into one mass so that they are mixed to such a degree that they no longer have separate identities.

common law The body of law developed from custom or judicial decisions in English and U.S. courts, not attributable to a legislature.

common stock A security that evidences ownership in a corporation. A share of common stock gives the owner a pro- portionate interest in the corporation with regard to control, earnings, and net assets. Common stock is lowest in priority with respect to payment of dividends and distribution of the corporation’s assets on dissolution.

community property A form of concurrent property owner- ship in which each spouse owns an undivided one-half interest in property acquired during the marriage.

comparative negligence A theory in tort law under which the liability for injuries resulting from negligent acts is shared by all parties who were negligent (including the injured party) on the basis of each person’s proportionate negligence.

compelling government interest A test of constitutionality that requires the government to have compelling reasons for passing any law that restricts fundamental rights, such as free speech, or distinguishes between people based on a suspect trait.

G L O S S A R Y G-5

compensatory damages A money award equivalent to the actual value of injuries or damages sustained by the aggrieved party.

complaint The pleading made by a plaintiff alleging wrong- doing on the part of the defendant; the document that, when filed with a court, initiates a lawsuit.

computer crime Any violation of criminal law that involves knowledge of computer technology for its perpetration, inves- tigation, or prosecution.

concentrated industry An industry in which a single firm or a small number of firms control a large percentage of market sales.

concurrent jurisdiction Jurisdiction that exists when two different courts have the power to hear a case. For example, some cases can be heard in either a federal or a state court.

concurrent ownership Joint ownership.

concurring opinion A court opinion by one or more judges or justices who agree with the majority but want to make or emphasize a point that was not made or emphasized in the majority’s opinion.

condemnation The judicial procedure by which the gov- ernment exercises its power of eminent domain. It generally involves two phases: a taking and a determination of fair value.

condition A possible future event, the occurrence or nonoc- currence of which will trigger the performance of a legal obli- gation or terminate an existing obligation under a contract.

condition precedent A condition in a contract that must be met before a party’s promise becomes absolute.

confiscation A government’s taking of privately owned busi- ness or personal property without a proper public purpose or an award of just compensation.

conforming goods Goods that conform to contract specifications.

consequential damages Special damages that compensate for a loss that is not direct or immediate (for example, lost prof-a loss that is not direct or immediate (for example, lost prof-a loss that is not direct or immediate (for example, lost prof its). The special damages must have been reasonably foresee- able at the time the breach or injury occurred in order for the plaintiff to collect them.

consideration Generally, the value given in return for a promise or a performance. The consideration, which must be present to make the contract legally binding, must be some- thing of legally sufficient value and must be bargained for.

constitutional law Law that is based on the U.S. Constitu- tion and the constitutions of the various states.

constructive discharge A termination of employment brought about by making the employee’s working conditions so intolerable that the employee reasonably feels compelled to leave.

consumer-debtor One whose debts result primarily from the purchase of goods for personal, family, or household use.

consumer law The body of statutes, agency rules, and judi- cial decisions protecting consumers of goods and services from dangerous manufacturing techniques, mislabeling, unfair credit practices, deceptive advertising, and other such practices.

contract An agreement that can be enforced in court; formed by two or more parties, each of whom agrees to perform or to refrain from performing some act now or in the future.

contractual capacity The legal ability to enter into contracts; the threshold mental capacity required by law for a party who enters into a contract to be bound by that contract.

contributory negligence A theory in tort law under which a complaining party’s own negligence contributed to or caused his or her injuries. Contributory negligence is an absolute bar to recovery in a minority of jurisdictions.

conversion The wrongful taking, using, or retaining posses- sion of personal property that belongs to another.

conveyance The transfer of title to real property from one person to another by deed or other document.

cookie A small file sent from a Web site and stored in a user’s Web browser to track the user’s Web browsing activities.

“cooling-off ” laws Laws that allow buyers of goods sold in certain transactions to cancel their contracts within three business days.

copyright The exclusive right of authors to publish, print, or sell an intellectual production for a statutory period of time. A copyright has the same monopolistic nature as a patent or trademark, but it differs in that it applies exclusively to works of art, literature, and other works of authorship, including computer programs.

corporate governance A set of policies specifying the rights and responsibilities of the various participants in a corporation and spelling out the rules and procedures for making corpo- rate decisions.

corporate social responsibility The concept that corpora- tions can and should act ethically, and be accountable to soci- ety for their actions.

cost-benefit analysis A decision-making technique that involves weighing the costs of a given action against the ben- efits of the action.

G-6 G L O S S A R Y

co-surety A joint surety; one who assumes liability jointly with another surety for the payment of an obligation.

counteradvertising New advertising that is undertaken to correct earlier false claims that were made about a product.

counterclaim A claim made by a defendant in a civil lawsuit that in effect sues the plaintiff.

counteroffer An offeree’s response to an offer in which the offeree rejects the original offer and at the same time makes a new offer.

court of equity A court that decides controversies and administers justice according to the rules, principles, and prec- edents of equity.

court of law A court in which the only remedies that could be granted were things of value, such as money damages. In the early English king’s courts, courts of law were distinct from courts of equity.

covenant not to compete A contractual promise to refrain from competing with another party for a certain period of time and within a certain geographic area. Although cov- enants not to compete restrain trade, they are commonly found in partnership agreements, business sale agreements, and employment contracts. If they are ancillary to such agree- ments, covenants not to compete will normally be enforced by the courts unless the time period or geographic area is deemed unreasonable.

covenant not to sue An agreement to substitute a contractual obligation for some other type of legal action based on a valid claim.

cover A buyer’s or lessee’s purchase on the open market of goods to substitute for those promised but never delivered by the seller or lessor. Under the Uniform Commercial Code, if the cost of cover exceeds the cost of the contract goods, the buyer or lessee can recover the difference, plus incidental and consequential damages.

cram-down provision A provision of the Bankruptcy Code that allows a court to confirm a debtor’s Chapter 11 reor- ganization plan even though only one class of creditors has accepted it.

creditors’ composition agreement An agreement formed between a debtor and his or her creditors in which the credi- tors agree to accept a lesser sum than that owed by the debtor in full satisfaction of the debt.

crime A wrong against society proclaimed in a statute and punishable by society through fines and/or imprisonment— or, in some cases, death.

criminal law The branch of law that defines and punishes wrongful actions committed against the public.

cross-examination The questioning of an opposing witness during a trial.

crowdfunding A cooperative activity in which people net- work and pool funds and other resources via the Internet to assist a cause (such as disaster relief ) or invest in a business venture (such as a startup).

cure Under the Uniform Commercial Code, the right of a party who tenders nonconforming performance to correct his or her performance within the contract period.

cyber crime A crime that occurs online, in the virtual com- munity of the Internet, as opposed to the physical world.

cyber fraud Fraud that involves the online theft of credit- card information, banking details, and other information for criminal use.

cyberlaw An informal term used to refer to all laws govern- ing electronic communications and transactions, particularly those conducted via the Internet.

cybersquatting Registering a domain name that is the same as, or confusingly similar to, the trademark of another and then offering to sell that domain name back to the trademark owner.

cyber tort A tort committed via the Internet.

D damages A monetary award sought as a remedy for a breach of contract or a tortious act.

debtor in possession (DIP) In Chapter 11 bankruptcy pro- ceedings, a debtor who is allowed to continue in possession of the estate in property (the business) and to continue business operations.

deceptive advertising Advertising that misleads consumers, either by making unjustified claims about a product’s perfor- mance or by omitting a material fact concerning the product’s composition or performance.

deed A document by which title to real property is passed.

defamation Any published or publicly spoken false state- ment that causes injury to another’s good name, reputation, or character.

default Failure to pay a debt when it is due.

default judgment A judgment entered by a court against a defendant who has failed to appear in court to answer or defend against the plaintiff ’s claim.

G L O S S A R Y G-7

defendant One against whom a lawsuit is brought, or the accused person in a criminal proceeding.

defense Reasons that a defendant offers in an action or suit as to why the plaintiff should not obtain what he or she is seeking.

delegation doctrine A doctrine based on Article I, Section 8, of the U.S. Constitution, which has been construed to allow Congress to delegate some of its power to make and implement laws to administrative agencies. The delegation is considered to be proper as long as Congress sets standards out- lining the scope of the agency’s authority.

delegation The transfer of a contractual duty to a third party. The party delegating the duty (the delegator) to the third party (the delegatee) is still obliged to perform on the contract should the delegatee fail to perform.

deposition The testimony of a party to a lawsuit or of a wit- ness taken under oath before a trial.

destination contract A contract in which the seller is required to ship the goods by carrier and deliver them at a par- ticular destination. The seller assumes liability for any losses or damage to the goods until they are tendered at the destina- tion specified in the contract.

dilution With respect to trademarks, a doctrine under which distinctive or famous trademarks are protected from certain unauthorized uses of the marks regardless of a showing of competition or a likelihood of confusion. Congress created a federal cause of action for dilution in 1995 with the passage of the Federal Trademark Dilution Act.

direct examination The examination of a witness by the attorney who calls the witness to the stand at trial to testify on behalf of the attorney’s client.

disaffirmance The legal avoidance, or setting aside, of a con- tractual obligation.

discharge (1) The termination of an obligation, such as occurs when the parties to a contract have fully performed their contractual obligations. (2) The termination of a bank-their contractual obligations. (2) The termination of a bank-their contractual obligations. (2) The termination of a bank ruptcy debtor’s obligation to pay debts.

discharge in bankruptcy The release of a debtor from all debts that are provable, except those specifically excepted from discharge by statute.

disclosed principal A principal whose identity is known to a third party at the time the agent makes a contract with the third party.

discovery A phase in the litigation process during which the opposing parties may obtain information from each other and from third parties prior to trial.

disparagement of property An economically injurious false statement made about another’s product or property. A general term for torts that are more specifically referred to as slander of quality or slander of title.

disparate-impact discrimination Discrimination that results from certain employer practices or procedures that, although not discriminatory on their face, have a discrimina- tory effect.

disparate-treatment discrimination A form of employment discrimination that results when an employer intentionally discriminates against employees who are members of protected classes.

dissenting opinion A court opinion that presents the views of one or more judges or justices who disagree with the major- ity’s decision.

dissociation The severance of the relationship between a partner and a partnership.

dissolution The formal disbanding of a partnership, corpora- tion, or other business entity. For instance, partnerships can be dissolved by acts of the partners, by operation of law, or by judicial decree.

distributed network A network that can be used by persons located (distributed) around the country or the globe to share computer files.

distribution agreement A contract between a seller and a distributor of the seller’s products setting out the terms and conditions of the distributorship.

diversity of citizenship Under Article III, Section 2, of the Constitution, a basis for federal court jurisdiction over a law- suit between (1) citizens of different states, (2) a foreign coun- try and citizens of a state or of different states, or (3) citizens of a state and citizens or subjects of a foreign coun- try. The amount in controversy must be more than $75,000 before a federal court can take jurisdiction in such cases.

divestiture A company’s sale of one or more of its divisions’ operating functions under court order as part of the enforce- ment of the antitrust laws.

dividend A distribution of corporate profits to the corpora- tion’s shareholders in proportion to the number of shares held.

document of title A writing exchanged in the regular course of business that evidences the right to possession of goods (for example, a bill of lading or a warehouse receipt).

domain name The series of letters and symbols used to iden- tify a site operator on the Internet; an Internet “address.”

domestic corporation In a given state, a corporation that is organized under the law of that state.

G-8 G L O S S A R Y

double jeopardy A situation occurring when a person is tried twice for the same criminal offense; prohibited by the Fifth Amendment to the Constitution.

down payment The part of the purchase price of real prop- erty that is paid in cash up front, reducing the amount of the loan or mortgage.

dram shop act A state statute that imposes liability on the owners of bars and taverns, as well as those who serve alco- holic drinks to the public, for injuries resulting from accidents caused by intoxicated persons when the sellers or servers of alcoholic drinks contributed to the intoxication.

due process clause The provisions of the Fifth and Four- teenth Amendments to the U.S. Constitution that guarantee that no person shall be deprived of life, liberty, or property without due process of law. Similar clauses are found in most state constitutions.

dumping The selling of goods in a foreign country at a price below the price charged for the same goods in the domestic market.

duress Unlawful pressure brought to bear on a person, caus- ing the person to perform an act that he or she would not oth- erwise perform (or refrain from doing something the person would otherwise have done).

duty-based ethics An ethical philosophy rooted in the idea that every person has certain duties to others, including both humans and the planet. Those duties may be derived from religious principles or from other philosophical reasoning.

duty of care The duty of all persons, as established by tort law, to exercise a reasonable amount of care in their dealings with others. Failure to exercise due care, which is normally determined by the “reasonable person standard,” constitutes the tort of negligence.

E e-agent A semiautonomous computer program that is capable of executing specific tasks.

early neutral case evaluation A form of alternative dis- pute resolution in which a neutral third party evaluates the strengths and weakness of the disputing parties’ positions. The evaluator’s opinion forms the basis for negotiating a settlement.

easement A nonpossessory right, established by express or implied agreement, to make limited use of another’s property without removing anything from the property.

e-contract A contract that is entered into in cyberspace and is evidenced only by electronic impulses (such as those that make up a computer’s memory), rather than, for example, a typewritten form.

e-evidence A type of evidence that consists of computer- generated or electronically recorded information, including e-mail, voice mail, spreadsheets, word-processing documents, and other data.

embezzlement The fraudulent appropriation of money or other property by a person to whom the money or property has been entrusted.

eminent domain The power of a government to take land from private citizens for public use on the payment of just compensation.

employment at will A common law doctrine under which either party may terminate an employment relationship at any time for any reason, unless a contract specifies otherwise.

employment discrimination Unequal treatment of employ-Unequal treatment of employ-Unequal treatment of employ ees or job applicants on the basis of race, color, national ori- gin, religion, gender, age, or disability; prohibited by federal statutes.

enabling legislation A statute enacted by Congress that authorizes the creation of an administrative agency and speci- fies the name, composition, purpose, and powers of the agency being created.

entrapment In criminal law, a defense in which the defen- dant claims that he or she was induced by a public official— usually an undercover agent or police officer—to commit a crime that he or she would otherwise not have committed.

entrepreneur One who initiates and assumes the financial risk of a new business enterprise and undertakes to provide or control its management.

environmental impact statement (EIS) A formal analysis required for any major federal action that will significantly affect the quality of the environment to determine the action’s impact and explore alternatives.

equal dignity rule A rule requiring that an agent’s authority be in writing if the contract to be made on behalf of the prin- cipal must be in writing.

equal protection clause The provision in the Fourteenth Amendment to the U.S. Constitution that guarantees that no state will “deny to any person within its jurisdiction the equal protection of the laws.” This clause mandates that state governments treat similarly situated individuals in a similar manner.

equitable maxims General propositions or principles of law that have to do with fairness (equity).

G L O S S A R Y G-9

escrow account An account generally held in the name of the depositor and escrow agent. The funds in the account are paid to a third person on fulfillment of the escrow condition.

e-signature As defined by the Uniform Electronic Transac- tions Act, “an electronic sound, symbol, or process attached to or logically associated with a record and executed or adopted by a person with the intent to sign the record.”

establishment clause The provision in the First Amendment to the U.S. Constitution that prohibits Congress from creating any law “respecting an establishment of religion.”

estopped Barred, impeded, or precluded.

ethical reasoning A reasoning process in which an individual links his or her moral convictions or ethical standards to the particular situation at hand.

ethics Moral principles and values applied to social behavior.

exclusionary rule In criminal procedure, a rule under which any evidence that is obtained in violation of the accused’s con- stitutional rights guaranteed by the Fourth, Fifth, and Sixth Amendments, as well as any evidence derived from illegally obtained evidence, will not be admissible in court.

exclusive agency An agency in which a principal grants an agent an exclusive territory and does not allow another agent to compete in that territory.

exclusive-dealing contract An agreement under which a seller forbids a buyer to purchase products from the seller’s competitors.

exclusive jurisdiction Jurisdiction that exists when a case can be heard only in a particular court or type of court, such as a federal court or a state court.

exculpatory clause A clause that releases a contractual party from liability in the event of monetary or physical injury, no matter who is at fault.

executed contract A contract that has been completely per- formed by both parties.

executive agency An administrative agency within the execu- tive branch of government. At the federal level, executive agencies are those within the cabinet departments.

executory contract A contract that has not yet been fully performed.

exhaustion doctrine In administrative law, the principle that a complaining party normally must have exhausted all avail- able administrative remedies before seeking judicial review.

export To sell products to buyers located in other countries.

express authority Authority expressly given by one party to another. In agency law, an agent has express authority to act for a principal if both parties agree, orally or in writing, that an agency relationship exists in which the agent has the power (authority) to act in the place of, and on behalf of, the principal.

express contract A contract in which the terms of the agree- ment are fully and explicitly stated in words, oral or written.

express warranty A seller’s or lessor’s oral or written promise, ancillary to an underlying sales or lease agreement, as to the quality, description, or performance of the goods being sold or leased.

expropriation The seizure by a government of privately owned business or personal property for a proper public pur- pose and with just compensation.

F family limited liability partnership (FLLP) A limited lia- bility partnership (LLP) in which the majority of the partners are members of a family.

federal form of government A system of government in which the states form a union and the sovereign power is divided between a central government and the member states.

federal question A question that pertains to the U.S. Con- stitution, acts of Congress, or treaties. A federal question pro- vides a basis for federal jurisdiction.

Federal Rules of Civil Procedure (FRCP) The rules con- trolling procedural matters in civil trials brought before the federal district courts.

fee simple absolute An ownership interest in land in which the owner has the greatest possible aggregation of rights, privi- leges, and power. The owner can use, possess, or dispose of the property as he or she chooses during his or her lifetime. On death, the interest in the property passes to the owner’s heirs.

felony A crime—such as arson, murder, rape, or robbery— that carries the most severe sanctions, usually ranging from one year in a state or federal prison to the forfeiture of one’s life.

fiduciary As a noun, a person having a duty created by his or her undertaking to act primarily for another’s benefit in matters connected with the undertaking; as an adjective, a relationship founded on trust and confidence.

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filtering software A computer program that screens incom- ing data according to rules built into the software and blocks access to Web sites with content not consistent with these rules.

final order The final decision of an administrative agency on an issue. If no appeal is taken, or if the case is not reviewed or considered anew by the agency commission, the administra- tive law judge’s initial order becomes the final order of the agency.

firm offer An offer (by a merchant) that is irrevocable with- out consideration for a period of time (not longer than three months). A firm offer by a merchant must be in writing and must be signed by the offeror.

fixed-term tenancy A type of tenancy under which property is leased for a specified period of time, such as a month, a year, or a period of years; also called a tenancy for years.

fixture An item of personal property that has become so closely associated with real property that it is legally regarded as part of that real property.

forbearance The act of refraining from exercising a legal right; an agreement between a lender and a borrower in which the lender agrees to temporarily cease requiring mortgage payments, to delay foreclosure, or to accept smaller payments than previously scheduled.

foreclosure A proceeding in which a mortgagee either takes title to or forces the sale of the mortgagor’s property in satis- faction of a debt.

foreign corporation In a given state, a corporation that does business in that state but is not incorporated there.

forgery The fraudulent making or altering of any writing in a way that changes the legal rights and liabilities of another.

formal contract A contract that by law requires a specific form, such as being executed under seal, to be valid.

forum-selection clause A provision in a contract designating the court, jurisdiction, or tribunal that will decide any dis- putes arising under the contract.

franchise Any arrangement in which the owner of a trade- mark, trade name, or copyright licenses another to use that trademark, trade name, or copyright in the selling of goods or services.

franchisee One receiving a license to use another’s (the fran- chisor’s) trademark, trade name, or copyright in the sale of goods and services.

franchisor One licensing another (the franchisee) to use the owner’s trademark, trade name, or copyright in the selling of goods or services.

fraudulent misrepresentation (fraud) Any misrepresenta- tion, either by misstatement or omission of a material fact, knowingly made with the intention of deceiving another and on which a reasonable person would and does rely to his or her detriment.

free exercise clause The provision in the First Amendment to the U.S. Constitution that prohibits Congress from making any law “prohibiting the free exercise” of religion.

free-writing prospectus A written, electronic, or graphic communication associated with the offer to sell a security and used during the waiting period to supplement other informa- tion about the security.

frustration of purpose A court-created doctrine under which a party to a contract will be relieved of his or her duty to per- form when the objective purpose for performance no longer exists (due to reasons beyond that party’s control).

full faith and credit clause A clause in Article IV, Section 1, of the U.S. Constitution that provides that “Full Faith and Credit shall be given in each State to the public Acts, Records, and Judicial Proceedings of every other State.” The clause ensures that rights established under deeds, wills, contracts, and the like in one state will be honored by the other states and that any judicial decision with respect to such property rights will be honored and enforced in all states.

fungible goods Goods that are alike by physical nature, by agreement, or by trade usage. Examples are wheat, oil, and wine that are identical in type and quality.

G garnishment A legal process used by a creditor to collect a debt by seizing property of the debtor (such as wages) that is being held by a third party (such as the debtor’s employer).

general damages In a tort case, an amount awarded to compensate individuals for the nonmonetary aspects of the harm suffered, such as pain and suffering; not available to companies.

general partner In a limited partnership, a partner who assumes responsibility for the management of the partnership and has full liability for all partnership debts.

Good Samaritan statute A state statute that provides that persons who rescue or provide emergency services to others in peril—unless they do so recklessly, thus causing further harm—cannot be sued for negligence.

goodwill In the business context, the valuable reputation of a business viewed as an intangible asset.

G L O S S A R Y G-11

grand jury A group of citizens called to decide, after hear- ing the state’s evidence, whether a reasonable basis (probable cause) exists for believing that a crime has been committed and whether a trial ought to be held.

grant deed A deed that simply states that property is being conveyed from the grantor to another. Under statute, a grant deed may impliedly warrant that the grantor has at least not conveyed the property’s title to someone else.

group boycott An agreement by two or more sellers to refuse to deal with a particular person or firm.

guarantor A person who agrees to satisfy the debt of another (the debtor) only after the principal debtor defaults. A guaran- tor’s liability is thus secondary.

H hacker A person who uses one computer to break into another.

hearsay An oral or written statement made out of court that is later offered in court by a witness (not the person who made the statement) to prove the truth of the matter asserted in the statement. Hearsay is generally inadmissible as evidence.

historical school A school of legal thought that looks to the past to determine what the principles of contemporary law should be.

holding company A company whose business activity is holding shares in another company.

homeowner’s insurance A form of property insurance that protects the home of the insured person and its contents against losses.

homestead exemption A law permitting a debtor to retain the family home, either in its entirety or up to a specified dollar amount, free from the claims of unsecured creditors or trustees in bankruptcy.

horizontal merger A merger between two firms that are competing in the same market.

horizontal restraint Any agreement that restrains competi- tion between rival firms competing in the same market.

hot-cargo agreement An illegal agreement in which employ-An illegal agreement in which employ-An illegal agreement in which employ ers voluntarily agree with unions not to handle, use, or deal in the non-union-produced goods of other employers.

I I-9 verification The process of verifying the employment eligibility and identity of a new immigrant worker. It must be completed within three days after the worker commences employment.

I-551 Alien Registration Receipt A document known as a “green card” that shows that a foreign-born individual can legally work in the United States.

identification In a sale of goods, the express designation of the specific goods provided for in the contract.

identity theft The act of stealing another’s identifying infor- mation—such as a name, date of birth, or Social Security number—and using that information to access the victim’s financial resources.

impeach To challenge the credibility of a person’s testimony or attempt to discredit a party or witness.

implication A way of creating an easement or profit in real property when it is reasonable to imply its existence from the circumstances surrounding the division of the property.

implied authority Authority that is created not by an explicit oral or written agreement but by implication. In agency law, implied authority (of the agent) can be conferred by custom, inferred from the position the agent occupies, or implied by virtue of being reasonably necessary to carry out express authority.

implied contract A contract formed in whole or in part from the conduct of the parties (as opposed to an express contract).

implied warranty A warranty that the law derives by impli- cation or inference from the nature of the transaction or the relative situation or circumstances of the parties.

implied warranty of fitness for a particular purpose A warranty that goods sold or leased are fit for a particular purpose. The warranty arises when any seller or lessor knows the particular purpose for which a buyer or lessee will use the goods and knows that the buyer or lessee is relying on the skill and judgment of the seller or lessor to select suitable goods.

implied warranty of habitability An implied promise by a seller of a new house that the house is fit for human habita- tion. Also, the implied promise by a landlord that rented resi- dential premises are habitable.

implied warranty of merchantability A warranty that goods being sold or leased are reasonably fit for the ordinary purpose for which they are sold or leased, are properly packaged and labeled, and are of fair quality. The warranty automatically arises in every sale or lease of goods made by a merchant who deals in goods of the kind sold or leased.

G-12 G L O S S A R Y

impossibility of performance A doctrine under which a party to a contract is relieved of his or her duty to perform when performance becomes impossible or totally impracti- cable (through no fault of either party).

incidental damages Damages that compensate for expenses directly incurred because of a breach of contract, such as those incurred to obtain performance from another source.

independent contractor One who works for, and receives payment from, an employer but whose working conditions and methods are not controlled by the employer. An indepen- dent contractor is not an employee but may be an agent.

independent regulatory agency An administrative agency that is not considered part of the government’s executive branch and is not subject to the authority of the president. Independent agency officials cannot be removed without cause.

indictment (pronounced in-dyte-ment) A charge by a grand jury that a reasonable basis (probable cause) exists for believ- ing that a crime has been committed and that a trial should be held.

industrial use Land use for light or heavy manufacturing, shipping, or heavy transportation.

informal contract A contract that does not require a speci- fied form or formality in order to be valid.

information A formal accusation or complaint (without an indictment) issued in certain types of actions (usually crimi- nal actions involving lesser crimes) by a law officer, such as a magistrate.

information return A tax return submitted by a partnership that reports the business’s income and losses. The partnership itself does not pay taxes on the income, but each partner’s share of the profit (whether distributed or not) is taxed as indi- vidual income to that partner.

initial order In the context of administrative law, an agency’s disposition in a matter other than a rulemaking. An admin- istrative law judge’s initial order becomes final unless it is appealed.

in personam jurisdiction Court jurisdiction over the “per- son” involved in a legal action; personal jurisdiction.

in rem jurisdiction Court jurisdiction over a defendant’s property.

inside director A person on a corporation’s board of directors who is also an officer of the corporation.

insider (1) A corporate director or officer, or other employee or agent, with access to confidential information and a duty not to disclose that information in violation of insider-trading laws. (2) In bankruptcy proceedings, an individual, partner, partnership, corporation, or officer or director of a corpora- tion (or a relative of one of these) who has a close relationship with the debtor.

insider trading The purchase or sale of securities on the basis of information that has not been made available to the public.

insurable interest (1) A property interest in goods being sold or leased that is sufficiently substantial to permit a party to insure against damage to the goods. (2) An interest either in a person’s life or well-being that is sufficiently substan- tial that insuring against injury to (or the death of ) the person does not amount to a mere wagering (betting) contract.

intangible property Property that is incapable of being apprehended by the senses (such as by sight or touch). Intellec- tual property is an example of intangible property.

intellectual property Property resulting from intellectual, creative processes. Patents, trademarks, and copyrights are examples of intellectual property.

intended beneficiary A third party for whose benefit a con- tract is formed; an intended beneficiary can sue the promisor if such a contract is breached.

intentional tort A wrongful act knowingly committed.

international law The law that governs relations among nations. International customs and treaties are generally considered to be two of the most important sources of international law.

international organization In international law, a term that generally refers to an organization composed mainly of nations and usually established by treaty. The United States is a member of more than one hundred multilateral and bilateral organizations, including at least twenty through the United Nations.

Internet service provider (ISP) A business or organization that offers users access to the Internet and related services.

interpretive rule A nonbinding rule or policy statement issued by an administrative agency that explains how it inter- prets and intends to apply the statutes it enforces.

interrogatories A series of written questions for which writ- ten answers are prepared and then signed under oath by a party to a lawsuit, usually with the assistance of the party’s attorney.

inverse condemnation The taking of private property by the government without payment of just compensation as required by the U.S. Constitution. The owner must sue the government to recover just compensation.

G L O S S A R Y G-13

investment company A company that acts on the behalf of many smaller shareholders-owners by buying a large portfolio of securities and professionally managing that portfolio.

investment contract In securities law, a transaction in which a person invests in a common enterprise reasonably expecting profits that are derived primarily from the efforts of others.

issue In negotiable instruments law, the first transfer, or delivery, of an instrument to a holder.

J joint and several liability In partnership law, a doctrine under which a plaintiff may sue, and collect a judgment from, all of the partners together (jointly) or one or more of the partners separately (severally, or individually). A partner can be held liable even if she or he did not participate in, ratify, or know about the conduct that gave rise to the lawsuit.

joint liability In partnership law, the partners’ shared liabil- ity for partnership obligations and debts. A third party must sue all of the partners as a group, but each partner can be held liable for the full amount.

joint tenancy Joint ownership of property by two or more co-owners in which each co-owner owns an undivided por- tion of the property. On the death of one of the joint tenants, his or her interest automatically passes to the surviving joint tenant(s).

judicial review The process by which courts decide on the constitutionality of legislative enactments and actions of the executive branch.

jurisdiction The authority of a court to hear a case and decide a specific action.

jurisprudence The science or philosophy of law.

L laches The equitable doctrine that bars a party’s right to legal action if the party has neglected for an unreasonable length of time to act on his or her rights.

larceny The wrongful taking and carrying away of another person’s personal property with the intent to permanently deprive the owner of the property. Some states classify larceny as either grand or petit, depending on the property’s value.

law A body of enforceable rules governing relationships among individuals and between individuals and their society.

leasehold estate An interest in real property that gives a ten- ant a qualified right to possess and/or use the property for a limited time under a lease.

legal positivism A school of legal thought centered on the assumption that there is no law higher than the laws created by a national government. Laws must be obeyed, even if they are unjust, to prevent anarchy.

legal realism A school of legal thought that holds that the law is only one factor to be considered when deciding cases and that social and economic circumstances should also be taken into account.

legal reasoning The process of reasoning by which a judge harmonizes his or her opinion with the judicial decisions in previous cases.

legislative rule An administrative agency rule that carries the same weight as a congressionally enacted statute.

liability The state of being legally responsible (liable) for something, such as a debt or obligation.

libel Defamation in writing or in some other form (such as in a digital recording) having the quality of permanence.

license In the context of intellectual property, a contract permitting the use of a trademark, copyright, patent, or trade secret of certain purposes. In the context of real property, a revocable right or privilege of a person to come on another person’s land.

licensee One who receives a license to use, or enter onto, another’s property.

lien (pronounced leen) A claim against specific property to satisfy a debt.

life estate An interest in land that exists only for the duration of the life of a specified individual, usually the holder of the estate.

limited liability company (LLC) A hybrid form of business enterprise that offers the limited liability of a corporation and the tax advantages of a partnership.

limited liability limited partnership (LLLP) A type of lim- ited partnership in which the liability of the general partner is the same as the liability of the limited partners—that is, the liability of all partners is limited to the amount of their invest- ments in the firm.

limited liability partnership (LLP) A hybrid form of busi- ness organization that is used mainly by professionals who normally do business in a partnership. An LLP is a pass-through entity for tax purposes, but a partner’s personal liability for the malpractice of other partners is limited.

G-14 G L O S S A R Y

limited partner In a limited partnership, a partner who contributes capital to the partnership but has no right to par- ticipate in its management and has no liability for partnership debts beyond the amount of her or his investment.

limited partnership (LP) A partnership consisting of one or more general partners and one or more limited partners.

liquidated damages An amount, stipulated in the contract, that the parties to a contract believe to be a reasonable estima- tion of the damages that will occur in the event of a breach.

liquidated debt A debt that is due and certain in amount.

liquidation The sale of the nonexempt assets of a debtor and the distribution of the funds received to creditors.

litigation The process of resolving a dispute through the court system.

lockout An action in which an employer shuts down to prevent employees from working, typically because it cannot reach a collective bargaining agreement with the employees’ union.

long arm statute A state statute that permits a state to obtain personal jurisdiction over nonresident defendants. A defen- dant must have “minimum contacts” with that state for the statute to apply.

M mailbox rule A rule providing that an acceptance of an offer becomes effective on dispatch.

majority opinion A court opinion that represents the views of the majority (more than half ) of the judges or justices deciding the case.

malpractice Professional misconduct or the failure to exercise the requisite degree of skill as a professional. Negligence—the failure to exercise due care—on the part of a professional, such as a physician or an attorney, is commonly referred to as malpractice.

malware Malicious software programs designed to disrupt or harm a computer, network, smartphone, or other device.

marketable title Title to real estate that is reasonably free from encumbrances, defects in the chain of title, and other matters that affect title, such as adverse possession.

market concentration The degree to which a small number of firms control a large percentage of a relevant market.

market power The power of a firm to control the market price of its product. A monopoly has the greatest degree of market power.

market-share liability A theory under which liability is shared among all firms that manufactured and distributed a particular product during a certain period of time. This theory of liability is used only when the specific source of the harmful product is unidentifiable.

mechanic’s lien A statutory lien on the real property of another, created to ensure payment for work performed and materials furnished in the repair or improvement of real prop- erty, such as a building.

mediation A method of settling disputes outside of court by using the services of a neutral third party, called a mediator. The mediator acts as a communicating agent between the par- ties and suggests ways in which the parties can resolve their dispute.

member A person who has an ownership interest in a limited liability company.

mens rea (pronounced mehns ray-uh) Criminal intent. The commission of a prohibited act and the intent to commit a crime are the two essential elements required for criminal liability.

merchant A person who is engaged in the purchase and sale of goods. Under the Uniform Commercial Code, a person who deals in goods of the kind involved in the sales contract; for further definitions, see UCC 2–104.

metadata Data that are automatically recorded by electronic devices on their hard drives and that provide information about who created a file and when, and who accessed, modi- fied, or transmitted it. Metadata can be described as “data about data.”

meta tag Word inserted into a Web site’s key-words field to increase the site’s appearance in search engine results.

metes and bounds A way of describing the boundary lines of land according to the distance between two points, often using physical features of the local geography.

minimum wage The lowest wage, either by government regulation or by union contract, that an employer may pay an hourly worker.

mini-trial A private proceeding in which each party to a dis- pute argues its position before the other side. A neutral third party may be present and act as an adviser if the parties fail to reach an agreement.

mirror image rule A common law rule that requires, for a valid contractual agreement, that the terms of the offeree’s acceptance adhere exactly to the terms of the offeror’s offer.

misdemeanor A lesser crime than a felony, punishable by a fine or imprisonment for up to one year in other than a state or federal penitentiary.

