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Appendix A

THE CONSTITUTION OF THE UNITED STATES OF AMERICA

Preamble We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defense, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.

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 several States, and the Electors in each State shall have the Qualifications 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, including those bound to Service for a Term of Years, and excluding Indians not taxed, three fifths of all other Persons. 1 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 choose three, Massachusetts 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 Election 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 composed of two Senators from each State, chosen by the Legislature thereof, 2 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 second 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

1 Changed by the Fourteenth Amendment. 2 Changed by the Seventeenth Amendment.

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be chosen every second Year; and if Vacancies happen by Resignation, or otherwise, during the Recess of the Legislature of any State, the Executive thereof may make temporary Appoint- ments until the next Meeting of the Legislature, which shall then fill such Vacancies. 3

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 President 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 Impeachments. 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 further 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, according to Law.

Section 4. The Times, Places and Manner of holding Elections for Senators and Represen- tatives, 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. 4

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 Behaviour, and with the Concurrence 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 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, without 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 Ser- vices, 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 privileged 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 encreased 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.

3 Changed by the Seventeenth Amendment.

4 Changed by the Twentieth Amendment.

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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 Representatives and the Senate, shall, before it becomes a Law, be presented to the President of the United States; If he approves he shall sign it, but if not he shall return it, with his Objections to that 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 presented 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 Representatives, according to the Rules and Limitations prescribed in the Case of a Bill.

Section 8. The Congress shall have Power To lay and collect 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 uniform 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 uniform Laws on the subject of Bank-

ruptcies 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 Securities 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 exclusive 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 Offences

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 Insurrec-

tions and repel Invasions; To provide for organizing, arming, and disciplining, the Militia, and for governing such Part

of them as may be employed in the Service of the United States, reserving to the States respec- tively, 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

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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 fore- going Powers, and all other Powers 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 exist- ing 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 suspended, 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 of Enu-

meration herein before directed to be taken. 5 No Tax or Duty shall be laid on Articles exported from any State. No Preference shall be given by any Regulation of Commerce 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 Consequence of Appropriations made by Law; and a regular Statement 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 Control 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 President of the United States of America. He shall hold his Office during the Term of four Years, and, together with the Vice President, 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 Congress: but no Senator or Representative, or Person holding an Office of Trust or Profit under the United States, shall be appointed an Elector.

5 Changed by the Sixteenth Amendment.

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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 transmit 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 Representatives, 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 Majority, 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 greatest 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. 6

The Congress may determine the Time of chusing the Electors, 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 Constitution, 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 Inabil- ity 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 President, and such Officer shall act accordingly, until the Disability be removed, or a President shall be elected. 7

The President shall, at stated Times, receive for his Services, a Compensation, which shall neither be encreased nor diminished 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 Militia 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 Pardons for Offences 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 Senators present concur; and he shall nominate, and by and with the Advice and Consent of the Senate, shall appoint Ambassadors, other public Minis- ters and Consuls, Judges of the supreme Court, and all other Officers of the United States, whose Appointments are not herein otherwise provided for, and which shall be established

6 Changed by the Twelfth Amendment.

7 Changed by the Twenty-Fifth Amendment.

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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 Commissions which shall expire at the End of their next Session.

Section 3. He shall from time to time give to the Congress 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 dimin- ished 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 Con- suls;—to all Cases of admiralty 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; 8 —between Citizens of different States;—between Citizens of the same State claiming Lands under Grants of different States, and between a State, or the Citizens thereof, and foreign States, Citizens or Subjects.

In all Cases affecting Ambassadors, other public Ministers and Consuls, and those in which a State shall be 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 Enemies, giving them Aid and Comfort. No Person shall be convicted 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.

8 Changed by the Eleventh Amendment.

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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 pre- scribe 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 Ser- vice or Labour, but shall be delivered up on Claim of the Party to whom such Service or Labour may be due. 9

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 protect 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 Constitution, or, on the Application of the Legislatures of two thirds of the several States, shall call a Convention for proposing Amendments, which, in either Case, shall be valid to all Intents and Purposes, as Part of this Constitution, when ratified by the legislatures of three fourths of the several States, or by Conventions in three fourths thereof, as the one or the other Mode of Ratification may be proposed by the Congress; Provided that no Amendment which may be made prior to the Year One thousand eight hundred and eight shall in any Man- ner 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 Suffrage 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.

The 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,

9 Changed by the Thirteenth Amendment.

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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 sev- eral States, shall be bound by Oath or Affirmation, to support this Constitution; but no reli- gious 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.

Done in Convention by the Unanimous Consent of the States present the Seventeenth Day of September in the Year of our Lord one thousand seven hundred and eighty seven and of the Independence of the United States of America the Twelfth. In witness whereof We have here- unto subscribed our Names.

Amendments [The first 10 amendments are known as the “Bill of Rights.”]

AMENDMENT I (RATIFIED 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 assemble, and to petition the Government for a redress of grievances.

AMENDMENT 2 (RATIFIED 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 3 (RATIFIED 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 4 (RATIFIED 1791) The right of the people to be secure in their persons, houses, papers, and effects, against unrea- sonable searches and seizures, shall not be violated, and no Warrants shall issue, but upon probable cause, supported by Oath or affirmation, and particularly describing the place to be searched, and the persons or things to be seized.

AMENDMENT 5 (RATIFIED 1791) No person shall be held to answer for a capital, or otherwise infamous crime, unless on a pre- sentment 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 public danger; nor shall any person be subject for the same offence to be twice put in jeopardy of life or limb; nor shall be compelled 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.

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AMENDMENT 6 (RATIFIED 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 assistance of counsel for his defence.

AMENDMENT 7 (RATIFIED 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 a jury, shall be otherwise re-examined in any Court of the United States, than according to the rules of the common law.

AMENDMENT 8 (RATIFIED 1791) Excessive bail shall not be required, nor excessive fines imposed, nor cruel and unusual punish- ments inflicted.

AMENDMENT 9 (RATIFIED 1791) The enumeration in the Constitution, of certain rights, shall not be construed to deny or dispar- age others retained by the people.

AMENDMENT 10 (RATIFIED 1791) The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people.

AMENDMENT 11 (RATIFIED 1795) The Judicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by Citizens of another State, or by Citizens or Subjects of any Foreign State.

AMENDMENT 12 (RATIFIED 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 themselves; they shall name in their ballots the person voted for as 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 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 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 Elec- tors 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 Repre- sentatives shall choose immediately, by ballot, the President. But in choosing the President, the votes shall be taken by states, the representation from each state having one vote; a quo- rum 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. And if the House of Representa- tives 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,

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as in the case of the death or other constitutional disability of the President. 10 —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 majority, 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 13 (RATIFIED 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 subject to their jurisdiction.

Section 2. Congress shall have power to enforce this article by appropriate legislation.

AMENDMENT 14 (RATIFIED 1868) Section 1. All persons born or naturalized in the United States, and subject to the jurisdic- tion 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 jurisdiction 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 11 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 Presi- dent 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.

11 Changed by the Twenty-Sixth Amendment.

10 Changed by the Twentieth Amendment.

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Section 5. The Congress shall have power to enforce, by appropriate legislation, the provisions of this article.

AMENDMENT 15 (RATIFIED 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 16 (RATIFIED 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 17 (RATIFIED 1913) The Senate of the United States shall be composed 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.

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 legislature of any State may empower the executive thereof to make temporary appointments until the people fill the vacancies by election as the legislature may direct.

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 18 (RATIFIED 1919; REPEALED 1933) Section 1. After one year from the ratification of this article the manufacture, sale, or trans- portation of intoxicating liquors within, the importation thereof into, or the exportation thereof from the United States and all territory subject to the jurisdiction 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 amend- ment to the Constitution by the legislatures of the several States, as provided in the Constitu- tion, within seven years from the date of the submission hereof to the States by the Congress. 12

AMENDMENT 19 (RATIFIED 1920) 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.

Congress shall have power to enforce this article by appropriate legislation.

AMENDMENT 20 (RATIFIED 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 3rd day of January,

12 Repealed by the Twenty-First Amendment.

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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 3rd 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 a 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 Presi- dent 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 rati- fication of this article.

Section 6. This article shall be inoperative unless it shall have been ratified as an amend- ment to the Constitution by the legislatures of three-fourths of the several States within seven years from the date of its submission.

AMENDMENT 21 (RATIFIED 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 amend- ment to the Constitution by conventions 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 22 (RATIFIED 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 the President more than once. But this Article shall not apply to any person holding the office of President when this Article was proposed by the Congress, and shall not prevent any person who may be holding the office of President, 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 amend- ment 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.

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AMENDMENT 23 (RATIFIED 1961) Section 1. The District constituting the seat of Government 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 Congress 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.

AMENDMENT 24 (RATIFIED 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 electors 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 25 (RATIFIED 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 Representatives his written declaration that he is unable to discharge the powers and duties of his office, and until he transmits to them a written declara- tion 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 President 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 Act- ing President.

Thereafter, when the President transmits to the President pro tempore of the Senate and the Speaker of the House of Representatives 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 Representatives 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 powers and duties of his office, the Vice President shall continue to

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discharge the same as Acting President; otherwise, the President shall resume the powers and duties of his office.

AMENDMENT 26 (RATIFIED 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 27 (RATIFIED 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.

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Uniform Commercial Code 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 uncondi- tional contract to sell or present sale is intended to operate only as a security transaction nor does this Article impair or repeal any statute regulating sales to consumers, farmers 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.

Appendix B

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“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 3–502.

“Draft” Section 3–104.

(4) In addition Article 1 contains general definitions and principles of construction and interpretation applicable throughout this Article.

As amended in 1994. See Appendix XI for material relating to changes made in text in 1994.

§ 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 knowledge or skill peculiar to the practices or goods involved in the transaction or to whom such knowledge or skill may be attributed by his employment of an agent or broker or other intermediary 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 arrange- ment 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 intervenes 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 interest 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.

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(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 commercial 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 Sales”; “Sale”; “Present Sale”; “Conforming” to Contract; “Termination”; “Cancellation”.

(1) In this Article unless the context otherwise requires “contract” and “agreement” are limited to those relating to the present 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 accordance 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 otherwise 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 subsec- tion (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. As amended in 1972.

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 parties and signed

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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, it satisfies the requirements of subsection (1) against such party unless written notice of objection to its contents is given within 10 days after it is received.

(3) A contract which does not satisfy the requirements of subsection (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 reasonably indicate that the goods are for the buyer, has made either a substantial beginning of their manufacture or commitments for their procurement; or

(b) if the party against whom enforcement is sought admits in his pleading, testimony or otherwise in court that a contract 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 (Section 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 oth- erwise set forth in a writing intended by the parties as a final expression of their agree- ment with respect to such terms as are included therein may not be contradicted by evidence of any prior agreement or of a contemporaneous oral agreement 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 complete 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 indefinite- ness 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 consid- eration, during the time stated or if no time is stated for a reasonable time, but in no event may such period of irrevocability exceed three months; but any such term of assurance on a form supplied by the offeree must be separately signed by the offeror.

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§ 2–206. Offer and Acceptance in Formation of Contract.

(1) Unless otherwise 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 current 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 non-conforming goods, but such a shipment of non- conforming goods does not constitute 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 written confirmation which is sent within a reasonable time operates 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 different 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; (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 provisions 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 modification 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 rescission except by a signed writ-

ing 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.

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(3) The requirements of the statute of frauds section of this Article (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 sub- section (2) or (3) it can operate as a waiver.

(5) A party who has made a waiver affecting an executory portion of the contract may retract the waiver by reasonable notification 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 otherwise agreed or unless the other party has a substantial interest 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) Unless otherwise 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 agree- ment otherwise.

(3) Unless the circumstances indicate the contrary a prohibition of assignment of “the con- tract” is to be construed as barring only the delegation to the assignee of the assignor’s performance.

(4) An assignment of “the contract” or of “all my rights under the contract” or an assignment in similar general terms is an assignment of rights and unless the language or the circum- stances (as in an assignment for security) indicate the contrary, it is a delegation of perfor- mance of the duties of the assignor and its acceptance 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.

(5) The other party may treat any assignment which delegates performance as creating reason- able grounds for insecurity and may without prejudice to his rights against the assignor demand assurances from the assignee (Section 2–609).

PART 3: GENERAL OBLIGATION AND CONSTRUCTION OF CONTRACT § 2–301. General Obligations of Parties. The obligation of the seller is to trans- fer 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 unconscionable clause, or it may so limit the application of any unconscionable 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 making the determination.

§ 2–303. Allocation or Division of Risks. Where this Article allocates a risk or a burden as between the parties “unless otherwise agreed”, the agreement may not only shift the allocation but may also divide the risk or burden.

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§ 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 him- self 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 portion 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 output 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 exclusive dealing in the kind of goods concerned imposes unless otherwise 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 business 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.

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(3) Termination of a contract by one party except on the happening 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

(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 sub- section (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 shipment but postdating 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 specifications 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 addition to all other remedies (a) is excused for any resulting delay in his own performance; and (b) may also either proceed to perform in any reasonable manner or after the time for a

material part of his own performance 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 Obliga- tion Against Infringement.

(1) Subject to subsection (2) there is in a contract for sale a warranty by the seller that (a) the title conveyed shall be good, and its transfer rightful; and (b) the goods shall be delivered free from any security interest or other lien or encum-

brance of which the buyer at the time of contracting has no knowledge. (2) A warranty under subsection (1) will be excluded or modified 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.

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§ 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 affirmation merely of the value of the goods or a statement purporting 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 merchant- able 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 quan-

tity 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 promise 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.

§ 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 warranty 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 conspicuous, 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

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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 examination 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 consistent 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:

(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 warranties 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 person 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 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. 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 war- ranty. 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 in 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 connection 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 manner provided in this Article (Section 2–503);

(c) when under either (a) or (b) the term is also F.O.B. vessel, car or other vehicle, the seller must in addition at his own expense and risk load the goods on board. If the

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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 connection with the stated price, is a delivery term under which the seller must (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 delivery or shipment.

(4) Under the term F.O.B. vessel or F.A.S. unless otherwise agreed the buyer must make pay- ment 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 connection 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 nego-

tiable 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 pro- viding 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.

§ 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

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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 identification 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 payment on or after arrival of the goods the seller must before payment 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 carriage 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 contains 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 in 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 provisions 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.

(3) A shipment by water or by air or a contract contemplating such shipment is “overseas” inso- far as by usage of trade or agreement it is subject to the commercial, financing or shipping practices 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 contract 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.

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(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 payment directly from him.

(3) Unless otherwise agreed the term “letter of credit” or “banker’s credit” in a contract for sale means an irrevocable credit issued by a financing agency of good repute and, where the shipment is overseas, of good international repute. The term “confirmed 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; Consignment Sales and Rights of Creditors.

(1) Unless otherwise agreed, if delivered goods may be returned by the buyer even though they conform to the contract, the transaction 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) Except as provided in subsection (3), 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) Where goods are delivered to a person for sale and such person maintains a place of busi- ness at which he deals in goods of the kind involved, under a name other than the name of the person making delivery, then with respect to claims of creditors of the person con- ducting the business the goods are deemed to be on sale or return. The provisions of this subsection are applicable even though an agreement purports to reserve title to the person making delivery until payment or resale or uses such words as “on consignment” or “on memorandum”. However, this subsection is not applicable if the person making delivery (a) complies with an applicable law providing for a consignor’s interest or the like to be

evidenced by a sign, or (b) establishes that the person conducting the business is generally known by his creditors

to be substantially engaged in selling the goods of others, or (c) complies with the filing provisions of the Article on Secured Transactions (Article 9).

(4) 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 on parol or extrinsic evidence (Section 2–202).

§ 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 acceptance; and (b) use of the goods consistent with the purpose of trial is not acceptance but failure sea-

sonably 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 commercial 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 manner. Where a bid is made while the hammer is falling in acceptance

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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 auctioneer 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 auction- eer’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 a 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 Applica- tion 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 provisions of this Article and matters concerning title become material 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 identification 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 provisions 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 particular 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 documents; or

(b) if the goods are at the time of contracting already identified 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 unsecured 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).

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(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 retention of possession by the seller is fraudulent under any rule of law of the state where the goods are situated, except that retention 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 Transactions (Article 9); or (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 purchased. 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 purchaser, 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 crimi-

nal 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 regard- less 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.

[ Publisher’s Editorial Note: If a state adopts the repealer of Article 6—Bulk Transfers (Alternative A), subsec. (4) should read as follows: ]

(4) The rights of other purchasers of goods and of lien creditors are governed by the Articles on Secured Transactions (Article 9) and Documents of Title (Article 7).

[ Publisher’s Editorial Note: If a state adopts Revised Article 6—Bulk Sales (Alternative B), subsec. (4) should read as follows: ]

(4) The rights of other purchasers of goods and of lien creditors are governed by the Articles on Secured Transactions (Article 9), Bulk Sales (Article 6) and Documents of Title (Article 7).

As amended in 1988.

For material relating to the changes made in text in 1988, see section 3 of Alternative A (Repealer of Article 6—Bulk Transfers) and Conforming Amendment to Section 2–403 following end of Alternative B (Revised Article 6—Bulk Sales).

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 explicitly agreed to by the parties. In the absence of explicit agreement identification occurs

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(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, 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 con- ceived if the contract is for the sale of unborn young to be born within twelve months after contracting 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 recognized under any other statute or rule of law.

§ 2–502. Buyer’s Right to Goods on Seller’s Insolvency.

(1) Subject to subsection (2) 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 the seller becomes insolvent within ten days after receipt of the first installment on their price.

(2) 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.