G L O S S A R Y G-15

mitigation of damages A rule requiring a plaintiff to have done whatever was reasonable to minimize the damages caused by the defendant.

money laundering Falsely reporting income that has been obtained through criminal activity as income obtained through a legitimate business enterprise—in effect, “launder- ing” the “dirty money.”

monopolization The possession of monopoly power in the rel- evant market and the willful acquisition or maintenance of that power, as distinguished from growth or development as a conse- quence of a superior product, business acumen, or historic accident.

monopoly A market in which there is a single seller or a very limited number of sellers.

monopoly power The ability of a monopoly to dictate what takes place in a given market.

moral minimum The minimum degree of ethical behavior expected of a business firm, which is usually defined as com- pliance with the law.

mortgage A written instrument that gives a creditor (the mortgagee) an interest in, or lien on, the debtor’s (mortgagor’s) real property as security for a debt. If the debt is not paid, the property can be sold by the creditor and the proceeds used to pay the debt.

mortgage insurance Insurance that compensates a lender for losses due to a borrower’s default on a mortgage loan.

motion A procedural request or application presented by an attorney to the court on behalf of a client.

motion for a directed verdict In a state court, a party’s request that the judge enter a judgment in her or his favor before the case is submitted to a jury because the other party has not presented sufficient evidence to support the claim. The federal courts refer to this request as a motion for judg-motion for judg-motion for judg ment as a matter of law.

motion for a judgment as a matter of law In a federal court, a party’s request that the judge enter a judgment in her or his favor before the case is submitted to a jury because the other party has not presented sufficient evidence to support the claim. The state courts refer to this request as a motion for a directed verdict.

motion for a new trial A motion asserting that the trial was so fundamentally f lawed (because of error, newly discovered evidence, prejudice, or other reason) that a new trial is neces- sary to prevent a miscarriage of justice.

motion for judgment n.o.v. A motion requesting the court to grant judgment in favor of the party making the motion on the ground that the jury verdict against him or her was unrea- sonable and erroneous.

motion for judgment on the pleadings A motion by either party to a lawsuit at the close of the pleadings requesting the court to decide the issue solely on the pleadings without pro- ceeding to trial. The motion will be granted only if no facts are in dispute.

motion for summary judgment A motion requesting the court to enter a judgment without proceeding to trial. The motion can be based on evidence outside the pleadings and will be granted only if no facts are in dispute.

motion to dismiss A pleading in which a defendant asserts that the plaintiff ’s claim fails to state a cause of action (that is, has no basis in law) or that there are other grounds on which a suit should be dismissed.

multiple product order An order requiring a firm that has engaged in deceptive advertising to cease and desist from false advertising in regard to all the firm’s products.

mutual fund A specific type of investment company that con- tinually buys or sells to investors shares of ownership in a portfolio.

mutual rescission An agreement between the parties to cancel their contract, releasing the parties from further obli- gations under the contract. The object of the agreement is to restore the parties to the positions they would have occupied had no contract ever been formed.

N national law Law that pertains to a particular nation (as opposed to international law).

natural law The oldest school of legal thought, based on the belief that the legal system should ref lect universal (“higher”) moral and ethical principles that are inherent in human nature.

necessity In criminal law, a defense against liability. Under Section 3.02 of the Model Penal Code, this defense is justifi- able if “the harm or evil sought to be avoided” by a given action “is greater than that sought to be prevented by the law defining the offense charged.” In real property law, a way of creating an easement when one party must have the easement in order to have access to his or her property.

negligence The failure to exercise the standard of care that a reasonable person would exercise in similar circumstances.

negotiation In regard to dispute settlement, a process in which parties attempt to settle their dispute without going to court, with or without attorneys to represent them. In regard to negotiable instruments, the transfer of an instrument in such a way that the transferee (the person to whom the instru- ment is transferred) becomes a holder.

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nominal damages A small monetary award (often one dollar) granted to a plaintiff when no actual damage was suffered or when the plaintiff is unable to show such loss with sufficient certainty.

nonpossessory interest In the context of real property, an interest that involves the right to use land but not the right to possess it.

normal trade relations (NTR) status A status granted through an international treaty by which each member nation must treat other members at least as well as it treats the coun- try that receives its most favorable treatment. This status was formerly known as most-favored-nation status.

notary public A public official authorized to attest to the authenticity of signatures.

notice-and-comment rulemaking An administrative rule- making procedure that involves the publication of a notice of a proposed rulemaking in the Federal Register, a comment period for interested parties to express their views on the pro- posed rule, and the publication of the agency’s final rule in the Federal Register.

novation The substitution, by agreement, of a new contract for an old one, with the rights under the old one being termi- nated. Typically, there is a substitution of a new person who is responsible for the contract and the removal of an original party’s rights and duties under the contract.

nuisance A common law doctrine under which persons may be held liable for using their property in a manner that unrea- sonably interferes with others’ rights to use or enjoy their own property.

O objective theory of contracts A theory under which the intent to form a contract will be judged by outward, objective facts as interpreted by a reasonable person, rather than by the party’s own secret, subjective intentions. Objective facts might include what a party said when entering into the contract, how a party acted or appeared, and the circumstances surrounding the transaction.

offer A promise or commitment to perform or refrain from performing some specified act in the future.

offeree A person to whom an offer is made.

offeror A person who makes an offer.

online dispute resolution (ODR) The resolution of dis- putes with the assistance of organizations that offer dispute- resolution services via the Internet.

opening statement A statement made to the jury at the beginning of a trial by a party’s attorney, prior to the presenta- tion of evidence. The attorney brief ly outlines the evidence that will be offered and the legal theory that will be pursued.

operating agreement An agreement in which the members of a limited liability company set forth the details of how the business will be managed and operated.

opinion A statement by a court expressing the reasons for its decision in a case.

option contract A contract under which the offeror cannot revoke his or her offer for a stipulated time period and the offeree can accept or reject the offer at any time during this period. The offeree must give consideration for the option to be enforceable.

order for relief A court’s grant of assistance to a complainant. In bankruptcy proceedings, the order relieves the debtor of the immediate obligation to pay the debts listed in the bankruptcy petition.

ordinance A law passed by a local governing unit, such as a city or a county.

outcome-based ethics An ethical philosophy that focuses on the impacts of a decision on society or on key stakeholders.

output contract An agreement in which a seller agrees to sell and a buyer agrees to buy all or up to a stated amount of what the seller produces.

outside director A person on a corporation’s board of directors who does not hold a management position at the corporation.

P partially disclosed principal A principal whose identity is unknown by a third party, but the third party knows that the agent is or may be acting for a principal at the time the agent and the third party form a contract.

partnership An agreement by two or more persons to carry on, as co-owners, a business for profit.

partnership by estoppel A partnership imposed by a court when nonpartners have held themselves out to be partners, or have allowed themselves to be held out as partners, and others have detrimentally relied on their misrepresentations.

pass-through entity A business entity that has no tax liabil- ity. The entity’s income is passed through to the owners, and they pay taxes on the income.

G L O S S A R Y G-17

past consideration Something given or some act done in the past, which cannot ordinarily be consideration for a later bargain.

patent A government grant that gives an inventor the exclu- sive right or privilege to make, use, or sell his or her invention for a limited time period.

peer-to-peer (P2P) networking The sharing of resources (such as files, hard drives, and processing styles) among multiple computers without the requirement of a central network server.

penalty A sum inserted into a contract not as a measure of compensation for its breach but rather as punishment for a default. The agreement as to the amount will not be enforced, and recovery will be limited to actual damages.

per curiam opinion By the whole court; a court opinion written by the court as a whole instead of being authored by a judge or justice.

perfect tender rule A common law rule under which a seller was required to deliver to the buyer goods that conformed perfectly to the requirements stipulated in the sales contract. A tender of nonconforming goods would automatically con- stitute a breach of contract. Under the Uniform Commercial Code, the rule has been greatly modified.

performance In contract law, the fulfillment of one’s duties arising under a contract with another; the normal way of dis- charging one’s contractual obligations.

periodic tenancy A lease interest in land for an indefinite period involving payment of rent at fixed intervals, such as week to week, month to month, or year to year.

per se violation A restraint of trade that is so anticompetitive that it is deemed inherently (per se) illegal.

persuasive authority Any legal authority or source of law that a court may look to for guidance but need not follow when making its decision.

petition in bankruptcy The document that is filed with a bankruptcy court to initiate bankruptcy proceedings.

petitioner In equity practice, a party that initiates a lawsuit.

petty offense In criminal law, the least serious kind of crimi- nal offense, such as a traffic or building-code violation.

phishing Online fraud in which criminals pretend to be legitimate companies by using e-mails or malicious Web sites that trick individuals and companies into providing useful information, such as bank account numbers, Social Security numbers, and credit-card numbers.

piercing the corporate veil The action of a court to disre- gard the corporate entity and hold the shareholders personally liable for corporate debts and obligations.

plaintiff A party that initiates a lawsuit.

plea bargaining The process by which a criminal defendant and the prosecutor in a criminal case work out a mutually satisfactory disposition of the case, subject to court approval; usually involves the defendant’s pleading guilty to a lesser offense in return for a lighter sentence.

pleadings Formal statements made by the plaintiff and the defendant in a lawsuit that detail the facts, allegations, and defenses involved in the litigation; the complaint and answer are part of the pleadings.

plurality opinion A court opinion that is joined by the larg- est number of the judges or justices hearing the case, but fewer than half of the total number.

police powers Powers possessed by states as part of their inherent sovereignty. These powers may be exercised to protect or promote the public order, health, safety, morals, and general welfare.

potentially responsible party (PRP) A party liable for the costs of cleaning up a hazardous waste disposal site under the Comprehensive Environmental Response, Compensation, and Liability Act.

power of attorney Authorization for another to act as one’s agent or attorney either in specified circumstances (special) or in all situations (general).

precedent A court decision that furnishes an example or authority for deciding subsequent cases involving identical or similar facts.

predatory pricing The pricing of a product below cost with the intent to drive competitors out of the market.

predominant-factor test A test courts use to determine whether a contract is primarily for the sale of goods or for the sale of services.

preemption A doctrine under which certain federal laws preempt, or take precedence over, conf licting state or local laws.

preemptive rights The right of a shareholder in a corpora- tion to have the first opportunity to purchase a new issue of that corporation’s stock in proportion to the amount of stock already owned by the shareholder.

preference In bankruptcy proceedings, a property transfer or payment made by the debtor that favors one creditor over others.

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preferred creditor In the context of bankruptcy, a creditor who has received a preferential transfer from a debtor.

preferred stock A security that entitles the holder to payment of fixed dividends and that has priority over common stock in the distribution of assets on the corporation’s dissolution.

prepayment penalty clause A provision in a mortgage loan contract that requires the borrower to pay a penalty if the mortgage is repaid in full within a certain period.

prescription A way of creating an easement or profit in real property by openly using the property, without the owner’s consent, for the required period of time (similar to adverse possession).

pretrial conference A conference, scheduled before the trial begins, between the judge and the attorneys litigating the suit. The parties may settle the dispute, clarify the issues, schedule discovery, and so on during the conference.

pretrial motion A written or oral application to a court for a ruling or order, made before trial.

price discrimination A seller’s act of charging competing buyers different prices for identical products or services.

price-fixing agreement An agreement between competitors to fix the prices of products or services at a certain level.

prima facie caseprima facie caseprima facie A case in which the plaintiff has produced sufficient evidence of his or her claim that the case will be decided for the plaintiff unless the defendant produces evi- dence to rebut it.

principle of rights The principle that human beings have certain fundamental rights (to life, freedom, and the pursuit of happiness, for example). A key factor in determining whether a business decision is ethical under this theory is how that deci- sion affects the rights of others, such as employees, consumers, suppliers, and the community.

private equity Capital funds invested by a private equity firm in an existing corporation, usually to purchase and reor- ganize it.

privilege In tort law, the ability to act contrary to another person’s right without that person’s having legal redress for such acts. Privilege may be raised as a defense to defamation.

privileges and immunities clause Article IV, Section 2, of the U.S. Constitution requires states not to discriminate against one another’s citizens. A resident of one state cannot be treated as an alien when in another state; he or she may not be denied such privileges and immunities as legal protection, access to courts, travel rights, and property rights.

privity of contract The relationship that exists between the promisor and the promisee of a contract.

probable cause Reasonable grounds for believing that a search should be conducted or that a person should be arrested.

probate court A state court of limited jurisdiction that con- ducts proceedings relating to the settlement of a deceased person’s estate.

procedural law Law that establishes the methods of enforc- ing the rights established by substantive law.

product liability The legal liability of manufacturers, sellers, and lessors of goods to consumers, users, and bystanders for injuries or damages that are caused by the goods.

product misuse A defense against product liability that may be raised when the plaintiff used a product in a manner not intended by the manufacturer. If the misuse is reasonably foreseeable, the seller will not escape liability unless measures were taken to guard against the harm that could result from the misuse.

profit In the context of real property, the right to enter onto another’s property and remove something of value from that property.

promise A person’s assurance that he or she will or will not do something.

promissory estoppel A doctrine that applies when a promi- sor makes a clear and definite promise on which the promisee justifiably relies. Such a promise is binding if justice will be better served by the enforcement of the promise.

prospectus A written document required by securities laws when a security is being sold. The prospectus describes the security, the financial operations of the issuing corporation, and the risk attaching to the security.

protected class A group of persons protected by specific laws because of the group’s defining characteristics, including race, color, religion, national origin, gender, age, and disability.

proximate cause Legal cause; exists when the connection between an act and an injury is strong enough to justify imposing liability.

proxy Authorization to represent a corporate shareholder to serve as his or her agent and vote his or her shares in a certain manner.

public corporation A corporation owned by a federal, state, or municipal government—not to be confused with a publicly held corporation.

G L O S S A R Y G-19

public figure An individual in the public limelight. Public figures include government officials and politicians, movie stars, well-known businesspersons, and generally anybody who becomes known to the public because of his or her position or activities.

publicly held corporation A corporation whose shares are publicly traded in securities markets, such as the New York Stock Exchange or the NASDAQ.

puffery A salesperson’s exaggerated claims concerning the quality of goods offered for sale. Such claims involve opinions rather than facts and are not considered to be legally binding promises or warranties.

punitive damages Money damages that may be awarded to a plaintiff to punish the defendant and deter future similar conduct.

Q question of fact In a lawsuit, an issue involving a factual dis- pute. A question of fact can be decided by a judge or a jury.

question of law In a lawsuit, an issue involving the applica- tion or interpretation of a law. Only a judge, and not a jury, can decide a question of law.

quitclaim deed A deed that conveys only whatever interest the grantor had in the property and therefore offers the least amount of protection against defects of title.

quorum The number of members of a decision-making body that must be present before business may be transacted.

quota A quota is a government-imposed trade restriction that limits the number, or sometimes the value, of goods and services that can be imported or exported during a particular time period.

R ratification The act of accepting and giving legal force to an obligation that previously was not enforceable. reaffirmation agreement An agreement between a debtor and a creditor in which the debtor voluntarily agrees to pay a debt dischargeable in bankruptcy.

real property Land and everything attached to it, such as trees and buildings.

reasonable person standard The standard of behavior expected of a hypothetical “reasonable person.” The stan- dard against which negligence is measured and that must be observed to avoid liability for negligence.

rebuttal The refutation of evidence introduced by an adverse party’s attorney.

record According to the Uniform Electronic Transac- tions Act, information that is either inscribed on a tangible medium or stored in an electronic or other medium, and that is retrievable.

recording statute A statute that allow deeds, mortgages, and other real property transactions to be recorded so as to provide notice to future purchasers or creditors of an existing claim on the property.

reformation A court-ordered correction of a written contract so that it ref lects the true intentions of the parties.

Regulation Z A set of rules issued by the Federal Reserve Board of Governors to implement the provisions of the Truth- in-Lending Act.

rejoinder The defendant’s answer to the plaintiff ’s rebuttal.

release A contract in which one party forfeits the right to pursue a legal claim against the other party.

relevant evidence Evidence tending to make a fact at issue in the case more or less probable than it would be without the evidence. Only relevant evidence is admissible in court.

remedy at law A remedy available in a court of law. Money damages are awarded as a remedy at law.

remedy in equity A remedy allowed by courts in situations where remedies at law are not appropriate. Remedies in equity include injunction, specific performance, rescission and resti- tution, and reformation.

remedy The relief given to an innocent party to enforce a right or compensate for the violation of a right.

replevin (pronounced rih-plehpronounced rih-plehpronounced rih- -vin) An action to recover specific goods in the hands of a party who is wrongfully with- holding them from the other party.

reporter A publication in which court cases are published, or reported.

requirements contract An agreement in which a buyer agrees to purchase and the seller agrees to sell all or up to a stated amount of what the buyer needs or requires.

resale price maintenance agreement An agreement between a manufacturer and a retailer in which the manufacturer specifies what the retail prices of its products must be.

rescission (pronounced rih-sih-zhen) A remedy whereby a contract is canceled and the parties are returned to the posi- tions they occupied before the contract was made; may be effected through the mutual consent of the parties, by their conduct, or by court decree.

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residential use Use of land for construction of buildings for human habitation only.

respondeat superior A doctrine under which a principal- employer is liable for any harm caused to a third party by an agent-employee in the course or scope of employment.

respondent In equity practice, the party who answers a com- plaint or other proceeding.

restitution An equitable remedy under which a person is restored to his or her original position prior to loss or injury, or placed in the position he or she would have been in had the breach not occurred.

restraint of trade Any contract or combination that tends to eliminate or reduce competition, effect a monopoly, artificially maintain prices, or otherwise hamper the course of trade and commerce as it would be carried on if left to the control of natural economic forces.

restrictive covenant A private restriction on the use of land. If its benefit or obligation passes with the land’s ownership, it is said to “run with the land.”

retained earnings The portion of a corporation’s profits that has not been paid out as dividends to shareholders.

revocation In contract law, the withdrawal of an offer by an offeror. Unless an offer is irrevocable, it can be revoked at any time prior to acceptance without liability.

right of contribution The right of a co-surety who pays more than his or her proportionate share on a debtor’s default to recover the excess paid from other co-sureties.

right of reimbursement The legal right of a person to be restored, repaid, or indemnified for costs, expenses, or losses incurred or expended on behalf of another.

right of subrogation The right of a person to stand in the place of (be substituted for) another, giving the substituted party the same legal rights that the original party had.

right-to-work law A state law providing that employees may not be required to join a union as a condition of retaining employment.

robbery The act of forcefully and unlawfully taking personal property of any value from another; force or intimidation is usually necessary for an act of theft to be considered a robbery.

rulemaking The process by which an administrative agency formally adopts a new regulation or amends an old one.

rule of four A rule of the United States Supreme Court under which the Court will not issue a writ of certiorari unless at certiorari unless at certiorari least four justices agree to do so.

rule of reason A test used to determine whether an anticom- petitive agreement constitutes a reasonable restraint on trade. Courts consider such factors as the purpose of the agreement, its effect on competition, and whether less restrictive means could have been used.

rules of evidence Rules governing the admissibility of evi- dence in trial courts.

S sale The passing of title (evidence of ownership rights) from a seller to a buyer for a price.

sales contract A contract for the sale of goods under which the ownership of goods is transferred from a seller to a buyer for a price.

S corporation A close business corporation that has most of the attributes of a corporation, including limited liability, but qualifies under the Internal Revenue Code to be taxed as a partnership.

search warrant An order granted by a public authority, such as a judge, that authorizes law enforcement personnel to search particular premises or property.

seasonably Within a specified time period. If no period is specified, within a reasonable time.

secondary boycott A union’s refusal to work for, purchase from, or handle the products of a secondary employer, with whom the union has no dispute, for the purpose of forc- ing that employer to stop doing business with the primary employer, with whom the union has a labor dispute.

SEC Rule 10b-5 A rule of the Securities and Exchange Com- mission that prohibits the commission of fraud in connection with the purchase or sale of any security.

securities Generally, stocks, bonds, or other items that rep- resent an ownership interest in a corporation or a promise of repayment of debt by a corporation.

self-defense The legally recognized privilege to protect one’s self or property against injury by another. The privilege of self-defense protects only acts that are reasonably necessary to protect one’s self or property.

self-incrimination Giving testimony in a trial or other legal proceeding that could expose the person testifying to criminal prosecution.

seniority system A system in which those who have worked longest for an employer are first in line for promotions, salary increases, and other benefits, and are last to be laid off if the workforce must be reduced.

G L O S S A R Y G-21

service mark A mark used in the sale or the advertising of services, such as to distinguish the services of one person from the services of others. Titles, character names, and other distinctive features of radio and television programs may be registered as service marks.

service of process The delivery of the complaint and sum- mons to a defendant.

sexual harassment The demanding of sexual favors in return for job promotions or other benefits, or language or conduct that is so sexually offensive that it creates a hostile working environment.

shareholder agreement An agreement between shareholders that restricts the transferability of shares, often entered into for the purpose of maintaining proportionate control of a close corporation.

shareholder’s derivative suit A suit brought by a shareholder to enforce a corporate cause of action against a third person.

shipment contract A contract in which the seller is required to ship the goods by carrier. The buyer assumes liability for any losses or damage to the goods after they are delivered to the carrier. Generally, a contract is assumed to be a shipment contract if nothing to the contrary is stated in the contract.

short sale A sale of real property for an amount that is less than the balance owed on the mortgage loan, usually due to financial hardship.

short-swing profits Profits earned by a purchase and sale, or sale and purchase, of the same security within a six-month period.

shrink-wrap agreement An agreement whose terms are expressed in a document located inside a box in which goods (usually software) are packaged; sometimes called a shrink- wrap license.

slander Defamation in oral form.

slander of quality The publication of false information about another’s product, alleging that it is not what its seller claims.

slander of title The publication of a statement that denies or casts doubt on another’s legal ownership of any property causing financial loss to that property’s owner; also called trade libel.

small claims court Special courts in which parties may liti- gate small claims (usually, claims involving $2,500 or less). Attorneys are not required in small claims courts and in many states are not allowed to represent the parties.

social media Forms of communication through which users create and share information, ideas, messages, and other con- tent via the Internet.

sociological school A school of legal thought that views the law as a tool for promoting justice in society.

sole proprietorship The simplest form of business organiza- tion, in which the owner is the business. The owner reports business income on his or her personal income tax return and is legally responsible for all debts and obligations incurred by the business.

sovereign immunity A doctrine that immunizes foreign nations from the jurisdiction of U.S. courts when certain con- ditions are satisfied.

sovereignty The quality of having independent authority over a geographic area. For instance, state governments have the authority to regulate affairs within their borders.

space law Law consisting of the international and national laws that govern activities in outer space.

spam Bulk, unsolicited (junk) e-mail.

special damages In a tort case, an amount awarded to com- pensate the plaintiff for quantifiable monetary losses, such as medical expenses, property damage, and lost wages and ben- efits (now and in the future).

special-use permit A permit granted by local zoning authori- ties that allows for a specific exemption to zoning regulations for a particular piece of land.

special warranty deed A deed that warrants only that the grantor held good title during his or her ownership of the property and does not warrant that there were no defects of title when the property was held by previous owners.

specific performance An equitable remedy requiring the breaching party to perform as promised under the contract; usually granted only when money damages would be an inad- equate remedy and the subject matter of the contract is unique (for example, real property).

stakeholders Groups, other than the company’s shareholders, that are affected by corporate decisions. Stakeholders include employees, customers, creditors, suppliers, and the community in which the corporation operates.

standing to sue The requirement that an individual must have a sufficient stake in a controversy before he or she can bring a lawsuit. The plaintiff must demonstrate that he or she has been either injured or threatened with injury.

stare decisis A common law doctrine under which judges are obligated to follow the precedents established in prior decisions.

Statute of Frauds A state statute under which certain types of contracts must be in writing to be enforceable.

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statute of limitations A federal or state statute setting the maximum time period during which a certain action can be brought or certain rights enforced.

statute of repose Basically, a statute of limitations that is not dependent on the happening of a cause of action. Statutes of repose generally begin to run at an earlier date and run for a longer period of time than statutes of limitations.

statutory law The body of law enacted by legislative bodies (as opposed to constitutional law, administrative law, or case law).

stock An ownership (equity) interest in a corporation, mea- sured in units of shares.

stock certificate A certificate issued by a corporation evi- dencing the ownership of a specified number of shares in the corporation.

stock option A right to buy a given number of shares of stock at a set price, usually within a specified time period.

stock warrant A certificate that grants the owner the option to buy a given number of shares of stock, usually within a set time period.

strict liability Liability regardless of fault. In tort law, strict liability may be imposed on defendants in cases involving abnormally dangerous activities, dangerous animals, or defec- tive products.

strike An action undertaken by unionized workers when col- lective bargaining fails. The workers leave their jobs, refuse to work, and (typically) picket the employer’s workplace.

substantive law Law that defines, describes, regulates, and creates legal rights and obligations.

summary jury trial A method of settling disputes in which a trial is held, but the jury’s verdict is not binding. The verdict acts only as a guide to both sides in reaching an agreement during the mandatory negotiations that immediately follow the summary jury trial.

summons A document informing a defendant that a legal action has been commenced against him or her and that the defendant must appear in court on a certain date to answer the plaintiff ’s complaint. The document is delivered by a sher- iff or any other person so authorized.

superseding cause An intervening force or event that breaks the connection between a wrongful act and an injury to another; in negligence law, a defense to liability.

supremacy clause The provision in Article VI of the U.S. Constitution that provides that the Constitution, laws, and treaties of the United States are “the supreme Law of the Land.” Under this clause, state and local laws that directly conf lict with federal law will be rendered invalid.

surety A person, such as a cosigner on a note, who agrees to be primarily responsible for the debt of another.

suretyship An express contract in which a third party to a debtor-creditor relationship (the surety) promises to be pri- marily responsible for the debtor’s obligation.

symbolic speech Nonverbal conduct that expresses opinions or thoughts about a subject. Symbolic speech is protected under the First Amendment’s guarantee of freedom of speech.

T taking The government’s taking of private property for pub- lic use through the power of eminent domain.

tangible employment action A significant change in employment status or benefits, such as occurs when an employee is fired, refused a promotion, or reassigned to a lesser position.

tangible property Property that has physical existence and can be distinguished by the senses of touch, sight, and so on. A car is tangible property.

tariff A tax on imported goods.

tenancy at sufferance A tenancy that arises when a tenant wrongfully continues to occupy leased property after the lease has terminated.

tenancy at will A type of tenancy that either the landlord or the tenant can terminate without notice.

tenancy by the entirety Joint ownership of property by a married couple in which neither spouse can transfer his or her interest in the property without the consent of the other.

tenancy in common Joint ownership of property in which each party owns an undivided interest that passes to his or her heirs at death.

tender An unconditional offer to perform an obligation by a person who is ready, willing, and able to do so.

tender of delivery Under the Uniform Commercial Code, a seller’s or lessor’s act of placing conforming goods at the disposal of the buyer or lessee and giving the buyer or lessee whatever notification is reasonably necessary to enable the buyer or lessee to take delivery.

G L O S S A R Y G-23

third party beneficiary One for whose benefit a promise is made in a contract but who is not a party to the contract.

tippee A person who receives inside information.

title insurance Insurance commonly purchased by a pur- chaser of real property to protect against loss in the event that the title to the property is not free from liens or superior own- ership claims.

tolling Temporary suspension of the running of a prescribed period (such as a statute of limitations). For instance, a statute of limitations may be tolled until the party suffering an injury has discovered it or should have discovered it.

tort A civil wrong not arising from a breach of contract. A breach of a legal duty that proximately causes harm or injury to another.

tortfeasor One who commits a tort.

toxic tort A civil wrong arising from exposure to a toxic sub- stance, such as asbestos, radiation, or hazardous waste.

trade dress The image and overall appearance of a product— for example, the distinctive decor, menu, layout, and style of service of a particular restaurant. Basically, trade dress is sub- ject to the same protection as trademarks.

trade fixture The personal property of a commercial tenant that has been installed or affixed to real property for a busi- ness purpose. When the lease ends, the tenant can remove the fixture but must repair any damage to the real property caused by the fixture’s removal.

trade libel The publication of false information about anoth- er’s product, alleging that it is not what its seller claims; also referred to as slander of quality.

trademark A distinctive mark, motto, device, or implement that a manufacturer stamps, prints, or otherwise affixes to the goods it produces so that they may be identified on the market and their origins made known. Once a trademark is estab- lished (under the common law or through registration), the owner is entitled to its exclusive use.

trade name A term that is used to indicate part or all of a business’s name and that is directly related to the business’s reputation and goodwill. Trade names are protected under the common law (and under trademark law, if the name is the same as the firm’s trademark).

trade secret Information or a process that gives a business an advantage over competitors who do not know the information or process.

transferred intent A legal principle under which a person who intends to harm one individual, but unintentionally harms a different individual, can be liable to the second victim for an intentional tort.

treaty An agreement formed between two or more indepen- dent nations.

treble damages Damages that, by statute, are three times the amount of actual damages suffered.

trespass to land The entry onto, above, or below the surface of land owned by another without the owner’s permission or legal authorization.

trespass to personal property The unlawful taking or harming of another’s personal property; interference with another’s right to the exclusive possession of his or her per- sonal property.

triple bottom line The idea that investors and others should consider not only corporate profits, but also the corporation’s impact on people and on the planet in assessing the firm. (The bottom line is people, planet, and profits.)

tying arrangement A seller’s act of conditioning the sale of a product or service on the buyer’s agreement to purchase another product or service from the seller.

typosquatting A form of cybersquatting that relies on mis- takes, such as typographical errors, made by Internet users when inputting information into a Web browser.

U ultra vires acts Acts of a corporation that are beyond its express and implied powers to undertake (the Latin phrase means “beyond the powers”).

unconscionable (pronounced un-kon-shun-uh-bul) con- tract or clause A contract or clause that is void on the basis of public policy because one party, as a result of his or her disproportionate bargaining power, is forced to accept terms that are unfairly burdensome and that unfairly benefit the dominating party.

undisclosed principal A principal whose identity is unknown by a third party, and that person has no knowledge that the agent is acting for a principal at the time the agent and the third party form a contract.

undue inf luence Persuasion that is less than actual force but more than advice and that induces a person to act according to the will or purposes of the dominating party.

unenforceable contract A valid contract rendered unenforce- able by some statute or law.

G-24 G L O S S A R Y

uniform law A model law created by the National Confer- ence of Commissioners on Uniform State Laws and/or the American Law Institute for the states to consider adopting. If the state adopts the law, it becomes statutory law in that state. Each state has the option of adopting or rejecting all or part of a uniform law.

unilateral contract A contract that results when an offer can be accepted only by the offeree’s performance.

unilateral mistake A mistake that occurs when one party to a contract is mistaken as to a material fact.

union shop A firm that requires all workers, once employed, to become union members within a specified period of time as a condition of their continued employment.

unliquidated debt A debt that is uncertain in amount.

unreasonably dangerous product In product liability, a product that is defective to the point of threatening a con- sumer’s health and safety. A product will be considered unrea- sonably dangerous if it is dangerous beyond the expectation of the ordinary consumer or if a less dangerous alternative was economically feasible for the manufacturer, but the manufac- turer failed to produce it.

U.S. trustee A government official who performs certain administrative tasks that a bankruptcy judge would otherwise have to perform.

usury Charging an illegal rate of interest.

utilitarianism An approach to ethical reasoning in which ethically correct behavior is related to an evaluation of the consequences of a given action on those who will be affected by it. In utilitarian reasoning, a “good” decision is one that results in the greatest good for the greatest number of people affected by the decision.

V valid contract A contract that results when the elements necessary for contract formation (agreement, consideration, contractual capacity, and legality) are present.

validation notice An initial notice to a debtor from a collec- tion agency informing the debtor that he or she has thirty days to challenge the debt and request verification.

variance An exception from zoning rules granted to a prop- erty owner by local zoning authorities.

venture capital Financing provided by professional, outside investors—that is, venture capitalists, usually groups of wealthy investors and securities firms—to new business ventures.

venue (pronounced ven-yoo) The geographical district in which an action is tried and from which the jury is selected.

verdict A formal decision made by a jury.

vertical merger The acquisition by a company at one stage of production of a company at a higher or lower stage of production (as when a company merges with one of its suppliers or retailers).

vertical restraint A restraint of trade created by an agree- ment between firms at different levels in the manufacturing and distribution process.

vertically integrated firm A firm that carries out two or more functional phases (manufacturing, distribution, and retailing, for example) of the chain of production.

vesting The creation of an absolute or unconditional right or power.

vicarious liability Indirect liability imposed on a supervisory party (such as an employer) for the actions of a subordinate (such as an employee) because of the relationship between the two parties.

virus A type of malware that is transmitted between comput- ers and attempts to do deliberate damage to systems and data.

void contract A contract having no legal force or binding effect.

voidable contract A contract that may be legally avoided (canceled) at the option of one of the parties.

voir dire A French phrase meaning, literally, “to see, to speak” that refers to the jury-selection process. In voir dire, the attorneys question prospective jurors to determine whether they are biased or have any connection with a party to the action or with a prospective witness.

voluntary consent Knowing and voluntary agreement to the terms of a contract. If voluntary consent is lacking, the con- tract will be voidable.

voting trust An agreement (trust contract) under which legal title to shares of corporate stock is transferred to a trustee who is authorized by the shareholders to vote the shares on their behalf.

W waiver An intentional, knowing relinquishment of a legal right.

warranty deed A deed in which the grantor promises that she or he has title to the property conveyed in the deed, that there are no undisclosed encumbrances on the property, and that the grantee will enjoy quiet possession of the property; provides the greatest amount of protection for the grantee.

G L O S S A R Y G-25

waste The use of real property in a manner that damages or destroys its value.

watered stock Shares of stock issued by a corporation for which the corporation receives, as payment, less than the fair market value of the shares.

wetlands Areas of land designated by government agencies as protected areas that support wildlife and that therefore cannot be filled in or dredged by private parties.

whistleblowing An employee’s disclosure to government authorities, upper-level managers, or the media that the employer is engaged in unsafe or illegal activities.

white-collar crime Nonviolent crime committed by indi- viduals or corporations to obtain a personal or business advantage.

winding up The second of two stages in the termination of a partnership or corporation, in which the firm’s assets are collected, liquidated, and distributed, and liabilities are discharged.

workers’ compensation law A state statute establishing an administrative procedure for compensating workers for injuries that arise out of, or in the course of, their employment, regardless of fault. Instead of suing the employer, an injured worker files a claim with the state agency or board that administers local workers’ compensation claims.

workout agreement A formal contract between a debtor and his or her creditors in which the parties agree to negotiate a payment plan for the amount due on the loan instead of pro- ceeding to foreclosure.

worm A type of malware that is designed to copy itself from one computer to another without human interaction. A worm can copy itself automatically and can replicate in great volume and with great speed.

writ of attachment A court’s order, prior to a trial to collect a debt, directing the sheriff or other officer to seize nonexempt property of the debtor. If the creditor prevails at trial, the seized property can be sold to satisfy the judgment.

writ of certiorari (pronounced sur-shee-uh-rah-ree) A writ from a higher court asking the lower court for the record of a case.

writ of execution A court’s order, after a judgment has been entered against the debtor, directing the sheriff to seize (levy) and sell any of the debtor’s nonexempt real or personal prop- erty. The proceeds of the sale are used to pay off the judgment, accrued interest, and costs of the sale. Any surplus is paid to the debtor.

wrongful discharge An employer’s termination of an employee’s employment in violation of the law or an employ-employee’s employment in violation of the law or an employ-employee’s employment in violation of the law or an employ ment contract.

Z zoning laws Rules and regulations that collectively manage the development and use of land.

TA B L E O F C A S E S TC-1

TC-1

Following is a list of all the cases mentioned in this text, including those within the footnotes, fea- tures, and case problems. Any case that was an excerpted case for a chapter is given special emphasis by having its title boldfaced.

A Abraham v. Alpha Chi Omega, 155 Access Cardiosystems, Inc., In re, 603 Aceves v. U.S. Bank, N.A., 261 Adams v. Sears Roebuck and Co., 297 A. Gadley Enterprises, Inc. v. Department of Labor and

Industry Office of Unemployment Compensation Tax Services, 352–353

Al-Dabagh v. Case Western Reserve University, 99 Alden v. Maine, 466 Alexander v. Stibal, 283 Allen v. City of Chicago, 98 Allied Concrete Co. v. Lester, 69 Allied Erecting and Dismantling Co. v. Genesis Equipment &

Manufacturing, Inc., 105 Allied Shelving and Equipment, Inc. v. National Deli, LLC, 312 Already, LLC v. Nike, Inc., 251–252 American Express Co. v. Italian Colors Restaurant, 109, 267 American Library Association, United States v., 80 Amsterdam Associates LLC v. Alianza LLC, 415 Anderson, In re, 332–333 Antilles Cement Corp. v. Fortuno, 87 APL Limited v. Washington State Department of Revenue, 549 Apple, Inc., United States v., 571 Apple, Inc. v. Samsung Electronics Co., 158 Appler v. Mead Johnson & Co., 179 Application of the United States of America for an Order Pursu-

ant to 18 U.S.C. Section 2703(d), In re, 186 Arbaugh v. Y&H Corp., 453 Arizona v. United States, 476 Arkansas Game and Fish Commission v. United States, 562 Arkansas-Missouri Forest Products, LLC v. Lerner, 260–261 Armadillo Distribution Enterprises, Inc. v. Hai Yun Musical

Instruments Manufacture Co., Ltd., 305 Armenian Assembly of America, Inc. v. Cafesjian, 398 Arnold, Schwinn & Co., United States v., 572 Arthur v. Medtronic, Inc., 308 Ashley County, Arkansas v. Pfizer, Inc., 105 Asphalt & Concrete Services, Inc. v. Perry, 431–432 AT&T Mobility, LLC v. Concepcion, 43, 108, 267 Auer v. Paliath, 437 Austin v. Nestlé USA, Inc., 46 Authors Guild, Inc. v. HathiTrust, 163 Ayers v. Shaffer, 266 Azur v. Chase Bank, USA, N.A., 420

B Bad Frog Brewery, Inc. v. New York State Liquor

Authority, 78–79 Bagley v. Mt. Bachelor, Inc., 257 Bahr v. Technical Consumer Products, Inc., 260 Bailey v. TitleMax of Georgia, Inc., 443–444 Baker v. Walnut Bowls, Inc., 554 Balboa Island Village Inn, Inc. v. Lemen, 88 Ballard v. Chicago Park District, 445 Bank of New England, United States v., 191 Baptist Memorial Hospital-North Mississippi, Inc. v. Lambert,

282–283 Barta, United States v., 210 Basis Technology Corp. v. Amazon.com, Inc., 240 Bates v. Dow Agrosciences, LLC, 543 Batson v. Live Nation Entertainment, Inc., 579 Bauer v. Lynch, 458–459 B&B Hardware Inc. v. Hargis Industries, Inc., 36 Beckham v. Bauer Pub. Co., L.P., 118 Bell Atlantic Corp. v. Twombly, 580 Bello v. Village of Skokie, 469 Belmont v. MB Investment Partners, Inc., 389 Bennett v. Islamic Republic of Iran, 215–216 Bergin v. Wild Mountain, Inc., 257 Bessemer & Lake Erie Railroad Co. v. Seaway Marine

Transport, 112 Best Cartage, Inc. v. Stonewall Packaging, LLC, 357 Bestfoods, United States v., 544 Biglane v. Under the Hill Corp., 550 Bishop v. U.S. ex rel. Holder, 72ex rel. Holder, 72ex rel Blackmon v. Iverson, 250 Blackwell Publishing, Inc. v. Custom Copies, Inc., 169 Blake v. Giustibelli, 115–116 Blanton v. Newton Associates, Inc., 473 Bluewater Logistics, LLC v. Williford, 386 BMW Group, LLC v. Castle Oil Corp., 293–294 Board of Supervisors of Louisiana State University v. Smack

Apparel Co., 155 Board of Trustees of the University of Alabama v. Garrett, 466 Boles v. Sun Ergoline, Inc., 145 Bradford v. Department of Community Based Services, 472 Brand v. Hyundai Motor America, 309 Brantley v. NBC Universal, Inc., 570 Brennan’s, Inc. v. Colbert, 400 Brinkley v. Pfizer, Inc., 142

Table of Cases

TC-2 TA B L E O F C A S E S

Broadcom Corp. v. Qualcomm, Inc., 573 Brothers v. Winstead, 58 Brown & Brown, Inc. v. Johnson, 255 Brown v. Board of Education of Topeka, 9 Brown v. Entertainment Merchants Association, 143 Brown v. Lagrange Development Corp., 243 Brown v. University of Kansas, 88 Brown v. Waldron, 372 Brown v. W.P. Media, Inc., 396 Bruesewitz v. Wyeth, LLC, 138–139 Brulotte v. Thys Co., 9 BUC International Corp. v. International Yacht

Council, Ltd., 161 Bunch v. Hoffinger Industries, Inc., 143 Burck v. Mars, Inc., 120 Burlington Industries, Inc. v. Ellerth, 463 Burwell v. Hobby Lobby Stores, Inc., 494 Busch v. Viacom International, Inc., 115

C Calles v. Scripto-Tokai Corp., 149 Campaign for Southern Equality v. Bryant, 72 Carlyle Investment Management, LLC v. Moonmouth Co.

SA, 222 Carman, In re, 293 Carrier Corp. v. Outokumpu Oyj, 583 Caterpillar, Inc. v. Sudlow, 439–440 Cayer v. Cox Rhode Island Telecom, LLC, 436 Century 21 Real Estate, LLC v. All Professional Realty, Inc., 366 Chamber of Commerce of the United States v. Securities and

Exchange Commission, 512 Chammas v. NavLink, Inc., 402 Checker Cab of Philadelphia v. Uber Technologies, Inc., 418 Chevron U.S.A., Inc. v. Natural Resources Defense Council,

Inc., 507–508 Chicago Board of Trade v. United States, 570 Chinasa, United States v., 196 Christy Sports, LLC v. Deer Valley Resort Co., 586 Citizens United v. Federal Election Commission, 77–78 City of Livonia Employees’ Retirement System and Local 295/

Local 851 v. Boeing Co., 600 Clean Vehicle Solutions America, LLC v. Carrolton Exempted

Village School District Board of Education, 320 Cleary v. Philip Morris USA, Inc., 530 Cleveland Construction, Inc. v. Levco Construction, Inc., 43 Clint Pharmaceuticals v. Northfield Urgent Care, LLC, 68–69 Coca-Cola Co., The v. The Koke Co. of America, 150–151 Coco Investments, LLC v. Zamir Manager River

Terrace, LLC, 386 Cohan Lipp, LLC v. Crabtree Ridge, LLC, 279 Cohen v. McDonald’s Corp., 530 Cohen v. Seinfeld, 283 Coker v. Pershad, 418 Coleman Holdings Limited Partnership v. Eklund, 263 Colgate & Co., United States v., 575 Collier v. Turner Industries Group, LLC, 457

Commonwealth v. ______________. See name of opposing See name of opposing See party

Comptroller of Treasury of Maryland v. Wynne, 75 Conley v. National Mines Corp., 513 Conrad v. Bendewald, 168 Consolidated Edison Co. v. Public Service Commission, 77 Contemporary Cars, Inc. v. National Labor Relations Board,

481–482 Continental T.V., Inc. v. GTE Sylvania, Inc., 572 Cooley v. Penguin Group (USA), Inc., 419 Cordance Corp. v. Amazon.com, Inc., 160 Cotter v. Lyft, Inc., 418 Country Contractors, Inc. v. A Westside Storage of Indianapolis,

Inc., 415 Covenant Health & Rehabilitation of Picayune, LP v.

Lumpkin, 47 Cowher v. Carson & Roberts, 376 Craker v. Drug Enforcement Administration, 506–507 Crawford v. Metropolitan Government of Nashville and David-

son County, Tennessee, 464 Cruise v. Kroger Co., 43 Cumbie v. Woody Woo, Inc., 442 Cummings, In re, 336

D Daimler AG v. Bauman, 223–224 Dartmouth College, Trustees of, v. Woodward, 391 David v. Textor, 181–182 Davis v. HSBC Bank Nevada, N.A., 106 Davis Wine Co. v. Vina Y Bodega Estampa, S.A., 372 Dawson v. Entek International, 473 Dayton Superior Corp. v. Spa Steel Products, Inc., 586 Delano Farms Co. v. California Table Grape Commission, 169 Dewhurst, In re, 354 DeWine v. Valley View Enterprises, Inc., 381–382 Dickman v. University of Connecticut Health Center, 105–106 DIRECTV, Inc. v. Imburgia, 267 Dissolution of Midnight Star Enterprises, LP, In re, 384 Dobrovolny v. Ford Motor Co., 148 Dodona I, LLC v. Goldman, Sachs & Co., 608 Doe 1 v. AOL, LLC, 25 Dog House Investments, LLC v. Teal Properties, Inc., 399 Domino’s Pizza, LLC v. Reddy, 370 Downey v. Bob’s Discount Furniture Holdings, Inc., 63 Drake Manufacturing Co. v. Polyflow, Inc., 390–391 Drake v. Walton County, 563 Durkee v. Geologic Solutions, Inc., 149 Dweck v. Nasser, 414 Dynea USA, Inc. v. Fairbanks, 451

E Eastern Railroad Presidents Conference v. Noerr Motor Freight,

Inc., 582 Ebanks v. Ebanks, 567 eBay, Inc. v. MercExchange, LLC, 159 EEOC v. Waffle House, Inc., 466

TA B L E O F C A S E S TC-3

Eldred v. Ashcroft, 160 Elliot v. Google, 155 Elonis v. United States, 79 Emerick v. Cardiac Study Center, Inc., 280 Engler v. Atlantic Resource Management, LLC, 530 Entergy Corp. v. Riverkeeper, Inc., 540–541 Equal Employment Opportunity Commission v.

Autozone, Inc., 25 Eriksson v. Nunnink, 282 Espinoza v. Arkansas Valley Adventures, LLC, 261 ESPN, Inc. v. Quiksilver, Inc., 154 Espresso Disposition Corp. 1 v. Santana Sales & Marketing

Group, Inc., 54–55 Eurodif, S.A., United States v., 228 Executive Home Care Franchising, LLC v. Marshall Health

Corp., 370

F Fabian v. Hospital of Central Connecticut, 461 Fadal Machining Centers, LLC v. Mid-Atlantic CNC, Inc., 386 Fair Housing Council of San Fernando Valley v. Roommate.com,

LLC, 180 Family Winemakers of California v. Jenkins, 74 Faragher v. City of Boca Raton, 463 Faretta v. California, 48 Farmers Insurance Exchange v. Morris, 283 Faush v. Tuesday Morning, Inc., 478 FCR Realty, LLC v. Green, 415 Federal Baseball Club of Baltimore, Inc. v. National League of

Professional Baseball Clubs, 582 Federal Communications Commission v. Fox Television

Stations, Inc., 502 Federal Express Corp. v. JetEx Management Services, Inc., 155 Federal Trade Commission v. Bronson Partners, LLC, 518 Federal Trade Commission v. Check Investors, Inc., 531 Federal Trade Commission v. MedLab, Inc., 515 Federal Trade Commission v. PCCare247, Inc., 53 Federal Trade Commission v. Ross, 530–531 Federal Trade Commission v. Verity International, Ltd., 518 Federal Trade Commission v. Wyndham Worldwide Corp., 231 Federal Treasury Enterprise Sojuzplodoimport v. Spirits Interna-

tional B.V., 229 FedEx Corp., United States v., 191 1545 Ocean Avenue, LLC, In re, 386 First National Bank of Boston v. Bellotti, 77 Fischer v. Magyar Államvasutak Zrt., 228–229 Fitl v. Strek, 306–307 Fleshner v. Pepose Vision Institute, 68 Flores, United States v., 83 FMS, Inc. v. Volvo Construction Equipment North America,

Inc., 364 Forman Awnings and Construction, LLC v. LO

Ventures, LLC, 312 Fortunato v. Chase Bank USA, 53 Franklin Collection Service, Inc. v. Mississippi Department of

Employment Security, 47

Friends of Animals v. Clay, 533–534 Frontenac Bank v. T.R. Hughes, Inc., 525 FS Partners v. York County Tax Claim Bureau, 370 Fteja v. Facebook, Inc., 246

G Gansman, United States v., 598 Garcia v. Lucero, 369 Gebhart v. SEC, 600 George V Restauration S.A. v. Little Rest Twelve, Inc., 157 Gianelli, In re, 168–169 Gibbons v. Ogden, 72 Gilmer v. Interstate Johnson Lane Corp., 43 Glacial Plains Cooperative v. Lindgren, 290 Glass, In re, 105 Gobran Auto Sales, Inc. v. Bell, 313 GoDaddy.com, LLC. v. Toups, 119 GoJet Airlines, LLC v. F.A.A., 513 Goldberg v. UBS AG, 214 Gomez-Perez v. Potter, 465 Gonzales v. Raich, 74 Gould v. North Kitsap Business Park Management, LLC, 133 Grand Harbour Condominium Owners Association, Inc. v.

Grogg, 345 Gray Printing Co. v. Blushing Brides, LLC, 387 Green, State of New York v., 210 Greenman v. Yuba Power Product, Inc., 138 Green Mountain Chrysler Plymouth Dodge Jeep v.

Crombie, 547 Grinnell Corp., United States v., 573 Griswold v. Connecticut, 85 Gross v. FBL Financial Services, 465 Guard Publishing v. NLRB, 483 Gucci America, Inc. v. Wang Huoqing, 32–33 Guffey v. Ostonakulov, 31 Guilliver Schools, Inc. v. Snay, 176 Gunasekera v. Irwin, 87 Guth v. Loft, Inc., 404–405 Gutierrez, United States v., 201 Gyabaah v. Rivlab Transportation Corp., 241

H Hallmark Cards, Inc. v. Murley, 275 Hall v. Geiger-Jones Co., 603 Hampton Road Bankshares, Inc. v. Harvard, 274 Hanjuan Jin, United States v., 168 Hann, In re, 344 Harvestons Securities, Inc. v. Narnia Investments, Ltd., 69 Hasbro, Inc. v. Internet Entertainment Group, Ltd., 173–174 Hashmi v. Mukasey, 490 Hassan, United States v., 185 H & C Ag Services, LLC v. Ohio Fresh Eggs, LLC, 285 Heart of Atlanta Motel v. United States, 73–74 Heller, District of Columbia v., 76 Henrichs v. Chugach Alaska Corp., 403 Hernandez v. Banks, 254

TC-4 TA B L E O F C A S E S

Hinkal v. Pardoe, 243–244 Hinners v. Robey, 31 H&J Ditching & Excavating, Inc. v. Cornerstone Community

Bank, 283 Hodge v. Strong Built International, LLC, 373–374 Hoffman v. Verizon Wireless, Inc., 415 Holden v. Holden, 436 Holiday Inn Franchising, Inc. v. Hotel Associates, Inc.,

367–368 Holmes v. Multimedia KSDK, Inc., 256 Holt v. Hobbs, 81 Horn v. Knight Facilities Management-GM, Inc., 473 Horton Automatics v. The Industrial Division of the Communi-

cations Workers of America, AFL-CIO, 46–47 HSBC Realty Credit Corp. (USA) v. O’Neill, 323 Huerta v. Pirker, 295 Hunter v. Mansell, 567 Hurst v. Socialist People’s Libyan Arab Jamahiriya, 229 Huskin v. Hall, 436 Hustler Magazine, Inc. v. Falwell, 115

I Illinois Tool Works, Inc. v. Independent Ink, Inc., 578 Imoff Investment, LLC v. Alfoccinio, Inc., 521 Inhale, Inc. v. Starbuzz Tobacco, Inc., 161 Integrity Staffing Solutions, Inc. v. Busk, 98 Intel Corp. Microprocessor Antitrust Litigation, In re, 60 Interactive Media Entertainment and Gaming Association, Inc.

v. Attorney General of United States, 347 International Shoe Co. v. State of Washington, 27 Izquierdo v. Gyroscope, Inc., 127

J Jacob & Youngs v. Kent, 269 Jamieson v. Woodward & Lothrop, 146 Jardines, Florida v., 202 Jaynes v. Commonwealth of Virginia, 204 Jernigan v. Crane, 72 Jiann Min Chang v. Alabama Agricultural and Mechanical

University, 455 Ji-Haw Industrial Co. v. Broquet, 27 Jirak Construction, LLC v. Balk, 345 Joel v. Morison, 432 Johnson Construction Co. v. Shaffer, 100 Johnson v. Federal Exp. Corp., 470 Johnson v. Medtronic, Inc., 142 Johnson v. Oxy USA, Inc., 36–37 Jones, United States v., 156, 201 Jones v. Star Credit Corp., 291 Juliana v. United States, 537

K Kelo v. City of New London, Connecticut, 562 Kenset Corp. v. Ilanjian, 105 Kent State University v. Ford, 277–278

Khulumani v. Barclay National Bank, Ltd., 223 Kimble v. Marvel Entertainment, LLC, 9 Kindred Nursing Centers East, LLC v. Jones, 436–437 King v. Burwell, 494 Kiobel v. Royal Dutch Petroleum Co., 223 Kirtsaeng v. John Wiley & Sons, Inc., 164 Kitchen v. Herbert, 72 Kiwanuka v. Bakilana, 132–133 Klinger v. Conan Doyle Estate, Ltd., 160 Knox Creek Coal Corp. v. Secretary of Labor, 513 Kohel v. Bergen Auto Enterprises, LLC, 270–271 Kolon Industries, Inc. v. E.I. DuPont de Nemours & Co., 573 Kozeny, United States v., 105 Krueger, In re, 345 KSR International Co. v. Teleflex Inc., 158 Kuehn, In re, 329 Kwan v. Clearwire Corp., 260

L LabMD, Inc. v. Tiversa, Inc., 185 Laborers’ International Union of North America, Local 578 v.

National Labor Relations Board, 490 Lane v. Facebook, Inc., 105 Laurel Creek Health Care Center v. Bishop, 420 Lawrence v. Fox, 258 Leegin Creative Leather Products, Inc. v. PSKS, Inc., 572 Lee v. Miner, 71 Lenz v. Universal Music Group, 175 Les Entreprises Jacques Defour & Fils, Inc. v. Dinsick Equip-

ment Corp., 304 Lesnick v. Duval Ford, LLC, 149 Lewis v. Twenty-First Century Bean Processing, 56–57 Lexmark International, Inc. v. Static Control Components,

Inc., 520–521 LFP IP, LLC v. Hustler Cincinnati, Inc., 153–154 LG Electronics, Inc., State of Washington v., 47 Li Li v. Canberra Industries, 451–452 Linde v. Arab Bank, PLC, 214 Lin v. Dane Construction Co., 376 Litwin v. Blackstone Group, LP, 595 Louis Vuitton Malletier S.A. v. Haute Diggity Dog, LLC, 152 Loving v. Internal Revenue Service, 500–501 Lucas Contracting, Inc. v. Altisource Portfolio

Solutions, Inc., 260 Lucy v. Zehmer, 238–239 Lumley v. Gye, 123 Lundberg v. Church Farm, Inc., 428 Lyons, United States v., 196

M Macias v. Excel Building Services, LLC, 43 Maciel v. Commonwealth, 268 MacPherson v. Buick Motor Co., 135 Main Omni Realty Corp. v. Matus, 551 Mala v. Crown Bay Marina, Inc., 29–30

TA B L E O F C A S E S TC-5

Manin v. National Transportation Safety Board, 513 Manitou North American, Inc. v. McCormick

International, LLC, 586 Maple Farms, Inc. v. City School District of Elmira, 301 Marbury v. Madison, 26–27, 71 Marcum, State of Oklahoma v., 202 Marshall v. Barlow’s, Inc., 504 Marty v. Anheuser-Busch Companies, LLC, 217 Marucci Sports, LLC v. National Collegiate Athletic

Association, 586 Massachusetts v. Environmental Protection Agency, 512–513,

537, 611 Matrixx Initiatives, Inc. v. Siracusano, 608 Maverick Recording Co. v. Harper, 175 Maxwell’s Pic-Pac, Inc. v. Dehner, 84 Maya v. Johnson and Johnson, 142 Mayo Foundation for Medical Education and Research v. United

States, 508 Mbaku v. Bank of America, N.A., 529 McGee v. Sentinel Offender Services, LLC, 191 McGuan v. Endovascular Technologies, Inc., 145 McKeag v. Finley, 566–567 McKee v. Laurion, 117 McMurtry v. Weatherford Hotel, Inc., 133 McWane, Inc. v. Federal Trade Commission, 574–575 Meinhard v. Salmon, 358–359 Mekonen v. Zewdu, 377 Mickletz, In re, 335 Microsoft Corp. v. AT&T Corp., 158 Miller v. Harris, 436 Miller v. Paul M. Wolff Co., 424 Milo’s Kitchen Dog Treats Consol, In re, 179 Mintel Learning Technology, Inc. v. Ambrow Education

Holding Ltd., 165 Miranda v. Arizona, 202 M’Naghten’s Case, 200M’Naghten’s Case, 200M’Naghten’s Mohamed v. Uber Technologies, Inc., 43 Monsanto Co. v. Bowman, 158 Monsanto Co. v. Scruggs, 158 Montgomery County v. Bhatt, 559–561, 567 Morales-Cruz v. University of Puerto Rico, 464 Moran v. Willensky, 370 Mora v. Jackson Memorial Foundation, Inc., 465 Morikawa v. Zoning Board of Appeals of Town of Weston, 566 Morrison, United States v., 74 Morriss v. BNSF Railway Co., 466 Morris v. Inside Outside, Inc., 313 Morse v. Frederick, 77 Moseley v. Pepco Energy Services, Inc., 100–101 Moseley v. V Secret Catalogue Inc., 152 Murphy Oil USA, Inc. v. National Labor Relations Board, 109

N National Aeronautics and Space Administration v. Nelson, 450 National Federation of Business v. Sebelius, 494

National Football League Management Council v. National Football League Players Association, 93

National Football League Players Association v. National Foot- ball League Management Council, 46

Nautilus Insurance Co. v. Cheran Investments, LLC, 296 Nevada Department of Human Resources v. Hibbs, 466 New England Precision Grinding, Inc. v. Simply

Surgical, LLC, 313 Newton, United States v., 602 New York Central and Hudson River Railroad v. United

States, 191 New York Times Co. v. Sullivan, 118 Ng, In re, 328 Nichols v. Tri-National Logistics, Inc., 69 Nistler, State of Oregon v., 589 Nixon v. Anheuser-Busch Companies, LLC, 217 NLRB v. Town & Country Electric, Inc., 477 Norman, United States v., 210 NRT New England, LLC v. Jones, 425–426 Nucci v. Target Corp., 182–183

O Obergefell v. Hodges, 72 O’Brien, In re, 177 O’Connor v. Uber Technologies, Inc., et al., 418et al., 418et al O’Donnell v. Burlington Coat Factory Warehouse, Inc., 472 OfficeSupplyStore.com v. Kansas City School Board, 288 Ogden v. All-State Career School, 179 Ohr v. Latino Express, Inc., 490 Olivares v. Transportation Security Administration, 508–510 Olmstead v. United States, 84–85 O’Malley, United States v., 538–539 Omnicare, Inc. v. Laborers District Council Construction

Industry Pension Fund, 594–595 Oncale v. Sundowner Offshore Services, Inc., 464 OnNet USA, Inc. v. Play9D.com, 172 Ora, Commonwealth v., 77 Oracle America, Inc. v. Google Inc., 164 Owner/Operator Independent Drivers Association, Inc. v.

Federal Motor Carrier Safety Administration, 513

P Pacific Bell Telephone Co. v. Linkline

Communications, Inc., 575 Paduano v. American Honda Motor Co., 145, 522 PAK Foods Houston, LLC v. Garcia, 253 Palsgraf v. Long Island Railroad Co., 128 Pantano v. Newark Museum, 391–392 Parker v. Brown, 582 PCS Nitrogen Inc. v. Ashley II of Charleston LLC, 546–547 Pegg v. Kohn, 269 Pelman v. McDonald’s Corp., 146 Persson v. Smart Inventions, Inc., 414 Peters, United States v., 210 PhoneDog v. Kravitz, 165

TC-6 TA B L E O F C A S E S

Picerne Construction Corp. v. Castellino Villas, 319–320 Pietrylo v. Hillstone Restaurant Group, 178 Plessy v. Ferguson, 9 Polk v. Polk, 375 POM Wonderful, LLC v. Federal Trade Commission,

516–517 PRM Energy Systems v. Primenergy, 46 Probuilders Specialty Insurance Co. v. Valley Corp., 59 Pryors Coalition v. Weldon, 547 Puente Arizona v. Arpaio, 477 Purdue Frederick Co., United States v., 90

Q Quality Egg, LLC, United States v., 192

R Ragsdale v. Wolverine World Wide, Inc., 446 Raido v. Blood-Dzraqu, 53 Ramirez v. Costco Wholesale Corp., 117 Ramirez v. Reemployment Assistance Appeals Commission, 452 Rand-Heart of New York, Inc. v. Dolan, 600–601 Rangel v. sanofi aventis U.S., LLC, 473 Ransom v. FIA Card Services, N.A., 340 Rawls v. Progressive Northern Insurance Co., 133 Reed v. Thurman, 369–370 Reese v. Newman, 378–379 Regency Transportation, Inc. v. Commissioner

of Revenue, 88 Regina v. Dudley and Stephens, 25 Remijas v. Neiman Marcus Group, LLC, 232 Revell v. Guido, 120–121 Reyes-Rivera, United States v., 609 Richman v. Hartley, 567 Riegel v. Medtronic, Inc., 75, 145 Riley v. Ford Motor Co., 141 River Runners for Wilderness v. Martin, 546 Roberts v. Mike’s Trucking, Ltd., 462–463 Rodriquez v. Wal-Mart Stores, Inc., 177 Roell v. Withrow, 38 Rohr v. Salt River Project Agricultural Improvement and Power

District, 467 Rolfe, State of South Dakota v., 185 Roman Catholic Church of Our Lady of Sorrows v. Prince Realty

Management, LLC, 555 Romero v. Scoggin-Dickey Chevrolet Buick, Inc., 301 Rosa and Raymond Parks Institute for Self Development v. Tar-

get Corporation, 20, 21–23 Rose, United States v., 587 Rosendahl v. Bridgepoint Education, Inc., 246 Rosen v. Uber Technologies, Inc., 418 Roundy’s, Inc. v. NLRB, 477 Russell Realty Associates v. Russell, 362 Rylands v. Fletcher, 134

S Sacco v. Paxton, 369 Sackett v. Environmental Protection Agency, 541 Safeco Insurance Co. of America v. Burr, 528 Saint Alphonsus Medical Center-Nampa Inc. v. St. Luke’s Health

System, Ltd., 586 Sánchez-Rodriguez v. AT&T Mobility Puerto Rico, Inc., 456 San Jose, City of, v. Office of the Commissioner of Baseball, 582 Santangelo v. Comcast Corporation, 526–527 Santivanez v. Estado Plurinacional de Bolivia, 228 Saunders v. Branch Banking & Trust Co. of Virginia, 528 Savant Homes, Inc. v. Collins, 169 Scarborough v. Rollins, 559 Schmude v. Tricam Industries, Inc., 140 Schneiderman v. Trump Entrepreneur Initiative, LLC,

264–265 Schuette v. Coalition to Defend Affirmative Action, Integration

and Immigrant Rights, 471 Schwarck v. Arctic Cat, Inc., 136–137 Scott v. Carpanzano, 91–92 Scotwood Industries, Inc. v. Frank Miller & Sons, Inc., 313 SDBC Holdings, Inc. v. National Labor Relations Board, 490 Seal Polymer Industries v. Med-Express, Inc., 46 SEC v. Big Apple Consulting USA, Inc., 608–609 SEC v. Jackson, 103 SEC v. Montana, 609 SEC v. Texas Gulf Sulphur Co., 596–597 SEC v. W.J. Howey Co., 588 Selleck v. Cuenca, 265 Services Employees International Union v. National Union of

Healthcare Workers, 478–479 7-Eleven, Inc. v. Upadhyaya, 366 Sexton, In re, 345 Shankle, In re, 344 Sheridan v. Egg Harbor Township Board of Education, 376 Shoun v. Best Formed Plastics, Inc., 467 Shoyoye v. County of Los Angeles, 114 Sierra Club v. ICG Hazard, LLC, 547 Siloam Springs Hotel, LLC v. Century Surety Co., 387 Simpson, United States v., 210 Singh, United States v., 192 Sisuphan, People v., 195–196 Sky Cable, LLC v. Coley, 371 Smith, State of Minnesota v., 193 SmithKline Beecham Corp. v. Abbott Laboratories, 88 Smith v. Johnson and Johnson, 443 Smith v. State of Georgia, 186 Snapp v. Castlebrook Builders, Inc., 414–415 Sniezek v. Kansas City Chiefs Football Club, 260 Socony-Vacuum Oil Co., United States v., 570 Southern Prestige Industries, Inc. v. Independence

Plating Corp., 28 Soverain Software, LLC v. Newegg, Inc., 159

TA B L E O F C A S E S TC-7

Spectrum Stores, Inc. v. Citgo Petroleum Corp., 214 Staffing Network Holdings, LLC v. National Labor Relations

Board, 486–487 Stambovsky v. Ackley, 556–557 Standard Oil Co. of California v. United States, 578 Standard Oil of Connecticut, Inc. v. Administrator, Unemploy-

ment Compensation Act, 437 Starbucks Corp. v. Lundberg, 152 Stark v. Ford Motor Co., 148–149 Starr v. Sony BMG Music Entertainment, 586 State Farm Mutual Automobile Insurance Co. v. Campbell, 113 State Oil Co. v. Khan, 572 Steffes, State of Wisconsin v., 194 Steiner Electric Co. v. Maniscalco, 400 Steiner v. Mitchell, 98 S & T Oil Equipment & Machinery, Ltd. v. Juridica Invest-

ments, Ltd., 221 Stonhard, Inc. v. Blue Ridge Farms, LLC, 429 Stults v. International Flavors and Fragrances, Inc., 146 Suffolk County Water Authority v. Dow Chemical Co., 143 Summerhill, LLC v. City of Meridan, 15 Sunlitz Holding Co., W.L.L. v. Trading Block

Holdings, Inc., 409 Supreme Court of New Hampshire v. Piper, 71

T Takata Airbag Products Liability Litigation, In re, 134 Taser International, Inc. v. Ward, 422–423 Taylor v. Baseball Club of Seattle, LP, 129–130 Tennessee Coal, Iron & R. Co. v. Muscoda Local No. 123, 98 Tennessee v. Lane, 466 Texas EquuSearch Mounted Search and Recovery Team, RP

Search Services, Inc. v. Federal Aviation Administration, 295 Texas v. Johnson, 77 Thomas, In re, 344–345 Thompson v. Holm, 81–82 Thompson v. Jefferson Partners, 452 Thompson v. North American Stainless, LP, 464 Three Kings Holdings, L.L.C. v. Six, 346 Tinsley v. Sun Trust Bank, 321 Toyota Motor Sales, U.S.A., Inc. v. Tabari, 173 TransWeb, LLC v. 3M Innovative Properties Co., 580–581 Tri-M Group, LLC v. Sharp, 74 Trunk v. City of San Diego, 80 Tull v. Atchison Leather Products, Inc., 452 Tummino v. Hamburg, 523 Turner v. State of Arkansas, 209 26 Gaming Machines, State of Arkansas v., 346 2007 Custom Motorcycle, United States v., 296

U Uhrhahn Construction & Design, Inc. v. Hopkins, 236 UMG Recordings, Inc. v. Augusto, 163

United Fabrics International, Inc. v. C&J Wear, Inc., 168 United Mine Workers of America v. Pennington, 582 United States Telecom Association v. Federal Communications

Commission, 502 United States v. _________________. See name of opposing See name of opposing See

party United Student Aid Funds, Inc. v. Espinosa, 341 Unity Health Plans Insurance Co. v. Iowa Health System, 155 U.S. Army Corps of Engineers v. Hawkes Co., Inc., 542 U.S. Department of Labor v. American Future Systems, Inc., 442 USS-POSCO Industries v. Case, 249