§ 2–503. Manner of Seller’s Tender of Delivery.

(1) Tender of delivery requires that the seller put and hold conforming 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 necessary 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 destination tender requires that he

comply with subsection (1) and also in any appropriate case tender documents as described in subsections (4) and (5) of this section.

(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 acknowledgment 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 sufficient 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 lading 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 constitutes non-acceptance or rejection.

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§ 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 destina- tion, 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 reasonable 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 material 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 financing 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 nominee 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 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 preced- ing section but impairs neither the rights given to the buyer by shipment 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 pur- chased the draft under commitment to or authority from the buyer is not impaired by sub- sequent discovery 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 intention to cure and may then within the contract time make a conforming delivery.

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(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 notifies the buyer have a further reasonable time to substitute a conforming 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 shipment is under reservation (Section 2–505); but

(b) if it does require him to deliver them 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 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 agreement 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 repudi- ates 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 extension of time reasonably necessary to procure it.

(3) Subject to the provisions of this Act on the effect of an instrument 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. See Appendix XI for material relating to changes made in text 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 making payment unless

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(a) the non-conformity appears without inspection; or (b) despite tender of the required documents the circumstances 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. See Appendix XIV for material relating to changes made in text 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 reasonable 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 presumed 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 Pay- ment. 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 ascertain- ing the facts and preserving evidence has the right to inspect, test and sample the goods including such of them as may be in the possession or control of the other; and

(b) the parties may agree to a third party inspection or survey to determine the confor- mity or condition of the goods and may agree that the findings shall be binding upon them in any subsequent litigation or adjustment.

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.

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§ 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 seasonably 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 possession of goods in which he does

not have a security interest under the provisions of this Article (subsection (3) of Section 2–711), he is under a duty after rejection to hold them with reasonable care at the seller’s disposition for a time sufficient 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 reasonable 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 reasonable if on demand indemnity for expenses is not forthcoming.

(2) When the buyer sells goods under subsection (1), he is entitled 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 commission 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.

§ 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 inspection 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 statement 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 signifies to the seller that the goods

are conforming or that he will take or retain them in spite of their non-conformity; or

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(b) fails to make an effective rejection (subsection (1) of Section 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 Establish- ing 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-conformity cannot be revoked because of it unless the accep- tance 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 discovers or should have discovered

any breach notify the seller of breach or be barred from any remedy; and (b) if the claim is one for infringement or the like (subsection (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 liti- gations, 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 (subsection (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 infringement 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 non-conformity would be cured and it has not

been seasonably cured; or (b) without discovery of such non-conformity if his acceptance was reasonably induced

either by the difficulty of discovery 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.

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§ 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 suspend any performance for which he has not already received the agreed return.

(2) Between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards.

(3) Acceptance of any improper delivery or payment does not prejudice the aggrieved 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 performance 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 Section 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 provi- sions of this Article on the seller’s right to identify goods to the contract notwithstand- ing 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 otherwise 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 sub- stantially 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 sub- section (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 without seasonably notifying of cancellation or if he brings an action with respect only to past installments or demands performance as to future installments.

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§ 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 nevertheless demand inspection and at his option either treat the contract as avoided or accept the goods with due allowance 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 reasonable 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 governmen- tal regulation, the seller may withhold or stop delivery unless the buyer provides a means or manner of payment which is commercially a substantial equivalent. If delivery has already been taken, payment by the means or in the manner provided by the regulation dis- charges 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 substi- tuted 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 perfor- mance as agreed has been made impracticable by the occurrence of a contingency the non-occurrence of which was a basic assumption on which the contract was made or by compliance 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 contract as well as his own requirements for further manufacture. He may so allocate in any manner which is fair and reasonable.

(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 indefinite 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 agreement except in so far as the seller has assumed a greater obligation under the preceding section.

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PART 7: REMEDIES § 2–701. Remedies for Breach of Collateral Contracts Not Impaired. Remedies for breach of any obligation or promise collateral or ancillary 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 misrepre- sentation 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 mis- representation 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 ordi- nary course or other good faith purchaser under this Article (Section 2–403). Successful reclamation of goods excludes all other remedies with respect to them.

As amended in 1966.

§ 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 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 unidentified 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 Notwith- standing 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 demonstrably 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 com-

mercial judgment for the purposes of avoiding loss and of effective realization either com- plete 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 insolvent (Section 2–702) and may stop delivery of carload, truckload, planeload or larger shipments of express or freight when the buyer repudiates or fails to make a payment due before delivery or if for any other reason the seller has a right to withhold or reclaim the goods.

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(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 buyer; or (c) such acknowledgment to the buyer by a carrier by reshipment 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 direc- tions of the seller but 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 noti- fication 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 undelivered 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 provisions 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 otherwise agreed resale may be at public or private sale including sale by way of one or more contracts to sell or of identifica- tion 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 necessary 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 pub-

lic 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 speed- ily 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 attending 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 (Section 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).

§ 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 otherwise holds a security interest or other right in goods similar to that of a seller.

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(2) A person in the position of a seller may as provided in this Article withhold or stop delivery (Section 2–705) and resell (Section 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 measure 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 incidental 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 performance 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 payments 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 damaged 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 repudiated (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 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 provided 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 provided 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).

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(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 reasonably incurred in their inspection, receipt, transportation, care and cus- tody 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 substitution for those due from the seller.

(2) The buyer may recover from the seller as damages the difference between the cost of cover and the contract price together with any incidental or consequential damages as herein- after 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 consequential damages provided in this Article (Section 2–715), but less expenses saved in consequence of the seller’s breach.

(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 (subsection (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 difference 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, transportation 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 prevented 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.

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(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.

§ 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 difficulties of proof of loss, and the inconvenience or nonfeasibility of otherwise obtaining an adequate remedy. A term fixing unreasonably 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 subject to offset to the extent that the

seller establishes (a) a right to recover damages under the provisions of this Article other than subsec-

tion (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 performance, 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 limitation 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 replacement of non-conforming goods or parts; and

(b) resort to a remedy as provided is optional unless the remedy 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.

(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.

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§ 2–720. Effect of “Cancellation” or “Rescission” on Claims for Ante- cedent Breach. Unless the contrary intention clearly appears, expressions of “cancel- lation” or “rescission” of the contract or the like shall not be construed 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 remedies available under this Article for non-fraudulent breach. Neither rescission or a claim for rescission of the contract for sale nor rejection 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 perfor- mance 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 prevail- ing 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 prevailing 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.

(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 gen- eral 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 commenced 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.

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(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 dis- covery of the breach must await the time of such performance the cause of action accrues when the breach is or should have been discovered.

(3) Where an action commenced within the time limited by subsection (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 termi- nation 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 Commercial Code—Leases.

See Appendix VI [following Amendment 24 therein] for material relating to changes in the Official Comment to conform to the 1990 amendments to various sections of Article 2A.

§ 2A–102. Scope. This Article applies to any transaction, regardless of form, that creates 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 secu- rity 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 preexist- ing 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 contract means goods or perfor- mance 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 lessee who is an individual and who takes under the lease primarily for a personal, family, or household purpose [, if the total payments to be made under the lease contract, excluding 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 possession and use of the goods in

connection with the lease; and

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(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 com- plete statement designating the promises and warranties, and any disclaim- ers 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 supplying the goods in connec- tion 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 lessee in writing (a) of the identity of the person supplying 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 the promises and warranties, including those of any third party, provided to the lessor by the person supplying 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, and (c) that the lessee may communicate with the person supplying the goods to the lessor and receive an accurate and complete statement of those promises and warranties, including any disclaimers 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, docu- ments, 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 retention 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 language 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 indicates otherwise, the term includes a sub- lease 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 possession 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 with-

out knowledge that the lease to him [or her] is in violation of the ownership rights or security interest 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

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or on secured or unsecured credit and includes receiving goods or documents of title under a preexisting 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 possession 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 per- formance 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 sufficient 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:

“Account” 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.

“Good faith” Section 2–103(1) (b).

“Instrument” Section 9–105(1) (i).

“Merchant” Section 2–104(1).

“Mortgage” Section 9–105(1) (j).

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“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 principles of construction and inter- pretation applicable throughout this Article.

As amended in 1990.

§ 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 certificate 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 consumer 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 Cer- tificate 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 statute are governed by the law (including the conflict of laws rules) of the jurisdiction issuing the certificate until the earlier of (a) surrender 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.

(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 consideration 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

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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 uncon- scionable 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 subsection (1) or (2), the court, on its own motion or that of a party, shall afford the parties a reasonable opportunity to present evidence 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 lessee 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 recovery 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 collateral 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 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 sufficient 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 enforceable 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 subsection (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 suit-

able for lease or sale to others in the ordinary course of the lessor’s business, and the lessor, before notice of repudiation is received and under circumstances that reason- ably 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, testi- mony 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.

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(5) The lease term under a lease contract referred to in subsection (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, testi-

mony, or otherwise in court a lease term, the term so admitted; or (c) a reasonable lease term.

§ 2A–202. Final Written Expression: Parol or Extrinsic Evidence. Terms with respect to which the confirmatory memoranda of the parties agree or which are other- wise 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 agreement but may be explained or supplemented:

(a) by course of dealing or usage of trade or by course of performance; 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 recognizes 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 per- son 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 construed 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.

§ 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 relevant 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.

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(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 consideration to be binding. (2) A signed lease agreement that excludes modification or rescission 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 sub- section (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 notification received by the other party that strict perfor- mance 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 a 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 of the warranty and of the supply contract and all defenses or claims arising therefrom.

(2) The extension of the benefit of a 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 rescis- sion, the supplier 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 war- ranties 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 supplier 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.

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(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 war- ranty, but an affirmation 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 warranty 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 merchant with respect to goods of that kind.

(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 agreement, 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 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 contract 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 warranty 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 con- spicuous. Subject to sub-section (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 fitness 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

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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 circum- stances to have revealed; and

(c) an implied warranty may also be excluded or modified by course of dealing, course of performance, or usage of trade.

(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 interest of any person.

§ 2A–215. Cumulation and Conflict of Warranties Express or Implied. Warranties, whether express or implied, must be construed as consistent with each other and as cumulative, but if that construction is unreasonable, the intention of the parties determines which warranty 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 warranties other than an implied war-

ranty 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 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 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 reasonably 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 warranty 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 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.

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§ 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 lessor’s identification of the goods, the lessor, until default or insolvency 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 recognized 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 covering the goods and by agreement may determine the ben- eficiary 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 fol- lowing 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 destination, the risk of loss passes to the lessee when the goods are duly delivered to the carrier; but

(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 acknowledgment by the bailee of the lessee’s right to posses- sion 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 passage 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.

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(b) If the lessee rightfully revokes acceptance, he [or she], to the extent of any deficiency in his [or her] effective insurance 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 lessee 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 defi- ciency 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 identi- fied 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 nevertheless 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 allowance 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.

PART 3: EFFECT OF LEASE CONTRACT § 2A–301. Enforceability of Lease Contract. Except as otherwise provided in this Article, a lease contract is effective and enforceable according to its terms between the par- ties, 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 possession 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 9–102(1) (b).

(2) Except as provided in subsections (3) and (4), a provision in a lease agreement which (i) prohibits the voluntary or involuntary transfer, including a transfer by sale, sublease, creation 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 (5), 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 the creation or enforcement of a secu- rity interest in an interest of a party under the lease contract or in the lessor’s residual inter- est in the goods, or (ii) makes such a transfer an event of default, is not enforceable unless, and then only to the extent that, there is an actual transfer by the lessee of the lessee’s right of possession or use of the goods in violation of the provision or an actual delegation of a material performance of either party to the lease contract in violation of the provision. Neither the granting nor the enforcement of a security interest in (i) the lessor’s interest under the lease contract or (ii) the lessor’s residual interest in the goods is a transfer that

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materially impairs the prospect of obtaining return performance by, materially changes the duty of, or materially increases the burden or risk imposed on, the lessee within the purview of subsection (5) unless, and then only to the extent that, there is an actual delegation of a material performance of the lessor.

(4) A provision in a lease agreement which (i) prohibits a transfer of a right to damages for default with respect to the whole lease contract or of a right to payment arising out of the transferor’s due performance of the transferor’s entire obligation, or (ii) makes such a trans- fer an event of default, is not enforceable, and such a transfer is not a transfer that materially 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 contract within the purview of subsection (5).

(5) Subject to subsections (3) and (4): (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) materially 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 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 reasonably be prevented by the party not making the transfer and (ii) a court having jurisdiction may grant other appropriate relief, including cancellation of the lease contract or an injunction against the transfer.

(6) 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 security, 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 per- form those duties. The promise is enforceable by either the transferor or the other party to the lease contract.

(7) Unless otherwise agreed by the lessor and the lessee, a delegation of performance does not relieve the transferor as against the other party of any duty to perform or of any liability for default.

(8) In a consumer lease, to prohibit the transfer of an interest 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.

§ 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 existing 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

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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.

(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 cer- tificate 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 contract obtains, to the extent of the interest transferred, the leasehold 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 lessee 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 crimi-

nal 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 juris- diction 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.

(2) Except as otherwise provided in subsections (3) and (4) and in Sections 2A–306 and 2A–308, a creditor of a lessor takes subject to the lease contract unless: (a) the creditor holds a lien that attached to the goods before the lease contract became

enforceable; (b) the creditor holds a security interest in the goods and the lessee did not give value and

receive delivery of the goods without knowledge of the security interest; or (c) the creditor holds a security interest in the goods which was perfected (Section 9–303)

before the lease contract became enforceable. (3) A lessee in the ordinary course of business takes the leasehold interest free of a security

interest in the goods created by the lessor even though the security interest is perfected (Section 9–303) and the lessee knows of its existence.

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(4) A lessee other than a lessee in the ordinary course of business takes the leasehold interest free of a security interest to the extent that it secures future advances made after the secured party acquires knowledge of the lease or more than 45 days after the lease contract becomes enforceable, whichever first occurs, unless the future advances are made pursuant to a commitment entered into without knowledge of the lease and before the expiration of the 45-day period.

As amended in 1990.

§ 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 lessor if the lease contract (a) becomes enforceable, not in current course of trade but in satisfaction of or as security for a preexisting 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 transac- tion 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 retention 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 particular real estate that an inter-

est 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 Section 9–402(5);

(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.

(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 incor- porated 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 interest 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 filing before the interest of the encum- brancer or owner is of record, the lessor’s interest has priority over any conflicting 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.

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(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 equip-

ment that is not primarily 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 enforce- able; or

(b) the conflicting interest is a lien on the real estate obtained by legal or equitable pro- ceedings 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 fixtures; or

(d) the lessee has a right to remove the goods as against the encumbrancer or owner. If the lessee’s right to remove terminates, the priority of the interest of the lessor continues for a reasonable time.

(6) Notwithstanding subsection (4) (a) but otherwise subject to subsections (4) and (5), the interest of a lessor of fixtures, including the lessor’s residual interest, is subordinate to the conflicting interest of an encumbrancer of the real estate under a construction mortgage recorded before the goods become fixtures if the goods become fixtures before the comple- tion of the construction. To the extent given to refinance a construction mortgage, the con- flicting interest of an encumbrancer of the real estate under a mortgage has this priority to the same extent as the encumbrancer 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 encum- brancer 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 residual 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 encumbrancers 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 necessity 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.

§ 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.

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(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, termination, or cancellation of the lease contract by the other party 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 insecure 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 insecurity and the adequacy of any assurance offered must be determined 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 performance not yet due under the lease contract, the loss of which per- formance 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 repudiation and performance by the repudiating party;

(b) make demand pursuant to Section 2A–401 and await assurance 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

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party would 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 fore- going 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 notwithstanding default or to sal- vage 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 con- tract 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 commer- cially 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 governmen- tal regulation: (a) the lessor may withhold or stop delivery or cause the supplier to withhold or stop deliv-

ery unless the lessee provides 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 discrimina- tory, oppressive, or predatory.

§ 2A–405. Excused Performance. Subject to Section 2A–404 on substituted per- formance, the following rules apply:

(a) Delay in delivery or nondelivery in whole or in part by a lessor or a supplier who complies with paragraphs (b) and (c) is not a default under the lease contract if per- formance 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 gov- ernmental 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 sup- plier’s capacity to perform, he [or she] shall allocate production and deliveries among his [or her] customers but at his [or her] option may include regular customers not then under 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.

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§ 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 includ-

ing assignees of the parties; and (b) is not subject to cancellation, termination, modification, repudiation, excuse, or substi-

tution 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 accep- tance of the goods.

As amended in 1990.

PART 5: DEFAULT § 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 contract, the party seeking enforce- ment has rights and remedies as provided in this Article and, except as limited by this Article, as provided in the lease agreement.

(3) If the lessor or the lessee is in default under the lease contract, the party seeking enforce- ment 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, including adminis- trative proceeding, arbitration, or the like, in accordance 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.

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§ 2A–503. Modification or Impairment of Rights and Remedies.

(1) Except as otherwise provided in this Article, the lease agreement 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 remedy 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 uncon- scionable. Limitation, alteration, or exclusion of consequential damages for injury to the person in the case of consumer goods is prima facie unconscionable 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.

(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 cir- cumstances cause to fail of its essential purpose, remedy may be had as provided 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 subsec-

tion (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 cancelling 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.

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(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 contract 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 omission on which the default or breach of warranty is based is or should have been discovered by the aggrieved party, or when the default occurs, whichever is later. A cause of action for indemnity accrues when the act or omission on which the claim for indemnity is based is or should have been dis- covered by the indemnified party, whichever is later.

(3) If an action commenced within the time limited by subsection (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 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 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 specified 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 sub- stitute 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 publications 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.