V Vann v. Toys R Us, 142 Van Orden v. Perry, 80 Venture Bank v. Lapides, 338 Venture Sales, LLC v. Perkins, 378 Verizon New York, Inc. v. National Labor Relations Board, 490 Verizon v. Federal Communication Commission, 502 VeRost v. Mitsubishi Caterpillar Forklift America, Inc.,

144–145 Video Software Dealers Association v. Schwarzenegger, 143 Village of Euclid v. Ambler Realty Co., 563 Vitt v. Apple Computer, Inc., 312

W Waddell v. Boyce Thompson Institute for Plant

Research, Inc., 439 Wagner v. CitiMortgage, Inc., 35 Walker Process Equipment v. Food Machine and Chemical

Corp., 580 Wallace v. County of Stanislaus, 473 Wal-Mart Stores, Inc. v. Dukes, 454 Warner, United States v., 205–206 Warrant to Search a Certain e-Mail Account Controlled and

Maintained by Microsoft Corp., In re, 398 Watts v. Medicis Pharmaceutical Corp., 149 Webster, Estate of, v. Thomas, 361 Weidner v. Carroll, 163 Welco Electronics, Inc. v. Mora, 125 Weston v. Cornell University, 235 West Star Transportation, Inc. v. Robison, 133 Weyerhaeuser Co. v. Ross-Simons Hardwood Lumber Co.,

576–577 Wheeler, United States v., 185–186 White Plains Coat & Apron Co. v. Cintas Corp., 133 Wickard v. Filburn, 72 Williams, United States v., 80 Willis v. Coca Cola Enterprises, Inc., 451 Wilson Sporting Goods Co. v. Hickox, 141 Wilson Sporting Goods Co. v. U.S. Golf and Tennis Centers,

Inc., 300 Windsor v. United States, 72

TC-8 TA B L E O F C A S E S

Wind Tower Trade Coalition v. United States, 228 Winstead v. Jackson, 161–162 Wolfe, In re, 335 Wooden, State of Missouri v., 87 World Trade Financial Corp. v. Securities and Exchange Com-

mission, 608 Wyeth v. Levine, 145

Y Yeagle v. Collegiate Times, 132 Yelp, Inc. v. Hadeed Carpet Cleaning, Inc., 180

Young v. United Parcel Service, Inc., 459–460 Yun Tung Chow v. Reckitt & Coleman, Inc., 148

Z 02 Development, LLC v. 607 South Park, LLC, 372 Zhejiang Photovoltaic Co., Ltd., In re, 293 Zippo Manufacturing Co. v. Zippo Dot Com, Inc., 31 Zortman v. J.C. Christensen & Associates, Inc., 529

I N D E X I-1

I-1

A Abnormally dangerous activities, 134–135 Absolute privilege, 117–118 Absolute promises, 268 Abuse of process, 122 Abusive litigation, 122 Acceptance. See also Contract(s); Lease

contract; Sales contract authorized means of, 244 of bankruptcy reorganization plan, 339 of bribe, 197 by buyer or lessee, 302 CISG on, 310 communication of, 243 of contract, 235, 238 mode and timeliness of, 244–245 for mutual rescission, 272 of offer, 238, 242–245 online, 246–247 partial, 302 revocation of, 305 silence as, 243 substitute method of, 245 UCC on, 287–289, 310 unequivocal, 242–243

Accepted goods, right to recover damages for, 305

Accommodation, 287–288. See also Reasonable accommodation

Accord and satisfaction discharge by, 272–273 settlement of claims through, 250–251

Accountability of administrative agencies, 510–511 of benefit corporation shareholders, 394 corporate governance and, 604–605 promotion of, 604

Accounting agent’s demand for, 426 agent’s duty of, 423 global rules for, 103 of partnership assets/profits, 357

Accredited investors, 592–593 ACPA. See Anticybersquatting Consumer See Anticybersquatting Consumer See

Protection Act Action, tangible employment, 463 Actionable, 114 Action of the parties, termination by, 241,

433–434 Act of commission, 189 Act of state doctrine, 214 Actual authority, of agent, 426, 427

Actual knowledge of particular purpose, 309 of security interest, 307

Actual malice, 115, 118 Actus reus (guilty act), 189, 191Actus reus (guilty act), 189, 191Actus reus ADA. See Americans with Disabilities ActSee Americans with Disabilities ActSee ADEA. See Age Discrimination in See Age Discrimination in See

Employment Act Adequate protection doctrine, 329 Adhesion contract, 266–267 Adjudication, by administrative agencies,

498, 505–506 Adjustable-rate mortgage (ARM), 324 Administrative agency, 496–502. See also

Regulation(s) adjudication by, 498, 505–506 creation of, 497 defined, 4–5, 496 enforcement by, 504 executive agencies, 497 hearing procedures for adjudication,

505, 506 implementation of legislation by, 496 independent regulatory agencies, 497 informal actions by, 504 investigations, social media posts and,

176–177 judicial deference to decisions of,

507–510 limits on demands by, 504 orders by, 504 powers of, 497–501 public accountability of, 510–511 tests by, 504 types of, 497

Administrative law. See also Administrative agency

defined, 4–5 finding, 14–15 practical significance of, 496–497

Administrative law judge (ALJ), 505 Administrative Procedure Act (APA,

1946), 499, 501–502, 504 Administrative process, 502–506 Admissible evidence, 56 Admissions

for oral contracts, 290 requests for, 59

ADR. See Alternative dispute resolution See Alternative dispute resolution See (ADR)

Ad testificandum subpoena, 504 Advance fee fraud, 204

Adversarial framework, of justice, 48 Adverse possession, 559, 561 Advertising, advertisement

deceptive, 501, 515–521 as invitation to negotiate, 239 “native ads” and, 519

Advice of counsel. See AttorneySee AttorneySee Affidavit, 56, 321, 327 Affirmation, of fact or promise, 308 Affirmative action, 470–471 Affirmative defense, 52, 129 Affordable Care Act (ACA, Obamacare,

2010), 70, 447, 448–449, 522 small businesses and, 492–494

After-acquired evidence, of employee misconduct, 470

Age. See also Minor; Seniors discrimination based on, 464–466 of majority, 253

Age Discrimination in Employment Act (ADEA, 1967), 453, 465–466

Agencies (government). See also Administrative agency; specific agencies

administrative, 496–502 creation and powers of, 497–502 executive, 5, 497 exemptions to antitrust enforcement

and, 582 federal, 582 independent regulatory, 5, 497, 499 informal actions by, 503–504 powers and Constitution, 497–501 preemption and, 497 state and local, 5, 533

Agency by agreement, 419–420 defined, 416 by estoppel, 420 exclusive, 424 by operation of law, 420 by ratification, 420 relationships (See Agency relationships)See Agency relationships)See termination of, 433–434

Agency law, 355, 417 Agency orders, 506 Agency relationships, 416

employer-employee, 416–417 employer-independent contractor, 417 with foreign firm, 218 formation of, 419–420, 421 termination of, 433–434

Index

I-2 I N D E X

Antitrust law, 568–587. See also specific acts

enforcement of, 580 exemptions from, 582 extraterritorial application of, 583 foreign, 583–584 in global context, 223, 583–584 mergers and, 579

APA. See Administrative Procedure ActSee Administrative Procedure ActSee Apparent authority, of agent, 426,

427–428, 430, 433 Appeal

appellate review, 65 filing, 65 to higher appellate court, 65–66 to Supreme Court, 40

Appearance, of factual evidence, 515–517

Appellant, 19 Appellate (reviewing) courts

federal (See Federal court system, See Federal court system, See appellate courts of )

state (See State court system, appellate See State court system, appellate See courts of )

Appellate jurisdiction, 28 Appellee, 19 Applicable standard, in establishment

clause, 80 Applicants, pool of, 455 Appropriate bargaining unit, 480 Appropriation, of identity, 119–120 Appurtenant easements and profits, 553 APR. See Annual percentage rateSee Annual percentage rateSee Arbitrability, 43 Arbitrary and capricious test, 498 Arbitrary trademarks, 154 Arbitration

class actions and, 108–109 forced, 267 mandatory in employment context, 43 as type of ADR, 41–43, 107–108

Arbitration clause in contract, 42, 45, 267 in international contracts, 221

Argument, closing, 63 ARM. See Adjustable-rate mortgageSee Adjustable-rate mortgageSee Arrest, 203 Arson, 194 Articles

of incorporation, 394–395 express powers in, 397 �ling with state, 395

of organization, of LLC, 372 of partnership, 356

Articles of Confederation, 70 Articles of Constitution. See Constitution See Constitution See

(U.S.) Artisan’s lien, 124, 320–321 Asia, antitrust enforcement in, 583

Air pollution, 536–539. See also Pollution control and air-quality standards

for, 496 federal statutes for, 535 mobile sources of, 536–537 stationary sources of, 537

Airspace rights, 548 Alien corporation, 389–390 Alien Registration Receipt, 475 Alien Tort Claims Act (ATCA), 223 ALJ. See Administrative law judgeSee Administrative law judgeSee Allege, 10 Alteration, material, 273 Alter-ego theory, 400 Alternative dispute resolution (ADR), 40

arbitration as, 41–43 differences in, 42 in early neutral case evaluation, 43 international transactions and,

44–45 vs. litigation, 40 mediation as, 41 in mini-trial, 43–44 negotiation as, 40–41 online (ODR), 44 service providers of, 44 summary jury trials as, 44

Amendments to credit-card rules, 525 to U.S. Constitution (See Bill of See Bill of See

Rights; specific amendments) America Invents Act (2011), 157 American Arbitration Association, 44, 45 American Bar Association, code of

ethics, 92 American Institute of Certified Public

Accountants (AICPA), Code of Professional Conduct, 92

American Law Institute (ALI), 4, 12, 247 American Nurses Association, code of

ethics, 92 Americans with Disabilities Act (ADA,

1990), 453, 466–468 reasonable accommodation under,

467–468 Annual percentage rate (APR), 525 Answer, in pleadings, 51–52 Anticipatory repudiation, 271–272, 302 Anticompetitive conduct, 580 Anti-Counterfeiting Trade Agreement

(ACTA, 2011), 167 Anticybersquatting Consumer Protection

Act (ACPA, 1999), 172 Antidelegation clause, 258 Antidiscrimination laws, 224–225. See

also Discrimination; Employment discrimination

Antidumping duties, 219–220

Agent. See also Agency relationships authority, 426–428, 433 corporate, 50 crimes of, 433 defined, 416 duties to principal, 421–423

loyalty as, 421–422 e-(electronic), 430 emergency powers of, 420, 428 employee as, 416–417 gratuitous agent, 421 intentional torts of, 432–433 liability of, 428–430 misrepresentation by, 430 negligence of, 430–432 nonpartner, 356–357 of offeree, 241 power of attorney and, 427 principal’s duties to, 423–426 principal’s rights and remedies

against, 426 ratification of unauthorized act

of, 428 rights and remedies against

principal, 426 tort and crime liability of, 430–433 unauthorized acts of, 428, 429–430

Agent’s authority, 433 scope of, 426–428

Aggravated burglary, 192 Aggravated robbery, 192 Aggregate, entity vs., 356 Aggregation test, 191 Agreement(s). See also Contract

agency by, 419–420 to agree, 240 click-on, 246 contractual, 235, 238–245 creditors’ composition

agreements, 322 defined, 238 discharge by, 272–273 in e-contract, 245–248 to exceptions to perfect tender

rule, 300 hot-cargo, 478 international, 212 lacking consideration, 249–250 lease (See Lease contract)See Lease contract)See noncompete, 250, 255 operating (LLC), 376–377 partnership, 356 preliminary, 240 reaffirmation, 336 regional trade, 220–221 shareholder, 393 shrink-wrap, 246–247 workout, 325

I N D E X I-3

Bankruptcy trustee, 327, 340. See also Debtor, in possession

duties and power of, 330–331, 340n Bargained-for exchange, 248–249 Bargaining, labor union, 477, 480,

482–483, 485–486 Basis of the bargain, 308 Bathrooms, transgender, 461 Battel of the forms, 289 Battery, assault and, tort law and,

114, 192 Beer, ethics of locally brewing imported

beers, 217 Beneficiary

incidental, 258 intended, 258 third party, 257, 258

Benefit corporation, 394 Benefits, for FMLA leave, 446 Berne Convention (1886), 166 Best available control technology

(BACT), 539–540 Best practical control technology

(BPCT), 540 Beyond a reasonable doubt, 63, 187, 204 BFOQ. See Bona fide occupational See Bona fide occupational See

qualification Bilateral agreement, 212 Bilateral contracts, 235, 257

consideration in, 248 Bilateral mistakes of fact, 262, 263 Bill of lading, 296 Bill of Rights. See also Constitution

(U.S.); individual amendments business and, 75–83 protections in, 76, 182

Binding authority, 8 Birth control pill, Plan B, 523 Blue sky laws, 603 Board of directors. See Directors, See Directors, See

corporate Bona fide occupational qualification

(BFOQ ), 470 Bond(s), 396, 588

posting of, 321 as securities, 589 stocks compared with, 396

Books. See AccountingSee AccountingSee Border searches, under ACTA, 167 Botnets, 171, 207 Boycotts

group, 571 secondary, 484

Branches of government, 499 Breach of contract. See also Damages;

Lease contracts; Sales contracts anticipatory repudiation and, 271–272 by buyer or lessee, 298, 303–305 compensatory damages for, 275–276

B Bad faith

in arbitration, 42 in bankruptcy, 329 in bargaining, 484

Bailee defined, 297 duties of, goods held by, 298

Bailment, 135, 297. See also Bailee Bait-and-switch advertising, 517 Bank customer, relationship with bank,

434n Bankruptcy, 318. See also Bankruptcy

Code comparison of forms, 342 creditors’ committees and, 339 creditors’ meeting and claims, 332 as defense, 323 discharge in, 273, 334–335, 339 dismissal of petition, 327, 328 estate in, 330 exemptions in, 331–332 fraud in, 197, 331 goals of, 326 involuntary, 328–329 LP and partner’s, 384 petition in, 327 property distribution in, 332–334 reaffirmation agreements in, 336 relief in, 328, 329 reorganization in, 326, 338–339 sole proprietorship and, 354 tax returns during, 327 termination of agency relationship

by, 434 voluntary, 327–328

Bankruptcy Code, 326–327. See also Bankruptcy

Chapter 7 of (liquidation proceedings), 326–338

Chapter 11 of (reorganization), 326, 338–339

Chapter 12 of (adjustment of debts by family farmers and family fisherman), 326, 339–340, 341–343

Chapter 13 of (adjustment of debts by individuals), 326, 339–341

exemptions in, 331–332 homestead exemption and, 331, 332

Bankruptcy courts, 28, 326, 328–329 Bankruptcy Reform Act. See also

Bankruptcy of 1978 (See Bankruptcy Code)See Bankruptcy Code)See of 2005 (Bankruptcy Abuse Prevention

and Consumer Protection Act), 326

Assault and battery, tort law and, 113–114, 192

Assets commingling of corporate assets for

personal benefit, 399–400 in dissolution, 362 of partnership, 357, 362, 384 personal, in sole proprietorship, 354

Assignee, 257 Assignment

defined, 257 prohibited by contract, 258 prohibited by statute, 258 relationships in, 257 of rights, 257–258

Assignor, 257 Associations. See specific associations and See specific associations and See

types Assumption of risk, 129

product liability and, 145 Assurance, right of, 301 Astronauts, agreements on, 225–226 At common law. See Common lawSee Common lawSee At sufferance, tenancy, 553 Attachment

defined, 321 writ of, 321

Attempted monopolization, 572, 575–576 Attorney

client relationship and, 48–49 fees of, 49 power of, 427

Attorney general (AG), 187 Attractive nuisance doctrine, 124 At will, tenancy, 553 Auctions

live and online, 239–240 offers, intent, and, 239–240 online fraud in, 204

Audit committee, of board of directors, 401, 604–605

Author, of online defamation, 179–180 Authority

of agent, 426–428, 430, 433 apparent, 426, 427–428, 430, 433 binding, 8 certificate of, 390 express, 426, 427 implied, 359, 426, 427 implied warranty of, 429–430 of partner, 359 persuasive, 10

Authorization card, 479–480 Authorized actions, contract liability and,

429, 430 Automatic stay, 329 Automobiles, emissions standards for, 536 Award, 64. See also Damages

I-4 I N D E X

Case(s) analyzing sample of, 20–23 citations of, 15–19 of first impression, 10 on point, 11 prima facie, 454, 455, 465 titles and terminology of, 19–20

Case law common law doctrines and, 3, 5, 7–8 defined, 5 finding, 15–19 reading and understanding, 19–23 terminology for, 19–20

Categorical imperative, 95 Causation, 35

in fact, 128, 136 in negligence action, 127–128

Cause proximate, 128, 136 superseding, 130

Cease-and-desist order, 477, 518 Central America-Dominican Republic-

United States Free Trade Agreement (CAFTA-DR), 220

Certificate 390, 743 of limited partnership, 382

Certification, of corporate financial accuracy, 605, 606

Certification mark, 155 Certiorari, writ of, 40 Chain-style business operation

franchise, 363 Chance, 346 Changed circumstances, termination of

agency relationship by, 434 Chapter 7 bankruptcy (liquidation

proceedings), 326–327, 326–338 comparison of forms, 342 exemptions and, 331–332 schedules in, 327

Chapter 11 bankruptcy (reorganization), 326, 338–339

comparison of forms, 342 Chapter 12 bankruptcy (adjustment

of debts by family farmers and family fisherman), 326, 339–340, 341–343

comparison of forms, 342 Chapter 13 bankruptcy (adjustment of debts

by individuals), 326, 340–341 Chattel. See also Personal property

trespass to, 124 Checks and balances system, 26, 71 Chevron deference, 507–509 Chief executive officer (CEO). See also

Officers, corporate ratio of compensation to median

compensation of workers, 590 under Sarbanes Oxley, 606

global, 102–103 image and, 90 importance of, 89–90 principles and philosophies of, 94–97

principle of rights in, 94–95 requirements, 92–93 social media and, 93–94

Business-extension exception, to ECPA, 177

Business invitees, 127 Business judgment rule, 403 Business necessity, 470 Business organization. See also specific

forms franchises as, 362–368 major forms compared, 411–412 partnerships, 355–362 small business and, 350–351 sole proprietorship as, 351–354

Business Process Pragmatism/, 97 Business relationship, wrongful

interference with, 123 Business torts, 123 Buyer

contract breached by, 298, 303–305 goods in possession of, 303–304 insolvency and breach of, 303–304 insurable interest of, 298 obligations of, 301–302 passage of title to, 295–296 remedies of, 303–305

Buyout price, 361 Buy-sell (buyout) agreements, of

partnership, 362 Bylaws, corporate

adopting, 395 corporate powers and, 397 election of directors and, 400

C Cabinet secretaries, 497 Cancellation. See also Rescission

of contract, 302, 303 CAN-SPAM Act (2003), 170–171 Capacity, contractual, 235, 253–254 Capital

private equity, 397 for small business, 351, 354 venture, 397

Capital structure, SEC regulation of, 496 Capper-Volstead Act, 582 Care. See Duty of careSee Duty of careSee Carriers

delivery via, 299–300 substitution of, 300

Cartel foreign, 583 price-fixing, 570–571

damages for compensatory, 275–276 consequential, 276 nominal, 276 punitive, 276

defined, 6, 269 equitable remedies for, 278–280 land-sale, 275, 279 material vs. minor, 270–271 remedies for, 302–305, 310 risk of loss and, 296–298 sale of land, by owner, 275 sales contract, 298, 302–305, 310 by seller or lessor, 298, 303–305 waiver of, 280–281

Breach of duty of care, 126–127 fiduciary, 410, 598 by principal, 426

Breach of loyalty. See Duty of loyaltySee Duty of loyaltySee Bribery, 197

Foreign Corrupt Practices Act and, 102–103

Brief, 20, 65 Britain. See England (Britain)See England (Britain)See Broadband operations, regulation

of, 502 Broker, regulation of state securities, 603 Brownfields, Small Business Liability

Relief and Brownfields Revitalization Act, 535

Browse-wrap terms, 247 Bubble policy, 507–508 Burden of demand, in agency

investigation, 504 Burden of proof, 187, 204 Burden-shifting procedure, 454 Bureaucracy, 499 Burglary, 192–193 Business contracts. See Contract(s)See Contract(s)See Business(es). See also Antitrust law;

Corporation; Small business Bill of Rights and, 75–83 criminalization of, 191 international (See International See International See

business; International contract) legal requirements for, 350 regulation of (See Regulation(s))See Regulation(s))See reorganizations of (Chapter 11

bankruptcy), 326, 338–339 small (See Small business)See Small business)See

Business ethics. See also Ethics business decisions and, 3, 90, 97–102 business law and, 2–3, 90–93 class actions and, 109 defined, 89 employee responsibilities, 93–94 ethical leadership and, 97–102

Breach of contract (continued)

I N D E X I-5

Coercion, by labor unions, 488 Collateral, secured party and, 318 Collection

of student debt, 335, 337 in voluntary bankruptcies, 334

Collection agency, 528 Collective bargaining, 474, 482–483 Collective mark, 155 Color, discrimination based on, 455–456 Comity, principle of, 213–214 Commerce clause, 71–72

current, 74 dormant, 74–75 expansion of national powers and,

72–73 Commerce Department (U.S.), 220 Commercial activity, FSIA on, 216 Commercial districts, zoning in, 564 Commercial impracticability, 274,

300–301 Commercial reasonableness, 298–299 Commercial spacef light, regulation

of, 226 Commercial Space Launch

Competitiveness Act (2015), 226 Commercial speech, 78 Commercial unit, UCC on, 302, 305 Commercial use, of land, 563 Commingle, of personal and corporate

interests, 399–400 Commission, act of, 189 Commission on International Trade

Law, 212 Committee on the Peaceful Uses of Outer

Space (COPUS), 225 Committees, of board of directors, 401 Common law

case law and, 3, 5 contracts and, 234 defined, 6 employment at will doctrine and,

438–439 invasion of privacy under, 118–120 as source of law, 3, 5 systems of, 212, 213 tradition of, 6–12

Commonly known danger defense, 146 Common Market, 220 Common stock, 396 Communication

of acceptance, 243, 288 of effective offer, 240–241 privileged, 117–118 stored, 177–178

Communications Act (1934) fair notice and, 501–502 Title II of, 502

Communications Decency Act (CDA, 1996), 180

no-strike, 484 unconscionable, 255–256

Clayton Act (1914), 568, 577–579, 582 private actions under, 580 Section 2 (price discrimination),

577–578 Section 3 (exclusionary practices),

578–579 Section 7 (mergers), 579 Section 8 (interlocking directorates),

579–580 Clean Air Act (1963), 496, 497, 535

on mobile source air quality, 536–537 pollution-control equipment standards

under, 540 on stationary source air quality, 537 violations of, 537

Clean Energy States Alliance, 611 Clean Power Plan (CPP), 611 Clean Water Act (CWA, 1972), 539–542

permit system for point-source emissions and, 539

pollution-control equipment standards under, 540

violations of, 542 wetlands and, 541

Click-on agreements (click-on license, click-wrap agreement), 246

Clients. See also Attorney; Confidentiality; Insurance

BFOQ defense and, 470 business Internet uses and, 179, 207 covenants not to compete and,

279–280 professional corporations and, 394

Climate change ethics of, 610–612 as global environmental issue, 536, 537

Close (closely held, family, privately held) corporation, 392–393

corporate assets used for personal benefit in, 399–400

oppressive conduct in, 410 preemptive rights in, 408 S corporation as, 393

Closed shop, 478, 488 Closing, 555–556 Closing argument, 63 Cloud computing, 175, 398 COBR A (Consolidated Omnibus Budget

Reconciliation Act, 1985), 448 Code of Federal Regulations (C.F.R.), 15, 503Code of Federal Regulations (C.F.R.), 15, 503Code of Federal Regulations Code of Professional Conduct, American

Institute of Certified Public Accountants, 92

Codes. See also Bankruptcy Code; United States Code

of ethics, 92–93 of Hammurabi, 2

Child labor, prohibition of, 441 Children. See also Minor

health-care protection for, 524 Choice-of-law clause

in international contracts, 44–45, 221 in online contracts, 246

Circuit courts of appeals, federal, 19, 39–40

CISG. See United Nations, Convention See United Nations, Convention See on Contracts for the International Sale of Goods

Citation case, 15, 17–18 defined, 14 parallel, 15 reading of federal, 14, 17–18 reading of state, 14–15, 17

Citizenship corporate, 89–90 diversity of, 28–29 state, of LLC, 373

Civil law criminal law vs., 14, 187–188 defined, 14, 187 systems of, 212, 213

Civil lawsuit, procedural rules in, 48–49 Civil liability

for criminal acts, 188, 189 for RICO violation, 198

Civil Rights Act (1964), 73, 102. See also Title VII

Civil sanctions for violations of Section 10(b) and Rule

10b-5, 602 for violations of Section 16(b) of

Securities Exchange Act (1934), 601

Claim(s) in deceptive advertising, 515–517 release from, 251 settlement of, 49, 250–252

Class action lawsuits, 107 arbitration and, 108–109 country-of-origin labeling, 217 limitations on employee

discrimination, 454 for privacy rights, 119

Classifications based on contract formation, 235–236 of corporations, 389–394 of law, 13–14 of torts, 113

Clause antidelegation, 258 arbitration, 42, 45, 267 exculpatory, 256, 281 forum-selection, 221 international contract, 221 limitation-of-liability, 281

I-6 I N D E X

Construction contracts, 278 measurement of damages for breach

of, 276 Constructive discharge, 461 Consumer. See Consumer-debtor; See Consumer-debtor; See

Consumer law Consumer credit, Fair Credit Reporting

Act and, 526–528 Consumer Credit Protection Act (1968),

Title I of (Truth-in-Lending Act), 524

Consumer-debtor, 326 Consumer-expectation test, 141 Consumer Financial Protection Bureau

(CFPB), 267 Consumer goods. See GoodsSee GoodsSee Consumer law, 515–531

areas regulated by statutes, 516 labeling, packaging, and, 522 sales and, 521–522

Consumer leases, 286 Consumer Product Safety Act (1972),

523–524 Consumer Product Safety Commission

(CPSC), 523–524 Consumer protections, against online

auction fraud, 204 Contact

minimum, 27–28, 31, 33 reasonable person standard for, 114

Content-neutral laws, 77 Contract law. See also Remedies; Statute

of Frauds employment (See Employment See Employment See

contract) function of, 234 international (See International See International See

contract) offer in, 235, 238 overview of, 234–237, 285 sales law and, 292 sources of, 234

Contractor, breach of contract by, 276 Contract(s). See also Breach of

contract; Discharge; Illegality; Performance; Sales contracts; Statute of Frauds

acceptance of, 235, 238 adhesion, 266–267 agreement in, 238–245 arbitration clauses in, 42, 45 assignment of, 257–258 assignment prohibited by, 258 bilateral, 235, 248, 257 cancellation of (See Cancellation)See Cancellation)See classifications based on formation of,

235–236 consideration and, 248–253, 289 construction, 276, 278

Conduct codes of ethics and, 92–93 intent expressed by, 419–420 misrepresentation by, 265–266 outrageous, 114

limited by First Amendment, 114–115

pattern of, 427–428 of principal, agency by estoppel

and, 420 principal-agent duties and, 420

Confidentiality of agent, 422 of employee medical information,

85, 467 Confirmation

of reorganization plan, 339 of repayment plan, 341, 343

Confiscation, 214, 219 Conf licts of interest, corporate directors

and, 405 Conforming goods, 287, 298, 299, 300 Congressional intent, 75 Consent

to contract, 235, 262–267 as defense to intentional torts, 113

Consequential (special) damages, 112, 276, 304

Conservation districts, 564 Consideration

agreements lacking, 249–250 bargained-for exchange and,

248–249 contractual, 235 defined, 248, 346 exceptions to, 252 legally sufficient value and, 248 for mutual rescission, 272 past, 249–250 settlement of claims and, 250–252 under UCC, 287, 289

Conspiracy, substantial effect by, 583 Constitution (U.S.), 70. See also Bill of

Rights; individual amendments agency powers and, 497–501 Article I, 71–72, 499 commerce clause of, 71–75 criminal procedure safeguards

and, 201 due process clause of (See Due process)See Due process)See federal powers granted in, 70 full faith and credit clause and, 71 privileges and immunities clause, 71 on relations among states, 71 on separation of powers, 71 state powers in, 70–71 supremacy clause of, 4, 75

Constitutional law, 3, 4, 5. See also Constitution (U.S.)

Community property, concurrent ownership as, 330, 552

Company. See Business(es); See Business(es); See Corporation(s); specific types of companies

Comparative negligence (fault), 113, 129, 131, 146

Compelling government interest test, 77

Compensation. See also Income; Payment; Wages

of chief executive officer (CEO), 590 of directors, 401 for eminent domain action, 562 partnership and, 357 principal’s duty of, 424 workers’ (See Workers’ compensation)See Workers’ compensation)See

Compensation committee, 605 Compensatory damages, 112–113, 464

for breach of contract, 275–276 for sale of goods, 275 for sale of land, 275 standard measure of, 275

Competition. See Antitrust law; See Antitrust law; See Covenant, not to compete

Competitive practices, predatory behavior and, 123

Competitor’s prices, meeting, 578 Compilations of facts, 161 Complaint

formal, 505 plaintiff ’s, 51 in pleadings, 50–51

Complete performance, 268 Composition agreements, 322 Comprehensive Environmental Response,

Compensation, and Liability Act (CERCLA, 1980), 544–545

Computer crime, 204. See also Cyber crime

Computer Fraud and Abuse Act (CFA A, 1984), 208

Concentrated industry, 571 Concurrent jurisdiction, 30, 31 Concurrent ownership, 552 Concurrent powers, of federal and state

governments, 75 Concurrent regulation, of securities

by state and federal governments, 603

Concurring opinion, 20 Condemnation

eminent domain and, 561 inverse, 562–563 as judicial proceeding, 561

Condition, of performance, 268 Condition precedent, in contracts, 268

I N D E X I-7

Corporation(s), 388. See also Business ethics; Shareholder; specific forms

benefit, 394 board of directors of (See Directors, See Directors, See

corporate) bylaws of (See Bylaws, corporate)See Bylaws, corporate)See under Chapter 12, 341n classification of, 389–394 close, 392–393 compared with other forms of

business, 411 criminal acts and, 190–192, 389 de facto, 395–396 de jure, 395 directors of (See Directors, corporate)See Directors, corporate)See domestic, foreign, and alien, 389–390 earnings of, 389 by estoppel, 396 financing of, 396–397 formation of, 394–397 holding companies, 389 incorporation procedures for, 394–395 minimum contacts and, 27–28 nonprofit, 391 officers of (See Officers, corporate)See Officers, corporate)See as person, 27, 75, 355, 388 personnel of, 388 powers of, 397–399 professional, 394 public and private, 391 S corporation, 393 shareholders of (See Shareholders)See Shareholders)See taxation of, 389 tort liability of, 389

Corporations commissioner, 603 Cost-benefit analysis, 95 Cost(s). See also Fees

of health insurance, 524 justification of, 578 for Superfund clean-up, 544

Co-sureties, 324 Counsel. See AttorneySee AttorneySee Counteradvertising, 518 Counterclaim, 52 Counterfeit Access Device and Computer

Fraud and Abuse Act. See Computer Fraud and Abuse Act

Counterfeit goods, 156 combating online sales of, 156 penalties for, 156, 167

Counteroffer, 241 Country-of-origin labeling, 217 Court(s). See also Bankruptcy; Federal

court system; Supreme Court alternative dispute resolution and, 40 of appeals (appellate), 15 (See also

Federal court system, appellate courts of; State court system, appellate courts of )

unconscionable, 255–256, 266–267 unenforceable, 237 unilateral, 235–236, 248 valid, 235, 237, 253–254 via e-mail, 244 void, 237, 253–254 voidable, 237, 253–254 voluntary consent to, 235, 262

factors indicating lack of, 262–267 waiver of breach and, 280–281

Contract theory, exceptions to employment-at-will doctrine based on, 438

Contractual capacity, 235, 253–254 Contractual relationship, 234

wrongful interference with, 123 Contribution, right of, 324 Contributory negligence, 130–131 Controlled Substance Act (CSA), 74 Controlling precedents, 8 Controlling the Assault of Non-Solicited

Pornography and Marketing (CAN-SPAM) Act. See CAN-See CAN-See SPAM Act

Convention on Contracts for the International Sale of Goods (CISG), 212

applicability of, 310 compared to UCC provisions, 310

Conversion, 124–125 Conveyance, of real property, 550 Cookies, data collection and, 184, 205 Cooking the books, 604 Cooling-off laws, 521–522 Cooperation, duty of, 301, 424 Copyright

categories for protection, 160 defined, 160 in digital information, 164, 174–175 duration of, 160 exclusions in, 161 fair use exception and, 163 for file-sharing technology, 175 first sale doctrine, 163 infringement of, 160, 161–164 software protection and, 164 work for hire and, 419

Copyright Act (1976), 160, 161, 163, 419 Corporate citizenship, 89–90 Corporate criminal liability, 190–192 Corporate governance, 603–605 Corporate law, 604 Corporate officers. See Officers, corporateSee Officers, corporateSee Corporate social responsibility (CSR), 96

corporate aspects of, 96 social aspects of, 96 stakeholders and, 96–97

Corporate veil, piercing of, 372, 388, 399–400

contrary to public policy, 254–256 contrary to statute, 254 defenses to enforceability of, 235 defined, 216 delegation prohibited by, 258 destination, 296, 297, 299–300 discharge of, 267–274 electronic (See E-contract)See E-contract)See elements of, 235 employment, 43, 438 enforceability of, 235, 237 exclusive-dealing, 578 executed, 237 executory, 237, 272 express, 236 express terms in, 236 formal, 236 formation of, 235–236, 286–290 formation of sales and lease, 286–290 franchise, 364–366 illegality of, 254–256 illegal through fraud, duress, or undue

inf luence, 264–266 implied, 236, 438 implied terms in, 236 informal, 236 international, 44–45 for international sales of goods, 314–316 by intoxicated persons, 253 investment, 588 legality of, 235, 254–256 material modification of, 323 mental incompetence and, 253–254 between merchants, 288, 290 by minors, 253 mistakes in, 262–263 mixed, 236 objective theory of, 235 offers for, 235, 238–242 option, 241, 287 output, 287 performance of, 237 personal, 269 for personal services, 279 preformation (preincorporation), 372 privity of, 135, 257 proper form for, 256 provisions limiting remedies, 281 ratification of (See Ratification)See Ratification)See requirements, 287 requiring writing, 256 rescission and, 249, 263, 266 in restraint of trade, 255 as securities, 588–589 shipment, 296, 297, 299 shrink-wrap agreements, 246–247 standard-form, 267 Statute of Frauds and, 256 types of, 235–237