§ 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),

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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 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 contract (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, transportation, and care and custody and may hold those goods and dispose of them in good faith and in a commer- cially 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 reasonable 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 substantially impairs the value of that delivery and cannot be cured or the nonconformity is a defect in the required documents; but if 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 nonconforming delivery without seasonably notifying of cancellation or brings an action with respect only to past deliveries or demands perfor- mance as to future deliveries.

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§ 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 rejec- tion 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 (Section 2A–512) disposes of goods, he [or she] is entitled to reimbursement 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 commission, 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 lessee 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 pursuant 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 subject to any security interest of a lessee (Section 2A–508(5)): (a) the lessee, after rejection of goods in the lessee’s possession, shall hold them with

reasonable care at the lessor’s or the supplier’s disposition for a reasonable time after the lessee’s seasonable notification of rejection;

(b) if the lessor or the supplier gives no instructions within a reasonable time after noti- fication 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 of them for the lessor’s or the supplier’s account with reimbursement 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 acceptance 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 acceptable 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

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(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 pro- poses to rely.

(2) A lessee’s failure to reserve rights when paying rent or other consideration against docu- ments precludes recovery of the payment 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 reasonable 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 Default After Acceptance; Notice of Claim or Litiga- tion 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 not notified;

(b) except in the case of a consumer lease, within a reasonable 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 liability 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 sup-

plier 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 person 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 settlement if the claim is one for infringement or the like (Section 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.

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§ 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: (a) except in the case of a finance lease, on the reasonable assumption that its nonconfor-

mity 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 substantially 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 liquidated 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 a 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 commencement 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 consequential 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 purchase 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.

§ 2A–519. Lessee’s Damages for Nondelivery, Repudiation, Default, and Breach of Warranty in Regard to Accepted Goods.

(1) Except as otherwise provided with respect to damages liquidated 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 nondelivery or repudiation by the lessor or for rejection or revocation 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

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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 nonconforming 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 reasonable together with incidental and consequen- tial 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, transportation, 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 les-

sor at the time of contracting had reason to know and which could not reasonably be prevented by cover or otherwise; and

(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 insolvent 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 con- form to the lease contract.

§ 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

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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 contract (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, together with incidental damages, less expenses saved in consequence 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 provided 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 demonstrably 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 commercial judgment for the purposes of avoiding loss and of effective 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 dispose 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 premises (Section 2A–527).

(3) The lessor may proceed under subsection (2) without judicial process if it can be done without breach of the peace or the lessor may proceed by action.

As amended in 1990.

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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 carrier 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 lessee; 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 direc- tions 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 notifi- cation 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 liquidated 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 commercially 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 inci- dental damages allowed under Section 2A–530, less expenses saved in consequence of the lessee’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 lessor 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 justifiably 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.

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§ 2A–528. Lessor’s Damages for Nonacceptance, Failure to Pay, Repu- diation, or Other Default.

(1) Except as otherwise provided with respect to damages liquidated 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 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 treatment 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 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 at the place where the goods are located computed for the same lease term, and (iii) any incidental 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 inadequate 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 allow- ance 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 subsection (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 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 reasonable 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 consequence 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 collection of the judgment for dam- ages obtained pursuant to subsection (1). If the disposition is before the end of the remain- ing 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.

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(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 nonacceptance under Section 2A–527 or Section 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 recov- ery 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 residual interest in the goods caused by the default of the lessee.

As added in 1990.

Article 3–Negotiable Instruments PART 1: GENERAL PROVISIONS AND DEFINITIONS § 3–101. Short Title. This Article may be cited as Uniform Commercial Code— Negotiable Instruments.

§ 3–102. Subject Matter.

(a) This Article applies to negotiable instruments. It does not apply to money, to payment orders governed by Article 4A, or to securities governed by Article 8.

(b) If there is conflict between this Article and Article 4 or 9, Articles 4 and 9 govern. (c) Regulations of the Board of Governors of the Federal Reserve System and operating cir-

culars of the Federal Reserve Banks supersede any inconsistent provision of this Article to the extent of the inconsistency.

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§ 3–103. Definitions. (a) In this Article:

(1) “Acceptor” means a drawee who has accepted a draft. (2) “Consumer account” means an account established by an individual primarily for

personal, family, or household purposes. (3) “Consumer transaction” means a transaction in which an individual incurs an obliga-

tion primarily for personal, family, or household purposes. (4) “Drawee” means a person ordered in a draft to make payment. (5) “Drawer” means a person who signs or is identified in a draft as a person ordering

payment. (6) [“Good faith” means honesty in fact and the observance of reasonable commercial

standards of fair dealing.] (7) “Maker” means a person who signs or is identified in a note as a person undertaking

to pay. (8) “Order” means a written instruction to pay money signed by the person giving the

instruction. The instruction may be addressed to any person, including the person giving the instruction, or to one or more persons jointly or in the alternative but not in succession. An authorization to pay is not an order unless the person authorized to pay is also instructed to pay.

(9) “Ordinary care” in the case of a person engaged in business means observance of rea- sonable commercial standards, prevailing in the area in which the person is located, with respect to the business in which the person is engaged. In the case of a bank that takes an instrument for processing for collection or payment by automated means, reasonable commercial standards do not require the bank to examine the instrument if the failure to examine does not violate the bank’s prescribed procedures and the bank’s procedures do not vary unreasonably from general banking usage not disap- proved by this Article or Article 4.

(10) “Party” means a party to an instrument. (11) “Principal obligor,” with respect to an instrument, means the accommodated party

or any other party to the instrument against whom a secondary obligor has recourse under this article.

(12) “Promise” means a written undertaking to pay money signed by the person under- taking to pay. An acknowledgment of an obligation by the obligor is not a promise unless the obligor also undertakes to pay the obligation.

(13) “Prove” with respect to a fact means to meet the burden of establishing the fact (Section 1–201(8)).

(14) [“Record” means information that is inscribed on a tangible medium or that is stored in electronic or other medium and is retrievable in perceivable form.]

(15) “Remitter” means a person who purchases an instrument from its issuer if the instru- ment is payable to an identified person other than the purchaser.

(16) “Remotely-created consumer item” means an item drawn on a consumer account, which is not created by the payor bank and does not bear a handwritten signature purporting to be the signature of the drawer.

(17) “Secondary obligor,” with respect to an instrument, means (a) an indorser or an accommodation party, (b) a drawer having the obligation described in Section 3–414(d), or (c) any other party to the instrument that has recourse against another party to the instrument pursuant to Section 3–116(b).

(b) Other definitions applying to this Article and the sections in which they appear are:

“Acceptance” Section 3–409.

“Accommodated party” Section 3–419.

“Accommodation party” Section 3–419.

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B-60 Appendix B

“Account” Section 4–104.

“Alteration” Section 3–407.

“Anomalous indorsement” Section 3–205.

“Blank indorsement” Section 3–205.

“Cashier’s check” Section 3–104.

“Certificate of deposit” Section 3–104.

“Certified check” Section 3–409.

“Check” Section 3–104.

“Consideration” Section 3–303.

“Draft” Section 3–104.

“Holder in due course” Section 3–302.

“Incomplete instrument” Section 3–115.

“Indorsement” Section 3–204.

“Indorser” Section 3–204.

“Instrument” Section 3–104.

“Issue” Section 3–105.

“Issuer” Section 3–105.

“Negotiable instrument” Section 3–104.

“Negotiation” Section 3–201.

“Note” Section 3–104.

“Payable at a definite time” Section 3–108.

“Payable on demand” Section 3–108.

“Payable to bearer” Section 3–109.

“Payable to order” Section 3–109.

“Payment” Section 3–602.

“Person entitled to enforce” Section 3–301.

“Presentment” Section 3–501.

“Reacquisition” Section 3–207.

“Special indorsement” Section 3–205.

“Teller’s check” Section 3–104.

“Transfer of instrument” Section 3–203.

“Traveler’s check” Section 3–104.

“Value” Section 3–303.

(c) The following definitions in other Articles apply to this Article:

“Banking day” Section 4–104.

“Clearing house” Section 4–104.

“Collecting bank” Section 4–105.

“Depositary bank” Section 4–105.

“Documentary draft” Section 4–104.

“Intermediary bank” Section 4–105.

“Item” Section 4–104.

“Payor bank” Section 4–105.

“Suspends payments” Section 4–104.

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(d) In addition, Article 1 contains general definitions and principles of construction and interpretation applicable throughout this Article.

Legislative Note. A jurisdiction that enacts this statute that has not yet enacted the revised version of UCC Article 1 should add to Section 3–103 the definition of “good faith” that appears in the official version of Section 1–201(b)(20) and the definition of “record” that appears in the official version of Section 1–201(b)(31). Sections 3–103(a)(6) and (14) are reserved for that purpose. A jurisdic- tion that already has adopted or simultaneously adopts the revised Article 1 should not add those definitions, but should leave those numbers “reserved.” If jurisdictions follow the numbering sug- gested here, the subsections will have the same numbering in all jurisdictions that have adopted these amendments (whether they have or have not adopted the revised version of UCC Article 1).

§ 3–104. Negotiable Instrument.

(a) Except as provided in subsections (c) and (d), “negotiable instrument” means an uncondi- tional promise or order to pay a fixed amount of money, with or without interest or other charges described in the promise or order, if it: (1) is payable to bearer or to order at the time it is issued or first comes into possession of

a holder; (2) is payable on demand or at a definite time; and (3) does not state any other undertaking or instruction by the person promising or ordering

payment to do any act in addition to the payment of money, but the promise or order may contain (i) an undertaking or power to give, maintain, or protect collateral to secure payment, (ii) an authorization or power to the holder to confess judgment or realize on or dispose of collateral, or (iii) a waiver of the benefit of any law intended for the advantage or protection of an obligor.

(b) “Instrument” means a negotiable instrument. (c) An order that meets all of the requirements of subsection (a), except paragraph (1), and

otherwise falls within the definition of “check” in subsection (f) is a negotiable instrument and a check.

(d) A promise or order other than a check is not an instrument if, at the time it is issued or first comes into possession of a holder, it contains a conspicuous statement, however expressed, to the effect that the promise or order is not negotiable or is not an instrument governed by this Article.

(e) An instrument is a “note” if it is a promise and is a “draft” if it is an order. If an instrument falls within the definition of both “note” and “draft,” a person entitled to enforce the instru- ment may treat it as either.

(f) “Check” means (i) a draft, other than a documentary draft, payable on demand and drawn on a bank or (ii) a cashier’s check or teller’s check. An instrument may be a check even though it is described on its face by another term, such as “money order.”

(g) “Cashier’s check” means a draft with respect to which the drawer and drawee are the same bank or branches of the same bank.

(h) “Teller’s check” means a draft drawn by a bank (i) on another bank, or (ii) payable at or through a bank.

(i) “Traveler’s check” means an instrument that (i) is payable on demand, (ii) is drawn on or payable at or through a bank, (iii) is designated by the term “traveler’s check” or by a substantially similar term, and (iv) requires, as a condition to payment, a countersignature by a person whose specimen signature appears on the instrument.

(j) “Certificate of deposit” means an instrument containing an acknowledgment by a bank that a sum of money has been received by the bank and a promise by the bank to repay the sum of money. A certificate of deposit is a note of the bank.

§ 3–105. Issue of Instrument.

(a) “Issue” means the first delivery of an instrument by the maker or drawer, whether to a holder or nonholder, for the purpose of giving rights on the instrument to any person.

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(b) An unissued instrument, or an unissued incomplete instrument that is completed, is binding on the maker or drawer, but nonissuance is a defense. An instrument that is conditionally issued or is issued for a special purpose is binding on the maker or drawer, but failure of the condition or special purpose to be fulfilled is a defense.

(c) “Issuer” applies to issued and unissued instruments and means a maker or drawer of an instrument.

§ 3–106. Unconditional Promise or Order.

(a) Except as provided in this section, for the purposes of Section 3–104(a), a promise or order is unconditional unless it states (i) an express condition to payment, (ii) that the promise or order is subject to or governed by another record, or (iii) that rights or obligations with respect to the promise or order are stated in another record. A reference to another record does not of itself make the promise or order conditional.

(b) A promise or order is not made conditional (i) by a reference to another record for a state- ment of rights with respect to collateral, prepayment, or acceleration, or (ii) because pay- ment is limited to resort to a particular fund or source.

(c) If a promise or order requires, as a condition to payment, a countersignature by a person whose specimen signature appears on the promise or order, the condition does not make the promise or order conditional for the purposes of Section 3–104(a). If the person whose specimen signature appears on an instrument fails to countersign the instrument, the failure to countersign is a defense to the obligation of the issuer, but the failure does not prevent a transferee of the instrument from becoming a holder of the instrument.

(d) If a promise or order at the time it is issued or first comes into possession of a holder contains a statement, required by applicable statutory or administrative law, to the effect that the rights of a holder or transferee are subject to claims or defenses that the issuer could assert against the original payee, the promise or order is not thereby made conditional for the purposes of Section 3–104(a); but if the promise or order is an instrument, there cannot be a holder in due course of the instrument.

§ 3–107. Instrument Payable in Foreign Money. Unless the instrument other- wise provides, an instrument that states the amount payable in foreign money may be paid in the foreign money or in an equivalent amount in dollars calculated by using the current bank offered spot rate at the place of payment for the purchase of dollars on the day on which the instrument is paid.

§ 3–108. Payable on Demand or at Definite Time.

(a) A promise or order is “payable on demand” if it (i) states that it is payable on demand or at sight, or otherwise indicates that it is payable at the will of the holder, or (ii) does not state any time of payment.

(b) A promise or order is “payable at a definite time” if it is payable on elapse of a definite period of time after sight or acceptance or at a fixed date or dates or at a time or times readily ascertainable at the time the promise or order is issued, subject to rights of (i) pre- payment, (ii) acceleration, (iii) extension at the option of the holder, or (iv) extension to a further definite time at the option of the maker or acceptor or automatically upon or after a specified act or event.

(c) If an instrument, payable at a fixed date, is also payable upon demand made before the fixed date, the instrument is payable on demand until the fixed date and, if demand for payment is not made before that date, becomes payable at a definite time on the fixed date.

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§ 3–109. Payable to Bearer or to Order. (a) A promise or order is payable to bearer if it:

(1) states that it is payable to bearer or to the order of bearer or otherwise indicates that the person in possession of the promise or order is entitled to payment;

(2) does not state a payee; or (3) states that it is payable to or to the order of cash or otherwise indicates that it is not

payable to an identified person. (b) A promise or order that is not payable to bearer is payable to order if it is payable (i) to the

order of an identified person or (ii) to an identified person or order. A promise or order that is payable to order is payable to the identified person.

(c) An instrument payable to bearer may become payable to an identified person if it is spe- cially indorsed pursuant to Section 3–205(a). An instrument payable to an identified per- son may become payable to bearer if it is indorsed in blank pursuant to Section 3–205(b).

§ 3–110. Identification of Person to Whom Instrument Is Payable.

(a) The person to whom an instrument is initially payable is determined by the intent of the person, whether or not authorized, signing as, or in the name or behalf of, the issuer of the instrument. The instrument is payable to the person intended by the signer even if that person is identified in the instrument by a name or other identification that is not that of the intended person. If more than one person signs in the name or behalf of the issuer of an instrument and all the signers do not intend the same person as payee, the instrument is payable to any person intended by one or more of the signers.

(b) If the signature of the issuer of an instrument is made by automated means, such as a check writing machine, the payee of the instrument is determined by the intent of the person who supplied the name or identification of the payee, whether or not authorized to do so.

(c) A person to whom an instrument is payable may be identified in any way, including by name, identifying number, office, or account number. For the purpose of determining the holder of an instrument, the following rules apply: (1) If an instrument is payable to an account and the account is identified only by

number, the instrument is payable to the person to whom the account is payable. If an instrument is payable to an account identified by number and by the name of a person, the instrument is payable to the named person, whether or not that person is the owner of the account identified by number.

(2) If an instrument is payable to: (i) a trust, an estate, or a person described as trustee or representative of a trust or

estate, the instrument is payable to the trustee, the representative, or a successor of either, whether or not the beneficiary or estate is also named;

(ii) a person described as agent or similar representative of a named or identified person, the instrument is payable to the represented person, the representative, or a successor of the representative;

(iii) a fund or organization that is not a legal entity, the instrument is payable to a representative of the members of the fund or organization; or

(iv) an office or to a person described as holding an office, the instrument is payable to the named person, the incumbent of the office, or a successor to the incumbent.

(d) If an instrument is payable to two or more persons alternatively, it is payable to any of them and may be negotiated, discharged, or enforced by any or all of them in posses- sion of the instrument. If an instrument is payable to two or more persons not alterna- tively, it is payable to all of them and may be negotiated, discharged, or enforced only by all of them. If an instrument payable to two or more persons is ambiguous as to whether it is payable to the persons alternatively, the instrument is payable to the persons alternatively.

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§ 3–111. Place of Payment. Except as otherwise provided for items in Article 4, an instrument is payable at the place of payment stated in the instrument. If no place of payment is stated, an instrument is payable at the address of the drawee or maker stated in the instrument. If no address is stated, the place of payment is the place of business of the drawee or maker. If a drawee or maker has more than one place of business, the place of payment is any place of business of the drawee or maker chosen by the person entitled to enforce the instrument. If the drawee or maker has no place of business, the place of payment is the residence of the drawee or maker.

§ 3–112. Interest.

(a) Unless otherwise provided in the instrument, (i) an instrument is not payable with interest, and (ii) interest on an interest bearing instrument is payable from the date of the instrument.