I-8 I N D E X

CWA. See Clean Water ActSee Clean Water ActSee Cyber attacks, 187 Cyber Civil Rights Initiative, 119 Cyber crime, 187

cyber fraud as, 204 cyber mercenaries, malware developed

by, 207 cyber theft and, 204–207 prosecution of, 207–208

Cyberlaw, 14 Cyber security, 230–231 Cyber security insurance, 231 Cyberspace. See also Internet

jurisdiction in, 30–33, 208 trade secrets in, 164–165

Cybersquatting domain names and, 171–172 typosquatting and, 172

Cyberstalking, 180–182 Cyberterrorism, 207 Cyber torts, 178

D Damages, 6, 49

for breach of contract, 274–278, 304, 305

for breach of warranty, 307 for buyer’s nonacceptance of

goods, 303 compensatory, 112–113, 128,

275–276, 464 consequential, 112, 276, 304 defined, 112 incidental, 275 for libel, 117 limiting, 113 liquidated, 276–278 mitigation of, 276 monetary, 6, 274–278 nominal, 276 punitive, 113, 276 right to recover

for accepted goods, 305 for failure to deliver goods, 304

for shareholder derivative suit, 410 for slander, 117 special and general, 112–113, 117 substantial performance and, 269 under Title VII, 464 treble, 580

Dangerous activities, abnormally dangerous, 134–135

Databases legal, 19 patent, 157

Data breach, 230 Data collection, cookies and, 184 Davis-Bacon Act (1931), 441

remedies for, 318–324 secured, 318, 332 surety and, 322–324 unsecured, 318, 334 writ of attachment and, 321

Creditors’ composition agreements, 322 Credit reporting agencies

Internet provider pulling of report, 526–527

remedies for violations by, 527–528

Crime. See also specific types agent’s, liability for, 430–433 classification of, 188 computer, 204 contracts to commit, 254 cyber, 187, 204–208 defined, 187 organized, 197–198 property, 192–194 types of, 192–198, 199 violent, 192 white-collar, 195–197

Criminal acts civil liability for, 188 corporations and, 190–192, 389 defined, 189 tort lawsuit and criminal prosecution

for same act, 188, 189 Criminal investigations, social media

posts in, 176 Criminalization, of American

business, 191 Criminal law

civil law vs., 14, 187–188 defined, 14, 187

Criminal liability, 189–192. See also Crime

corporate, 190–192 Criminal negligence, 190 Criminal penalties

for CWA violations, 542 for RCR A violations, 544 for violations of Section 10(b) and Rule

10b-5, 601–602 Criminal procedures, 201–204 Criminal sanctions, 187, 188 Cross-examination, 61 Crowdfunding, 397 CSR. See Corporate social responsibilitySee Corporate social responsibilitySee Cumulative voting, by shareholders,

406n, 407, 408 Cure

of breach, franchise termination and, 366

right to, 300 Customer restrictions, in distribution,

571–572 Customs, international, 211

bankruptcy, 28, 326 on commercial drone use, 295 on employee status, 417 English, 6 of equity, 6, 7 federal (See Federal court system)See Federal court system)See of law, 6, 7 piercing the corporate veil by, 388,

399–400 probate, 28 reviewing (See Federal court system, See Federal court system, See

appellate courts of; State court system, appellate courts of )

role in government, 26–27 rules of interpretation of, 508 on Section 1 violation under rule of

reason, 570 state (See State court system)See State court system)See Supreme (See Supreme Court)See Supreme Court)See tiers of, 35, 41 trial (See Trial courts)See Trial courts)See unconscionability and, 266–267

Court systems. See Federal court system; See Federal court system; See State court system

Covenant. See also Promise not to compete, 250

employment contracts involving (restrictive covenants), 255, 351

reformation for, 255, 279–280 sale of ongoing business and, 255

not to sue, 251 quiet enjoyment, 558 warranty deed and, 558

Cover, right of, 304 Co-workers, sexual harassment by, 464 Cram-down provision, 339 Credit

consumer, 526–528 discrimination and, 525 protection of, 524–529 report, Internet service provider pulling

of, 526–527 Credit card

protection of, 524–526 rules for, 525

amendments to, 525 Creditor(s)

affidavit filed by, 321 best interests of (bankruptcy), 338 bond posted by, 321 claims of (bankruptcy), 332 committee of, 339 laws assisting, 318–324 liens, 318–321 meetings of (bankruptcy), 332 of partners and partnership, 384 preferred, 331 protection for, 324–325

Court(s) (continued)

I N D E X I-9

Deposited acceptance rule, 244 Deposition, 59 Description, goods conforming to, 308 Design defects, 140–141 Destination contracts, 296, 297, 299–300 Destruction

of identified goods, 301 of subject matter, termination of offer

by, 241–242 Detour, frolic and, 432 Detrimental reliance, 252 Digital information, copyrights in, 164,

174–175 Digital Millennium Copyright Act

(DMCA, 1998), 174–175 Dilution, of trademarks, 152 Directed verdict, motion for, 63 Direct examination, 61 Direct exporting, 218 Directorates, interlocking, 579–580 Directors, corporate

accountability of, 604–605 committees of

audit committee, 401, 604–605 compensation committee, 605

compensation of, 401 conf licts of interest and, 405 dissenting, 403 duties of, 402–403 election of, 400–401 failure to declare dividend and, 409 fiduciary duties of, 402, 405 inside director, 401 liability of, 192, 405 management responsibilities of, 388, 401 meetings of, 401 outside director, 401, 604 removal of, 400, 406 rights of, 401–402 role of, 400–402 voting by, 763–76401

Disability association with, 467 defined, 466 discrimination based on, 466–468 mitigating measures, 467 types of, 466

Disaffirmance defined, 253 minor’s right to, 253

Discharge by accord and satisfaction, 272–273 by agreement, 272–273 in bankruptcy, 273, 327, 334–335,

339, 341 constructive, 461 of contract, 267 defined, 267 by operation of law, 273–274

Defect(s) cure for, 298 implied warranty and goods with, 308 in incorporation, 395 product, 140–141 revocation of acceptance and, 305

Defendant defined, 6, 19 response (answer) of, 51–52

Defense Department (U.S.), 533 Defense of Marriage Act (DOMA), 72 Defense Production Act, 582 Defense(s)

affirmative, 52 to contract enforceability, 235,

237, 266 to criminal liability, 198–201 to defamation, 117–118 defined, 6, 113 Ellerth/Faragher affirmative, 463Ellerth/Faragher affirmative, 463Ellerth/Faragher to employment discrimination,

469–470 to liability

for price discrimination, 577–578 under Superfund, 545

to negligence, 129–131 to price-fixing, 570 to product liability, 144–147 of surety and guarantor, 323 to torts, 113 against trespass to land, 124 to violations of Securities Act

(1933), 595 to wrongful interference, 123

Deficiency judgment, 325 Definiteness of terms, in offer, 240 De jure corporations, 395De jure corporations, 395De jure Delay, in performance, 299 Delegatee, 258 Delegation, 257

of duties, 257, 258 prohibited by contract, 258 relationships of, 258

Delegation doctrine, 499 Delegator, 258 Delivery

by carrier, 299–300 with movement of goods (carrier cases),

297 place of, 299 requirements for stopping, 303 right to withhold, 302–303 tender of, 296, 297, 299 without movement of goods, 296,

297–298 De novo review, by appellate court, 56 Density, of residential districts, 564 Departments of government. See specific See specific See

departments

Deadly force, 198 Dealer, regulation of state securities, 603 Death

impossibility of performance and, 273

of proprietor, 354 termination of agency relationship

by, 434 termination of offer by, 241–242

Debentures. See Bond(s)See Bond(s)See Debt

bonds as, 588 collection of, 528–529 garnishment and, 321–322 liquidated, 251 reaffirmation of, 336–338 real property securing, 318 unliquidated, 251 unsecured, in bankruptcy, 328

Debtor. See also Bankruptcy challenge to involuntary petition, 329 conduct of, in bankruptcy, 335 consumer as (See Consumer-debtor)See Consumer-debtor)See estate in bankruptcy, 330 means test applied to, in bankruptcy,

327–328 in possession (DIP), 338 protection for, 325–326 unsecured, in bankruptcy, 343

Debtor-creditor relationship, 318 Debt security. See Bond(s)See Bond(s)See Deceit, intentional, 120 Deceptive advertising, 501,

515–521 online, 518 restitution for, 518

Decision making ethics and, 3, 90, 97–102 laws and, 2–3

Decision(s) arbitrator’s, 42 ethical business, 97–102 opinions and, 7–8, 20

Declaration, 50n Deeds, 558

grant, 558 quitclaim, 558 real property transfer and, 550, 555 recording statutes for, 559 warranty, 558

De facto corporations, 395–396 Defamation, 115–118

defenses to, 117–118 online, 116, 178–180

Default, 318 by debtor, 325 student loan, 335, 337

Default judgment, 50 Defective goods, liability for, 139, 140

I-10 I N D E X

Drugs safety regulation of, 523 testing employees for, 449–450

Duces tecum subpoena, 504 Due care

product liability and, 135 standard (See Duty of care)See Duty of care)See

Due diligence, standard, of Securities Act (1933), 595

Due process clause, 76, 83, 201, 321 Dumping, ocean, 219–220, 542–543 Durable power of attorney, 427n Duration, of partnership, 356 Duress

contract illegal through, 266 as defense, to criminal liability, 200 threatened act must be wrongful or

illegal, 266 Duty. See also Breach of duty; Duty of

care; Duty of loyalty; Taxation of agents, 421–423 cannot be delegated, 258 of cooperation, 301 delegation of, 257, 258 in dissociation, 361 fiduciary (See Fiduciary duty)See Fiduciary duty)See of honesty and fidelity, breach of, 366 of landowners, 127 in LLC, 375 of majority shareholders, 410 of partners, 358–359, 382 to perform, 269 preexisting, 249 of principals, 423–426 of professionals, 127 of trustee, 330

Duty-based ethics, 94–95 Duty of care. See also Reasonable person

standard of agent, 421 director’s and officer’s, 402–403 member’s, 375, 377 negligence and, 125, 126–127 partner’s, 358 rule of reasonable, 124

Duty of loyalty agent’s, 421–422 directors and officers and, 403–404 member’s, 375, 377 partner’s, 358

E e-agent, 430 Early neutral case evaluation, in ADR, 43 Earnings, corporate, 389 Easement, 550, 553

appurtenant, 553 creation of, 554

Dispute-settlement provisions, for online offers, 245–246

Dissenting opinion, 9, 20 Dissociation

in LP, 384 of member of LLC, 377 of partner, 360–361

Dissolution of LLC, 377–379 of LP, 384 of partnership, 361–362

Distributed network, 175 Distribution

agreement, 218 of domain names, 171 of partnership assets, 384 of property, 332–334

Distributorship contract with foreign firm, 218 as type of franchise, 363

District attorney (D.A.), 14, 187 District (trial) courts, 15, 19, 28, 36, 39 Diversity of citizenship, 28–29 Divestiture, 580 Dividends, 389

directors’ failure to declare, 409 illegal, 409

Doctrine(s) act of state, 214 of Collective Knowledge, 191 employment-at-will, 438–439 first sale, 163–164 international principles and, 213–216 respondeat superior, 389, 430–431, 432respondeat superior, 389, 430–431, 432respondeat superior of sovereign immunity, 214–216 stare decisis, 7–10, 212

Documentation, of employment, 475 Document(s)

destruction or alteration of, 606 of title, 296, 298

Dodd-Frank Wall Street Reform and Consumer Protection Act, 588, 590

Domain name cybersquatting and, 171–172 defined, 155, 171 distribution of, 171

Domestic corporation, 389–390 Dominant estate, 553 Do Not Call Registry, 521 Dormant commerce clause, 74–75 Double jeopardy, 201 Down payment, 324 Dram shop acts, 129 Drinking water, contamination of, 542 Drones, commercial use of, 295 Drug Enforcement Administration

(DEA), 506 rulemaking by, 503

by performance, 267–272 wrongful, 441

Disclaimer for goods purchased online, 245 of warranty, 309

Disclosed principal, 428 Disclosure

of confidential medical information, 85, 467

of conf licts of interests, 405 in Franchise Rule, 363–364 of hidden defects, 556 public, of private facts, 118–119 reaffirmation, 337–338 under Regulation Z, 525 under Sarbanes-Oxley, 605 state, in franchising, 364 state securities laws, 603 of total compensation of chief executive

officer, 590 Disclosure law, 524 Discovery, 54, 57–60 Discrimination

affirmative action and, 470–471 age-based, 464–466 antidiscrimination laws and, 224–225 based on sexual orientation, 464 credit, 525 disability, 466–468 disparate-impact, 455 disparate-treatment, 454 employment (See Employment See Employment See

discrimination) gender-based, 456–461 hiring (See Hiring, discrimination in)See Hiring, discrimination in)See insurance companies and, 494 international protection for intellectual

property and, 166 by labor unions, 488 military status and, 469 nonprotected class and, 376 price, 577–578 for race, color, and national origin,

455–456 religion-based, 456 reverse, 455

Dismissals of debtor’s voluntary petition, 327, 328 motion to, 53–54

Disparagement of property, 125 Disparate-impact discrimination, 455 Disparate-treatment discrimination, 454 Displaying the offer, 245 Disposable income, in bankruptcy, 328 Disposal, of goods, 303 Disputes. See also Alternative dispute

resolution international, 221

Discharge (continued)

I N D E X I-11

Employment. See also Workplace; specific entries under Employment

discrimination in (See Employment See Employment See discrimination)

foreign supplier practices and, 102 I-9 verification and, 474 laws of (See Employment law)See Employment law)See scope under respondeat superior, 431respondeat superior, 431respondeat superior

Employment at will, 438 exceptions to, 438–439 wrongful discharge and, 441

Employment Authorization Document, 475

Employment-based visas, 476 Employment contract(s)

covenants not to compete in, 255, 351

mandatory arbitration in, 43 mitigation of damages, 276

Employment discrimination. See also Sexual harassment

affirmative action and, 470–471 age-based, 464–466 class-action lawsuits for, 454 defenses to, 469–470 disability and, 466–468 gender and, 456–461 intentional (disparate-treatment), 454 military status and, 469 online harassment and, 464 for pregnancy, 459–460 race, color, national origin, and,

455–456 religion and, 456 sexual harassment and, 462–464 Title VII and, 453–464 transgender persons and, 460–461 unintentional (disparate-impact),

454–455 in wages, 460

Employment law employment at will, 438–439 family and medical leave, 444–446 wages, hours, layoffs, and,

441–444 worker health and safety, 426

Enabling legislation, 497 Encumbrances, 548 Endangered Species Act (1973), 535 Energy efficiency, 611 Energy Policy and Conservation Act

(1975), 522 Enforceability

of contracts, 237 of covenants not to compete, 255 of oral contract, 256

Enforceable contract, 237 Enforceable contract terms, shrink-wrap

agreement and, 246–247

Employee(s). See also Labor unions after-acquired evidence of misconduct

by, 470 as agents, 416–417 CEO-worker compensation ratio, 590 with disabilities, 466–468 foreign workers as, 12, 102 garnishment and, 321–322 health and safety of, 426 income security and, 447–449 Internet and social media use by,

178, 179 layoffs of, 444 NLR A protection of, 477–478 privacy rights of, 179, 449–450 religion of, reasonable accommodation

for, 456 “right of disconnecting,” 98 social media rights of, 93–94 state, not covered by ADEA, 465–466 status of, 417–419 tipped, 441–442 travel time of, 432 wages and hours for, 441–443 workplace safety and, 446 works for hire and, 419

Employer-employee relationships, 416–417

Employer-independent contractor relationships, 417

Employer(s) discrimination laws and, 454–455,

466, 469–470 group health plans of, 448 lockouts by, 485 monitoring by, 178, 179, 449–450 practices unfair to labor, 477 reasonable accommodation by

for employees’ religion by, 456 for employees with disabilities,

467–468 retaliation by, 463–464 self-insured, 447 social media and hiring practices

of, 457 social media policies of, 93, 177 undue hardship vs. reasonable

accommodation by, 456, 467–468

unions and discrimination against union

employees, 487 domination of, 487 interference in activities of,

486–487 refusal to recognize and negotiate,

485–486 use of independent contractors by,

417–419

in gross, 554 termination of, 554

e-commerce, UETA and, 247 Economic Espionage Act, 164, 197 Economic strikes, 483–485 e-contract, 244

agreement in, 245–248 UETA and, 244, 247–248

ECPA. See Electronic Communications See Electronic Communications See Privacy Act

EDGAR (Electronic Data Gathering, Analysis and Retrieval) system (SEC), 589

e-discovery, 60 e-documents, federal law on, 247 EEOC. See Equal Employment See Equal Employment See

Opportunity Commission e-evidence, for discovery, 60 Eighth Amendment, criminal protections

in, 201 Elderly. See Age; SeniorsSee Age; SeniorsSee Election

of corporate directors, 400–401 labor union, 480–482

Electronic Communications Privacy Act (ECPA, 1986), 85, 449

social media and, 177–178 Electronic evidence. See E-discovery; See E-discovery; See

E-evidence Electronic monitoring, of employees, 449 Electronic records, 247

contracts requiring, 289 UETA and, 247–248

Electronic signature. See E-signatureSee E-signatureSee Electronic sites. See InternetSee InternetSee Eleventh Amendment, 466 Ellerth/Faragher affirmative defense, 463Ellerth/Faragher affirmative defense, 463Ellerth/Faragher e-mail

hacking, 230 service of process via, 50 spam, 170–171 union organizing using company’s, 483 valid contract via, 244 writing requirement and, 256, 289

Emancipation, of minor, 253 Embezzlement, 195–196 Emergency powers, of agent, 428 Eminent domain, 561–562 Emissions

limits on, 612 mobile sources of, 536–537 reducing, 610–611 standards for, 537

Emotional distress, intentional inf liction of, 114–115

Employee Polygraph Protection Act, 449

Employee Retirement Income Security Act (ERISA, 1974), 448

I-12 I N D E X

relevant, 61 rules of, 61

E visa, 476 Examination

request for, 59–60 in trial, 61–63

Exceptions to automatic stay, 329 to bankruptcy discharge, 334–335 to consideration requirement, 252 fair use, 163 to Government in the Sunshine

Act, 510 to perfect tender rule, 300

Exchange, bargained-for, 248–249 Exclusionary practices, under Clayton

Act, 578–579 Exclusionary rule, 202 Exclusions, from Copyright Act, 161 Exclusive agency, 424 Exclusive-dealing contract, 578 Exclusive jurisdiction, 30, 31 Exclusive possession and control, 550 Exculpatory clauses, 256, 281 Executed contract, 237 Execution, writ of, 66, 321 Executive agencies, 5, 497 Executive branch, control over agencies

by, 499 Executive committee, of board of

directors, 401 Executive(s). See Chief executive officer See Chief executive officer See

(CEO); Officers, corporate Executory contract, 237, 272, 338 Exemptions

from antitrust laws, 582 federal, 331 homestead, 325 private placement, 593 under Rule 505, 592 from securities registration

requirements, 591–593 for smaller companies, 605 state, 331

Exhaustion doctrine, 501 Existing goods, 293 Ex parte (private) communications, 505Ex parte (private) communications, 505Ex parte Expert testimony, 140 Expert witnesses, 62–63 Exploration and exploitation of outer

space, laws governing, 225 Export Administration Act, 219 Export(s), 217–218

controls of, 219 of space technology, 226

Export Trading Company Act, 219, 582 Express authority, of agent, 427 Express authorization, 245 Express contracts, 236

Error. See MistakesSee MistakesSee Escrow account, for real estate, 556 E-SIGN Act (Electronic Signatures in

Global and National Commerce Act, 2000), 247

UETA and, 248 e-signature, 247. See also Signature Establishment clause, 80 Estate

in bankruptcy, 330 leasehold, 552–553 life, 550–551

Estates in land, 550 Estoppel

agency by, 420 corporation by, 396 partnership by, 356–357 promissory, 252–253

ETA 9035 form, 476 Ethical leadership, importance of, 97–102 Ethical reasoning, 94 Ethics. See also Business ethics

of brewing imported beer locally, 217 of climate change, 610–612 data breach and, 232 defined, 3, 89 duty-based, 94–95 of eminent domain, 562 fantasy sports, gambling, and, 348 forced arbitration and, 267 gray areas of, 93 hiring procedures, social media,

and, 93 independent contractors in

transportation-sharing industry, 418

Kantian principles of, 95 law and, 3, 90–93 management and, 97–102 outcome-based, 94, 95 payment for personal breaks, 442 relief for student loan defaults, 337 small businesses, ACA, and, 494 stare decisis and patent law, 9stare decisis and patent law, 9stare decisis

European Patent Office, Web site of, 157 European Union (EU), 220

antitrust enforcement by, 583, 584 emissions limits and, 612 foods banned in, 523 intellectual property protection

and, 166 Europol, 156 Event, occurrence of

agency termination and, 434 dissociation and, 360–361, 384

Evidence. See also Discovery admissible, 56 hearsay, 61 preponderance of the, 63, 187

Enforcement as agency power, 498 of antitrust laws, 580 of employment verification, 475 of international arbitration clauses, 221 of judgment, 66 of rules, 504

England (Britain) common law heritage from, 6 early courts in, 6 U.S. law system based on, 6–12

Entity, partnership as, 356 Entrapment, 200 Entrepreneur, 350 Enumerated powers, 70 Environment, state, local, and federal

regulations, 533–535 Environmental impact statement (EIS),

535, 536 Environmental law, 532–547 Environmental Protection Agency (EPA,

1970), 5, 191, 496–497, 499, 611

bubble policy of, 507–508 regulation by, 533 Superfund violations and, 544–545 toxic chemicals and, 543

Environmental regulatory agencies, 533 Equal Credit Opportunity Act (ECOA,

1974), 525 Equal dignity rule, 427 Equal Employment Opportunity

Commission (EEOC, 1964), 499 ADA claims and, 466 employer-employee relationship

regulation, 496 on hiring discrimination based on

social media posts, 457 Title VII claims and, 453–454

Equality, marriage, 72 Equal Pay Act (1963), 460, 470 Equal protection

affirmative action and, 471 clause, 84

Equipment standards, best available control technology (BACT) for, 539–540

Equitable maxims, 6, 7 Equitable remedies. See also Remedies

for breach of contract, 278–280 reformation as, 279–280 rescission as, 278 restitution as, 278

Equity courts of, 6 remedies in (See Equitable remedies)See Equitable remedies)See

Equity securities. See Stock(s)See Stock(s)See ERISA. See Employee Retirement Income See Employee Retirement Income See

I N D E X I-13

Federal powers, concurrent with states, 75

Federal question, 28 Federal Register, 15Federal Register, 15Federal Register

food labeling regulations published in, 522

rulemaking notice in, 503 Federal regulations. See Regulation(s)See Regulation(s)See Federal Reporter, 19Federal Reporter, 19Federal Reporter Federal Reserve System (the Fed)

Board of Governors of, 499 Regulation Z of, 525 Truth-in-Lending Act administration

by, 524–525 Federal Rules of Bankruptcy

Procedure, 326 Federal Rules of Civil Procedure (FRCP),

48, 50, 60, 326 Federal statutes. See Statute(s); specific See Statute(s); specific See

statutes Federal Supplement, 19 Federal Trade Commission (FTC, 1914),

5, 497, 499 cyber security and, 231 deceptive advertising and, 501, 518 enabling legislation and, 497 on foreign spamming, 171 Franchise Rule of, 363–364 guidelines for “native ads,” 519 marketing and, 496 merger guidelines from, 579, 580 on privacy rights, 3, 184

Federal Trade Commission Act (1914), 568, 580

Federal Trademark Dilution Act (1995), 152

Federal Unemployment Tax Act (FUTA, 1935), 448

Federal Water Pollution Control Act (FWPCA, 1948), 535

Fees, attorney, 49 Fee simple, absolute, 550 Felonies, 188

cyber crime as, 208 Fiduciary, 416, 420 Fiduciary duty

breach of, 358 of corporate officers and directors,

402, 405 liability under tipper/tippee theory,

597–598 in LLCs, 375 of majority shareholder, 410 of partners, 358–359 waiver of, 359

Fiduciary relationship, 416, 420 undue inf luence and, 266

FIFR A. See Federal Insecticide, See Federal Insecticide, See Fungicide, and Rodenticide Act

Farmers. See Family farmers and See Family farmers and See fishermen

Fault. See Comparative negligence (fault); See Comparative negligence (fault); See Strict liability

FCC. See Federal Communications See Federal Communications See Commission

FCPA. See Foreign Corrupt Practices ActSee Foreign Corrupt Practices ActSee FCR A. See Fair Credit Reporting ActSee Fair Credit Reporting ActSee FDCPA. See Fair Debt Collection See Fair Debt Collection See

Practices Act Featherbedding, 478 Federal agencies. See Agencies See Agencies See

(government); specific agencies Federal Arbitration Act (FA A), 267 Federal Aviation Administration (FA A)

commercial spacef light regulation by, 226

rules on commercial use of drones, 295

Federal Communications Commission (FCC), 5

and broadband operator regulation, 501–502

on offensive language, 501–502 TCPA enforcement by, 521

Federal court system, 15, 26, 35, 38–40. See also Court(s); Supreme Court

appellate courts of, 15, 39–40 boundaries of appellate and district

courts, 39 decisions of, 19 district (trial) courts in, 19, 28 jurisdiction of, 27–35 reading citations for, 17–18 right to jury trial in, 60 tiers of, 35, 38–39

Federal crimes. See also Crime sentencing guidelines for, 204 strict liability, overcriminalization,

and, 190 Federal Food, Drug and Cosmetic Act

(FDCA, 1938), 523 Federal form of government, 70 Federal government

courts of (See Federal court system)See Federal court system)See powers of, 70 spam regulation by, 170–171

Federal Insecticide, Fungicide, and Rodenticide Act (FIFR A, 1947), 535, 543

Federal Insurance Contributions Act (FICA), 447

Federal law, 13, 14. See also specific laws on e-signatures and e-documents, 247 franchising regulation by, 363 gambling, 347 labor, 477–479 on privacy rights, 85 on trade secrets, 164

Expressions of ideas, copyright exclusions and, 161

Expressions of opinion, 239 Express powers, corporate, 397 Express terms, in contracts, 236 Express warranty, 307–308, 309 Expropriation, of private property,

214, 219 Extraterritorial application, of antitrust

laws, 583 Exxon Valdez disaster, 543Exxon Valdez disaster, 543Exxon Valdez

F Facebook

facial recognition software of, 170 legal challenges to, 2–3 for service of process, 53

Facial recognition software, 170 Fact(s)

causation in, 128 claims appearing to be based on,

515–517 compilation of, copyright and, 161 material, 262 mistakes of, 200, 262 public disclosure of private, 118–119 statement of, 115, 116, 121, 308

Fair and Accurate Credit Transactions Act (FACT Act, 2003), 528

Fair Credit Reporting Act (FCR A, 1970), 526–528

Fair dealing, franchises and, 367 Fair Debt Collection Practices Act

(FDCPA), 528–529 Fair Labor Standards Act (FLSA), 98,

441, 442, 466 Fair notice, 501–502 Fair Packaging and Labeling Act

(1966), 522 Fair use exception, 163, 174 Fair value

antidumping and, 220 of land, 562

False advertising, claims under Lanham Act, 519

False imprisonment, 114 False light, 118 Family and medical leave, 444–446 Family and Medical Leave Act (FMLA,

1993), 444, 466 Family (close) corporation, 392–393 Family farmers and fishermen, 339–340,

341–343 Chapter 12 bankruptcy and, 326

Family limited liability partnerships (FLLP), 380

Fanciful trademarks, 154 Fantasy sports, gambling and, 346–348

I-14 I N D E X

Fourth Amendment, 82–83 criminal protections in, 201, 202 drug testing and, 450 on search and seizure, 504

Franchisee, franchisor, 362. See also Franchise(s)

Franchise Rule (FTC), 363–364 Franchise(s)

contract for, 364–366 defined, 362 in foreign countries, 218 laws governing, 363–364 premises of, 365 termination of, 364, 366–367 types of, 362–363

Fraud. See also Fraudulent transfer; Statute of Frauds

antifraud provisions of SEC Rule 10b-5, 599

bankruptcy, 197 cyber, 204 as defense, 323 Internet, 196–197 mail, 196–197 online securities, 602 reformation for, 279 securities, 605, 606 violations of Securities Act (1933),

593–595 wire, 196–197

Fraudulent misrepresentation (fraud), 137, 264–266. See also Fraud; Misrepresentation

defined, 120 elements of, 264 statements of fact vs. opinion

and, 121 Fraudulent telemarketing, 521 Fraudulent transfer, in bankruptcy, 331 Freedom Act. See USA Freedom ActSee USA Freedom ActSee Freedom of Information Act (FOIA,

1966), 85, 510 Freedom(s). See also Bill of Rights;

Right(s) of religion, 80–82 of speech (See Free speech)See Free speech)See

Free exercise clause, 80–82 Free speech, 76–77, 449, 484

commercial speech, 78 corporate political speech, 77–78 defamation and, 115 international laws on, 31 online, 79–80 outrageous conduct and, 114–115 unprotected speech and, 79–80

Free trade agreements, 220–221 Free-writing prospectus, 590 Frivolous litigation, 122 Frolic, detour and, 432

Food and Drug Administration (FDA), 5 environment and, 533 on food labeling, 522

Food Safety Modernization Act (FSMA, 2011), 523

Forbearance, 248, 325 For cause, 400, 406 Force, reasonable, 114 Forced arbitration, 267 Foreclosure

avoiding, 325 defined, 318, 325 on personal property, 320–321

Foreign antitrust laws, 583–584 Foreign companies. See also International

business bribery of and by, 102–103 employment practices of suppliers, 102 in foreign cartel, 583

Foreign corporation, out-of-state corporation as, 389–390

Foreign Corrupt Practices Act (FCPA, 1977), 102–103

Foreign counterfeiters, of goods, combating, 156

Foreign governments act of state doctrine and, 214 sovereign immunity and, 214–216 U.S. cloud storage business and, 398

Foreign investment. See also International business

in LLC, 374 Foreign LLC, 372, 375 Foreign qualification, statement of, 380 Foreign Sovereign Immunities Act (FSIA,

1976), 214–216 Foreign state, FSIA on, 216 Foreseeability

product misuse defense and, 141, 142 proximate cause and, 128

Forgery, 194 Formal complaints

by administrative agencies, 505 by FTC, 518

Formal contracts, 236 Formation. See also specific types of

organizations contract, 235–236, 286–290

Form(s) of business, 350

compared, 411–412 of contract, 235

Forum-selection clause, 44–45, 221, 246 Forward-looking statements, safe harbor

for, 598 Fourteenth Amendment

affirmative action and, 471 on due process, 76, 83, 201 equal protection clause of, 84

Fifth Amendment criminal protections in, 201 on double jeopardy, 201 on due process, 83 on self-incrimination, 83, 200 takings clause of, 561

File-sharing technology, 175 Filing

of articles of incorporation, 395 of bankruptcy reorganization

plan, 339 of Chapter 7 petition, 327 of Chapter 12 petition, 341–343 of Chapter 13 petition, 340

Filtering software, 79–80 Final order, 506 Final rule, in agency rulemaking, 503 Finance, corporate financing and,

396–397 Financial Services Modernization Act

(Gramm-Leach-Bliley Act, 1999), 85

Financial statements, 589, 593, 605, 606 Firm offer, 287, 310 First Amendment. See also Freedom(s)

commercial speech and, 78 corporate political speech and, 77–78 establishment clause and, 80 on freedom of religion, 80–82 on freedom of speech, 76–80, 449 free exercise clause and, 80–82 obscene speech and, 79–80 outrageous conduct limited by,

114–115 strike activities and, 484 unprotected speech and, 79–80

First impression, cases of, 10 First sale doctrine, 163–164 Fish and Wildlife Service (U.S.), 191, 533 Fisheries Cooperative Marketing Act, 582 Fisherman. See Family farmers and See Family farmers and See

fishermen Fitness for a particular purpose, implied

warranty of, 309 Fixed-income securities, 396. See also

Bond(s) Fixed-rate mortgages, 324 Fixed-term tenancy, 553 Fixtures

personal property as, 549 trade, as personal property, 550

FLSA. See Fair Labor Standards ActSee Fair Labor Standards ActSee FMLA. See Family and Medical Leave See Family and Medical Leave See

Act F.O.B., defined, 297 Food

labeling and packaging of, 522 merchantable, 308 tainted, 523

I N D E X I-15

gTLD (generic top-level domain name), 171

Guarantor, 322–324 actions releasing, 323 defenses of, 323 rights of, 323–324

Guaranty, 322–323, 322–324 parties to, 322–323

Guilty act, 189

H H-1B visa program, 476 H-2 visas, 476 Habitability, implied warranty of, 556 Hackers/hacking, 207, 230

prosecution of, 231 Half-truths, claims based on, 517 Harassment

online, 464 sexual, 462–464

Hardship situations, of property owners, 564

Harm, 35 from pollution under nuisance

doctrine, 532 Hazardous air pollutants (HAPs), 537 Hazardous Substance Response Trust

Fund (Superfund), 544 Hazardous waste, environmental

protections against, 542–545 Health

consumer protection and, 523 of employees, 446–449

Health and Human Services Department (U.S.), 5, 523

Food and Drug Administration of (See Food and Drug Administration)

Health care, reforms of, 524 Health insurance

Affordable Care Act and, 70, 447, 448–449, 492–494

COBR A and, 448 costs of, 524 employer-sponsored, 448 rebates, 493 for workers with disabilities, 468

Health Insurance Portability and Accountability Act (HIPA A, 1996), 85, 448

Hearing procedures, for administrative agency adjudication, 505, 506

Hearsay, 61 Herbicides, 543 Herfindahl-Hirschman Index

(HHI), 579n Hidden defects, disclosure of, 556 High-tech companies, patent

infringement suits and, 158

defective, 139, 140 defined, 284–285 delivery with movement of, 297 delivery without movement of, 296,

297–298 existing, 293 fungible, 293 future, 293 held by bailee, 298 held by seller, 297 identified, 301 merchantable, 308–309 nonconforming, 287 obtaining by false pretenses, 194 in possession of buyer or lessee,

303–304 in possession of seller or lessor,

302–303, 303–304 and real estate, 284, 285 receiving stolen, 194 right to reject, 304–305 right to replevy, 304 sale of, 275, 284–286 services combined with, 285 specially manufactured, 290 in transit, 303

Good Samaritan statutes, 128–129 Good title, 307 Goodwill, 171, 355 Google

EU antitrust complaint against, 584 as protected trademark, 155

Governance, corporate, 603–605 Government. See also specific types

branches of U.S., 499 federal form of (See Federal See Federal See

government) judiciary’s role in (See Court(s))See Court(s))See national (See Federal government)See Federal government)See regulation by (See Regulation(s))See Regulation(s))See state (See State)See State)See

Government in the Sunshine Act (1976), 510

Government regulation. See Regulation(s)See Regulation(s)See antitrust (See Antitrust law)See Antitrust law)See consumer (See Consumer law)See Consumer law)See by states (See State(s))See State(s))See

Grand jury, in criminal case, 204 Grand theft, 194 Grant deed, 558 Gratuitous agent, 421 Gray areas of ethics, 93 Green card, 475 Greenhouse effect, 610 Greenhouse gases

climate change and, 536, 610–611 regulating, 536–537

Gross negligence, 113 Group boycott, 571

Frustration of purpose, discharge by operation of law, 274

FTC. See Federal Trade CommissionSee Federal Trade CommissionSee Full faith and credit clause, 71 Funds

misappropriation of, 393 mutual fund, 591

Fungible goods, 293 Future goods, 293 Future intent, statements of, 239

G Gambling

contract contrary to statute and, 254 fantasy sports and, 346–348

Garnishment, 321–322 Gender

employment discrimination based on, 456–461

same-gender harassment, 464 same-sex marriage, 72

Gender-neutral pronouns, 461 General damages, 112–113 General (unlimited) jurisdiction

courts of, 28 state courts of, 36

General partner, in LP, 381, 382, 384 General partnership, 355. See also

Partnership limited partnerships compared with, 383

General power of attorney, 427 Generic terms, trademarks and, 155 Generic top-level domain names

(gTLDs), 171 Geographic market, relevant, 575 Gig economy, 416 Global accounting rules, 103 Global business ethics, 102–103 Global context, U.S. laws in

antidiscrimination laws, 224–225 antitrust laws, 223, 583–584 international tort claims, 223

Globalization. See Global business ethics; See Global business ethics; See International business

Good cause, for franchise termination, 364

Good faith in bankruptcy, 340 contract performance and, 298–299 franchises and, 367 in labor bargaining, 477, 482–483, 484 price competition and, 578 in UCC, 287

Goods. See also Contract(s); Product; Product liability; Sales contracts

conforming, 287, 298, 299, 300 contracts for sale of, 281 counterfeit, 156

I-16 I N D E X

Incorporation articles of, 394–395 improper, 395–396 procedures of, 394–395 state of, 394

Incorporator, 395 Indemnification

agent’s negligent conduct and, 426 director’s right to, 402 with joint and several liability, 360 principal’s duty of, 424

Independent contractor, 417 vs. employee status, 417–419 liability for torts of, 433

Independent regulatory agencies, 5, 497, 499

Indictment, 204 in criminal case, 203–204

Indirect exporting, 218 Individual(s), Chapter 13 bankruptcy

and, 326, 340–341 Indorsement. See SignatureSee SignatureSee Industrial use, of land, 563 Industry, concentrated, 571 Infancy. See Children; MinorSee Children; MinorSee Infants. See Children; MinorSee Children; MinorSee Inf luence, undue, 266 Informal agency actions, 503–504 Informal contracts, 236 Information. See also Digital information;

Freedom of Information Act in criminal case, 204 health, of employees, 85, 467 return, 356

Informed decisions, duty to make, 402 Infringement

of title, 307 patent, 158–160 trademark, 152–153 trade secret, 164

In gross easements and profits, 553, 554 Initial order, 506 Initial public offering (IPO), 397, 591 Injunction, 6

as remedy against ultra viresultra vires acts, 399

as remedy for trademark infringement, 153

Injury damages and, 128, 518 to innocent party, 266 legally recognizable, 128 strict product liability and, 139, 140

Innocent landowner defense, 545 Innocent party, injury to, 266 In personam (personal) jurisdiction, 27 In rem (property) jurisdiction, 27

Immigration Act (1990), 474, 475–476 Immigration and Customs Enforcement

(ICE), 475 Immigration law, 474–477 Immigration Reform and Control Act

(IRCA, 1986), 474–475 Immunity. See also Privilege

self-incrimination privilege and, 200–201

sovereign, 214–216 state, 465–466

Impeach, defined, 59 Implication, easement or profit created

by, 554 Implied authority

of agent, 426, 427 of partners, 359

Implied contracts, 236 employment, 438 implied-in-fact, 236

Implied powers, corporate, 397–398 Implied terms, in contracts, 236 Implied warranty, 308–309

of authority, 429–430 disclaimer of, 309 of fitness for a particular purpose, 309 of habitability, 556 of merchantability, 308–309 in sale of new homes, 556

Import(s) controls of, 219–220 country-of-origin labeling violations

and, 217 Impossibility of performance

discharge by mutual rescission, 272 discharge by operation of law,

273–274 objective, 273–274 subjective, 273 temporary, 274 termination of agency relationship

by, 434 Impracticability, commercial, 274,

300–301 Impracticality, of partnership, 361–362 Imprisonment, false, 114 Improper incorporation, 395–396 Inadequate warning, 141–142 Incapacity, mental. See Mental See Mental See

incompetence Incentives

for exports, 219 for zoning exceptions, 565

Incidental beneficiary, 258 Incidental damages, 275 Income. See also Wages

disposable, in bankruptcy, 328 security for employees, 447–449

Incompetence. See Mental incompetenceSee Mental incompetenceSee

Hiring discrimination in (See also Employment

discrimination) based on social media posts, 457

procedures, social media, ethics, and, 93 rate of, 455

Historical school of thought, 12, 13 Holding company, 389 Holdup game, 249 Home equity loans, cancellation rules

for, 522 Homeland Security, Department of,

Immigration and Customs Enforcement (ICE) of, 475

Homeowners’ insurance, 324 Home sales, 522

implied warranty for new homes, 556 Homestead exemption, 325, 331, 332 Homosexuals. See also Sexual orientation

same-gender harassment and, 464 Horizontal market division, 571 Horizontal merger, 579 Horizontal restraint, in Sherman

Antitrust Act, 569, 570 Hostile-environment harassment, 462 Hot-cargo agreements, 478 Hours, laws on work, 442–443 Howey test, 588–589Howey test, 588–589Howey Human rights, universality of, 12

I I-9 employment verifications, 474 I-551 Alien Registration Receipt (green

card), 475 ICE. See Immigration and Customs See Immigration and Customs See

Enforcement Idea, copyrighting of, 161 Identical mark, as trademark dilution, 152 Identification, 292

of cyber criminals, 208 of goods in contract, 292–293

Identified goods, 301 Identity, appropriation of, 119–120 Identity theft, red f lag indicators of,

205–206, 528 Illegal immigrants. See Undocumented See Undocumented See

immigrants Illegality

of contracts, 254–256 of partnership, 361–362 termination of offer by, 241–242

Illegal strikes, 484 Illusory promises, 250 Image, business ethics and, 90 Immigration

documentation for, 475–476 undocumented immigrants and,

I N D E X I-17

International customs, 211 International law

defined, 211 legal systems and, 212–213 for outer space activities, 225–226 sources of, 211–212

International organizations, 212 International principles and doctrines,

213–216 International tort claims, in global

context, 223 International Trade Administration

(ITA), 220 International Trade Commission, 220 International Traffic in Arms

Regulations, 226 Internet. See also Cyber entries; Digital

entries; Internet service provider; Online entries

business contacts on, 30–31 cyber fraud and, 204 fantasy sports and gambling on,

346–348 fraud, 196–197 hiring procedures and, 93 “native ads” on, 519 pornography on, 79–80 proxy material on, 407 purchase contracts on, 522 reputations ruined on, 90 searches on, 584 securities offerings via, 591

Internet companies, privacy policies of, 3, 184

Internet Corporation for Assigned Names and Numbers (ICANN), 171

Internet law, 14, 170–174 Internet service provider (ISP), 179–180

liability of, 171, 175, 180 regulation of, 171, 502

Interpretation agency, 508 of contracts, 263

Interpretive rules, 498–499 Interrogatories, 59 Interstate commerce, 72, 577 Interstate Oil Compact, 582 Intoxication, 253 In transit goods, 303 Intrastate commerce, 72 Intrusion, 118 Invasion of privacy. See also Privacy entries

acts qualifying as, 118–120 revenge porn and, 119

Inventions. See Patents; Patent(s)See Patents; Patent(s)See Inverse condemnation, 562–563 Investigation

by administrative agencies, 176–177, 504 criminal, 176

negligence and, 125 partnership and, 355 in tort law (See Intentional torts)See Intentional torts)See transferred, 113

Intentional discrimination, 454 Intentional misrepresentation, 120, 121 Intentional torts, 113

of agent, 432–433 deceit as, 120 against persons, 113–123

abusive or frivolous litigation as, 122 appropriation as, 119–120 assault and battery as, 113–114 defamation as, 115–118 false imprisonment as, 114 fraudulent misrepresentation as,

120–122 in�iction of emotional distress as,

114–115 invasion of privacy as, 118–120 wrongful interference as, 123

against property, 123–125 conversion as, 124–125 disparagement of property as, 125 trespass to land as, 123–124 trespass to personal property as, 124

Intent requirement, 575 Interest(s)

insurable, 298 in partnership, 357, 361 protected, 112 security (See Security interest)See Security interest)See

Interior Department (U.S.), 533 Interlocking directorates, 579–580 Intermediate scrutiny, 84 Internal controls, of public companies,

605, 606 Internal Revenue Code, authority to

make enforcement rules for, 508 Internal Revenue Service (IRS)

determining if worker is employee or independent contractor, 418–419

determining living expenses, in bankruptcy, 328

Internal social media systems, 178 International agreements, 212 International business

dispute resolution in, 44–45, 221–222 franchising and, 218 intellectual property protection and,

166–167 international law and, 211–216 jurisdiction over, 31 regulation of, 219–221 transactions in, 216–218 U.S. antitrust laws and, 223

International contracts arbitration clauses in, 221 sales, 236, 314–316

Insanity. See also Mental incompetence as defense to criminal liability,

199–200 termination of agency relationship

by, 434 Inside director, 401 Inside information, SEC Rule 10b-5 and,

596–598 Insider, preferences to, 331 Insider reporting, 598

Section 16(b) of Securities Exchange Act (1934) and, 598

Insider trading, 197, 596 Section 16(b) of Securities Exchange

Act (1934) and, 598 Insider Trading and Securities Fraud

Enforcement Act, 602 Insolvency, of seller or lessor, 303–304 Inspection

by buyer or lessee, 301 corporate director’s right of, 401–402 ICE, 475 OSHA, 446 partner’s right of, 357 shareholder’s right of, 409

Instagram, 182 Installment(s), delivery of goods in, 299 Instrumentality, FSIA on, 216 Insurable interest, 298 Insurance

cyber security, 231 health (See Health insurance)See Health insurance)See homeowners’, 324 mortgage, 325 title, 556 unemployment, 448

Intangible property, 285 Intellectual property

copyrights (See Copyright)See Copyright)See defined, 150 forms of, 165 international protection for, 156,

166–167 licensing of, 156–157, 174 patents, 157–160 small business and, 350–351 trademarks and related property,

150–157 trade secrets, 164–165, 197

Intended beneficiaries, 258 Intent, intention

congressional, 75 in contract law, 235 in conversion, 125 in criminal law, 189 to deceive, 120 of effective offer, 238 fixtures and, 549 lack of, 239–240

I-18 I N D E X

Labor unions coercion by, 488 company’s e-mail used in

organizing, 483 discrimination by, 488 elections and, 480–482 employer’s discrimination against

employees, 487 employer’s domination of, 487 employer’s interference in activities of,

486–487 employer’s refusal to recognize and

negotiate, 485–486 labor laws and, 477–479 lockouts and, 485 organization by, 479–482 strikes and, 483–485 unfair labor practices of, 487–488 union security clause, 488

Laches, 6 Land. See also Real property

permissible uses of, 563–564 trespass to, 123–124

Land containment, hazardous waste and, 544

Landlord-tenant relationships, real property and, 548–567

Landowner duty of, 127 innocent landowner, 545

Land sale contract breach of, 275, 279 Statute of Frauds and, 256

Lanham Act (1946), 152, 158, 172 false advertising claims under, 519

Lapse of time, termination of offer by, 241–242

Larceny, 194 Latin America, antitrust enforcement

in, 583 Law courts. See Court(s)See Court(s)See Law(s). See also Statute; specific laws and

types of law administrative (See Administrative law; See Administrative law; See

Regulation(s)) antitrust (See Antitrust law)See Antitrust law)See bankruptcy, 326 case (See Case law)See Case law)See civil (See Civil law)See Civil law)See classifications of, 13–14 common (See Common law)See Common law)See Constitutional (See Constitutional law)See Constitutional law)See consumer (See Consumer law)See Consumer law)See contract (See Contract law)See Contract law)See on corporate political speech, 77–78 courts of equity and, 6, 7 for creditors, 318–324 criminal (See Criminal law)See Criminal law)See decision making and, 2–3

Judicial review, 26–27 Jurisdiction

appellate, 28 concurrent, 30, 31 in cyberspace, 30–33, 208 defined, 8, 27 exclusive, 30, 31 of federal courts, 27–35 general (unlimited), 28, 36 international issues and, 31 limited, 28, 36 of LLC, 373 original, 28 over subject matter, 28 in personam (personal) jurisdiction,

27–28 in rem (property) jurisdiction, 27 of Sherman Antitrust Act, 569 of state courts, 27–35, 36

Jurisprudence, 12 Jury, 187

grand, 204 instructions to, 63 right to trial by, 60–61 selection of, 61

Justice adversarial system of, 48 defined, 19

Justice Department (DOJ), 103, 204, 497, 595

antitrust law enforcement by, 579 merger guidelines from, 579

Justices (U.S. Supreme Court), 40 Justification, of costs, 578

K Kantian ethics, 95 Key employee exception, 446 Keystroke logging, 206 Knowledgeable user defense, 146 KORUS FTA. See Republic of Korea-See Republic of Korea-See

United States Free Trade Agreement

L Labeling laws, 522, 543, 544 Labor. See also Employee(s); Labor unions

child, 441 Labor Certification application, 475 Labor Department (U.S.), 442, 448

environment and, 533 Labor law, federal, 477–479 Labor-Management Relations Act

(LMR A, 1947), 478, 487–488 Labor-Management Reporting and

Disclosure Act (LMRDA, 1959), 478

Investment, protection in foreign countries, 219

Investment company, 591 Investment contract, 588 Investment newsletters, online securities

fraud and, 602 Investors, accredited, 592–593 Invitation, to submit bids, 239 Involuntary bankruptcy, 328–329 Involuntary manslaughter, 190 Involuntary title transfer, 559 IPO. See Initial public offeringSee Initial public offeringSee IR AC method, of legal reasoning, 10 IRCA. See Immigration Reform and See Immigration Reform and See

Control Act Irresistible-impulse test, 200 Irrevocable offers, 241–242, 310 Islamic courts, state, 36 Islamic law (sharia), 36, 212–213 ISP. See Internet service providerSee Internet service providerSee

J Job applicants, pool of, 455 Job application process, people with

disabilities and, 468 Joining together, in Sherman Act, 569 Joint and several liability

of partners, 360 of PRPs, 544–545

Joint liability, of partners, 360 Joint property ownership, in

partnership, 356 Joint tenancy, 552 Joint venture

antitrust laws and, 571 in foreign countries, 218

Judges defined, 19 federal court, 39 function of, 12 sociological thought and, 13 state court, 36 U.S. magistrate, 38

Judgment default, 50 enforcement of, 66 as a matter of law, 63 motion for

n.o.v., 64–65 on pleadings, 54, 56

Judicial branch. See also Court(s); Supreme Court (U.S.)

Article III (Constitution) on, 26, 28

control over agency powers, 501 Judicial deference, to agency decisions,

507–510 Judicial lien, 321

I N D E X I-19

for e-agent’s actions, 430 for independent contractor’s torts, 433 of Internet service providers, 171,

175, 180 legal, 2 in LLC, 371–372, 373–374 in LLP, 380 in LP, 382 market-share, 143 for negligence, 532 partnership, 356, 359–360, 361 of principal, 428–433 of PRPs, 544–545 RICO and, 198 under Section 10b-5 of SEC, 597–598 under Section 10(b) of Securities

Exchange Act (1934), 597–598 under Section 16(b) of Securities

Exchange Act (1934), 601 shareholder, 410 of sole proprietorship, 353–354 for space objects causing personal

injury and property damage, 225 strict (without fault), 134–135 strict product, 137–143 under Superfund, 544–545 for torts and crimes, 430–433 vicarious (indirect, contributory),

430–431 waivers of, 257

Liability Convention, 225 Libel, 115

damages for, 117 Liberties. See Bill of Rights; Freedom(s); See Bill of Rights; Freedom(s); See

Right(s) License, 554

defenses against trespass and, 124 real property, 554–555 shrink-wrap, 246–247

Licensee, 9, 124, 157 Licensing

of intellectual property, 156–157, 174 manufacturing abroad and, 218 online, 245 trademark and, 156–157

Licensing statutes, and illegality of contract, 254

Licensor, 157 Lie-detector tests, 449 Lien

artisan’s, 320–321 defined, 318 judicial, 321 by life tenant, 550 mechanic’s, 318–320 no liens warranty of title, 307

Life estate, 550–551 Lilly Ledbetter Fair Pay Act (2009), 460 Limitation-of-liability clauses, 281

formation of, 286–290 risk of loss, 298

Leave, family and medical, 444–446 LEED (Leadership in Energy and

Environmental Design) certification/, 96

Legal cause, 128 Legal counsel. See AttorneySee AttorneySee Legality

of contract, 235, 254–256 of fantasy sports, 346–348

Legally sufficient value, 248 Legal malpractice, 127 Legal positivism, 12 Legal realism, 12–13 Legal reasoning

stare decisis and, 10–11stare decisis and, 10–11stare decisis steps in, 10–11

Legal stability, stare decisis and, 8–10stare decisis and, 8–10stare decisis Legal systems, in international law,

212–213 Legal thought, schools of, 12–13 Legislation. See also Law(s)

enabling, 497 implementation by, 496

Legislative branch, authority over agencies, 499–500

Legislative regulations, 502–503 Legislative rules, 498–499 Legitimate purpose, for imposing

territorial or customer restrictions, 572

Lessee, 286 contract breached by, 298,

303–305 goods in possession of, 303–304 insolvency and breach of, 303–304 insurable interest of, 298 obligations of, 301–302 remedies of, 303–305

Lessor, 286 contract breached by, 298, 303–305 goods in possession of, 302–303,

303–304 insolvency of, 303–304 insurable interest of, 298 obligations of, 299–301 remedies of, 302–303

Letters of credit, 236 Liability. See also Civil liability; Crime;

Limited liability; Negligence; Product liability; Strict liability

of agent, 389, 433 civil, 188, 189, 198 for contracts, 428–430 corporate criminal, 190–192 criminal, 189–192 defenses to, criminal liability, 198–201 of directors and officers, 192, 405

defined, 2 disclosure, 524 due process of (See Due process)See Due process)See environmental, 532–547 ethics and, 3, 90–93 franchise, 363–364 on garnishment, 322 immigration, 474–477 international (See International law)See International law)See Internet (See Internet law)See Internet law)See Islamic (Sharia), 36, 212–213 labor, 477–479 mistakes of, 200 national, 211 operation of (See Operation of law)See Operation of law)See partnership (See Partnership)See Partnership)See primary sources of, 3–4, 14–19 regulating business (See Regulation(s))See Regulation(s))See remedies at, 6, 7 sources of, 3–5, 6–12 space, 225–226 state securities, 603 statutory, 3, 4 tort (See Tort law)See Tort law)See on trade secrets, 164 zoning, 563

Lawsuit. See also Alternative dispute resolution; Class-action lawsuits; Litigation

civil and criminal for same act, 188, 189

parties to, 48 patent infringement, 158 product liability, 142 shareholder’s derivative, 405, 409–410 stages in, 48, 49 standing to sue and, 33–35 under Title VII, 453 in transportation-sharing industry, 418

Lawyer. See AttorneySee AttorneySee Lawyers’ Edition of the Supreme Court

Reports (L.Ed.), 19Reports (L.Ed.), 19Reports Layoffs, employee, 444 Leadership. See Ethical leadership; See Ethical leadership; See

Management; Officers, corporate Lease agreement, 286 Lease contracts. See also Performance

breach of contract (See Breach of See Breach of See contract; Damages)

formation of, 284, 286–290 performance of, 298–302 risk of loss when breached, 298 warranties in, 307

Leased property. See Landlord-tenant See Landlord-tenant See relationship

Leasehold, estate, 552–553 Lease(s), 338

consumer, 286 defined, 286

I-20 I N D E X

Manufacturing abroad, 218 defects in products and, 140

Manufacturing or processing-plant franchise, 363

Marine Protection, Research, and Sanctuaries Act (Ocean Dumping Act, 1972), 542–543

Marketable title, 556 Market concentration, 579 Marketing, federal regulation of, 521–522 Market power, 569 Market(s)

changing conditions in, 578 horizontal division of, 571 relevant, 573–575

Market-share liability, 143 Marriage, equality of, 72 Material alteration, discharge by, 273

operation of law, 273 Material breach

of contract, 269–271 of performance, 269

Material fact fraudulent misrepresentation and, 264 mistakes and, 262

Material facts, disclosure under SEC Rule 10b-5, 596

Material loss of goods, 299 Material modification, of contract, 323 Maturity date, of bond, 396 Maximum achievable control technology

(MACT), 537, 540 Maximum resale price maintenance

agreements, 572 McCarran-Ferguson Act, 582 Means test, in bankruptcy, 327–328,

330, 340 Mechanic’s lien, 318–320 Media. See Social mediaSee Social mediaSee Mediation, as type of ADR, 41 Medical devices, regulation of, 523 Medical information, privacy of, 85, 467 Medical malpractice, 127 Medicare, 447 Medications, warnings on, 142 Meetings

to adopt corporate bylaws, 395 board of directors’, 401 shareholders’, 406–407

Member, of LLC, 371 Member-managed LLC, 375 Men. See GenderSee GenderSee Mens rea (mental state), 189–190, 191Mens rea (mental state), 189–190, 191Mens rea Mental incapacity. See Mental See Mental See

incompetence Mental incompetence. See also Insanity

contracts and, 241–242, 253–254 as defense of surety and guarantor, 323

Litigation. See also Class-action lawsuits; Lawsuit

abusive or frivolous, 122 alternatives to, 40–45 defined, 40 phases of, 48 social media and, 176 workers’ compensation vs., 447

LMR A. See Labor-Management Relations See Labor-Management Relations See Act

LMRDA. See Labor-Management See Labor-Management See Reporting and Disclosure Act

Loan(s), for small business, 351 Local agencies, 5 Local regulations, for environmental

preservation and protection, 533 Location, of franchise, 365 Lockouts, labor, 485 Long arm statute, 27 Long-run profit maximization, 90 Loss

compensatory damages for, 112–113 in partnership, 355 punitive damages for, 113 risk of, 296–298 in sole proprietorship, 353

Loyalty. See Duty of loyaltySee Duty of loyaltySee L visa, 476

M Madrid Protocol (2003), 166 Magistrate judge, U.S., 38 Mailbox rule, 244 Mail fraud, 196–197 Mail or Telephone Order Merchandise

Rule (FTC), 522 Maintenance agreements, resale

price, 572 Majority, age of, 253 Majority opinion, 20 Majority shareholder. See ShareholdersSee ShareholdersSee Malice, actual, 115, 118 Malicious prosecution, 122 Malpractice

defined, 127 legal, 127 medical, 127

Malware, 207 Management

of close corporations, 393 ethics and, 97–102 of LLC, 374, 375 misbehavior of, 100

Management responsibilities, corporate directors’, 388, 401

Management rights, in partnership, 357 Manager-managed LLC, 375 Manslaughter, involuntary, 190

Limitation(s) on class actions, 454 on homestead exemption, 325, 332 on partner’s authority, 359 on property owners’ rights, 561–563 on remedies, contract provisions

for, 281 statute of, 113, 200

Limited jurisdiction courts of, 28 state courts of, 36

Limited liability of corporate shareholders, 371, 388 in LLC, 371, 373–374

Limited liability company (LLC), 350 advantages of, 373–374 articles of organization of, 372 compared with other forms of business,

371–372, 412 defined, 371 disadvantages of, 374–375 dissociation of, 377 dissolution of, 377–379 fiduciary duties of, 375 foreign investment in, 374 formation of, 372 jurisdictional requirements of, 373 liability of, 371–372, 373–374 management of, 374, 375 nature of, 371–372 operating agreement for, 376–377 as person, 372 taxation of, 374 winding up, 379

Limited liability limited partnership (LLLP), 384

Limited liability partnership (LLP), 350 compared with other forms of

business, 412 family, 380 formation of, 380 liability in, 380

Limited partner, in LP, 381, 382 Limited partnership (LP), 350, 381

compared with general partnerships, 383 compared with other forms of

business, 412 dissociation and dissolution

of, 384 formation of, 382 liability and, 382

Limited warranty deed, 558 Liquidated damages, for breach of

contract, 276–278 Liquidated debt, 251 Liquidation

in Chapter 7 bankruptcy, 326–327

I N D E X I-21

N NAFTA. See North American Free Trade See North American Free Trade See

Agreement Name, securing corporate, 394 National Association of Securities Dealers

(NASD), 595 National Conference of Commissioners

on Uniform State Laws (NCCUSL), 4, 247, 355, 371, 603

National Environmental Policy Act (NEPA, 1969), 535

National government. See Federal See Federal See government

National Highway Transportation Safety Administration, 611

National Labor Relations Act (NLR A, 1935), 477–478, 480, 484

firm-union relationships and, 496 workers protected by, 477–478

National Labor Relations Board (NLRB, 1935), 477–478, 499

social media regulation and, 93 union elections and, 480

National law, 12, 211 in global context, 223–225

National origin, discrimination based on, 455–456

National Pollutant Discharge Elimination System (NPDES), 539

National Reporter System (West), 15 National Security Agency (NSA), phone

data collection by, 86 Nation(s), defined, 211 Native ads, on Internet, 519 Natural law theory, 12, 13 Natural rights, 12 NCCUSL. See National Conference of See National Conference of See

Commissioners on Uniform State Laws

Necessity, 554 as defense to criminal liability,

198–199 easement created by, 554

Negligence. See also Malpractice of agent, 430–432 causation and, 127–128 comparative, 113, 131, 146 contributory, 130–131 of corporate director or officer, 402 criminal, 190 defenses to, 129–131 dram shop acts and, 129 duty of care and, 125, 126–127 Good Samaritan statutes and,

128–129 gross, 113 liability for, 128, 532 product liability based on,

135–137

Model Business Corporation Act (MBCA), 388

Model Penal Code, on legal insanity, 199

Model Rules of Professional Conduct (American Bar Association), 92

Monetary damages, 6 Money laundering, 197–198 Monitoring

electronic, of employees, 449 of employee online communications, 179 other types of, 449–450 Sarbanes-Oxley Act and, 605

Monopolization, 572–575 attempted, 572, 575–576

Monopoly, 569, 573 Monopoly power, 569, 573

intent requirement, 575 unilateral refusals to deal, 575

Moral minimum, 91 Mortgagee, mortgagor, 324 Mortgage insurance, 325 Mortgage(s)

adjustable-rate, 324 defined, 324 fixed-rate, 324 foreclosure, 325 insurance for, 325 lender assignment of collection

rights, 258 provisions, 324–325

Motion to compel discovery, 54 defined, 52–53 for a directed verdict, 63 to dismiss, 53–54 for judgment as a matter of law, 63 for judgment n.o.v., 65 for judgment on the pleadings,

54, 56 to make more definite or

certain, 54 for new trial, 64 posttrial, 64–65 pretrial, 53, 54 to strike, 54 for summary judgment, 54, 56

Movies, piracy and file-sharing of, 175 Multilateral agreement, 212 Multiple product order, 518 Music files, sharing, 175 Muslims, Islamic state courts and, 36 Mutual assent. See Agreement(s), See Agreement(s), See

contractual Mutual fund, 591 Mutuality of interest, 480 Mutual mistake, 262

reformation for, 279 Mutual rescission, discharge by, 272

Merchantability of food, 308 of goods, 308–309 implied warranty of, 308–309

Merchant buyers, duties when goods are rejected, 305

Merchant(s) contracts

between merchants, 288, 290 when one or both parties are

nonmerchants, 288 defined, 286 firm offer by, 287, 310

Mergers antitrust law and, 579 horizontal, 579 vertical, 579

Metadata, 60 Meta tags, 80, 172–173 Metes and bounds system, 558 Military status, discrimination based

on, 469 Minimum contacts, 27–28, 31, 33 Minimum resale price maintenance

agreements, 572 Minimum wage, 441 Mini-trial, in ADR, 43–44 Minor, 253. See also Children

right to disaffirm, 253 Minor breach, 270–271 Minority shareholder. See ShareholdersSee ShareholdersSee Minors, undue inf luence, 266 Miranda rule, 202Miranda rule, 202Miranda Mirror image rule, 241, 242, 288, 310 Misappropriation

of close corporation funds, 393 theory, 598

insider trading under, 598 Misclassification lawsuit, 418 Misdemeanors, 188 Misrepresentation

by agent, 430 by conduct, 265–266 fraudulent, 120–122, 137, 264–266 negligent, 121–122

Mistakes bilateral (mutual), 262, 263 of fact, 200, 262–263 of law, 200 unilateral, 262 of value or quality, 262, 263

Misuse, product, 145–146 Mitigation of damages, 276 Mixed contracts, with express and

implied terms, 236 M’Naghten test, 200 Mobile sources, of air pollution,

536–537 Mode, of acceptance, 244–245

I-22 I N D E X

Offeree, offeree, of contract, 235, 238, 288 Office of the National Ombudsman,

at Small Business Administration, 511

Officers, corporate. See also Chief executive officer (CEO)

duties of, 402–403 implied powers of, 397–398 liability of, 192, 405 role of, 402

Oil Pollution Act (1990), 543 Ombudsman, at Small Business

Administration, 511 Ongoing business, sale of, and covenant

not to compete, 255 Online dispute resolution (ODR), 44 Online environment. See also Internet

Internet law and, 170–184 patent trolls in, 159 privacy rights in, 182–184 trademark dilution in, 173–174

Online fraud, for securities, 602 Online initial public offering (IPO), 591 Online issues

acceptances, 246–247 advertising, 518 auction fraud, 204 contracts (See E-contract)See E-contract)See defamation, 116, 178–180 harassment, 464

Online offers, 245–246 Online sales, of counterfeit goods, 156 Online startups, personal liability for, 354 Opening statements, 61 Open Internet Order, 502 Open meeting law. See Government in See Government in See

the Sunshine Act Open quantity terms

output contracts and, 287 requirements contracts and, 287

Operating agreement, for LLC, 376–377 Operation of law

agency by, 420 contract discharge by, 273–274 termination by, 241–242, 434

Opinion decisions and, 7–8 expressions of, 239 statement of, 116, 121, 308 types of, 20

Oppressive conduct, 410 Option contract, 241, 287 Options, stock, 604 Oral contracts

admissions for, 290 partial performance of, 290 Statute of Frauds and, 256 writing requirement and, 290 written contract incorrectly states, 279

Nuisance, doctrine as remedy against pollution, 532

Nutritional content, labeling of, 522 Nutrition Labeling and Education Act, 522

O Obamacare. See Affordable Care Act See Affordable Care Act See

(ACA, Obamacare, 2010) Obamacare effect, 494 Obamanet, 502 Obedience, agent’s duty of, 423 Objection, to discharge in

bankruptcy, 335 Objective impossibility of

performance, 273 Objective theory of contracts, 235 Obligations

of buyer or lessee, 301–302 of seller or lessor, 299–301

Obligee, 258 performance by third party varies

materially from that expected by, 258

Obligor, 258 Obscenity, 79–80 Obvious risks, 143 Occupational Safety and Health Act

(1970), 446 Occupational Safety and Health

Administration (OSHA), 446, 497

manufacturing and, 496 Ocean dumping, 542–543 Ocean Dumping Act (1972), 535,

542–543 ODR. See Online dispute resolutionSee Online dispute resolutionSee Offenses against society, crimes as, 187 Offensive language, FCC on, 501–502 Offer

acceptance of, 238, 242–245 of bribe, 197 communication of, 240–241 for contract, 235, 238–242 counteroffers and, 241 defined, 238 definiteness of terms in, 240 display for e-contract, 245 irrevocable, 241–242 by merchant, 287 for mutual rescission, 272 online, 245–246 open term, 286–287 rejection of, 241 requirements of, 238–241 revocation of, 241 statements not offers, 239 termination of, 241–242 under UCC, 289

professional (See Malpractice)See Malpractice)See toxic torts and, 532 as unintentional torts, 113