(b) Interest may be stated in an instrument as a fixed or variable amount of money or it may be expressed as a fixed or variable rate or rates. The amount or rate of interest may be stated or described in the instrument in any manner and may require reference to informa- tion not contained in the instrument. If an instrument provides for interest, but the amount of interest payable cannot be ascertained from the description, interest is payable at the judgment rate in effect at the place of payment of the instrument and at the time interest first accrues.

§ 3–113. Date of Instrument.

(a) An instrument may be antedated or postdated. The date stated determines the time of payment if the instrument is payable at a fixed period after date. Except as provided in Section 4–401(c), an instrument payable on demand is not payable before the date of the instrument.

(b) If an instrument is undated, its date is the date of its issue or, in the case of an unissued instrument, the date it first comes into possession of a holder.

§ 3–114. Contradictory Terms of Instrument. If an instrument contains con- tradictory terms, typewritten terms prevail over printed terms, handwritten terms prevail over both, and words prevail over numbers.

§ 3–115. Incomplete Instrument.

(a) “Incomplete instrument” means a signed writing, whether or not issued by the signer, the contents of which show at the time of signing that it is incomplete but that the signer intended it to be completed by the addition of words or numbers.

(b) Subject to subsection (c), if an incomplete instrument is an instrument under Section 3–104, it may be enforced according to its terms if it is not completed, or according to its terms as augmented by completion. If an incomplete instrument is not an instrument under Section 3–104, but, after completion, the requirements of Section 3–104 are met, the instrument may be enforced according to its terms as augmented by completion.

(c) If words or numbers are added to an incomplete instrument without authority of the signer, there is an alteration of the incomplete instrument under Section 3–407.

(d) The burden of establishing that words or numbers were added to an incomplete instrument without authority of the signer is on the person asserting the lack of authority.

§ 3–116. Joint and Several Liability; Contribution.

(a) Except as otherwise provided in the instrument, two or more persons who have the same liability on an instrument as makers, drawers, acceptors, indorsers who indorse as joint payees, or anomalous indorsers are jointly and severally liable in the capacity in which they sign.

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(b) Except as provided in Section 3–419(f) or by agreement of the affected parties, a party having joint and several liability who pays the instrument is entitled to receive from any party having the same joint and several liability contribution in accordance with applicable law.

§ 3–117. Other Agreements Affecting Instrument. Subject to applicable law regarding exclusion of proof of contemporaneous or previous agreements, the obligation of a party to an instrument to pay the instrument may be modified, supplemented, or nullified by a separate agreement of the obligor and a person entitled to enforce the instrument, if the instru- ment is issued or the obligation is incurred in reliance on the agreement or as part of the same transaction giving rise to the agreement. To the extent an obligation is modified, supplemented, or nullified by an agreement under this section, the agreement is a defense to the obligation.

§ 3–118. Statute of Limitations.

(a) Except as provided in subsection (e), an action to enforce the obligation of a party to pay a note payable at a definite time must be commenced within six years after the due date or dates stated in the note or, if a due date is accelerated, within six years after the accelerated due date.

(b) Except as provided in subsection (d) or (e), if demand for payment is made to the maker of a note payable on demand, an action to enforce the obligation of a party to pay the note must be commenced within six years after the demand. If no demand for payment is made to the maker, an action to enforce the note is barred if neither principal nor interest on the note has been paid for a continuous period of 10 years.

(c) Except as provided in subsection (d), an action to enforce the obligation of a party to an unaccepted draft to pay the draft must be commenced within three years after dishonor of the draft or 10 years after the date of the draft, whichever period expires first.

(d) An action to enforce the obligation of the acceptor of a certified check or the issuer of a teller’s check, cashier’s check, or traveler’s check must be commenced within three years after demand for payment is made to the acceptor or issuer, as the case may be.

(e) An action to enforce the obligation of a party to a certificate of deposit to pay the instru- ment must be commenced within six years after demand for payment is made to the maker, but if the instrument states a due date and the maker is not required to pay before that date, the six-year period begins when a demand for payment is in effect and the due date has passed.

(f) An action to enforce the obligation of a party to pay an accepted draft, other than a certi- fied check, must be commenced (i) within six years after the due date or dates stated in the draft or acceptance if the obligation of the acceptor is payable at a definite time, or (ii) within six years after the date of the acceptance if the obligation of the acceptor is pay- able on demand.

(g) Unless governed by other law regarding claims for indemnity or contribution, an action (i) for conversion of an instrument, for money had and received, or like action based on conversion, (ii) for breach of warranty, or (iii) to enforce an obligation, duty, or right aris- ing under this Article and not governed by this section must be commenced within three years after the [cause of action] accrues.

§ 3–119. Notice of Right to Defend Action. In an action for breach of an obliga- tion for which a third person is answerable over pursuant to this Article or Article 4, the defen- dant may give the third person notice of the litigation in a record, and the person notified may then give similar notice to any other person who is answerable over. If the notice states (i) that the person notified may come in and defend and (ii) that failure to do so will bind the person notified in an action later brought by the person giving the notice as to any determination of fact common to the two litigations, the person notified is so bound unless after seasonable receipt of the notice the person notified does come in and defend.

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PART 2: NEGOTIATION, TRANSFER, AND INDORSEMENT § 3–201. Negotiation.

(a) “Negotiation” means a transfer of possession, whether voluntary or involuntary, of an instrument by a person other than the issuer to a person who thereby becomes its holder.

(b) Except for negotiation by a remitter, if an instrument is payable to an identified person, nego- tiation requires transfer of possession of the instrument and its indorsement by the holder. If an instrument is payable to bearer, it may be negotiated by transfer of possession alone.

§ 3–202. Negotiation Subject to Rescission.

(a) Negotiation is effective even if obtained (i) from an infant, a corporation exceeding its powers, or a person without capacity, (ii) by fraud, duress, or mistake, or (iii) in breach of duty or as part of an illegal transaction.

(b) To the extent permitted by other law, negotiation may be rescinded or may be subject to other remedies, but those remedies may not be asserted against a subsequent holder in due course or a person paying the instrument in good faith and without knowledge of facts that are a basis for rescission or other remedy.

§ 3–203. Transfer of Instrument; Rights Acquired by Transfer.

(a) An instrument is transferred when it is delivered by a person other than its issuer for the purpose of giving to the person receiving delivery the right to enforce the instrument.

(b) Transfer of an instrument, whether or not the transfer is a negotiation, vests in the trans- feree any right of the transferor to enforce the instrument, including any right as a holder in due course, but the transferee cannot acquire rights of a holder in due course by a transfer, directly or indirectly, from a holder in due course if the transferee engaged in fraud or ille- gality affecting the instrument.

(c) Unless otherwise agreed, if an instrument is transferred for value and the transferee does not become a holder because of lack of indorsement by the transferor, the transferee has a specifically enforceable right to the unqualified indorsement of the transferor, but negotia- tion of the instrument does not occur until the indorsement is made.

(d) If a transferor purports to transfer less than the entire instrument, negotiation of the instru- ment does not occur. The transferee obtains no rights under this Article and has only the rights of a partial assignee.

§ 3–204. Indorsement.

(a) “Indorsement” means a signature, other than that of a signer as maker, drawer, or accep- tor, that alone or accompanied by other words is made on an instrument for the purpose of (i) negotiating the instrument, (ii) restricting payment of the instrument, or (iii) incurring indorser’s liability on the instrument, but regardless of the intent of the signer, a signature and its accompanying words is an indorsement unless the accompanying words, terms of the instrument, place of the signature, or other circumstances unambiguously indicate that the signature was made for a purpose other than indorsement. For the purpose of determin- ing whether a signature is made on an instrument, a paper affixed to the instrument is a part of the instrument.

(b) “Indorser” means a person who makes an indorsement. (c) For the purpose of determining whether the transferee of an instrument is a holder, an

indorsement that transfers a security interest in the instrument is effective as an unqualified indorsement of the instrument.

(d) If an instrument is payable to a holder under a name that is not the name of the holder, indorsement may be made by the holder in the name stated in the instrument or in the holder’s name or both, but signature in both names may be required by a person paying or taking the instrument for value or collection.

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§ 3–205. Special Indorsement; Blank Indorsement; Anomalous Indorsement.

(a) If an indorsement is made by the holder of an instrument, whether payable to an identi- fied person or payable to bearer, and the indorsement identifies a person to whom it makes the instrument payable, it is a “special indorsement.” When specially indorsed, an instrument becomes payable to the identified person and may be negotiated only by the indorsement of that person. The principles stated in Section 3–110 apply to special indorsements.

(b) If an indorsement is made by the holder of an instrument and it is not a special indorse- ment, it is a “blank indorsement.” When indorsed in blank, an instrument becomes pay- able to bearer and may be negotiated by transfer of possession alone until specially indorsed.

(c) The holder may convert a blank indorsement that consists only of a signature into a special indorsement by writing, above the signature of the indorser, words identifying the person to whom the instrument is made payable.

(d) “Anomalous indorsement” means an indorsement made by a person who is not the holder of the instrument. An anomalous indorsement does not affect the manner in which the instrument may be negotiated.

§ 3–206. Restrictive Indorsement.

(a) An indorsement limiting payment to a particular person or otherwise prohibiting further transfer or negotiation of the instrument is not effective to prevent further transfer or nego- tiation of the instrument.

(b) An indorsement stating a condition to the right of the indorsee to receive payment does not affect the right of the indorsee to enforce the instrument. A person paying the instrument or taking it for value or collection may disregard the condition, and the rights and liabilities of that person are not affected by whether the condition has been fulfilled.

(c) If an instrument bears an indorsement (i) described in Section 4–201(b), or (ii) in blank or to a particular bank using the words “for deposit,” “for collection,” or other words indicat- ing a purpose of having the instrument collected by a bank for the indorser or for a particu- lar account, the following rules apply: (1) A person, other than a bank, who purchases the instrument when so indorsed converts

the instrument unless the amount paid for the instrument is received by the indorser or applied consistently with the indorsement.

(2) A depositary bank that purchases the instrument or takes it for collection when so indorsed converts the instrument unless the amount paid by the bank with respect to the instrument is received by the indorser or applied consistently with the indorsement.

(3) A payor bank that is also the depositary bank or that takes the instrument for imme- diate payment over the counter from a person other than a collecting bank converts the instrument unless the proceeds of the instrument are received by the indorser or applied consistently with the indorsement.

(4) Except as otherwise provided in paragraph (3), a payor bank or intermediary bank may disregard the indorsement and is not liable if the proceeds of the instrument are not received by the indorser or applied consistently with the indorsement.

(d) Except for an indorsement covered by subsection (c), if an instrument bears an indorse- ment using words to the effect that payment is to be made to the indorsee as agent, trustee, or other fiduciary for the benefit of the indorser or another person, the following rules apply: (1) Unless there is notice of breach of fiduciary duty as provided in Section 3–307,

a person who purchases the instrument from the indorsee or takes the instrument from the indorsee for collection or payment may pay the proceeds of payment or the value given for the instrument to the indorsee without regard to whether the indorsee violates a fiduciary duty to the indorser.

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(2) A subsequent transferee of the instrument or person who pays the instrument is neither given notice nor otherwise affected by the restriction in the indorsement unless the transferee or payor knows that the fiduciary dealt with the instrument or its proceeds in breach of fiduciary duty.

(e) The presence on an instrument of an indorsement to which this section applies does not prevent a purchaser of the instrument from becoming a holder in due course of the instru- ment unless the purchaser is a converter under subsection (c) or has notice or knowledge of breach of fiduciary duty as stated in subsection (d).

(f) In an action to enforce the obligation of a party to pay the instrument, the obligor has a defense if payment would violate an indorsement to which this section applies and the pay- ment is not permitted by this section.

§ 3–207. Reacquisition. Reacquisition of an instrument occurs if it is transferred to a former holder, by negotiation or otherwise. A former holder who reacquires the instrument may cancel indorsements made after the reacquirer first became a holder of the instrument. If the cancellation causes the instrument to be payable to the reacquirer or to bearer, the reacquirer may negotiate the instrument. An indorser whose indorsement is canceled is discharged, and the discharge is effective against any subsequent holder.

PART 3: ENFORCEMENT OF INSTRUMENTS § 3–301. Person Entitled to Enforce Instrument. “Person entitled to enforce” an instrument means (i) the holder of the instrument, (ii) a nonholder in possession of the instrument who has the rights of a holder, or (iii) a person not in possession of the instrument who is entitled to enforce the instrument pursuant to Section 3–309 or 3–418(d). A person may be a person entitled to enforce the instrument even though the person is not the owner of the instrument or is in wrongful possession of the instrument.

§ 3–302. Holder in Due Course.

(a) Subject to subsection (c) and Section 3–106(d), “holder in due course” means the holder of an instrument if: (1) the instrument when issued or negotiated to the holder does not bear such apparent

evidence of forgery or alteration or is not otherwise so irregular or incomplete as to call into question its authenticity; and

(2) the holder took the instrument (i) for value, (ii) in good faith, (iii) without notice that the instrument is overdue or has been dishonored or that there is an uncured default with respect to payment of another instrument issued as part of the same series, (iv) without notice that the instrument contains an unauthorized signature or has been altered, (v) without notice of any claim to the instrument described in Section 3–306, and (vi) without notice that any party has a defense or claim in recoupment described in Section 3–305(a).

(b) Notice of discharge of a party, other than discharge in an insolvency proceeding, is not notice of a defense under subsection (a), but discharge is effective against a person who became a holder in due course with notice of the discharge. Public filing or recording of a document does not of itself constitute notice of a defense, claim in recoupment, or claim to the instrument.

(c) Except to the extent a transferor or predecessor in interest has rights as a holder in due course, a person does not acquire rights of a holder in due course of an instrument taken (i) by legal process or by purchase in an execution, bankruptcy, or creditor’s sale or similar proceeding, (ii) by purchase as part of a bulk transaction not in ordinary course of business of the transferor, or (iii) as the successor in interest to an estate or other organization.

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(d) If, under Section 3–303(a)(1), the promise of performance that is the consideration for an instrument has been partially performed, the holder may assert rights as a holder in due course of the instrument only to the fraction of the amount payable under the instrument equal to the value of the partial performance divided by the value of the promised performance.

(e) If (i) the person entitled to enforce an instrument has only a security interest in the instru- ment and (ii) the person obliged to pay the instrument has a defense, claim in recoup- ment, or claim to the instrument that may be asserted against the person who granted the security interest, the person entitled to enforce the instrument may assert rights as a holder in due course only to an amount payable under the instrument which, at the time of enforcement of the instrument, does not exceed the amount of the unpaid obligation secured.

(f) To be effective, notice must be received at a time and in a manner that gives a reasonable opportunity to act on it.

(g) This section is subject to any law limiting status as a holder in due course in particular classes of transactions.

§ 3–303. Value and Consideration.

(a) An instrument is issued or transferred for value if: (1) the instrument is issued or transferred for a promise of performance, to the extent the

promise has been performed; (2) the transferee acquires a security interest or other lien in the instrument other than a

lien obtained by judicial proceeding; (3) the instrument is issued or transferred as payment of, or as security for, an antecedent

claim against any person, whether or not the claim is due; (4) the instrument is issued or transferred in exchange for a negotiable instrument; or (5) the instrument is issued or transferred in exchange for the incurring of an irrevocable

obligation to a third party by the person taking the instrument. (b) “Consideration” means any consideration sufficient to support a simple contract. The

drawer or maker of an instrument has a defense if the instrument is issued without consid- eration. If an instrument is issued for a promise of performance, the issuer has a defense to the extent performance of the promise is due and the promise has not been performed. If an instrument is issued for value as stated in subsection (a), the instrument is also issued for consideration.

§ 3–304. Overdue Instrument.

(a) An instrument payable on demand becomes overdue at the earliest of the following times: (1) on the day after the day demand for payment is duly made; (2) if the instrument is a check, 90 days after its date; or (3) if the instrument is not a check, when the instrument has been outstanding for a

period of time after its date which is unreasonably long under the circumstances of the particular case in light of the nature of the instrument and usage of the trade.

(b) With respect to an instrument payable at a definite time the following rules apply: (1) If the principal is payable in installments and a due date has not been accelerated, the

instrument becomes overdue upon default under the instrument for nonpayment of an installment, and the instrument remains overdue until the default is cured.

(2) If the principal is not payable in installments and the due date has not been acceler- ated, the instrument becomes overdue on the day after the due date.

(3) If a due date with respect to principal has been accelerated, the instrument becomes overdue on the day after the accelerated due date.

(c) Unless the due date of principal has been accelerated, an instrument does not become overdue if there is default in payment of interest but no default in payment of principal.

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§ 3–305. Defenses and Claims in Recoupment; Claims in Consumer Transactions.

(a) Except as otherwise provided in this section, the right to enforce the obligation of a party to pay an instrument is subject to the following: (1) a defense of the obligor based on (i) infancy of the obligor to the extent it is a defense

to a simple contract, (ii) duress, lack of legal capacity, or illegality of the transaction which, under other law, nullifies the obligation of the obligor, (iii) fraud that induced the obligor to sign the instrument with neither knowledge nor reasonable opportunity to learn of its character or its essential terms, or (iv) discharge of the obligor in insol- vency proceedings;

(2) a defense of the obligor stated in another section of this Article or a defense of the obligor that would be available if the person entitled to enforce the instrument were enforcing a right to payment under a simple contract; and

(3) a claim in recoupment of the obligor against the original payee of the instrument if the claim arose from the transaction that gave rise to the instrument; but the claim of the obligor may be asserted against a transferee of the instrument only to reduce the amount owing on the instrument at the time the action is brought.