Negligent misrepresentation, 121–122 Negotiable document of title, 298 Negotiated settlement, 505 Negotiation

defined, 40 preliminary, 239 as type of ADR, 40–41

Networks, social media, 178 New York Convention, 221 No liens warranty title, 307 Nominal damages, 276 Nonacceptance, right to recover damages

for buyer’s, 303 Noncompete agreement, 250, 255 Noncompete covenants. See Covenant, See Covenant, See

not to compete Nonconforming goods, 287, 300 Nondeadly force, 198 Nondiscriminatory pricing, ACA and, 494 Nonemployees, sexual harassment by, 464 Noninvestment company, 591 Nonmerchants, as parties to contract, 288 Nonnegotiable document of title, 298 Nonpartner agents, 356–357 Nonpersonal duties, delegation of, 258 Nonpossessory interests, 553–555 Nonpracticing entities (NPEs), 159 Nonprofit corporation, 391 Non-prosecution agreements, 191 Nonprotected class, discrimination suits

by, 376 Normal trade relations (NTR) status, 220 Norris-LaGuardia Act (1932), 477 North American Free Trade Agreement

(NAFTA), 220 No-strike clause, 484 Notary public, 427 Not-for-profit corporation, 391 Notice. See also Notification

of motion, 52–53 of revocation, 305 shareholders’ meeting, 406 of termination, 366, 434

Notice-and-comment rulemaking, 503 Notice-and-cure provision, 366 Notification. See also Notice

by agent of principal, 421 fair credit reporting and, 527 of food, drug, and cosmetic hazards,

524 Novation, 372

defined, 272 discharge by, 272

Nuclear Regulatory Commission (NRC, 1975), 499, 533

Negligence (continued)

I N D E X I-23

PCAOB. See Public Company See Public Company See Accounting Oversight Board

Peer-to-peer (P2P) networking, 175 Penalties

for Clean Air Act violations, 537 for Clean Water Act violations, 542 for counterfeiting goods, 156 defined, 277 for FIFR A violations, 543 for hazardous waste materials, 544 for HIPPA violations, 448 for immigration law violations,

474–475 for ocean dumping, 543 for Sarbanes-Oxley Act violations,

601, 606 Pension plans. See Social SecuritySee Social SecuritySee Per curiam opinion, 20 Perfect tender rule, 300

exceptions to, 300 Performance

agent’s duty of, 421 complete, 268 conditions of, 268 contract, 237 discharge by, 267–272 impossibility of, 273–274, 434 of oral contract, 272 right to obtain specific, 304 of sales and lease contracts, 298–302 to satisfaction of another, 269 specific, 279, 304 substantial, 268–269 tender of, 268, 299 by third party, varies materially from

that expected by obligee, 258 time for, 272

Periodic tenancy, 553 Permits, for point-source water

pollution, 539 Per se slander, 117Per se slander, 117Per se Per se violation, of antitrust laws, Per se violation, of antitrust laws, Per se

569–570, 571, 572, 578, 583 Personal assets, sole proprietorship

liability and, 354 Personal breaks, payment for, 442 Personal contracts, 269 Personal digital assistant (PDA), 98 Personal duties, cannot delegate, 258 Personal income tax, sole proprietorship

and, 352 Personal injury cases, from exposure to

toxic substance, 532 Personal jurisdiction. See In personam

jurisdiction Personal liability, of sole proprietor, 354 Personal property, 320

conversion of, 124–125 crops as, 549

Partnership. See also Limited liability partnership; Limited partnership; specific forms

agreement, 356 articles of, 356 basic concepts of, 355–356 buy-sell (buyout) agreements, 362 under Chapter 12, 341n comparison of, with other forms of

business, 388, 411 compensation and, 357 defined, 355 dissolution of, 361–362 duration of, 356 duties of, 358–359 elements of, 355 by estoppel, 356–357 formation of, 356–357 general, 355 interest in, 357 law, 355 liability of, 359–360 limited, 355, 379–384 limited liability, 355, 380 limited liability limited, 384 LLC taxed as, 374 property rights of, 357 taxation of, 356 for a term, 356 termination of, 361–362 at will, 356 winding up of, 362

Pass-through entity, 356, 380 Passwords

online theft of, 206 protection for social media, 178

Past consideration, 249–250 Patent assertion entities (PAEs), 159 Patent law, 9 Patent(s), 157

duration of, 157 infringement of, 9, 158 qualities determining, 157–158 remedies for infringement, 159–160 searchable databases for, 157 software, 159

Patent trolls, 159 Patient Protection and Affordable Care Act

(ACA, 2010). See Affordable Care See Affordable Care See Act (ACA, Obamacare, 2010)

Patriot Act. See USA Patriot ActSee USA Patriot ActSee Pattern of conduct, waiver of breach

and, 281 Pay. See WagesSee WagesSee Payment

by buyer or lessee, 301 by debtor, 323 for e-contracted goods, 245 for franchise, 365

Order(s). See also Check cease-and-desist, 477 FTC, 518 for relief, 328, 329

Ordinances, 4 Ordinary (straight) bankruptcy,

326–327 Organizational form(s), 350

of franchise, 365 Organization(s). See also specific

organizations international, 212

Organized crime, 197–198 Original jurisdiction, 28 OSHA. See Occupational Safety and See Occupational Safety and See

Health Administration Outcome-based ethics, 94

utilitarianism as, 95 Outer space. See Space entries Outer Space Treaty, 225–226 Outrageous conduct, 114 Outside director, 401, 604 Outsiders, SEC Rule 10b-5 and, 597–598 Overcriminalization, strict liability

and, 190 Overtime, 98, 442–443 O visas, 476 Owners

breach of contract by, 276 misbehavior of, 100

Ownership. See also Landowner; Personal property; Property; Real property

concurrent, 552 by partners, 355 of real property, 550–555 of sole proprietorship, 351 transfer of, 555–561

P Packaging laws, 522, 544 Parallel citation, 15 Parent company, 389 Paris Convention (1883), 166 Partial acceptance, 302 Partially disclosed principal, 428–429 Partial performance, of oral

contract, 290 Participation, right to, 401 Parties. See Third partySee Third partySee Partner

buyout of, 362 dissociation of, 360–361 duties of, 358–359 general, 381 liability of, 359–360, 380 limited, 381 rights of, 357 sharing LLP liability, 380

I-24 I N D E X

Preponderance of the evidence, as standard of proof, 63, 187

Prescription, easement created by, 554 Presumption, of undue inf luence, 266 Pretext, pretexting, 454, 465 Pretrial, procedures, 50–61, 62 Pretrial conference, 60 Pretrial motions, 53, 54 Pretrial phase, of litigation, 48 Price discrimination, defenses to liability

for, 577–578 Price fixing

agreement, 570, 572 cartels, 570–571

Pricing in franchise, 366 meeting competitor’s prices, 578

Prima facie case, 454, 455, 465, 469Prima facie case, 454, 455, 465, 469Prima facie Primary sources of law

defined, 3–4 locating, 14–19

Principal, 416. See also Agency relationships

agency by estoppel and, 420 agent’s duties to, 421–423 agent’s rights and remedies against, 426 disclosed, 428 duties to agent, 423–426 liability of, 428–430 partially disclosed, 428–429 ratification of agent’s unauthorized act

and, 428 revocation by, 434 rights and remedies against agent, 426 tort and crime liability of, 430–433 unauthorized acts of agent and,

429–430 undisclosed, 429

Principle international doctrines and, 213–216 of rights, 94–95

Prior dealing, warranties implied from, 309

Privacy, 84–86. See also Privacy rights monitoring of employees and,

449–450 policies of Internet companies, 3,

184, 245 protection for employees, 179, 449 reasonable expectation of, 182–183,

202, 449 Privacy Act (1974), 85 Privacy rights. See also Privacy

acts qualifying as invasion of privacy, 118–120

of employees, 179 federal statutes affecting, 85, 86 of medical information, 85 online issues and, 182–184

nuisance doctrine and, 532 oil, 543 water, 539–543

Ponzi scheme, 602 Pornography

on Internet, 79–80 revenge porn, 119 virtual child, 80

Port Authority of New York and New Jersey, 533

Positivist school of thought, 12, 13 Possession

adverse, 559, 561 debtor in (DIP), 338

Possessory lien, artisan’s lien as, 320 Posteffective period, of securities, 590 Posttrial motions, 64–65 Posttrial phase, of litigation, 48

options, 66 Potentially responsible party (PRP), 544 Power of attorney, 427

durable, 427n Power(s). See also Monopoly power

of administrative agencies, 497–501 agency, 497–501 corporate, 397–399 to dissociate from LLC, 377 monopsony, 576 of shareholders, 406 of trustee, 330

Powers of avoidance, 330 Precedent, 7–8

departures from, 8–10 Predatory behavior, 123 Predatory bidding, 576 Predatory pricing, 572, 576 Predominant-factor test, 285 Preemption, 75, 145 Preemptive rights, to shareholders, 408 Preexisting duty, 249 Preferences

affirmative action and, 471 in bankruptcy, 330–331

Preferred creditor, 331 Preferred stock, 396–397 Prefiling period, in securities registration

process, 589 Preformation contracts, for LLCs, 372 Pregnancy, employment discrimination

for, 459–460 Preincorporation contracts, 372 Prejudgment remedy

attachment as, 321 garnishment as, 322

Preliminary agreements, 240 Preliminary negotiations, 239 Preliminary prospectus, 589–590 Premises, franchise, 365 Prepayment penalty clause, 324

defined, 123 exempted, 325–326 failure to return, 125 as fixtures, 549

trade �xtures, 550 foreclosure on, 320–321 trespass to, 124

Personal services breach of contract for, 279 contract for, 258

Personalty, trespass to, 124 Person(s)

corporation as, 355, 388 defined in bankruptcy, 327 intentional torts against, 113–123 UPA definition of, 355

Persuasive authorities, 10 Pesticides, 543 Petitioner, 6, 19 Petition(s), 50n

in bankruptcy, 327, 340, 341–343 for emancipation, 253 granted by Supreme Court, 40

Petroleum Marketing Practices Act (PMPA), 363n

Petty offenses, 188 Petty theft, 194 Pharmaceuticals. See DrugsSee DrugsSee Phishing, 206–207 Physical exams, preemployment, 468 Physical harm, 139 Picketing, 484 Piercing the corporate veil, 372, 388,

399–400 Place of delivery, 299 Plaintiff

complaint of, 50–51 defined, 19

Plan in Chapter 12 bankruptcy, 343 in Chapter 13 bankruptcy, 340–341 in reorganization (Chapter 11

bankruptcy), 339 Plan B (morning-after birth control

pill), 523 Plant life, as real property, 549 Plea bargaining, 200–201 Pleadings, 50–52

motion for judgment on, 54, 56 Plurality opinion, 20 PMSI. See Purchase-money security See Purchase-money security See

interest Point-source water pollution emissions, 539 Police powers, 70–71 Political speech, corporate, 77–78 Pollution. See also Environment entries

air, 536–539 control equipment standards, 540

Personal property (continued)

I N D E X I-25

of employee privacy, 179, 449 of FMLA leave, 446 of social media passwords, 178 under Title VII retaliation provisions,

463–464 of trade secrets, 178

Provisions, to include in online offer, 245 Proximate cause, 128, 136, 140 Proxy, 406

electronic, 407 statements, regulation of, 406, 599

PRP. See Potentially responsible partySee Potentially responsible partySee Public accountability, of administrative

agencies, 510–511 Publication, defamation and, 116–117 Public company (publicly held

corporation), 391 Public Company Accounting Oversight

Board (PCAOB), 605 Public corporation, 391 Public disclosure, of private facts, 118–119 Public domain

Public employers, drug testing by, 450 Public figures, defamation and, 118 Public f loat (market capitalization), 605 Public health. See Environment; HealthSee Environment; HealthSee Public hearing, for variance, 564 Publicly held corporation (public

company), 391 Public order crime, 194–195 Public policy

contracts contrary to, 254–256 exceptions to employment-at-will

doctrine, 439 exculpatory clauses violating, 256 statement, on strict product

liability, 138 Public welfare exception, to free exercise

clause, 82 Puffery, 120, 515 Punitive damages, 113, 276, 464 Purchase, of securities, 603 Purchase-money security interest

(PMSI), 341 Purpose

of agency investigation, 504 of benefit corporation, 394 frustration of, 274 implied warranty of fitness for, 309

Q Qualified (conditional) privilege, 118 Qualified right, to possession, 553 Quality, slander of, 125 Quality control, 140

in franchise, 365–366

Prohibitions, on imports, 219 Promise. See also Covenant; Offer

consideration and, 248 defined, 234 of fact, 308 illusory, 250

Promisee, 234 Promisor, 234, 258 Promissory estoppel, 252–253. See also

Detrimental reliance Promotion

accountability, 604 corporate preincorporation, 394

Pronouns, gender neutral, 461 Proper purpose, shareholder rights

and, 409 Property

CERCLA defenses and, 545 crimes involving, 192–194 disparagement of, 125 distribution of (bankruptcy), 332–334 estate in, 330 expropriation of private, 214 intangible, 285 intellectual (See Intellectual property)See Intellectual property)See intentional torts against, 123–125 jurisdiction over, 27 liens on, 318–321 limitations on owners’ rights, 561–563 partnership and ownership of, 357 personal (See Personal property)See Personal property)See real (See Real property)See Real property)See secured, 329 surrender of, 323 tangible, 285 trespass to, 123–124

Property jurisdiction. See In rem jurisdiction

Property rights of partnership, 357 of private corporation, 391n in space, 226

Proportionate liability, 380 Proposals, shareholder, 406 Prosecution

civil and criminal for same act, 188, 189 of cyber crime, 207–208 malicious, 122

Pro se representation, 48Pro se representation, 48Pro se Prospectus, 589

free-writing, 590 for securities, 589

Protected class(es), defined, 453 Protected expression, 161 Protected interests, 112 Protection

of credit cards, 524–525 for creditors, 318–324 for debtors, 325–326

Private actions, under Clayton or Sherman Act, 580

Private company, codes of ethics of, 92 Private corporation, 391 Private employers, drug testing by, 449–450 Private equity capital, 397 Privately held (close) corporation,

392–393 Private party

civil law and, 14 suits of Section 10(b) violators, 602

Private placement exemption, 593 Private property, foreign government

expropriation of, 214 Private Securities Litigation Reform Act

(PSLR A, 1995), 598–599 Privilege, 117–118

absolute, 117–118 qualified, 118

Privileges and immunities clause, 71 Privity, of contract, 135, 257 Probable cause, 82, 201–202 Probate court, 28 Procedural due process, 83 Procedural law, 13 Procedural unconscionability, 255–256 Product liability, 135–137, 144–147

defenses to, 144–147 defined, 134 due care and, 135 lawsuit over, 142 preemption and, 145 quality control and, 140 statutes of limitations and, 146 strict, 137–143 strict liability applied to, 135 warnings and, 141–143

Product market, relevant, 573 Product misuse, 145–146 Product(s). See also Goods; Trademark

unreasonably dangerous, 139, 140 Professional. See also Attorney

duty of, 127 Professional and Amateur Sports

Protection Act (PAPSA, 1992), 347

Professional corporations, 394 Profit

appurtenant, 553 corporate, 389 creation of, 554 in gross, 554 maximization, 89, 90 in partnership, 355, 357 in real property law, 553 short-swing, 598 in sole partnership, 351 as subsurface owner right, 548–549 termination of, 554

I-26 I N D E X

of Internet, 170–171 of Internet service providers (ISPs), 502 legislative, 502–503 of marketing, 521–522 of proxy statements, 599 of securities acts, 588 of solicitation of proxies for Section 12

corporations, 599 of space, 225–226

Regulation Z (the Fed), 525 Regulatory agencies. See also

Administrative agency; specific agencies

environmental, 533 independent, 497, 499

Regulatory Flexibility Act (1980), 510–511

Reimbursement principal’s duty of, 424 right of, 324

Rejection of goods, 304–305 of offer, 241

Rejoinder, 63 Release

from legal claim, 251 of surety and guarantor, 323

Relevance of information, in subpoena, 504

Relevant evidence, 61 Relevant market, 573–575

geographic, 575 product, 573

Reliance. See Promissory estoppelSee Promissory estoppelSee Relief

from automatic stay, 329 bankruptcy, 328, 329, 339–343 from pollution under nuisance

doctrine, 532 Religion

discrimination based on, 456 displays of, 80 ethical principles based on, 94 freedom of, 80–82

Remedies, 35 agent’s, against principal, 426 for breach of contract, 302–305, 310 of buyer or lessee, 303–305 contract provisions limiting, 281 for copyright infringement, 163 for creditors, 318–324 for credit reporting violations, 527–528 defined, 6 in equity, 6, 7, 8, 278–280 FTC, 518 at law, 6, 7 limitation for online purchases, 245 for patent infringement, 159–160 principal’s, against agent, 426

for duty of care, 126–127 for performance to satisfaction of

another, 269 Reasonable restrictions, on freedom of

speech, 77 Reasonable supervision, duty to

exercise, 403 Reasonable time, for performance, 272 Rebuttal, 63 Receipt, warehouse, 296 Receiver, in Chapter 11 bankruptcy, 338 Recklessness, criminal, 190 Record. See also Electronic record;

Writing defined, 247–248 UETA and, 247–248

Recording statute, for deed, 559 Recovery, of damages, for buyer’s

nonacceptance, 303 Recross-examination, 62 Red f lag indicators, of identity theft, 528 Redirect examination, 61 Reform, of health care, 524

Obamacare, 70, 448–449, 492–493 Reformation

for breach of contract, 279–280 of contract, 255 of covenants not to compete, 255,

279–280 as equitable remedy, 279–280

Regional Small Business Fairness Boards, 511

Registered agent, of corporation, 50 Registration

of copyright, 160 of domain names, 171, 172 of securities, 589–590, 593

by state, 603 of trademark, 152, 351

Registration Convention, 225 Registration statement, 589–590 Regulation A, 591 Regulation D, 591–593 Regulation(s). See also specific agencies

and laws administrative, 15, 496–497 of advertising, 518–519 of broadband operators, 502 of employee wages and hours, 441–443 of employer-employee

relationships, 496 for environmental preservation and

protection, 533, 535 federal, state, and local environmental

preservation and protection, 533 of franchising, 363–364 government, 2, 3, 563 of international business activities,

219–221

Quantity, of goods, 287 Question

of fact, 36 federal, 28 of law, 36

Quid pro quo harassment, 462 Quiet enjoyment covenant, 558 Quitclaim deed, 558 Quorum

of directors, 401 of shareholders, 407

Quotas, on exports and imports, 219 Qur’an, 36

R Race, discrimination based on, 455–456 Racketeer Inf luenced and Corrupt

Organizations Act (RICO, 1970), 198

Racketeering, 198 Railway Labor Act, 479 Ratification

agency by, 420 of agent’s unauthorized act, 428 in contract law, 237

Rational basis test, 84 RCR A. See Resource Conservation and See Resource Conservation and See

Recovery Act Reaffirmation agreement, 336 Real estate. See also Land; Mortgage(s);

Real property goods associated with, 284, 285 sales contracts for, 555–556

Real property, 123, 318. See also Land; Mortgage(s)

exempted, 325 landlord-tenant law and, 548–567 license of, 554–555 nature of, 548–550 ownership and other interests in, 550–555 plant life and vegetation as, 549 rights in, 550 transfer of, 550

Realty (real estate). See Land; Real estate; See Land; Real estate; See Real property

Reasonable accommodation for employees’ religion, 456 for employees with disabilities, 467–468

Reasonable duty of care, 124 Reasonable expectation of privacy,

182–183, 202, 449 Reasonable force, 114 Reasonable hour, for performance, 299 Reasonable manner, for performance, 299 Reasonableness test, for consumer

warnings, 141 Reasonable person standard, 114

I N D E X I-27

to obtain specific performance, 304 of partners, 357, 382 principal’s, against agent, 426 principle of, 94–95 privacy, 84–86, 449–450 of property owners, 561–563 in real property, 550 to recover

damages for accepted goods, 305

damages for failure to deliver goods, 304

purchase price or lease payments due, 304

of reimbursement, 324 of rejection, 304–305 of replevy goods, 304 to resell or dispose of goods, 303 of shareholders, 408–410 of strike, 484 of subrogation, 323–324 subsurface, 548–549 of surety and guarantor,

323–324 of survivorship, 552 of third party, 256–258 voidable, in bankruptcy, 330 to withhold delivery, 302–303

Right-to-work laws, 478 Risk

assumption of, 129, 145 landowner’s duty to warn, 127 of loss (See Risk of loss)See Risk of loss)See obvious, 143

Risk of loss, 296–298 when sales or lease contract

breached, 298 Risk-utility analysis, 141 Rivers and Harbors Appropriations Act

(1899), 535 RMBCA. See Revised Model Business See Revised Model Business See

Corporation Act Robbery, 192 Robinson-Patman Act (1936), 577 Royalties, defined, 9, 157 Rule(s)

administrative, 15 business judgment, 403 credit-card, 525 defined, 502 enforcement of, 504 equal dignity, 427 exclusionary, 202 of interpretation, 508 interpretive, 498–499 legislative (substantive), 498 mailbox, 244 mirror image, 241, 242, 310 procedural, 48–49

Restatement (Second) of Contracts, 262n on online acceptances, 246

Restatement (Second) of Torts, strict product liability requirements and, 139–140

Restatement (Third) of Torts, Product Liability, 140, 141, 142

Restatements of the Law, 4, 12 Restaurants, menu labeling and, 522 Restitution

for breach of contract, 278 for deceptive advertising, 518

Restraint of trade, 568, 583 contracts in, 255 horizontal, 569, 570–571 unreasonable, 569 vertical, 569, 571–572

Restricted securities, 593 Restrictive covenant, 255, 563 Retained earnings, 389 Retaliation, by employers, 463–464 Retirement insurance. See Social SecuritySee Social SecuritySee Retirement plans, 448 Retraction, of repudiation, 302 Return

of goods purchased online, 245 sale or, 298

Revenge porn, and invasion of privacy, 119

Reverse discrimination, 455 Reviewing courts. See Federal court See Federal court See

system, appellate courts of; State court system, appellate courts of

Revised Model Business Corporation Act (RMBCA), 388, 395, 401, 402, 409

Revised Uniform Limited Partnership Act (RULPA), 381

Revocation. See also Cancellation of acceptance, 305 of agency relationship, 434 of offer, 241

Reward, 346 Right(s). See also Bill of Rights

agent’s, against principal, 426 airspace, 548 assignment of, 257–258 of assurance, 301 to cancel contract, 302, 303 conf licting, 94–95 of contribution, 324 of cover, 304 of directors, 401–402 dissociation and, 361 of inspection, 301 to jury trial, 60–61 of life tenants, 550–551 to obtain goods upon insolvency,

303–304

for Securities Act (1933) violations, 595 of seller or lessor, 302–303 under Title VII, 464 tort and contract, 426 for trademark infringement, 153 for trade secret infringement, 164 for ultra vires acts, 399ultra vires acts, 399ultra vires

Remote tippees, 597 Rental agreements, 276 Renunciation, of agency relationship, 434 Reorganization (Chapter 11 bankruptcy),

326, 338–339 Repayment plans, in Chapter 12 and 13

bankruptcy, 340–341, 343 Replevin, 304 Reporters, reports, 8, 15

regional, 15, 16 Repose, statute of, 146 Repricing, of options, 604 Republic of Korea-United States Free

Trade Agreement (KORUS FTA), 220

Repudiation anticipatory, 271–272, 302 of offer, 241 retraction of, 302

Reputation, Internet ruin of, 90 Requests, for information, 59–60 Requirements. See also Writing

requirement for business forms, 350 Franchise Rule, 364 for S corporation status, 393 for seller in interstate commerce, 577

Requirements contract, 287 Resale

of goods, 303 of securities, 593

Resale price, maintenance agreements, 572 Rescission, 6. See also Cancellation

for breach of contract, 278 for breach of warranty, 307 of contract, 249, 263, 266 defined, 272, 278 discharge by mutual, 272

Rescue Agreement, 225 Residential use, of land, 563, 564 Residual position, of common stock

investors, 396 Resolutions, corporate, 407 Resource Conservation and Recovery Act

(RCR A, 1976), 544 Respondeat superior, 430–431, 432Respondeat superior, 430–431, 432Respondeat superior

corporations and, 389 Respondent, 6, 19 Responsible corporate officer doctrine, 192 Restatement (Third) of Agency

agency defined in, 416 independent contractor defined in, 417

I-28 I N D E X

Secured property, automatic stay on, 329 Securities, 396, 588. See also Bond(s);

Debt; Stock(s) exemptions from registration of, 591 online fraud and, 602 registration of, 589–590, 593 resales of, 593 restricted, 593 state laws for, 603 types of, 396, 589

Securities Act (1933), 588–595 exemptions to, 591–593 registration requirements of, 589–590 violations of, 593–595 on well-known seasoned issuer

(WKSI), 590–591 Securities and Exchange Commission

(SEC, 1934), 5, 499, 588 capital structure regulation by, 496 on disclosure rule, 590 federal executive departments and, 497 liability under

Section 10b-5 of, 596 Section 10(b) of, 596

on offering and selling securities through crowdfunding, 397

on proxies and shareholder proposals, 406

Regulation A of, 591 Regulation D of, 591–593 Rule 10b-5 of, 595–598

outsiders and, 597–598 Rule 14a-9, 599 securities markets regulation by, 588

Securities Exchange Act (1934), 588, 595–602

Section 10b-5 of, 596–598 Section 10(b) of, 595–596 Section 12 of, 598 Section 16(b) of, 598, 601 state securities laws and, 603 violations of, 599–602, 606

Security cyber, 230–231 defined, 588

Security interest(s), 298 warranty of title and, 307

Selection rates, of employer, 455 Self-defense, as defense to criminal

liability, 198 Self-incrimination, 83, 200 Seller

contract breached by, 298, 303–305 goods in possession of, 297, 302–303,

303–304 insolvency of, 303–304 insurable interest of, 298 obligations of, 299–301 passage of title and, 295–296

Same-sex marriage, 72 Sample/model, goods conforming to, 308 Sanctions, criminal, 187, 188 Sarbanes-Oxley Act (2002), 102, 204

audit committee requirement of, 401 criminal penalties under, 601, 606 provisions of, 606 Section 302, 605, 606 Section 404, 605 Section 404(a), 606 Section 404(b), 606 Section 906, 606 violations of, 601–602, 606

Satisfaction accord and, 250–251 discharge by, 272–273 of performance, 269

Scienter inference of, 600 Securities Exchange Act (1934) and,

599–600 Scope of employment, under respondeat

superior, agent’s torts and, 431 S corporation, 393

double taxation and, 393 Scrutiny

intermediate, 84 strict, 84

Search. See also Search and seizure Fourth Amendment on, 82–83 warrantless, 504

Searchable patent databases, 157 Search and seizure, 82–83 Search warrant, 82, 201, 202, 504 Seasonably, defined, 287 SEC. See Securities and Exchange See Securities and Exchange See

Commission Second Amendment, 76 Secondary boycott, 484 Secondary meaning, trademarks and,

154–155 Secondary sources of law, 4 Second-level domain (SLD), 171 SEC Rule 10b-5. See Rule 10b-5 (SEC)See Rule 10b-5 (SEC)See Section 1 and Section 2 cases. See

Sherman Antitrust Act Section 10(b), of Securities Exchange Act

(1934), 595–598 Section 12, of Securities Exchange Act

(1934), 598 Section 12 companies, 595, 598 Section 16(b), 598

compared with Rule 10b-5, 598, 599 scienter not required for violations, 601scienter not required for violations, 601scienter

Section 102 exclusions, from Copyright Act, 161

Section 1981 claims (42 U.S.C.), 456 Secured creditors, 318

property distribution to, 332

Rule 10b-5 (SEC), 595–598 compared with Section 16(b) of

Securities Exchange Act (1934), 598, 599

state securities laws and, 603 violations of, 599

Rule 14a-9 (SEC), 599 Rule 144 (SEC), 593 Rule 144A (SEC), 593 Rule 504 (SEC), 591 Rule 505 (SEC), 592, 593 Rule 506 (SEC), 593 Rulemaking, agency, 498, 502–503

comment period, 503 failure to follow procedures, 503

Rule of four, 40 Rule of reason, per se antitrust violations per se antitrust violations per se

vs., 569–570, 572, 578 Rules of evidence, 61 Runoff, 539

S Safe Drinking Water Act (1974), 535, 542 Safe harbor

for ISPs, 171 for publicly held companies making

forward-looking statements, 598 resales of securities and, 593

Safety consumer protection and, 523–524 employee, 426, 446–449 (See also

Workplace) Sale(s)

consumer protection for, 521–522 defined, 284 foreign, patent infringement and, 158 of goods, 275, 284–286 implied warranty for new home, 556 of land

compensatory damages for, 275 speci�c performance and, 279

of real estate, 555–556 of securities, 603 warranties and (See Warranty)See Warranty)See

Sales contracts. See also Damages; International contract; Performance; Statute of Frauds

breach of contract, 298, 302–305, 310 formation of, 284, 286–290 for goods, 281, 284–286 international, 236, 314–316 performance of, 298–302 real estate, 555–556 risk of loss and, 296–298 warranties in, 307

Sales law, differences with contract law, 292

I N D E X I-29

internal, in workplace, 178 legal documents served via, 50, 53 legal issues, 176–177 password protection and, 178 trade secret misappropriation via,

164–165 work-related issues discussed on, 93–94

Social responsibility, corporate, 96–97 Social Security, 447 Social Security Act (OASDI, 1935), 447 Society, climate change effects on, 610 Sociological school, 13 Software

copyright protection for, 164 e-agent, 430 e-signature, 247 facial recognition, 170 filtering, 79–80 password theft and, 206 patents, 159

Sole proprietorships, 350 advantages of, 351–353 compared with other forms of

business, 411 disadvantages of, 353–354 LLC taxed as, 374

Solicitation, telephone, 521 Sovereign immunity, 214–216 Sovereignty, state, 70 Space debris, U.N. guidelines to

reduce, 226 Spacef light, commercial, 226 Space law

defined, 225 international, 225–226 U.S., 226

Spam (junk e-mail), 170–171 Special (consequential) damages,

112, 276 Special incentives, for zoning

exceptions, 565 Specially manufactured goods, 290 Special power of attorney, 427 Special-use permits, for zoning, 564–565 Special warranty deed, 558 Specific event, agency termination by

occurrence of, 434 Specificity of demand for testimony or

documents, of subpoena, 504 Specific performance, 6, 275

as remedy for breach of contract, 279 right to obtain, 304

Speech freedom of (See Free speech)See Free speech)See obscene, 79–80

Stakeholders CSR and, 96–97 out-come based ethics and, 94

Standard-form contracts, 267

private actions under, 580 provisions of, 568 Section 1 of, 568–572 Section 2 of, 568–569, 572–576 violations of, 569, 580

Shipment, contract for, 296, 297, 299 Short-run profit maximization, 90 Short sale, 325 Short-swing profits, 598 Shrink-wrap agreement (shrink-wrap

license), 246–247 enforceable contract terms and,

246–247 terms that may not be enforced, 247

Signature e-signature, 247 on firm offer, 287

Silence, as acceptance, 243 Similar mark, as trademark dilution, 152 Simple contracts, 236 Sit-down strikes, 484 Sixth Amendment, criminal protections

in, 201 Slander, 115

damages for, 117 per se, 117 of quality (trade libel), 125 of title, 125

Sliding-scale standard, for Internet-based jurisdiction, 30–31

Small business. See also Business(es); Partnership

ACA and, 492–494 bankruptcy choices for, 339 defined in ACA, 492 “fast-track” Chapter 11 for, 338 forms of, 350–362 regulatory burden on, 511

Small Business Administration (SBA), loans from, 351

Small Business Administration Act, 582 Small Business Health Options Program

(SHOP), 493 Small Business Liability Relief and

Brownfields Revitalization Act (2002), 535

Small Business Regulatory Enforcement Fairness Act (SBREFA, 1996), 511

Small claims courts, state, 36 Small offerings, Regulation D, 591–593 Smartphone, minimum contacts and, 33 Social hosts, 129 Social media

business ethics and, 93–94 company-wide networks, 178 employer policies for, 93, 177, 179 hiring discrimination based on

posts, 457

remedies of, 302–303 risk of loss and, 298

Seniority systems, 470 Seniors, undue inf luence, 266 Seniors, health-care protection for, 524 Sentencing, federal guidelines for, 204 Separation of powers, in national

government, 71 Serious-and-objective-intent test, 238 Service-based hacking, 207 Service mark, 155, 350 Service members. See Military statusSee Military statusSee Service of process, 50

using social media for, 50, 53 waiver of, 50–51

Service(s). See also Personal services ADR, 44 goods combined with, 285

Servient estate, 553 Settlement

of claims, 49, 250–252 negotiated, 505

Settlement agreements discharge by, 176, 272 social media posts and, 176

Seventh Amendment, 60 Sexual harassment, 462–464

for sexual orientation, 464 Sexual orientation, discrimination based

on, 464 Shareholder agreements

for close corporation, 393 voting agreement, 407–408

Shareholders. See also Directors, corporate

in benefit corporation, 394 of close corporation, 392–393 corporate, 371, 395 derivative suit, 405, 409–410 duties and liabilities of, 410 limited liability of, 388 majority, 410 meetings of, 406–407 minority, 410 powers of, 406 in professional corporation, 394 rights of, 408–410 role of, 405–408 of S corporation, 393 in ultra vires acts and, 399ultra vires acts and, 399ultra vires voting by, 407–408

Share(s) transfer in close corporations, 393 transfer of, 409

Sharia, 36, 212–213 Sherman Antitrust Act (1890), 223,

568–576 conspiracy with substantial effect

I-30 I N D E X

as securities, 589 transaction reports, 605 watered, 410

Stock certificates, 408 Stockholders. See ShareholdersSee ShareholdersSee Stock options, 604 Stock warrants, 408 Stolen goods, receiving, 194 Stop Counterfeiting in Manufactured

Goods Act (SCMGA, 2006), 156 Stored Communications Act (SCA),

177–178 Straight bankruptcy, 326–327 Strict liability, 134–135. See also Strict

product liability applied to product liability, 135 overcriminalization and, 190 of PRPs, 544 under Section(b) 16, 601

Strict product liability, 137–143 inadequate warnings and, 141–143 market-share liability and, 143 requirements for, 139–140

Strict scrutiny, 84 Strike (labor), 477, 483–485

illegal, 484 strikers’ rights after strike ends, 484–485

Strong-arm power, 330 Strong marks, trademarks and, 154 Student Aid Bill of Rights, 337 Student loan defaults, 337 Subjective impossibility of

performance, 273 Subject matter, jurisdiction over, 28 Subpoena, by administrative agencies, 504 Subrogation, right of, 323–324 Subsidiary, in foreign country, 218 Subsidies, for exports, 219 Substance abusers, ADA and, 468 Substantial abuse, of bankruptcy law,

327–328 Substantial effect, 223, 583 Substantial performance, 268–269 Substantive due process, 83 Substantive law, 13 Substantive rules, 498 Substantive unconscionability, 256 Subsurface rights, 548–549 Suggestive trademarks, 154 Suit. See LawsuitSee LawsuitSee Summary judgment, motion for, 54, 56 Summary jury trials, in federal courts, 44 Summons, 50, 52 Superfund, 544–545

Comprehensive Environmental Response, Compensation, and Liability Act as, 535

Hazardous Substance Response Trust Fund as, 544

powers concurrent with federal

government, 75 regulatory, 70–71

privileges and immunities clause and, 71

securities laws of, 603 sovereignty of, 70 space tourism regulations of, 226 spam regulation by, 170 uniform law and, 4 workers’ compensation laws of, 13,

446–447 Stationary sources, of air pollution, 537 Statute(s). See also Law(s); specific statutes

arbitration, 42–43 areas of consumer law regulated by, 516 assignment prohibited by, 258 contracts contrary to, 254 court interpretation of, 11–12 federal environmental, 535 of Frauds (See Statute of Frauds)See Statute of Frauds)See Good Samaritan, 128–129 of the International Court of Justice,

211 licensing, 254 of limitations (See Statute of See Statute of See

limitations) long arm, 27 of repose, 146 state (See State law; State(s))See State law; State(s))See workers’ compensation (See Workers’ See Workers’ See

compensation) Statute of Frauds

exceptions to writing requirement, 290 and oral contracts, 256 writing requirement and, 256,

289–290, 324 Statute of limitations, 6, 84

on crimes, 200 as defense, 113, 323 discharge by operation of law, 273 fraudulent misrepresentation, 264 against product liability, 146 for securities fraud, 606

Statutory code, in civil law system, 212 Statutory law, 3, 5, 11

defined, 4 finding, 14–15 reading citations for, 17–18 sales of goods and, 284 on trademarks, 152 on trade secrets, 164

Statutory liens, 318 Stock(s), 588

bonds compared with, 396 common, 396 defined, 396 preferred, 396–397

Standard measure, of compensatory damages, 275

Standard(s), of due care, 421 Standing to sue, 33–35 Stare decisis

doctrine of, 7–10, 212 legal reasoning and, 10–11

State agencies, 5 State and Local Climate and Energy

Program, 611–612 State court system, 15, 26, 35–38

appellate courts of, 15, 36, 65 highest (supreme) courts of, 38 jurisdiction of, 27–35 reading case citations for, 17 small claims court in, 36 trial courts of, 15

State crimes, 190 State immunity, under Eleventh

Amendment, 465–466 State law, 4, 13

caps on damages, 113 constitutionality of product label

warnings and, 143 for corporate governance, 388, 400 franchising regulation by, 364 prohibiting affirmative action, 471 for statutory liens, 318

Statement(s). See also Financial statements of fact, 115, 116

creating express warranties, 308 fraudulent misrepresentation

and, 121 of future intent, 239 opening, in trial, 61 of opinion, 116

fraudulent misrepresentation and, 121, 265–266

registration, 589–590 State of mind, 189–190 State regulations, for environmental

preservation and protection, 533 State(s). See also Alternative dispute

resolution; Workers’ compensation

Bill of Rights limits on, 76 codes of, 14–15 Constitution (U.S.) and, 4 corporate certificate of authority in, 390 courts of (See State court system)See State court system)See employees not covered by ADEA,

465–466 E-Sign Act and UETA in, 248 exemptions, 331 full faith and credit clause and, 71 immigration legislation in, 476–477 incorporation procedures in, 394–395 LLC statutes of, 371, 374–375 LLP liability by, 380

I N D E X I-31

Term(s) contractual, 240, 263, 289 in partnership agreement, 356

Territorial restrictions, in distributions, 571–572

Terrorism, cyberterrorism, 207 Testamentary trusts, 248 Testing the waters, for securities

offerings, 591 Test(s)

by administrative agencies, 504 aggregation, 191 compelling government interest, 77 consumer-expectation, 141 for drugs, 449–45051–652 lie-detector, 449 means test, in bankruptcy, 327–328 M’Naghten, 200 predominant-factor, 285 reasonableness, for consumer

warnings, 141 testing employees for drugs, 449–450

Theft conversion and, 125 cyber, 204–207 identity, 205–206 obtaining goods by false pretenses

as, 194 petty and grand, 194 of trade secrets, 164, 197

Third party apparent authority of agent and, 420,

427–428 assignments, 257–258 beneficiaries, 257, 258 delegations, 258 knowledge of, 430 partnership liability to, 360, 361 rights of, 256–258 in suretyship, 322–323

Threatening speech, 79 Time. See also Lapse of time; Reasonable

time for performance, 272

Timeliness, of acceptance, 244–245 Tipped workers, 441–442 Tippees, 597 Tipper/tippee theory, 597–598 Title, 292

document of, 296, 298 identification and, 292–293 marketable, 556 passage of, 295–296 slander of, 125 warranty of (See Title warranties)See Title warranties)See

Title insurance, 556 Title VII, of Civil Rights Act (1964)

affirmative action and, 470 constructive discharge under, 461

of LLC, 374 Medicare, 447 of partnership, 356 of S corporation, 393 Social Security, 447 sole proprietorship and, 352 tariffs as, 219

Tax credit, small business health-care, 493

Taxing and spending powers, 75 Tax returns, during bankruptcy, 327 TDR A. See Trademark Dilution See Trademark Dilution See

Revision Act Technology

export restrictions on, 219, 226 intellectual property rights and, 150,

174–175 maximum achievable control

(MACT), 537 Telecommunications Act (1996), 502 Telemarketing, fraudulent, 521 Telemarketing and Consumer Fraud and

Abuse Prevention Act, 521 Telemarketing Sales Rule (TSR),

of FTC, 521 Telephone, solicitation regulation

and, 521 Telephone Consumer Protection Act

(TCPA), 521 Television, piracy and file-sharing of, 175 Temporary impossibility of

performance, 274 Temporary possession, by tenant,

552–553 Tenancy, tenant

in common, 293, 552 by the entirety, 552 fixed-term (for years), 553 periodic, 553 at sufferance, 553 trade fixtures and, 550 at will, 553 for years, 553

Tender defined, 268 of delivery, 268, 296, 297, 299 of payment, 268, 323

Tenth Amendment, 4, 70 Termination. See also Discharge

by act of parties, 241, 433–434 of agency, 433–434 of easement or profit, 554 of franchises, 364, 366–367 notice of, 434 of offer, 241–242 by operation of law, 241–242 of partnership, 361–362 of power of attorney, 427

Terminology, for case law, 19–20

Superseding cause, 130 Supervisors, sexual harassment by, 463 Supremacy clause, 4, 75 Supreme court (state), 15, 27, 38 Supreme Court (U.S.)

on Affordable Care Act, 70 on antitrust in professional

baseball, 582 appeals to, 15, 35, 40 Bill of Rights and, 76 businesspersons’ joint efforts to seek

government action, 582 on Chevron deference to agency

interpretation, 508 controlling precedents of, 8 decisions of, 26 on employee discrimination, 453 Federal Rules of Civil Procedure

and, 48n on mandatory arbitration clauses,

43, 267 on price fixing, 570 privacy rights and (See Privacy rights)See Privacy rights)See on same-gender harassment, 464 on same-sex marriage bans, 72 on sexual harassment by

supervisors, 463 on state antitrust actions, 582 on wetlands, 541

Supreme Court Reporter (S. Ct.), 19Supreme Court Reporter (S. Ct.), 19Supreme Court Reporter Surety, 322

actions releasing, 323 defenses of, 323 rights of, 323–324

Suretyship, 322–324 defined, 322 parties to, 322–323

Surrender, of property, 323 Survivorship, right of, 552 Survivors’ insurance. See Social SecuritySee Social SecuritySee Suspension, of performance

obligations, 302 Symbolic speech, 77

T Taft-Hartley (LMR A) Act (1947), 478 Taking, 561

eminent domain and, 561–562 Takings clause (Fifth Amendment), land-

use regulations and, 561 Tangible employment action, 463 Tangible property, 285 Tariffs, 219 Taxation

corporate, 389 employee-independent contractor

status and, 418–419 export, 219

I-32 I N D E X

Trespass to land, 123–124 to personal property, 124

Trial criminal, 204 mini-, 43–44 motion for a new, 64 procedures in, 48–49, 61–64 right to jury trial, 60–61 summary jury, 44 venue for, 33

Trial courts, 15, 36 district courts as, 19, 28 federal, 15, 19, 39 jurisdiction of, 28, 36 state, 15

Trial phase, of litigation, 48 Triple bottom line, 89 TRIPS Agreement (1994), 166 Trust, testamentary, 248 Trustee

bankruptcy, 327, 330–331, 340 U.S., 327

Truth-in-Lending Act (TILA, 1968), 524–525

Tying arrangement (tie-in sales agreement), 578–579

Typosquatting, 172

U UCC. See Uniform Commercial CodeSee Uniform Commercial CodeSee UETA. See Uniform Electronic See Uniform Electronic See

Transactions Act Ultrahazardous activities, liability for

injuries from, 532 Ultra vires acts, 398–399Ultra vires acts, 398–399Ultra vires Unanimous opinion, 20 Unauthorized acts

contract liability and, 429–430 ratification of, 428

Unauthorized alien. See Undocumented See Undocumented See immigrants

Unconscionability of contracts, 255–256, 266–267 exculpatory clauses and, 256 of liability waivers, 257 procedural, 255–256 substantive, 256 under UCC, 255, 290

Undertaking Spam, Spyware, and Fraud Enforcement with Enforcers Beyond Borders Act (2006). See U.S. Safe Web Act (2006)

Undisclosed principal, 429 Undocumented immigrants, 453,

474–475, 476 Undue hardship, vs. reasonable

accommodation, 456, 467–468

Trade libel, 125 Trademark, 150, 350–351. See also

Lanham Act certification marks, 155 collective marks, 155 counterfeit goods and, 156 dilution of, 152, 173–174 distinctiveness of, 154–155 duration of, 152 infringement of, 152–153 licensing and, 156–157 in meta tag, 172–173 registration of, 152, 172 service marks, 155, 350–351 statutory protection of, 152

Trademark Dilution Revision Act (TDR A, 2006), 152

Trade name, 156 Trade-Related Aspects of Intellectual

Property Rights (TRIPS Agreement). See TRIPS See TRIPS See Agreement

Trade secrets, 164, 351 in cyberspace, 164–165 social media and protection of, 178 theft of, 164

Trading, insider, 197 Trading with the Enemy Act (1917), 219 Transaction

exemption from registration requirements, 591–593

reports, Sarbanes-Oxley, 605 UETA and, 248

Transfer, of shares, 409 of close corporations, 393

Transferred intent, 113 Transfer(s)

fraudulent, 331 of ownership, 555–561 of real property (See Real property)See Real property)See

Transgender bathrooms, 461 Transgender persons, employment

discrimination and, 460–461 Trans-Pacific Partnership (TPP),

220–221 Transparency, of benefit corporation, 394 Transportation-sharing companies,

workers’ status in, 418 Treaties

defined, 212 in international space law, 225–226 of Rome (1957), 220

Treaty on Principles Governing the Activities of States in the Exploration and Use of Outer Space, including the Moon and Other Celestial Bodies (U.N.). See Outer Space TreatySee Outer Space TreatySee

Treble damages, 580

employment discrimination and, 453–464

sexual harassment under, 462–464 Title warranties, 307

good title, 307 no liens, 307

Tolled period for product liability claim, 146 for statute of limitations, 146, 200

Top-level domain (TLD), 171 Tort(s). See also Tort liability

agent’s, 430–433, 432–433 classification of, 113 cyber, 178 defamation, 115–118 defined, 112 disparagement of property, 125 independent contractor’s, 433 intentional (See Intentional torts)See Intentional torts)See international claims in, 223 invasion of privacy, 118–120 lawsuits for, and criminal prosecution

for same act, 188, 189 strict product liability, 137–143 toxic, 532 unintentional (See Negligence)See Negligence)See

Tortfeasor, 113 Tort law. See also Negligence

damages in, 112–113 importance to business, 112 purpose of, 112

Tort liability. See also Tort(s) agent’s, 430–433 corporations and, 389 employee-independent contractor

status and, 417–418 principal’s, 430–433

Tort theory, exceptions to employment-at- will doctrine, 438–439

Toxic chemicals, environmental protection efforts against, 542–545

Toxic substances, 543–544 Toxic Substances Control Act (1976), 535,

543–544 Toxic torts, 532 Trade. See also Export(s); Import(s);

International business contracts in restraint of, 255 regional trade agreements, 220–221 unfair, 583

Trade associations, 571 Trade barriers, 220 Trade custom, warranties implied from

prior dealings or, 309 Trade dress, 155–156 Trade fixture, 550

Title VII, of Civil Rights Act (1964)

employment discrimination and, Act (1964)

employment discrimination and, (continued)

employment discrimination and,

I N D E X I-33

Undue inf luence, 266 Unemployment insurance, 448 Unenforceable contract, 237 Unequivocal acceptance, of offer,

242–243 Unfair trade, 583 Unforeseen difficulties, 249 Uniform Commercial Code (UCC), 4.

See also Statute of Frauds; Title Article 2A (Leases) of, 247, 284,

286–290 Article 2 (Sales Contracts) of, 247,

284–286, 286–290, 363 Article 8 (purchase and sale of

securities), 603 commercial reasonableness and, 298–299 compared to CISG, 310 contract law and, 234 on crop sales, 549 discharge by mutual rescission, 272 framework of, 284 future goods under, 293 goal of, 284 good faith and, 298–299 negotiable instruments and, 236 on online acceptances, 246 sales contracts limiting remedies, 281 unconscionability under, 255, 290 warranties under, 307–310, 309

Uniformed Services Employment and Reemployment Rights Act (USERR A, 1994), 469

Uniform Electronic Transactions Act (UETA, 1999), 247–248

Uniform laws, 4 Uniform Limited Liability Company Act

(ULLCA), 371, 375, 377. See also Limited liability company

Uniform Negotiable Instruments Law (1896), 4

Uniform Partnership Act (UPA), 355. See also Partner; Partnership

Uniform Rapid Suspension (URS) system, 172

Uniform Securities Act (2002), 603 Uniform Trade Secrets Act, 164 Unilateral contracts, 235–236

consideration in, 248 Unilateral mistakes of fact, 262–263 Unilateral refusals to deal, 575 Unintentional discrimination,

454–455 Unintentional torts (negligence), 113. See

also Negligence Unions. See Labor unionsSee Labor unionsSee Union security clause, 488 Union shop, 478, 488 United Nations

Climate Change Conference (2015), 612

Commission on International Trade Law, 212

Committee on the Peaceful Uses of Outer Space (COPUS), 225

Convention on Contracts for the International Sale of Goods (CISG), 212, 284, 309–310

Convention on the Recognition and Enforcement of Foreign Arbitral Awards, 45, 221

Outer Space Treaty and agreements, 225–226

resolutions and declarations of, 212 United States, space law of, 226 United States Code (U.S.C.), 14United States Code (U.S.C.), 14United States Code

Title 11 of, 326 United States Code AnnotatedUnited States Code Annotated

(U.S.C.A.), 14 United States Departments. See specific See specific See

departments United States Reports (U.S.), 19United States Reports (U.S.), 19United States Reports United States Statutes at Large, 14 United States Trade Office, 221 Unlawful Internet Gambling

Enforcement Act (UIGEA, 2006), 347

Unlimited jurisdiction. See General See General See (unlimited) jurisdiction

Unlimited liability, of sole proprietorship, 354

Unliquidated debt, 251 Unprotected speech, 79–80 Unpublished opinions, 19 Unreasonable restraint of trade, 569 Unreasonably dangerous products, 139, 140 Unsecured creditors, 318

property distribution to, 334 Unsecured debtors, in bankruptcy, 343 USA Freedom Act (2015), 86 USA Patriot Act, 86 USERR A. See Uniformed Services See Uniformed Services See

Employment and Reemployment Rights Act

U.S. magistrate judge, 38 U.S. Patent and Trademark Office, 152,

157, 351 U.S. Safe Web Act (2006), 171 U.S. Sentencing Commission, 204 U.S. trustee, 327 U.S. Trustee Program, 327 Usury, 254 Utilitarianism, as outcome-based ethics, 95

V Vacancies, on board of directors,

400–401 Validation notice, 528 Valid contract, 235, 237, 253–254

Value legally sufficient, 248 mistakes of, 262, 263 statement of, 308

Variance, 564 Vegetation, as real property, 549 Venture capital, as corporate financing, 397 Venue, 33 Verdict, 64

directed, 63 Verification, employment, 474 Vertically integrated firm, 571 Vertical merger, 579 Vertical restraint, in Sherman Antitrust

Act, 569 Vesting, ERISA on, 448 Veterans, USERR A and, 469 Vicarious liability, 430–431 Victimless crimes, 194–195 Violations. See also specific issues

of CFA A, 208 of Clayton Act, 577, 580 of Clean Air Act, 537 of Clean Water Act, 542 of FCPA, 103 of FIFR A, 543 of FMLA, 446 of Ocean Dumping Act, 543 of RCR A, 544 remedies for, fair credit reporting and,

527–528 of Sarbanes-Oxley Act (2002), 606 of Securities Act (1933), 593–595 of Securities Exchange Act (1934),

599–602 of Sherman Act, 569, 578, 583 Superfund, 544–545

Violent crime, 192 Violent strikes, 484 Virtual child pornography, 80 Virus, 207 Visas

employment-based, 476 H-1B, 476 H-2, O, L, and E, 476

Voidable contract, 237, 253–254 Voidable rights, in bankruptcy, 330 Void contract, 237, 253–254 Voir dire, 61 Voluntary bankruptcy, 327–328, 334 Voluntary consent, to contract, 235, 262

factors indicating lack of, 262–267 Voluntary surrender of possession, 320 Voting

by directors, 401 by shareholders, 407–408 for union organization, 480

Voting list, 407 Voting trust, 407–408

I-34 I N D E X

W Wages. See also Income

CEO-worker pay ratio, 590 employment discrimination in, 460 garnishment of, 321–322 hours and, 442–443 laws for, 441, 442–443 minimum, 441

Waiting period, in securities registration process, 589–590

Waiver, 280 of breach of contract, 280–281 fiduciary duties and, 359 of formal service of process, 50–51 liability, 257

Walker Process claim, 580Walker Process claim, 580Walker Process Walsh-Healey Act (1936), 441 War, termination of agency relationship

by, 434 Warehouse receipts, 296 Warning(s)

content of, 141–142 inadequate, 141–142 on medication, 142 on product labels, 141–143 product liability lawsuits and, 142

Warrant, search, 82, 201, 202, 504 Warranties

disclaimers of, 309 express, 307–308, 309 implied, 308–309, 556 of title, 307

Warrantless searches, 504 Warranty deeds, 558 Waste, injury to land as, 550–551 Watered stock, 410 Water pollution

Clean Water Act and, 539–542 federal statutes for, 535 (See also

Pollution) drinking water and, 542

Water Quality Act (1987), 539

Weather, climate change and, 610 Web. See Internet; See Internet; See Online entries Webb-Pomerene Act, 582 Web sites, privacy rights and, 119 Well-known seasoned issuer (WKSI), in

securities registration process, 589, 590–591

Wellness programs, 493 Westlaw- (WL), citations to, 18, 19 West’s National Reporter System, 15, 16 Wetlands, 541 Whistleblower Protection Act (1989), 439 Whistleblowing, Sarbanes Oxley

protection for, 606 White-collar crime, 195–197, 204

penalties for criminal violations, 606 Wildcat strikes, 484 Will, 248

real property transfer and, 550 Winding up, 361

of LLC, 379 of partnership, 362

Wire fraud, 196–197 Wiretapping, electronic communications

and, 177 Witness(es), in trial

examination of, 61–63 expert, 62–63

Women. See GenderSee GenderSee Worker Adjustment and Retraining

Notification (WARN) Act (1988), 444

Worker(s). See Employee(s)See Employee(s)See Workers’ compensation

laws (state), 13, 446–447 litigation vs., 447

Work hours. See HoursSee HoursSee Workout, 338 Workout agreement, 325 Workplace

internal social media networks in, 178 OSHA and safety in, 446

principal’s duty to provide safe, 426 privacy rights in, 179

Work-related issues, social media discussions of, 93–94

Works for hire, 419 World Trade Organization (WTO), trade

barriers and, 220 Worm, 207 Writ

of attachment, 321 of certiorari, 40 of execution, 66, 321

Writing contracts requiring, 256 sufficiency of, Statute of Frauds

and, 290 Writing requirement

exceptions to, 290 for firm offer, 287 for mortgages, 324 oral contracts and, 256 Statute of Frauds and, 289–290, 324

Written contracts, incorrectly states parties’ oral agreement, 279

Written demand requirement, 410 Wrongful dissociation, 361 Wrongful interference, 123 Wrongful termination

of agency relationship, 434 of franchise, 367

Wrongful threat, 200

Y Year Books, 7–8

Z Zoning laws

exceptions to, 564–565 government regulations and, 533,

563–565 purpose and scope of, 563–564

DIGITAL UPDATE

Using Social Media for Service of Process Chapter 3, p. 53

Should Employees Have a “Right of Disconnecting”? Chapter 5, p. 98

Revenge Porn and Invasion of Privacy Chapter 6, p. 119

The Problem of Patent Trolls Chapter 8, p. 159

Monitoring Employees’ Social Media—Right or Wrong? Chapter 9, p. 179

A Sole Proprietorship, Facebook Poker, and Bankruptcy Chapter 16, p. 354

Hiring Discrimination Based on Social Media Posts Chapter 21, p. 457

Imposing a 1930s Regulatory Law on Broadband Operators Chapter 23, p. 502

Regulating “Native” Ads on the Internet Chapter 24, p. 519

Google Faces an Antitrust Complaint from the European Union Chapter 27, p. 584

GLOBAL INSIGHT

Does Cloud Computing Have a Nationality? Chapter 18, p. 398

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Contents
Preface
Unit 1: The Foundations

Chapter 1: Law and Legal Reasoning

Business Activities and the Legal Environment
Sources of American Law
The Common Law Tradition
Schools of Legal Thought
Classifications of Law
How to Find Primary Sources of Law
How to Read and Understand Case Law

Chapter 2: Courts and Alternative Dispute Resolution

The Judiciary’s Role in American Government
Basic Judicial Requirements
Case Analysis 2.1 Mala v. Crown Bay Marina, Inc.
Spotlight on Gucci: Case 2.2 Gucci America, Inc. v. Wang Huoqing
The State and Federal Court Systems
Case 2.3: Johnson v. Oxy USA, Inc.
Alternative Dispute Resolution
International Dispute Resolution

Chapter 3: Court Procedures

Procedural Rules
Pretrial Procedures
Case Analysis 3.1 Espresso Disposition Corp. 1 v. Santana Sales & Marketing Group, Inc.
Case 3.2 Lewis v. Twenty-First Century Bean Processing
Case 3.3 Brothers v. Winstead
The Trial
Posttrial Motions
The Appeal
Enforcing the Judgment

Chapter 4: Business and the Constitution

The Constitutional Powers of Government
Classic Case 4.1 Heart of Atlanta Motel v. United States
Business and the Bill of Rights
Spotlight on Beer Labels: Case 4.2 Bad Frog Brewery, Inc. v. New York State Liquor Authority
Case Analysis 4.3 Thompson v. Holm
Due Process and Equal Protection
Privacy Rights

Chapter 5: Business Ethics

Business Ethics
Case 5.1: Scott v. Carpanzano
Business Ethics and Social Media
Ethical Principles and Philosophies
Making Ethical Business Decisions
Case 5.2: Al-Dabagh v. Case Western Reserve University
Case Analysis 5.3 Moseley v. Pepco Energy Services, Inc.
Global Business Ethics

Unit One Application and Ethics: "Arbitration, No Class Actions"

Unit 2: The Public and International Environment

Chapter 6: Tort Law

The Basis of Tort Law
Intentional Torts against Persons
Case Analysis 6.1 Blake v. Giustibelli
Case 6.2: Revell v. Guido
Intentional Torts against Property
Unintentional Torts—Negligence
Defenses to Negligence
Spotlight on the Seattle Mariners: Case 6.3 Taylor v. Baseball Club of Seattle, LP

Chapter 7: Strict Liability and Product Liability

Strict Liability
Product Liability
Case Analysis 7.1 Schwarck v. Arctic Cat, Inc.
Strict Product Liability
Spotlight on Injuries from Vaccines: Case 7.2 Bruesewitz v. Wyeth, LLC
Defenses to Product Liability
Case 7.3: VeRost v. Mitsubishi Caterpillar Forklift America, Inc.

Chapter 8: Intellectual Property Rights

Trademarks and Related Property
Classic Case 8.1 The Coca-Cola Co. v. The Koke Co. of America
Case 8.2: LFP IP, LLC v. Hustler Cincinnati, Inc.
Patents
Copyrights
Case Analysis 8.3 Winstead v. Jackson
Trade Secrets
International Protection for Intellectual Property

Chapter 9: Internet Law, Social Media, and Privacy

Internet Law
Spotlight on Internet Porn: Case 9.1 Hasbro, Inc. v. Internet Entertainment Group, Ltd.
Copyrights in Digital Information
Social Media
Online Defamation
Other Actions Involving Online Posts
Case Analysis 9.2 David v. Textor
Privacy
Case 9.3: Nucci v. Target Corp.

Chapter 10: Criminal Law and Cyber Crime

Civil Law and Criminal Law
Criminal Liability
Types of Crimes
Case 10.1: State of Minnesota v. Smith
Spotlight on White-Collar Crime Case 10.2 People v. Sisuphan
Defenses to Criminal Liability
Criminal Procedures
Cyber Crime
Case Analysis 10.3 United States v. Warner

Chapter 11: International and Space Law

International Law
Case Analysis 11.1 Bennett v. Islamic Republic of Iran
Doing Business Internationally
Regulation of Specific Business Activities
International Dispute Resolution
Case 11.2: Carlyle Investment Management, LLC v. Moonmouth Co. SA
U.S. Laws in a Global Context
Spotlight on International Torts: Case 11.3 Daimler AG v. Bauman
Space Law

Unit Two Application and Ethics: The Biggest Data Breach of All Time

Unit 3: The Commercial Environment

Chapter 12: Formation of Traditional and E-Contracts

An Overview of Contract Law
Agreement
Classic Case 12.1 Lucy v. Zehmer
Case Analysis 12.2 Hinkal v. Pardoe
E-Contracts
Consideration
Spotlight on Nike: Case 12.3 Already, LLC v. Nike, Inc.
Contractual Capacity
Legality
Form
Third Party Rights

Chapter 13: Contract Performance, Breach, and Remedies

Voluntary Consent
Case 13.1: Schneiderman v. Trump Entrepreneur Initiative, LLC
Performance and Discharge
Case Analysis 13.2 Kohel v. Bergen Auto Enterprises, L.L.C.
Damages
Spotlight on Liquidated Damages: Case 13.3 Kent State University v. Ford
Equitable Remedies
Waiver of Breach
Contract Provisions Limiting Remedies

Chapter 14: Sales and Lease Contracts

The Scope of Articles 2 (Sales) and 2A (Leases)
The Formation of Sales and Lease Contracts
Classic Case 14.1 Jones v. Star Credit Corp.
Title, Risk, and Insurable Interest
Case Analysis 14.2 BMW Group, LLC v. Castle Oil Corp.
Performance and Breach of Sales and Lease Contracts
Remedies for Breach of Sales and Lease Contracts
Spotlight on Baseball Cards: Case 14.3 Fitl v. Strek
Warranties
Contracts for the International Sale of Goods
Appendix to Chapter 14: An Example of a Contract for the International Sale of Coffee

Chapter 15: Creditor-Debtor Relations and Bankruptcy

Laws Assisting Creditors
Case Analysis 15.1 Picerne Construction Corp. v. Villas
Mortgages
Protection for Debtors
Bankruptcy Law
Liquidation Proceedings
Case 15.2: In re Anderson
Case 15.3: In re Cummings
Reorganizations
Bankruptcy Relief under Chapter 12 and Chapter 13

Unit Three Application and Ethics: Fantasy Sports—Legal Gambling?

Unit 4: The Business and Employment Environment

Chapter 16: Small Businesses and Franchises

General Considerations for Small Businesses
Sole Proprietorships
Case Analysis 16.1 A. Gadley Enterprises, Inc. v. Department of Labor and Industry Office of Unemployment Compensation Tax Services
Partnerships
Classic Case 16.2 Meinhard v. Salmon
Franchises
Spotlight on Holiday Inns: Case 16.3 Holiday Inn Franchising, Inc. v. Hotel Associates, Inc.

Chapter 17: Limited Liability Business Forms

The Limited Liability Company
Case 17.1: Hodge v. Strong Built International, LLC
LLC Management and Operation
Dissociation and Dissolution of an LLC
Case Analysis 17.2 Reese v. Newman
Limited Liability Partnerships
Limited Partnerships
Case 17.3: DeWine v. Valley View Enterprises, Inc.

Chapter 18: Corporations

Nature and Classification
Case 18.1: Drake Manufacturing Co. v. Polyflow, Inc.
Case Analysis 18.2 Pantano v. Newark Museum
Formation and Powers
Piercing the Corporate Veil
Directors and Officers
Classic Case 18.3 Guth v. Loft, Inc.
Shareholders
Major Business Forms Compared

Chapter 19: Agency Relationships

Agency Law
Formation of the Agency Relationship
Duties of Agents and Principals
Spotlight on Taser International Case: 19.1 Taser International, Inc. v. Ward
Case Analysis 19.2 NRT New England, LLC v. Jones
Agent’s Authority
Liability in Agency Relationships
Case 19.3: Asphalt & Concrete Services, Inc. v. Perry
Termination of an Agency

Chapter 20: Themployment Law

Employment at Will
Case Analysis 20.1 Caterpillar, Inc. v. Sudlow
Wages, Hours, and Layoffs
Case 20.2: Bailey v. TitleMax of Georgia, Inc.
Family and Medical Leave
Case 20.3: Ballard v. Chicago Park District
Health, Safety, and Income Security
Employee Privacy Rights

Chapter 21: Themployment Discrimination

Title VII of the Civil Rights Act
Case Analysis 21.1 Bauer v. Lynch
Case 21.2: Young v. United Parcel Service, Inc.
Case 21.3: Roberts v. Mike’s Trucking, Ltd.
Discrimination Based on Age
Discrimination Based on Disability
Discrimination Based on Military Status
Defenses to Employment Discrimination
Affirmative Action

Chapter 22: Immigration and Labor Law

Immigration Law
Federal Labor Laws
Case 22.1: Services Employees International Union v. National Union of mployees ational Healthcare Workers ealthcare
Union Organization
Case Analysis 22.2 Contemporary Cars, Inc. v. National Labor ational Relations Board elations
Collective Bargaining
Strikes and Lockouts
Unfair Labor Practices
Case 22.3: Staffing Network Holdings, LLC v. National Labor taffing ational Relations Board oldings, elations

Unit Four Application and Ethics: Health Insurance and Small Business

Unit 5: The Regulatory Environment

Chapter 23: Administrative Agencies

The Practical Significance of Administrative Law
Agency Creation and Powers
Case 23.1: Loving v. Internal Revenue Service
The Administrative Process
Case 23.2: Craker v. Drug Enforcement Administration
Judicial Deference to Agency Decisions
Case Analysis 23.3 Olivares v. Transportation Security Administration
Public Accountability

Chapter 24: Consumer Protection

Advertising, Marketing, and Sales
Case 24.1: POM Wonderful, LLC v. Federal Trade Commission
Case 24.2: Lexmark International, Inc. v. Static Control Components, Inc.
Labeling and Packaging Laws
Protection of Health and Safety
Credit Protection
Case Analysis 24.3 Santangelo v. Comcast Corporation

Chapter 25: Thenvironmental Law

Common Law Actions
Federal, State, and Local Regulations
Case Analysis 25.1 Friends of Animals v. Clay
Air Pollution
Case 25.2: United States v. O’Malley
Water Pollution
Case 25.3: Thentergy Corp. v. Riverkeeper, Inc.
Toxic Chemicals and Hazardous Waste

Chapter 26: Real Property and Land-Use Control

The Nature of Real Property
Ownership and Other Interests in Real Property
Case 26.1: Main Omni Realty Corp. v. Matus
Transfer of Ownership
Spotlight on Sales of Haunted Houses: Case 26.2 Stambovsky v. Ackley
Case Analysis 26.3 Montgomery County v. Bhatt
Limitations on the Rights of Property Owners
Land-Use Control and Zoning

Chapter 27: Antitrust Law

The Sherman Antitrust Act
Section 1 of the Sherman Act
Section 2 of the Sherman Act
Case Analysis 27.1 McWane, Inc. v. Federal Trade Commission
Spotlight on Weyerhaeuser: Case 27.2 Weyerhaeuser Co. v. Ross-S immons Hardwood Lumber Co. ardwood
The Clayton Act
Enforcement and Exemptions
Case 27.3: TransWeb, LLC v. 3M Innovative Properties Co.
U.S. Antitrust Laws in the Global Context

Chapter 28: Investor Protection and Corporate Governance

The Securities Act of 1933
Case 28.1: Omnicare, Inc. v. Laborers District Council Construction Industry Pension Fund
The Securities Exchange Act of 1934
Classic Case 28.2 SEC v. Texas Gulf Sulphur Co.
Case Analysis 28.3 Rand-Heart of New York, Inc. v. Dolan
State Securities Laws
Corporate Governance

Unit Five Application and Ethics: Climate Change

Appendices

Appendix A: How to Brief Cases and Analyze Case Problems
Appendix B: The Constitution of the United States
Appendix C: Articles 2 and 2A of the Uniform Commercial Code
Appendix D: Answers to the Issue Spotters
Appendix E: Sample Answers for Business Case Problems with Sample Answer

Glossary
Table of Cases
Index

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