(b) The right of a holder in due course to enforce the obligation of a party to pay the instru- ment is subject to defenses of the obligor stated in subsection (a)(1), but is not subject to defenses of the obligor stated in subsection (a)(2) or claims in recoupment stated in subsec- tion (a)(3) against a person other than the holder.

(c) Except as stated in subsection (d), in an action to enforce the obligation of a party to pay the instrument, the obligor may not assert against the person entitled to enforce the instru- ment a defense, claim in recoupment, or claim to the instrument (Section 3–306) of another person, but the other person’s claim to the instrument may be asserted by the obligor if the other person is joined in the action and personally asserts the claim against the person enti- tled to enforce the instrument. An obligor is not obliged to pay the instrument if the person seeking enforcement of the instrument does not have rights of a holder in due course and the obligor proves that the instrument is a lost or stolen instrument.

(d) In an action to enforce the obligation of an accommodation party to pay an instrument, the accommodation party may assert against the person entitled to enforce the instrument any defense or claim in recoupment under subsection (a) that the accommodated party could assert against the person entitled to enforce the instrument, except the defenses of discharge in insolvency proceedings, infancy, and lack of legal capacity.

(e) In a consumer transaction, if law other than this article requires that an instrument include a statement to the effect that the rights of a holder or transferee are subject to a claim or defense that the issuer could assert against the original payee, and the instrument does not include such a statement: (1) the instrument has the same effect as if the instrument included such a statement; (2) the issuer may assert against the holder or transferee all claims and defenses that

would have been available if the instrument included such a statement; and (3) the extent to which claims may be asserted against the holder or transferee is deter-

mined as if the instrument included such a statement. (f) This section is subject to law other than this article that establishes a different rule for

consumer transactions.

Legislative Note: If a consumer protection law in this state addresses the same issue as subsec- tion (g), it should be examined for consistency with subsection (g) and, if inconsistent, should be amended.

§ 3–306. Claims to an Instrument. A person taking an instrument, other than a person having rights of a holder in due course, is subject to a claim of a property or possessory right in the instrument or its proceeds, including a claim to rescind a negotiation and to recover the instrument or its proceeds. A person having rights of a holder in due course takes free of the claim to the instrument.

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§ 3–307. Notice of Breach of Fiduciary Duty.

(a) In this section: (1) “Fiduciary” means an agent, trustee, partner, corporate officer or director, or other

representative owing a fiduciary duty with respect to an instrument. (2) “Represented person” means the principal, beneficiary, partnership, corporation, or

other person to whom the duty stated in paragraph (1) is owed. (b) If (i) an instrument is taken from a fiduciary for payment or collection or for value,

(ii) the taker has knowledge of the fiduciary status of the fiduciary, and (iii) the represented person makes a claim to the instrument or its proceeds on the basis that the transaction of the fiduciary is a breach of fiduciary duty, the following rules apply: (1) Notice of breach of fiduciary duty by the fiduciary is notice of the claim of the repre-

sented person. (2) In the case of an instrument payable to the represented person or the fiduciary as such,

the taker has notice of the breach of fiduciary duty if the instrument is (i) taken in payment of or as security for a debt known by the taker to be the personal debt of the fiduciary, (ii) taken in a transaction known by the taker to be for the personal benefit of the fiduciary, or (iii) deposited to an account other than an account of the fiduciary, as such, or an account of the represented person.

(3) If an instrument is issued by the represented person or the fiduciary as such, and made payable to the fiduciary personally, the taker does not have notice of the breach of fiduciary duty unless the taker knows of the breach of fiduciary duty.

(4) If an instrument is issued by the represented person or the fiduciary as such, to the taker as payee, the taker has notice of the breach of fiduciary duty if the instrument is (i) taken in payment of or as security for a debt known by the taker to be the personal debt of the fiduciary, (ii) taken in a transaction known by the taker to be for the per- sonal benefit of the fiduciary, or (iii) deposited to an account other than an account of the fiduciary, as such, or an account of the represented person.

§ 3–308. Proof of Signatures and Status as Holder in Due Course.

(a) In an action with respect to an instrument, the authenticity of, and authority to make, each signature on the instrument is admitted unless specifically denied in the pleadings. If the validity of a signature is denied in the pleadings, the burden of establishing validity is on the person claiming validity, but the signature is presumed to be authentic and authorized unless the action is to enforce the liability of the purported signer and the signer is dead or incompetent at the time of trial of the issue of validity of the signature. If an action to enforce the instrument is brought against a person as the undisclosed principal of a person who signed the instrument as a party to the instrument, the plaintiff has the burden of establishing that the defendant is liable on the instrument as a represented person under Section 3–402(a).

(b) If the validity of signatures is admitted or proved and there is compliance with subsection (a), a plaintiff producing the instrument is entitled to payment if the plaintiff proves entitlement to enforce the instrument under Section 3–301, unless the defendant proves a defense or claim in recoupment. If a defense or claim in recoupment is proved, the right to payment of the plaintiff is subject to the defense or claim, except to the extent the plaintiff proves that the plaintiff has rights of a holder in due course which are not subject to the defense or claim.

§ 3–309. Enforcement of Lost, Destroyed, or Stolen Instrument.

(a) A person not in possession of an instrument is entitled to enforce the instrument if: (1) the person seeking to enforce the instrument: (i) was entitled to enforce the instrument when loss of possession occurred; or (ii) has directly or indirectly acquired ownership of the instrument from a person

who was entitled to enforce the instrument when loss of possession occurred;

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(2) the loss of possession was not the result of a transfer by the person or a lawful seizure; and

(3) the person cannot reasonably obtain possession of the instrument because the instru- ment was destroyed, its whereabouts cannot be determined, or it is in the wrongful possession of an unknown person or a person that cannot be found or is not amenable to service of process.

(b) A person seeking enforcement of an instrument under subsection (a) must prove the terms of the instrument and the person’s right to enforce the instrument. If that proof is made, Section 3–308 applies to the case as if the person seeking enforcement had produced the instrument. The court may not enter judgment in favor of the person seeking enforcement unless it finds that the person required to pay the instrument is adequately protected against loss that might occur by reason of a claim by another person to enforce the instrument. Adequate protection may be provided by any reasonable means.

§ 3–310. Effect of Instrument on Obligation for Which Taken.

(a) Unless otherwise agreed, if a certified check, cashier’s check, or teller’s check is taken for an obligation, the obligation is discharged to the same extent discharge would result if an amount of money equal to the amount of the instrument were taken in payment of the obli- gation. Discharge of the obligation does not affect any liability that the obligor may have as an indorser of the instrument.

(b) Unless otherwise agreed and except as provided in subsection (a), if a note or an uncerti- fied check is taken for an obligation, the obligation is suspended to the same extent the obligation would be discharged if an amount of money equal to the amount of the instru- ment were taken, and the following rules apply: (1) In the case of an uncertified check, suspension of the obligation continues until dis-

honor of the check or until it is paid or certified. Payment or certification of the check results in discharge of the obligation to the extent of the amount of the check.

(2) In the case of a note, suspension of the obligation continues until dishonor of the note or until it is paid. Payment of the note results in discharge of the obligation to the extent of the payment.

(3) Except as provided in paragraph (4), if the check or note is dishonored and the obligee of the obligation for which the instrument was taken is the person entitled to enforce the instrument, the obligee may enforce either the instrument or the obligation. In the case of an instrument of a third person which is negotiated to the obligee by the obligor, discharge of the obligor on the instrument also discharges the obligation.

(4) If the person entitled to enforce the instrument taken for an obligation is a person other than the obligee, the obligee may not enforce the obligation to the extent the obligation is suspended. If the obligee is the person entitled to enforce the instrument but no longer has possession of it because it was lost, stolen, or destroyed, the obliga- tion may not be enforced to the extent of the amount payable on the instrument, and to that extent the obligee’s rights against the obligor are limited to enforcement of the instrument.

(c) If an instrument other than one described in subsection (a) or (b) is taken for an obligation, the effect is (i) that stated in subsection (a) if the instrument is one on which a bank is liable as maker or acceptor, or (ii) that stated in subsection (b) in any other case.

§ 3–311. Accord and Satisfaction by Use of Instrument.

(a) If a person against whom a claim is asserted proves that (i) that person in good faith ten- dered an instrument to the claimant as full satisfaction of the claim, (ii) the amount of the claim was unliquidated or subject to a bona fide dispute, and (iii) the claimant obtained payment of the instrument, the following subsections apply.

(b) Unless subsection (c) applies, the claim is discharged if the person against whom the claim is asserted proves that the instrument or an accompanying written communication

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contained a conspicuous statement to the effect that the instrument was tendered as full satisfaction of the claim.

(c) Subject to subsection (d), a claim is not discharged under subsection (b) if either of the following applies: (1) The claimant, if an organization, proves that (i) within a reasonable time before the

tender, the claimant sent a conspicuous statement to the person against whom the claim is asserted that communications concerning disputed debts, including an instru- ment tendered as full satisfaction of a debt, are to be sent to a designated person, office, or place, and (ii) the instrument or accompanying communication was not received by that designated person, office, or place.

(2) The claimant, whether or not an organization, proves that within 90 days after payment of the instrument, the claimant tendered repayment of the amount of the instrument to the person against whom the claim is asserted. This paragraph does not apply if the claimant is an organization that sent a statement complying with paragraph (1)(i).

(d) A claim is discharged if the person against whom the claim is asserted proves that within a reasonable time before collection of the instrument was initiated, the claimant, or an agent of the claimant having direct responsibility with respect to the disputed obligation, knew that the instrument was tendered in full satisfaction of the claim.

§ 3–312. Lost, Destroyed, or Stolen Cashier’s Check, Teller’s Check, or Certified Check.

(a) In this section: (1) “Check” means a cashier’s check, teller’s check, or certified check. (2) “Claimant” means a person who claims the right to receive the amount of a cashier’s

check, teller’s check, or certified check that was lost, destroyed, or stolen. (3) “Declaration of loss” means a statement, made in a record under penalty of perjury,

to the effect that (i) the declarer lost possession of a check, (ii) the declarer is the drawer or payee of the check, in the case of a certified check, or the remitter or payee of the check, in the case of a cashier’s check or teller’s check, (iii) the loss of possession was not the result of a transfer by the declarer or a lawful seizure, and (iv) the declarer cannot reasonably obtain possession of the check because the check was destroyed, its whereabouts cannot be determined, or it is in the wrongful pos- session of an unknown person or a person that cannot be found or is not amenable to service of process.

(4) “Obligated bank” means the issuer of a cashier’s check or teller’s check or the accep- tor of a certified check.

(b) A claimant may assert a claim to the amount of a check by a communication to the obli- gated bank describing the check with reasonable certainty and requesting payment of the amount of the check, if (i) the claimant is the drawer or payee of a certified check or the remitter or payee of a cashier’s check or teller’s check, (ii) the communication contains or is accompanied by a declaration of loss of the claimant with respect to the check, (iii) the communication is received at a time and in a manner affording the bank a reasonable time to act on it before the check is paid, and (iv) the claimant provides reasonable identification if requested by the obligated bank. Delivery of a declaration of loss is a warranty of the truth of the statements made in the declaration. If a claim is asserted in compliance with this subsection, the following rules apply: (1) The claim becomes enforceable at the later of (i) the time the claim is asserted, or

(ii) the 90th day following the date of the check, in the case of a cashier’s check or teller’s check, or the 90th day following the date of the acceptance, in the case of a certified check.

(2) Until the claim becomes enforceable, it has no legal effect and the obligated bank may pay the check or, in the case of a teller’s check, may permit the drawee to pay the check. Payment to a person entitled to enforce the check discharges all liability of the obligated bank with respect to the check.

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(3) If the claim becomes enforceable before the check is presented for payment, the obligated bank is not obliged to pay the check.

(4) When the claim becomes enforceable, the obligated bank becomes obliged to pay the amount of the check to the claimant if payment of the check has not been made to a person entitled to enforce the check. Subject to Section 4–302(a)(1), payment to the claimant discharges all liability of the obligated bank with respect to the check.

(c) If the obligated bank pays the amount of a check to a claimant under subsection (b)(4) and the check is presented for payment by a person having rights of a holder in due course, the claimant is obliged to (i) refund the payment to the obligated bank if the check is paid, or (ii) pay the amount of the check to the person having rights of a holder in due course if the check is dishonored.

(d) If a claimant has the right to assert a claim under subsection (b) and is also a person entitled to enforce a cashier’s check, teller’s check, or certified check which is lost, destroyed, or stolen, the claimant may assert rights with respect to the check either under this section or Section 3–309.

PART 4: LIABILITY OF PARTIES § 3–401. Signature.

(a) A person is not liable on an instrument unless (i) the person signed the instrument, or (ii) the person is represented by an agent or representative who signed the instrument and the signature is binding on the represented person under Section 3–402.

(b) A signature may be made (i) manually or by means of a device or machine, and (ii) by the use of any name, including a trade or assumed name, or by a word, mark, or symbol executed or adopted by a person with present intention to authenticate a writing.

§ 3–402. Signature by Representative.

(a) If a person acting, or purporting to act, as a representative signs an instrument by sign- ing either the name of the represented person or the name of the signer, the represented person is bound by the signature to the same extent the represented person would be bound if the signature were on a simple contract. If the represented person is bound, the signature of the representative is the “authorized signature of the represented person” and the represented person is liable on the instrument, whether or not identified in the instrument.

(b) If a representative signs the name of the representative to an instrument and the signature is an authorized signature of the represented person, the following rules apply: (1) If the form of the signature shows unambiguously that the signature is made on behalf

of the represented person who is identified in the instrument, the representative is not liable on the instrument.

(2) Subject to subsection (c), if (i) the form of the signature does not show unambigu- ously that the signature is made in a representative capacity or (ii) the represented person is not identified in the instrument, the representative is liable on the instru- ment to a holder in due course that took the instrument without notice that the rep- resentative was not intended to be liable on the instrument. With respect to any other person, the representative is liable on the instrument unless the representative proves that the original parties did not intend the representative to be liable on the instrument.

(c) If a representative signs the name of the representative as drawer of a check without indi- cation of the representative status and the check is payable from an account of the repre- sented person who is identified on the check, the signer is not liable on the check if the signature is an authorized signature of the represented person.

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§ 3–403. Unauthorized Signature.

(a) Unless otherwise provided in this Article or Article 4, an unauthorized signature is inef- fective except as the signature of the unauthorized signer in favor of a person who in good faith pays the instrument or takes it for value. An unauthorized signature may be ratified for all purposes of this Article.

(b) If the signature of more than one person is required to constitute the authorized signature of an organization, the signature of the organization is unauthorized if one of the required signatures is lacking.

(c) The civil or criminal liability of a person who makes an unauthorized signature is not affected by any provision of this Article which makes the unauthorized signature effective for the purposes of this Article.

§ 3–404. Impostors; Fictitious Payees.

(a) If an impostor, by use of the mails or otherwise, induces the issuer of an instrument to issue the instrument to the impostor, or to a person acting in concert with the impostor, by impersonating the payee of the instrument or a person authorized to act for the payee, an indorsement of the instrument by any person in the name of the payee is effective as the indorsement of the payee in favor of a person who, in good faith, pays the instrument or takes it for value or for collection.

(b) If (i) a person whose intent determines to whom an instrument is payable (Section 3–110(a) or (b)) does not intend the person identified as payee to have any interest in the instrument, or (ii) the person identified as payee of an instrument is a fictitious person, the following rules apply until the instrument is negotiated by special indorsement: (1) Any person in possession of the instrument is its holder. (2) An indorsement by any person in the name of the payee stated in the instrument is

effective as the indorsement of the payee in favor of a person who, in good faith, pays the instrument or takes it for value or for collection.

(c) Under subsection (a) or (b), an indorsement is made in the name of a payee if (i) it is made in a name substantially similar to that of the payee or (ii) the instrument, whether or not indorsed, is deposited in a depositary bank to an account in a name substantially similar to that of the payee.

(d) With respect to an instrument to which subsection (a) or (b) applies, if a person paying the instrument or taking it for value or for collection fails to exercise ordinary care in paying or taking the instrument and that failure substantially contributes to loss resulting from payment of the instrument, the person bearing the loss may recover from the person failing to exercise ordinary care to the extent the failure to exercise ordinary care contributed to the loss.

§ 3–405. Employer’s Responsibility for Fraudulent Indorsement by Employee.

(a) In this section: (1) “Employee” includes an independent contractor and employee of an independent con-

tractor retained by the employer. (2) “Fraudulent indorsement” means (i) in the case of an instrument payable to the

employer, a forged indorsement purporting to be that of the employer, or (ii) in the case of an instrument with respect to which the employer is the issuer, a forged indorsement purporting to be that of the person identified as payee.

(3) “Responsibility” with respect to instruments means authority (i) to sign or indorse instruments on behalf of the employer, (ii) to process instruments received by the employer for bookkeeping purposes, for deposit to an account, or for other disposi- tion, (iii) to prepare or process instruments for issue in the name of the employer,

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(iv) to supply information determining the names or addresses of payees of instruments to be issued in the name of the employer, (v) to control the disposition of instru- ments to be issued in the name of the employer, or (vi) to act otherwise with respect to instruments in a responsible capacity. “Responsibility” does not include authority that merely allows an employee to have access to instruments or blank or incom- plete instrument forms that are being stored or transported or are part of incoming or outgoing mail, or similar access.

(b) For the purpose of determining the rights and liabilities of a person who, in good faith, pays an instrument or takes it for value or for collection, if an employer entrusted an employee with responsibility with respect to the instrument and the employee or a person acting in concert with the employee makes a fraudulent indorsement of the instrument, the indorsement is effective as the indorsement of the person to whom the instrument is payable if it is made in the name of that person. If the person paying the instrument or taking it for value or for collection fails to exercise ordinary care in paying or taking the instrument and that failure substantially contributes to loss result- ing from the fraud, the person bearing the loss may recover from the person failing to exercise ordinary care to the extent the failure to exercise ordinary care contributed to the loss.

(c) Under subsection (b), an indorsement is made in the name of the person to whom an instru- ment is payable if (i) it is made in a name substantially similar to the name of that person or (ii) the instrument, whether or not indorsed, is deposited in a depositary bank to an account in a name substantially similar to the name of that person.

§ 3–406. Negligence Contributing to Forged Signature or Alteration of Instrument.

(a) A person whose failure to exercise ordinary care substantially contributes to an alteration of an instrument or to the making of a forged signature on an instrument is precluded from asserting the alteration or the forgery against a person who, in good faith, pays the instru- ment or takes it for value or for collection.

(b) Under subsection (a), if the person asserting the preclusion fails to exercise ordinary care in paying or taking the instrument and that failure substantially contributes to loss, the loss is allocated between the person precluded and the person asserting the preclusion according to the extent to which the failure of each to exercise ordinary care contributed to the loss.

(c) Under subsection (a), the burden of proving failure to exercise ordinary care is on the per- son asserting the preclusion. Under subsection (b), the burden of proving failure to exercise ordinary care is on the person precluded.

§ 3–407. Alteration.

(a) “Alteration” means (i) an unauthorized change in an instrument that purports to modify in any respect the obligation of a party, or (ii) an unauthorized addition of words or num- bers or other change to an incomplete instrument relating to the obligation of a party.

(b) Except as provided in subsection (c), an alteration fraudulently made discharges a party whose obligation is affected by the alteration unless that party assents or is precluded from asserting the alteration. No other alteration discharges a party, and the instrument may be enforced according to its original terms.

(c) A payor bank or drawee paying a fraudulently altered instrument or a person taking it for value, in good faith and without notice of the alteration, may enforce rights with respect to the instrument (i) according to its original terms, or (ii) in the case of an incomplete instrument altered by unauthorized completion, according to its terms as completed.

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§ 3–408. Drawee Not Liable on Unaccepted Draft. A check or other draft does not of itself operate as an assignment of funds in the hands of the drawee available for its payment, and the drawee is not liable on the instrument until the drawee accepts it.

§ 3–409. Acceptance of Draft; Certified Check.

(a) “Acceptance” means the drawee’s signed agreement to pay a draft as presented. It must be written on the draft and may consist of the drawee’s signature alone. Acceptance may be made at any time and becomes effective when notification pursuant to instructions is given or the accepted draft is delivered for the purpose of giving rights on the acceptance to any person.

(b) A draft may be accepted although it has not been signed by the drawer, is otherwise incom- plete, is overdue, or has been dishonored.

(c) If a draft is payable at a fixed period after sight and the acceptor fails to date the accep- tance, the holder may complete the acceptance by supplying a date in good faith.

(d) “Certified check” means a check accepted by the bank on which it is drawn. Acceptance may be made as stated in subsection (a) or by a writing on the check which indicates that the check is certified. The drawee of a check has no obligation to certify the check, and refusal to certify is not dishonor of the check.

§ 3–410. Acceptance Varying Draft.

(a) If the terms of a drawee’s acceptance vary from the terms of the draft as presented, the holder may refuse the acceptance and treat the draft as dishonored. In that case, the drawee may cancel the acceptance.

(b) The terms of a draft are not varied by an acceptance to pay at a particular bank or place in the United States, unless the acceptance states that the draft is to be paid only at that bank or place.

(c) If the holder assents to an acceptance varying the terms of a draft, the obligation of each drawer and indorser that does not expressly assent to the acceptance is discharged.

§ 3–411. Refusal to Pay Cashier’s Checks, Teller’s Checks, and Certi- fied Checks.

(a) In this section, “obligated bank” means the acceptor of a certified check or the issuer of a cashier’s check or teller’s check bought from the issuer.

(b) If the obligated bank wrongfully (i) refuses to pay a cashier’s check or certified check, (ii) stops payment of a teller’s check, or (iii) refuses to pay a dishonored teller’s check, the person asserting the right to enforce the check is entitled to compensation for expenses and loss of interest resulting from the nonpayment and may recover consequential damages if the obligated bank refuses to pay after receiving notice of particular circumstances giving rise to the damages.

(c) Expenses or consequential damages under subsection (b) are not recoverable if the refusal of the obligated bank to pay occurs because (i) the bank suspends payments, (ii) the obli- gated bank asserts a claim or defense of the bank that it has reasonable grounds to believe is available against the person entitled to enforce the instrument, (iii) the obligated bank has a reasonable doubt whether the person demanding payment is the person entitled to enforce the instrument, or (iv) payment is prohibited by law.

§ 3–412. Obligation of Issuer of Note or Cashier’s Check. The issuer of a note or cashier’s check or other draft drawn on the drawer is obliged to pay the instrument (i) according to its terms at the time it was issued or, if not issued, at the time it first came into possession of a holder, or (ii) if the issuer signed an incomplete instrument, according to its

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terms when completed, to the extent stated in Sections 3–115 and 3–407. The obligation is owed to a person entitled to enforce the instrument or to an indorser who paid the instrument under Section 3–415.

§ 3–413. Obligation of Acceptor.

(a) The acceptor of a draft is obliged to pay the draft (i) according to its terms at the time it was accepted, even though the acceptance states that the draft is payable “as originally drawn” or equivalent terms, (ii) if the acceptance varies the terms of the draft, according to the terms of the draft as varied, or (iii) if the acceptance is of a draft that is an incomplete instrument, according to its terms when completed, to the extent stated in Sections 3–115 and 3–407. The obligation is owed to a person entitled to enforce the draft or to the drawer or an indorser who paid the draft under Section 3–414 or 3–415.

(b) If the certification of a check or other acceptance of a draft states the amount certified or accepted, the obligation of the acceptor is that amount. If (i) the certification or acceptance does not state an amount, (ii) the amount of the instrument is subsequently raised, and (iii) the instrument is then negotiated to a holder in due course, the obligation of the acceptor is the amount of the instrument at the time it was taken by the holder in due course.

§ 3–414. Obligation of Drawer.

(a) This section does not apply to cashier’s checks or other drafts drawn on the drawer. (b) If an unaccepted draft is dishonored, the drawer is obliged to pay the draft (i) according

to its terms at the time it was issued or, if not issued, at the time it first came into posses- sion of a holder, or (ii) if the drawer signed an incomplete instrument, according to its terms when completed, to the extent stated in Sections 3–115 and 3–407. The obligation is owed to a person entitled to enforce the draft or to an indorser who paid the draft under Section 3–415.

(c) If a draft is accepted by a bank, the drawer is discharged, regardless of when or by whom acceptance was obtained.

(d) If a draft is accepted and the acceptor is not a bank, the obligation of the drawer to pay the draft if the draft is dishonored by the acceptor is the same as the obligation of an indorser under Section 3–415(a) and (c).

(e) If a draft states that it is drawn “without recourse” or otherwise disclaims liability of the drawer to pay the draft, the drawer is not liable under subsection (b) to pay the draft if the draft is not a check. A disclaimer of the liability stated in subsection (b) is not effective if the draft is a check.

(f) If (i) a check is not presented for payment or given to a depositary bank for collection within 30 days after its date, (ii) the drawee suspends payments after expiration of the 30–day period without paying the check, and (iii) because of the suspension of payments, the drawer is deprived of funds maintained with the drawee to cover payment of the check, the drawer to the extent deprived of funds may discharge its obligation to pay the check by assigning to the person entitled to enforce the check the rights of the drawer against the drawee with respect to the funds.

§ 3–415. Obligation of Indorser.

(a) Subject to subsections (b), (c), (d), (e) and to Section 3–419(d), if an instrument is dishon- ored, an indorser is obliged to pay the amount due on the instrument (i) according to the terms of the instrument at the time it was indorsed, or (ii) if the indorser indorsed an incom- plete instrument, according to its terms when completed, to the extent stated in Sections 3–115 and 3–407. The obligation of the indorser is owed to a person entitled to enforce the instrument or to a subsequent indorser who paid the instrument under this section.

(b) If an indorsement states that it is made “without recourse” or otherwise disclaims liability of the indorser, the indorser is not liable under subsection (a) to pay the instrument.

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(c) If notice of dishonor of an instrument is required by Section 3–503 and notice of dishonor complying with that section is not given to an indorser, the liability of the indorser under subsection (a) is discharged.

(d) If a draft is accepted by a bank after an indorsement is made, the liability of the indorser under subsection (a) is discharged.

(e) If an indorser of a check is liable under subsection (a) and the check is not presented for payment, or given to a depositary bank for collection, within 30 days after the day the indorsement was made, the liability of the indorser under subsection (a) is discharged.

§ 3–416. Transfer Warranties.

(a) A person who transfers an instrument for consideration warrants to the transferee and, if the transfer is by indorsement, to any subsequent transferee that: (1) the warrantor is a person entitled to enforce the instrument; (2) all signatures on the instrument are authentic and authorized; (3) the instrument has not been altered; (4) the instrument is not subject to a defense or claim in recoupment of any party which

can be asserted against the warrantor; (5) the warrantor has no knowledge of any insolvency proceeding commenced with

respect to the maker or acceptor or, in the case of an unaccepted draft, the drawer; and (6) with respect to a remotely-created consumer item, that the person on whose account the

item is drawn authorized the issuance of the item in the amount for which the item is drawn. (b) A person to whom the warranties under subsection (a) are made and who took the instru-

ment in good faith may recover from the warrantor as damages for breach of warranty an amount equal to the loss suffered as a result of the breach, but not more than the amount of the instrument plus expenses and loss of interest incurred as a result of the breach.

(c) The warranties stated in subsection (a) cannot be disclaimed with respect to checks. Unless notice of a claim for breach of warranty is given to the warrantor within 30 days after the claimant has reason to know of the breach and the identity of the warrantor, the liability of the warrantor under subsection (b) is discharged to the extent of any loss caused by the delay in giving notice of the claim.

(d) A [cause of action] for breach of warranty under this section accrues when the claimant has reason to know of the breach.

§ 3–417. Presentment Warranties.

(a) If an unaccepted draft is presented to the drawee for payment or acceptance and the drawee pays or accepts the draft, (i) the person obtaining payment or acceptance, at the time of presentment, and (ii) a previous transferor of the draft, at the time of transfer, warrant to the drawee making payment or accepting the draft in good faith that: (1) the warrantor is, or was, at the time the warrantor transferred the draft, a person enti-

tled to enforce the draft or authorized to obtain payment or acceptance of the draft on behalf of a person entitled to enforce the draft;

(2) the draft has not been altered; (3) the warrantor has no knowledge that the signature of the drawer of the draft is unau-

thorized; and (4) with respect to any remotely-created consumer item, that the person on whose account

the item is drawn authorized the issuance of the item in the amount for which the item is drawn.

(b) A drawee making payment may recover from any warrantor damages for breach of war- ranty equal to the amount paid by the drawee less the amount the drawee received or is entitled to receive from the drawer because of the payment. In addition, the drawee is entitled to compensation for expenses and loss of interest resulting from the breach. The right of the drawee to recover damages under this subsection is not affected by any failure of the drawee to exercise ordinary care in making payment. If the drawee accepts the draft,

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breach of warranty is a defense to the obligation of the acceptor. If the acceptor makes payment with respect to the draft, the acceptor is entitled to recover from any warrantor for breach of warranty the amounts stated in this subsection.

(c) If a drawee asserts a claim for breach of warranty under subsection (a) based on an unau- thorized indorsement of the draft or an alteration of the draft, the warrantor may defend by proving that the indorsement is effective under Section 3–404 or 3–405 or the drawer is precluded under Section 3–406 or 4–406 from asserting against the drawee the unauthor- ized indorsement or alteration.

(d) If (i) a dishonored draft is presented for payment to the drawer or an indorser or (ii) any other instrument is presented for payment to a party obliged to pay the instrument, and (iii) payment is received, the following rules apply: (1) The person obtaining payment and a prior transferor of the instrument warrant to the

person making payment in good faith that the warrantor is, or was, at the time the warrantor transferred the instrument, a person entitled to enforce the instrument or authorized to obtain payment on behalf of a person entitled to enforce the instrument.

(2) The person making payment may recover from any warrantor for breach of warranty an amount equal to the amount paid plus expenses and loss of interest resulting from the breach.

(e) The warranties stated in subsections (a) and (d) cannot be disclaimed with respect to checks. Unless notice of a claim for breach of warranty is given to the warrantor within 30 days after the claimant has reason to know of the breach and the identity of the warrantor, the liability of the warrantor under subsection (b) or (d) is discharged to the extent of any loss caused by the delay in giving notice of the claim.

(f) A [cause of action] for breach of warranty under this section accrues when the claimant has reason to know of the breach.

§ 3–418. Payment or Acceptance by Mistake.

(a) Except as provided in subsection (c), if the drawee of a draft pays or accepts the draft and the drawee acted on the mistaken belief that (i) payment of the draft had not been stopped pursuant to Section 4–403 or (ii) the signature of the drawer of the draft was authorized, the drawee may recover the amount of the draft from the person to whom or for whose benefit payment was made or, in the case of acceptance, may revoke the acceptance. Rights of the drawee under this subsection are not affected by failure of the drawee to exercise ordinary care in paying or accepting the draft.

(b) Except as provided in subsection (c), if an instrument has been paid or accepted by mis- take and the case is not covered by subsection (a), the person paying or accepting may, to the extent permitted by the law governing mistake and restitution, (i) recover the payment from the person to whom or for whose benefit payment was made or (ii) in the case of acceptance, may revoke the acceptance.

(c) The remedies provided by subsection (a) or (b) may not be asserted against a person who took the instrument in good faith and for value or who in good faith changed position in reliance on the payment or acceptance. This subsection does not limit remedies provided by Section 3–417 or 4–407.

(d) Notwithstanding Section 4–215, if an instrument is paid or accepted by mistake and the payor or acceptor recovers payment or revokes acceptance under subsection (a) or (b), the instrument is deemed not to have been paid or accepted and is treated as dishonored, and the person from whom payment is recovered has rights as a person entitled to enforce the dishonored instrument.

§ 3–419. Instruments Signed for Accommodation.

(a) If an instrument is issued for value given for the benefit of a party to the instrument (“accommodated party”) and another party to the instrument (“accommodation party”) signs the instrument for the purpose of incurring liability on the instrument without being

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a direct beneficiary of the value given for the instrument, the instrument is signed by the accommodation party “for accommodation.”

(b) An accommodation party may sign the instrument as maker, drawer, acceptor, or indorser and, subject to subsection (d), is obliged to pay the instrument in the capacity in which the accommodation party signs. The obligation of an accommodation party may be enforced notwithstanding any statute of frauds and whether or not the accommodation party receives consideration for the accommodation.

(c) A person signing an instrument is presumed to be an accommodation party and there is notice that the instrument is signed for accommodation if the signature is an anomalous indorsement or is accompanied by words indicating that the signer is acting as surety or guarantor with respect to the obligation of another party to the instrument. Except as provided in Section 3–605, the obligation of an accommodation party to pay the instru- ment is not affected by the fact that the person enforcing the obligation had notice when the instrument was taken by that person that the accommodation party signed the instru- ment for accommodation.

(d) If the signature of a party to an instrument is accompanied by words indicating unam- biguously that the party is guaranteeing collection rather than payment of the obliga- tion of another party to the instrument, the signer is obliged to pay the amount due on the instrument to a person entitled to enforce the instrument only if (i) execution of judgment against the other party has been returned unsatisfied, (ii) the other party is insolvent or in an insolvency proceeding, (iii) the other party cannot be served with process, or (iv) it is otherwise apparent that payment cannot be obtained from the other party.

(e) If the signature of a party to an instrument is accompanied by words indicating that the party guarantees payment or the signer signs the instrument as an accommodation party in some other manner that does not unambiguously indicate an intention to guarantee collec- tion rather than payment, the signer is obliged to pay the amount due on the instrument to a person entitled to enforce the instrument in the same circumstances as the accommodated party would be obliged, without prior resort to the accommodated party by the person entitled to enforce the instrument.

(f) An accommodation party who pays the instrument is entitled to reimbursement from the accommodated party and is entitled to enforce the instrument against the accommodated party. In proper circumstances, an accommodation party may obtain relief that requires the accommodated party to perform its obligations on the instrument. An accommodated party that pays the instrument has no right of recourse against, and is not entitled to contri- bution from, an accommodation party.

§ 3–420. Conversion of Instrument.

(a) The law applicable to conversion of personal property applies to instruments. An instru- ment is also converted if it is taken by transfer, other than a negotiation, from a person not entitled to enforce the instrument or a bank makes or obtains payment with respect to the instrument for a person not entitled to enforce the instrument or receive payment. An action for conversion of an instrument may not be brought by (i) the issuer or acceptor of the instrument or (ii) a payee or indorsee who did not receive delivery of the instru- ment either directly or through delivery to an agent or a co-payee.

(b) In an action under subsection (a), the measure of liability is presumed to be the amount payable on the instrument, but recovery may not exceed the amount of the plaintiff’s inter- est in the instrument.

(c) A representative, other than a depositary bank, who has in good faith dealt with an instru- ment or its proceeds on behalf of one who was not the person entitled to enforce the instru- ment is not liable in conversion to that person beyond the amount of any proceeds that it has not paid out.

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PART 5: DISHONOR § 3–501. Presentment.

(a) “Presentment” means a demand made by or on behalf of a person entitled to enforce an instrument (i) to pay the instrument made to the drawee or a party obliged to pay the instru- ment or, in the case of a note or accepted draft payable at a bank, to the bank, or (ii) to accept a draft made to the drawee.

(b) The following rules are subject to Article 4, agreement of the parties, and clearing-house rules and the like: (1) Presentment may be made at the place of payment of the instrument and must be made

at the place of payment if the instrument is payable at a bank in the United States; may be made by any commercially reasonable means, including an oral, written, or electronic communication; is effective when the demand for payment or acceptance is received by the person to whom presentment is made; and is effective if made to any one of two or more makers, acceptors, drawees, or other payors.

(2) Upon demand of the person to whom presentment is made, the person making pre- sentment must (i) exhibit the instrument, (ii) give reasonable identification and, if presentment is made on behalf of another person, reasonable evidence of authority to do so, and (iii) sign a receipt on the instrument for any payment made or surrender the instrument if full payment is made.

(3) Without dishonoring the instrument, the party to whom presentment is made may (i) return the instrument for lack of a necessary indorsement, or (ii) refuse payment or acceptance for failure of the presentment to comply with the terms of the instrument, an agreement of the parties, or other applicable law or rule.

(4) The party to whom presentment is made may treat presentment as occurring on the next business day after the day of presentment if the party to whom presentment is made has established a cut-off hour not earlier than 2 p.m. for the receipt and process- ing of instruments presented for payment or acceptance and presentment is made after the cut-off hour.

§ 3–502. Dishonor.

(a) Dishonor of a note is governed by the following rules: (1) If the note is payable on demand, the note is dishonored if presentment is duly made

to the maker and the note is not paid on the day of presentment. (2) If the note is not payable on demand and is payable at or through a bank or the terms

of the note require presentment, the note is dishonored if presentment is duly made and the note is not paid on the day it becomes payable or the day of presentment, whichever is later.

(3) If the note is not payable on demand and paragraph (2) does not apply, the note is dishonored if it is not paid on the day it becomes payable.

(b) Dishonor of an unaccepted draft other than a documentary draft is governed by the follow- ing rules: (1) If a check is duly presented for payment to the payor bank otherwise than for immediate

payment over the counter, the check is dishonored if the payor bank makes timely return of the check or sends timely notice of dishonor or nonpayment under Section 4–301 or 4–302, or becomes accountable for the amount of the check under Section 4–302.

(2) If a draft is payable on demand and paragraph (1) does not apply, the draft is dishon- ored if presentment for payment is duly made to the drawee and the draft is not paid on the day of presentment.

(3) If a draft is payable on a date stated in the draft, the draft is dishonored if (i) present- ment for payment is duly made to the drawee and payment is not made on the day the draft becomes payable or the day of presentment, whichever is later, or (ii) present- ment for acceptance is duly made before the day the draft becomes payable and the draft is not accepted on the day of presentment.

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(4) If a draft is payable on elapse of a period of time after sight or acceptance, the draft is dishonored if presentment for acceptance is duly made and the draft is not accepted on the day of presentment.

(c) Dishonor of an unaccepted documentary draft occurs according to the rules stated in sub- section (b)(2), (3), and (4), except that payment or acceptance may be delayed without dishonor until no later than the close of the third business day of the drawee following the day on which payment or acceptance is required by those paragraphs.

(d) Dishonor of an accepted draft is governed by the following rules: (1) If the draft is payable on demand, the draft is dishonored if presentment for payment

is duly made to the acceptor and the draft is not paid on the day of presentment. (2) If the draft is not payable on demand, the draft is dishonored if presentment for pay-

ment is duly made to the acceptor and payment is not made on the day it becomes payable or the day of presentment, whichever is later.

(e) In any case in which presentment is otherwise required for dishonor under this section and presentment is excused under Section 3–504, dishonor occurs without presentment if the instrument is not duly accepted or paid.

(f) If a draft is dishonored because timely acceptance of the draft was not made and the person entitled to demand acceptance consents to a late acceptance, from the time of acceptance the draft is treated as never having been dishonored.

§ 3–503. Notice of Dishonor.

(a) The obligation of an indorser stated in Section 3–415(a) and the obligation of a drawer stated in Section 3–414(d) may not be enforced unless (i) the indorser or drawer is given notice of dishonor of the instrument complying with this section or (ii) notice of dishonor is excused under Section 3–504(b).

(b) Notice of dishonor may be given by any person; may be given by any commercially rea- sonable means, including an oral, written, or electronic communication; and is sufficient if it reasonably identifies the instrument and indicates that the instrument has been dishon- ored or has not been paid or accepted. Return of an instrument given to a bank for collec- tion is sufficient notice of dishonor.

(c) Subject to Section 3–504(c), with respect to an instrument taken for collection by a col- lecting bank, notice of dishonor must be given (i) by the bank before midnight of the next banking day following the banking day on which the bank receives notice of dishonor of the instrument, or (ii) by any other person within 30 days following the day on which the person receives notice of dishonor. With respect to any other instrument, notice of dishonor must be given within 30 days following the day on which dishonor occurs.

§ 3–504. Excused Presentment and Notice of Dishonor.

(a) Presentment for payment or acceptance of an instrument is excused if (i) the person entitled to present the instrument cannot with reasonable diligence make presentment, (ii) the maker or acceptor has repudiated an obligation to pay the instrument or is dead or in insolvency proceedings, (iii) by the terms of the instrument presentment is not necessary to enforce the obligation of indorsers or the drawer, (iv) the drawer or indorser whose obligation is being enforced has waived presentment or otherwise has no reason to expect or right to require that the instrument be paid or accepted, or (v) the drawer instructed the drawee not to pay or accept the draft or the drawee was not obligated to the drawer to pay the draft.

(b) Notice of dishonor is excused if (i) by the terms of the instrument notice of dishonor is not necessary to enforce the obligation of a party to pay the instrument, or (ii) the party whose obligation is being enforced waived notice of dishonor. A waiver of presentment is also a waiver of notice of dishonor.

(c) Delay in giving notice of dishonor is excused if the delay was caused by circumstances beyond the control of the person giving the notice and the person giving the notice exer- cised reasonable diligence after the cause of the delay ceased to operate.

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§ 3–505. Evidence of Dishonor.

(a) The following are admissible as evidence and create a presumption of dishonor and of any notice of dishonor stated: (1) a document regular in form as provided in subsection (b) which purports to be a

protest; (2) a purported stamp or writing of the drawee, payor bank, or presenting bank on or

accompanying the instrument stating that acceptance or payment has been refused unless reasons for the refusal are stated and the reasons are not consistent with dishonor;

(3) a book or record of the drawee, payor bank, or collecting bank, kept in the usual course of business which shows dishonor, even if there is no evidence of who made the entry.

(b) A protest is a certificate of dishonor made by a United States consul or vice consul, or a notary public or other person authorized to administer oaths by the law of the place where dishonor occurs. It may be made upon information satisfactory to that person. The protest must identify the instrument and certify either that presentment has been made or, if not made, the reason why it was not made, and that the instrument has been dishonored by nonacceptance or nonpayment. The protest may also certify that notice of dishonor has been given to some or all parties.

PART 6: DISCHARGE AND PAYMENT § 3–601. Discharge and Effect of Discharge.

(a) The obligation of a party to pay the instrument is discharged as stated in this Article or by an act or agreement with the party which would discharge an obligation to pay money under a simple contract.

(b) Discharge of the obligation of a party is not effective against a person acquiring rights of a holder in due course of the instrument without notice of the discharge.

§ 3–602. Payment.

(a) Subject to subsection (e), an instrument is paid to the extent payment is made by or on behalf of a party obliged to pay the instrument, and to a person entitled to enforce the instrument.

(b) Subject to subsection (e), a note is paid to the extent payment is made by or on behalf of a party obliged to pay the note to a person that formerly was entitled to enforce the note only if at the time of the payment the party obliged to pay has not received adequate notifica- tion that the note has been transferred and that payment is to be made to the transferee. A notification is adequate only if it is signed by the transferor or the transferee; reasonably identifies the transferred note; and provides an address at which payments subsequently are to be made. Upon request, a transferee shall seasonably furnish reasonable proof that the note has been transferred. Unless the transferee complies with the request, a payment to the person that formerly was entitled to enforce the note is effective for purposes of sub- section (c) even if the party obliged to pay the note has received a notification under this paragraph.

(c) Subject to subsection (e), to the extent of a payment under subsections (a) and (b), the obligation of the party obliged to pay the instrument is discharged even though payment is made with knowledge of a claim to the instrument under Section 3–306 by another person.

(d) Subject to subsection (e), a transferee, or any party that has acquired rights in the instru- ment directly or indirectly from a transferee, including any such party that has rights as a holder in due course, is deemed to have notice of any payment that is made under sub- section (b) after the date that the note is transferred to the transferee but before the party obliged to pay the note receives adequate notification of the transfer.

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(e) The obligation of a party to pay the instrument is not discharged under subsections (a) through (d) if: (1) a claim to the instrument under Section 3–306 is enforceable against the party receiv-

ing payment and (i) payment is made with knowledge by the payor that payment is prohibited by injunction or similar process of a court of competent jurisdiction, or (ii) in the case of an instrument other than a cashier’s check, teller’s check, or certi- fied check, the party making payment accepted, from the person having a claim to the instrument, indemnity against loss resulting from refusal to pay the person entitled to enforce the instrument; or

(2) the person making payment knows that the instrument is a stolen instrument and pays a person it knows is in wrongful possession of the instrument.

(f) As used in this section, “signed,” with respect to a record that is not a writing, includes the attachment to or logical association with the record of an electronic symbol, sound, or process with the present intent to adopt or accept the record.

§ 3–603. Tender of Payment.

(a) If tender of payment of an obligation to pay an instrument is made to a person entitled to enforce the instrument, the effect of tender is governed by principles of law applicable to tender of payment under a simple contract.

(b) If tender of payment of an obligation to pay an instrument is made to a person entitled to enforce the instrument and the tender is refused, there is discharge, to the extent of the amount of the tender, of the obligation of an indorser or accommodation party having a right of recourse with respect to the obligation to which the tender relates.

(c) If tender of payment of an amount due on an instrument is made to a person entitled to enforce the instrument, the obligation of the obligor to pay interest after the due date on the amount tendered is discharged. If presentment is required with respect to an instrument and the obligor is able and ready to pay on the due date at every place of payment stated in the instrument, the obligor is deemed to have made tender of payment on the due date to the person entitled to enforce the instrument.

§ 3–604. Discharge by Cancellation or Renunciation.

(a) A person entitled to enforce an instrument, with or without consideration, may discharge the obligation of a party to pay the instrument (i) by an intentional voluntary act, such as surrender of the instrument to the party, destruction, mutilation, or cancellation of the instrument, cancellation or striking out of the partyís signature, or the addition of words to the instrument indicating discharge, or (ii) by agreeing not to sue or otherwise renouncing rights against the party by a signed record.

(b) Cancellation or striking out of an indorsement pursuant to subsection (a) does not affect the status and rights of a party derived from the indorsement.

(c) In this section, “signed,” with respect to a record that is not a writing, includes the attach- ment to or logical association with the record of an electronic symbol, sound, or process with the present intent to adopt or accept the record.

§ 3–605. Discharge of Secondary Obligors.

(a) If a person entitled to enforce an instrument releases the obligation of a principal obligor in whole or in part, and another party to the instrument is a secondary obligor with respect to the obligation of that principal obligor, the following rules apply: (1) Any obligations of the principal obligor to the secondary obligor with respect to

any previous payment by the secondary obligor are not affected. Unless the terms of the release preserve the secondary obligor’s recourse, the principal obligor is dis- charged, to the extent of the release, from any other duties to the secondary obligor under this article.

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(2) Unless the terms of the release provide that the person entitled to enforce the instru- ment retains the right to enforce the instrument against the secondary obligor, the secondary obligor is discharged to the same extent as the principal obligor from any unperformed portion of its obligation on the instrument. If the instrument is a check and the obligation of the secondary obligor is based on an indorsement of the check, the secondary obligor is discharged without regard to the language or circumstances of the discharge or other release.

(3) If the secondary obligor is not discharged under paragraph (2), the secondary obligor is discharged to the extent of the value of the consideration for the release, and to the extent that the release would otherwise cause the secondary obligor a loss.

(b) If a person entitled to enforce an instrument grants a principal obligor an extension of the time at which one or more payments are due on the instrument and another party to the instrument is a secondary obligor with respect to the obligation of that principal obligor, the following rules apply: (1) Any obligations of the principal obligor to the secondary obligor with respect to any

previous payment by the secondary obligor are not affected. Unless the terms of the extension preserve the secondary obligor’s recourse, the extension correspondingly extends the time for performance of any other duties owed to the secondary obligor by the principal obligor under this article.

(2) The secondary obligor is discharged to the extent that the extension would otherwise cause the secondary obligor a loss.

(3) To the extent that the secondary obligor is not discharged under paragraph (2), the secondary obligor may perform its obligations to a person entitled to enforce the instrument as if the time for payment had not been extended or, unless the terms of the extension provide that the person entitled to enforce the instrument retains the right to enforce the instrument against the secondary obligor as if the time for pay- ment had not been extended, treat the time for performance of its obligations as hav- ing been extended correspondingly.

(c) If a person entitled to enforce an instrument agrees, with or without consideration, to a modification of the obligation of a principal obligor other than a complete or partial release or an extension of the due date and another party to the instrument is a secondary obligor with respect to the obligation of that principal obligor, the following rules apply: (1) Any obligations of the principal obligor to the secondary obligor with respect to any

previous payment by the secondary obligor are not affected. The modification corre- spondingly modifies any other duties owed to the secondary obligor by the principal obligor under this article.

(2) The secondary obligor is discharged from any unperformed portion of its obligation to the extent that the modification would otherwise cause the secondary obligor a loss.

(3) To the extent that the secondary obligor is not discharged under paragraph (2), the secondary obligor may satisfy its obligation on the instrument as if the modification had not occurred, or treat its obligation on the instrument as having been modified correspondingly.

(d) If the obligation of a principal obligor is secured by an interest in collateral, another party to the instrument is a secondary obligor with respect to that obligation, and a person enti- tled to enforce the instrument impairs the value of the interest in collateral, the obliga- tion of the secondary obligor is discharged to the extent of the impairment. The value of an interest in collateral is impaired to the extent the value of the interest is reduced to an amount less than the amount of the recourse of the secondary obligor, or the reduc- tion in value of the interest causes an increase in the amount by which the amount of the recourse exceeds the value of the interest. For purposes of this subsection, impairing the value of an interest in collateral includes failure to obtain or maintain perfection or recor- dation of the interest in collateral, release of collateral without substitution of collateral of equal value or equivalent reduction of the underlying obligation, failure to perform a duty to preserve the value of collateral owed, under Article 9 or other law, to a debtor or other

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person secondarily liable, and failure to comply with applicable law in disposing of or otherwise enforcing the interest in collateral.

(e) A secondary obligor is not discharged under subsections (a)(3), (b), (c), or (d) unless the person entitled to enforce the instrument knows that the person is a secondary obligor or has notice under Section 3–419(c) that the instrument was signed for accommodation.

(f) A secondary obligor is not discharged under this section if the secondary obligor consents to the event or conduct that is the basis of the discharge, or the instrument or a separate agreement of the party provides for waiver of discharge under this section specifically or by general language indicating that parties waive defenses based on suretyship or impairment of collateral. Unless the circumstances indicate otherwise, consent by the principal obligor to an act that would lead to a discharge under this section constitutes consent to that act by the secondary obligor if the secondary obligor controls the prin- cipal obligor or deals with the person entitled to enforce the instrument on behalf of the principal obligor.

(g) A release or extension preserves a secondary obligorís recourse if the terms of the release or extension provide that: (1) the person entitled to enforce the instrument retains the right to enforce the instrument

against the secondary obligor; and (2) the recourse of the secondary obligor continues as if the release or extension had not

been granted. (h) Except as otherwise provided in subsection (i), a secondary obligor asserting discharge

under this section has the burden of persuasion both with respect to the occurrence of the acts alleged to harm the secondary obligor and loss or prejudice caused by those acts.

(i) If the secondary obligor demonstrates prejudice caused by an impairment of its recourse, and the circumstances of the case indicate that the amount of loss is not reasonably sus- ceptible of calculation or requires proof of facts that are not ascertainable, it is presumed that the act impairing recourse caused a loss or impairment equal to the liability of the secondary obligor on the instrument. In that event, the burden of persuasion as to any lesser amount of the loss is on the person entitled to enforce the instrument.

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Appendix C

TITLE VII OF THE CIVIL RIGHTS ACT OF 1964 The U.S. Equal Employment Opportunity Commission

An Act To enforce the constitutional right to vote, to confer jurisdiction upon the district courts of the United States to provide injunctive relief against discrimination in public accommodations, to authorize the attorney General to institute suits to protect constitutional rights in public facili- ties and public education, to extend the Commission on Civil Rights, to prevent discrimination in federally assisted programs, to establish a Commission on Equal Employment Opportunity, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled, That this Act may be cited as the “Civil Rights Act of 1964.”

***

DEFINITIONS SEC. 2000e. [Section 701]. For the purposes of this subchapter- (a) The term “person” includes one or more individuals, governments, governmental agencies, political subdivisions, labor unions, partnerships, associations, corporations, legal representa- tives, mutual companies, joint stock companies, trusts, unincorporated organizations, trustees, trustees in cases under title 11 [bankruptcy], or receivers. (b) The term “employer” means a person engaged in an industry affecting commerce who has fifteen or more employees for each working day in each of twenty or more calendar weeks in the current or preceding calendar year, and any agent of such a person, but such term does not include (1) the United States, a corporation wholly owned by the Government of the United States, an Indian tribe, or any department or agency of the District of Columbia subject by stat- ute to procedures of the competitive service (as defined in section 2102 of title 5 [of the United States Code] ), or (2) a bona fide private membership club (other than a labor organization) which is exempt from taxation under section 501(c) of title 26 [the Internal Revenue Code of 1954], except that during the first year after March 24, 1972 [the date of enactment of the Equal Employment Opportunity Act of 1972], persons having fewer than twenty five employees (and their agents) shall not be considered employers. (c) The term “employment agency” means any person regularly undertaking with or without compensation to procure employees for an employer or to procure for employees opportunities to work for an employer and includes an agent of such a person. (d) The term “labor organization” means a labor organization engaged in an industry affecting commerce, and any agent of such an organization, and includes any organization of any kind, any agency, or employee representation committee, group, association, or plan so engaged in which employees participate and which exists for the purpose, in whole or in part, of deal- ing with employers concerning grievances, labor disputes, wages, rates of pay, hours, or other terms or conditions of employment, and any conference, general committee, joint or system board, or joint council so engaged which is subordinate to a national or international labor organization. (e) A labor organization shall be deemed to be engaged in an industry affecting commerce if (1) it maintains or operates a hiring hall or hiring office which procures employees for an employer or procures for employees opportunities to work for an employer, or (2) the number

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of its members (or, where it is a labor organization composed of other labor organizations or their representatives, if the aggregate number of the members of such other labor organization) is (A) twenty five or more during the first year after March 24, 1972 [the date of enactment of the Equal Employment Opportunity Act of 1972], or (B) fifteen or more thereafter, and such labor organization-

(1) is the certified representative of employees under the provisions of the National Labor Relations Act, as amended [29 U.S.C. 151 et seq.], or the Railway Labor Act, as amended [45 U.S.C. 151 et seq.];

(2) although not certified, is a national or international labor organization or a local labor organization recognized or acting as the representative of employees of an employer or employ- ers engaged in an industry affecting commerce; or

(3) has chartered a local labor organization or subsidiary body which is representing or actively seeking to represent employees of employers within the meaning of paragraph (1) or (2); or

(4) has been chartered by a labor organization representing or actively seeking to represent employees within the meaning of paragraph (1) or (2) as the local or subordinate body through which such employees may enjoy membership or become affiliated with such labor organiza- tion; or

(5) is a conference, general committee, joint or system board, or joint council subordinate to a national or international labor organization, which includes a labor organization engaged in an industry affecting commerce within the meaning of any of the preceding paragraphs of this subsection. (f) The term “employee” means an individual employed by an employer, except that the term “employee” shall not include any person elected to public office in any State or political subdi- vision of any State by the qualified voters thereof, or any person chosen by such officer to be on such officer’s personal staff, or an appointee on the policy making level or an immediate adviser with respect to the exercise of the constitutional or legal powers of the office. The exemption set forth in the preceding sentence shall not include employees subject to the civil service laws of a State government, governmental agency or political subdivision. With respect to employment in a foreign country, such term includes an individual who is a citizen of the United States. (g) The term “commerce” means trade, traffic, commerce, transportation, transmission, or com- munication among the several States; or between a State and any place outside thereof; or within the District of Columbia, or a possession of the United States; or between points in the same State but through a point outside thereof. (h) The term “industry affecting commerce” means any activity, business, or industry in com- merce or in which a labor dispute would hinder or obstruct commerce or the free flow of com- merce and includes any activity or industry “affecting commerce” within the meaning of the Labor Management Reporting and Disclosure Act of 1959 [29 U.S.C. 401 et seq.], and further includes any governmental industry, business, or activity. (i) The term “State” includes a State of the United States, the District of Columbia, Puerto Rico, the Virgin Islands, American Samoa, Guam, Wake Island, the Canal Zone, and Outer Continen- tal Shelf lands defined in the Outer Continental Shelf Lands Act [43 U.S.C. 1331 et seq.]. (j) The term “religion” includes all aspects of religious observance and practice, as well as belief, unless an employer demonstrates that he is unable to reasonably accommodate to an employee’s or prospective employee’s religious observance or practice without undue hardship on the conduct of the employer’s business. (k) The terms “because of sex” or “on the basis of sex” include, but are not limited to, because of or on the basis of pregnancy, childbirth, or related medical conditions; and women affected by pregnancy, childbirth, or related medical conditions shall be treated the same for all employ- ment related purposes, including receipt of benefits under fringe benefit programs, as other persons not so affected but similar in their ability or inability to work, and nothing in section 2000e-2(h) of this title [section 703(h)] shall be interpreted to permit otherwise. This subsec- tion shall not require an employer to pay for health insurance benefits for abortion, except where the life of the mother would be endangered if the fetus were carried to term, or except

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where medical complications have arisen from an abortion: Provided, That nothing herein shall preclude an employer from providing abortion benefits or otherwise affect bargaining agree- ments in regard to abortion. (l) The term “complaining party” means the Commission, the Attorney General, or a per- son who may bring an action or proceeding under this subchapter. (m) The term “demonstrates” means meets the burdens of production and persuasion. (n) The term “respondent” means an employer, employment agency, labor organiza- tion, joint labor management committee controlling apprenticeship or other training or retraining program, including an on the job training program, or Federal entity subject to section 2000e-16 of this title.

EXEMPTION SEC. 2000e-1. [Section 702]. (a) This subchapter shall not apply to an employer with respect to the employment of aliens outside any State, or to a religious corporation, association, educational institution, or society with respect to the employment of individuals of a particular religion to perform work con- nected with the carrying on by such corporation, association, educational institution, or society of its activities. (b) It shall not be unlawful under section 2000e-2 or 2000e-3 of this title [section 703 or 704] for an employer (or a corporation controlled by an employer), labor organization, employment agency, or joint labor management committee controlling apprenticeship or other training or retraining (including on the job training programs) to take any action otherwise prohibited by such section, with respect to an employee in a workplace in a for- eign country if compliance with such section would cause such employer (or such corpo- ration), such organization, such agency, or such committee to violate the law of the foreign country in which such workplace is located. (c) (1) If an employer controls a corporation whose place of incorporation is a foreign country, any practice prohibited by section 2000e-2 or 2000e-3 of this title [section 703 or 704] engaged in by such corporation shall be presumed to be engaged in by such employer.

(2) Sections 2000e-2 and 2000e-3 of this title [sections 703 and 704] shall not apply with respect to the foreign operations of an employer that is a foreign person not controlled by an American employer.

(3) For purposes of this subsection, the determination of whether an employer controls a corporation shall be based on-

(A) the interrelation of operations; (B) the common management; (C) the centralized control of labor relations; and (D) the common ownership or financial control, of the employer and the corporation.

UNLAWFUL EMPLOYMENT PRACTICES SEC. 2000e-2. [Section 703]. (a) It shall be an unlawful employment practice for an employer-

(1) to fail or refuse to hire or to discharge any individual, or otherwise to discriminate against any individual with respect to his compensation, terms, conditions, or privileges of employ- ment, because of such individual’s race, color, religion, sex, or national origin; or

(2) to limit, segregate, or classify his employees or applicants for employment in any way which would deprive or tend to deprive any individual of employment opportunities or other- wise adversely affect his status as an employee, because of such individual’s race, color, reli- gion, sex, or national origin. (b) It shall be an unlawful employment practice for an employment agency to fail or refuse to refer for employment, or otherwise to discriminate against, any individual because of his race, color, religion, sex, or national origin, or to classify or refer for employment any individual on the basis of his race, color, religion, sex, or national origin.

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(c) It shall be an unlawful employment practice for a labor organization- (1) to exclude or to expel from its membership, or otherwise to discriminate against, any

individual because of his race, color, religion, sex, or national origin; (2) to limit, segregate, or classify its membership or applicants for membership, or to clas-

sify or fail or refuse to refer for employment any individual, in any way which would deprive or tend to deprive any individual of employment opportunities, or would limit such employment opportunities or otherwise adversely affect his status as an employee or as an applicant for employment, because of such individual’s race, color, religion, sex, or national origin; or

(3) to cause or attempt to cause an employer to discriminate against an individual in viola- tion of this section. (d) It shall be an unlawful employment practice for any employer, labor organization, or joint labor management committee controlling apprenticeship or other training or retraining, includ- ing on the job training programs to discriminate against any individual because of his race, color, religion, sex, or national origin in admission to, or employment in, any program estab- lished to provide apprenticeship or other training. (e) Notwithstanding any other provision of this subchapter, (1) it shall not be an unlaw- ful employment practice for an employer to hire and employ employees, for an employment agency to classify, or refer for employment any individual, for a labor organization to classify its membership or to classify or refer for employment any individual, or for an employer, labor organization, or joint labor management committee controlling apprenticeship or other training or retraining programs to admit or employ any individual in any such program, on the basis of his religion, sex, or national origin in those certain instances where religion, sex, or national origin is a bona fide occupational qualification reasonably necessary to the normal operation of that particular business or enterprise, and (2) it shall not be an unlawful employment practice for a school, college, university, or other educational institution or institution of learning to hire and employ employees of a particular religion if such school, college, university, or other educational institution or institution of learning is, in whole or in substantial part, owned, sup- ported, controlled, or managed by a particular religion or by a particular religious corporation, association, or society, or if the curriculum of such school, college, university, or other edu- cational institution or institution of learning is directed toward the propagation of a particular religion. (f) As used in this subchapter, the phrase “unlawful employment practice” shall not be deemed to include any action or measure taken by an employer, labor organization, joint labor man- agement committee, or employment agency with respect to an individual who is a member of the Communist Party of the United States or of any other organization required to regis- ter as a Communist action or Communist front organization by final order of the Subversive Activities Control Board pursuant to the Subversive Activities Control Act of 1950 [50 U.S.C. 781 et seq.]. (g) Notwithstanding any other provision of this subchapter, it shall not be an unlawful employ- ment practice for an employer to fail or refuse to hire and employ any individual for any posi- tion, for an employer to discharge any individual from any position, or for an employment agency to fail or refuse to refer any individual for employment in any position, or for a labor organization to fail or refuse to refer any individual for employment in any position, if-

(1) the occupancy of such position, or access to the premises in or upon which any part of the duties of such position is performed or is to be performed, is subject to any requirement imposed in the interest of the national security of the United States under any security program in effect pursuant to or administered under any statute of the United States or any Executive order of the President; and

(2) such individual has not fulfilled or has ceased to fulfill that requirement. (h) Notwithstanding any other provision of this subchapter, it shall not be an unlawful employ- ment practice for an employer to apply different standards of compensation, or different terms, conditions, or privileges of employment pursuant to a bona fide seniority or merit system, or a system which measures earnings by quantity or quality of production or to employees who work in different locations, provided that such differences are not the result of an intention to

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discriminate because of race, color, religion, sex, or national origin, nor shall it be an unlawful employment practice for an employer to give and to act upon the results of any professionally developed ability test provided that such test, its administration or action upon the results is not designed, intended or used to discriminate because of race, color, religion, sex or national origin. It shall not be an unlawful employment practice under this subchapter for any employer to differentiate upon the basis of sex in determining the amount of the wages or compensation paid or to be paid to employees of such employer if such differentiation is authorized by the provisions of section 206(d) of title 29 [section 6(d) of the Fair Labor Standards Act of 1938, as amended]. (i) Nothing contained in this subchapter shall apply to any business or enterprise on or near an Indian reservation with respect to any publicly announced employment practice of such busi- ness or enterprise under which a preferential treatment is given to any individual because he is an Indian living on or near a reservation. (j) Nothing contained in this subchapter shall be interpreted to require any employer, employ- ment agency, labor organization, or joint labor management committee subject to this subchap- ter to grant preferential treatment to any individual or to any group because of the race, color, religion, sex, or national origin of such individual or group on account of an imbalance which may exist with respect to the total number or percentage of persons of any race, color, religion, sex, or national origin employed by any employer, referred or classified for employment by any employment agency or labor organization, admitted to membership or classified by any labor organization, or admitted to, or employed in, any apprenticeship or other training program, in comparison with the total number or percentage of persons of such race, color, religion, sex, or national origin in any community, State, section, or other area, or in the available work force in any community, State, section, or other area. (k) (1) (A) An unlawful employment practice based on disparate impact is established under this title only if-

(i) a complaining party demonstrates that a respondent uses a particular employment practice that causes a disparate impact on the basis of race, color, religion, sex, or national origin and the respondent fails to demonstrate that the challenged practice is job related for the position in question and consistent with business necessity; or

(ii) the complaining party makes the demonstration described in subparagraph (C) with respect to an alternative employment practice and the respondent refuses to adopt such alternative employment practice.

(B) (i) With respect to demonstrating that a particular employment practice causes a disparate impact as described in subparagraph (A)(i), the complaining party shall dem- onstrate that each particular challenged employment practice causes a disparate impact, except that if the complaining party can demonstrate to the court that the elements of a respondent’s decision making process are not capable of separation for analysis, the deci- sion making process may be analyzed as one employment practice.

(ii) If the respondent demonstrates that a specific employment practice does not cause the disparate impact, the respondent shall not be required to demonstrate that such prac- tice is required by business necessity.

(C) The demonstration referred to by subparagraph (A)(ii) shall be in accordance with the law as it existed on June 4, 1989, with respect to the concept of “alternative employ- ment practice”.

(2) A demonstration that an employment practice is required by business necessity may not be used as a defense against a claim of intentional discrimination under this title.

(3) Notwithstanding any other provision of this title, a rule barring the employment of an individual who currently and knowingly uses or possesses a controlled substance, as defined in schedules I and II of section 102(6) of the Controlled Substances Act (21 U.S.C. 802(6)), other than the use or possession of a drug taken under the supervision of a licensed health care professional, or any other use or possession authorized by the Controlled Substances Act [21 U.S.C. 801 et seq.] or any other provision of Federal law, shall be considered an unlawful employment practice under this title only if such rule is

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adopted or applied with an intent to discriminate because of race, color, religion, sex, or national origin. (l) It shall be an unlawful employment practice for a respondent, in connection with the selection or referral of applicants or candidates for employment or promotion, to adjust the scores of, use different cutoff scores for, or otherwise alter the results of, employment related tests on the basis of race, color, religion, sex, or national origin. (m) Except as otherwise provided in this title, an unlawful employment practice is estab- lished when the complaining party demonstrates that race, color, religion, sex, or national origin was a motivating factor for any employment practice, even though other factors also motivated the practice. (n) (1) (A) Notwithstanding any other provision of law, and except as provided in para- graph (2), an employment practice that implements and is within the scope of a litigated or consent judgment or order that resolves a claim of employment discrimination under the Constitution or Federal civil rights laws may not be challenged under the circum- stances described in subparagraph (B).

(B) A practice described in subparagraph (A) may not be challenged in a claim under the Constitution or Federal civil rights laws-

(i) by a person who, prior to the entry of the judgment or order described in subpara- graph (A), had-

(I) actual notice of the proposed judgment or order sufficient to apprise such person that such judgment or order might adversely affect the interests and legal rights of such person and that an opportunity was available to present objections to such judgment or order by a future date certain; and

(II) a reasonable opportunity to present objections to such judgment or order; or (ii) by a person whose interests were adequately represented by another person who

had previously challenged the judgment or order on the same legal grounds and with a similar factual situation, unless there has been an intervening change in law or fact.

(2) Nothing in this subsection shall be construed to- (A) alter the standards for intervention under rule 24 of the Federal Rules of Civil Pro-

cedure or apply to the rights of parties who have successfully intervened pursuant to such rule in the proceeding in which the parties intervened;

(B) apply to the rights of parties to the action in which a litigated or consent judgment or order was entered, or of members of a class represented or sought to be represented in such action, or of members of a group on whose behalf relief was sought in such action by the Federal Government;

(C) prevent challenges to a litigated or consent judgment or order on the ground that such judgment or order was obtained through collusion or fraud, or is transparently invalid or was entered by a court lacking subject matter jurisdiction; or

(D) authorize or permit the denial to any person of the due process of law required by the Constitution.

(3) Any action not precluded under this subsection that challenges an employment consent judgment or order described in paragraph (1) shall be brought in the court, and if possible before the judge, that entered such judgment or order. Nothing in this subsection shall preclude a transfer of such action pursuant to section 1404 of title 28, United States Code.

OTHER UNLAWFUL EMPLOYMENT PRACTICES SEC. 2000e-3. [Section 704]. (a) It shall be an unlawful employment practice for an employer to discriminate against any of his employees or applicants for employment, for an employment agency, or joint labor man- agement committee controlling apprenticeship or other training or retraining, including on the job training programs, to discriminate against any individual, or for a labor organization to discriminate against any member thereof or applicant for membership, because he has opposed

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any practice made an unlawful employment practice by this subchapter, or because he has made a charge, testified, assisted, or participated in any manner in an investigation, proceeding, or hearing under this subchapter. (b) It shall be an unlawful employment practice for an employer, labor organization, employ- ment agency, or joint labor management committee controlling apprenticeship or other training or retraining, including on the job training programs, to print or publish or cause to be printed or published any notice or advertisement relating to employment by such an employer or member- ship in or any classification or referral for employment by such a labor organization, or relating to any classification or referral for employment by such an employment agency, or relating to admission to, or employment in, any program established to provide apprenticeship or other training by such a joint labor management committee, indicating any preference, limitation, specification, or discrimination, based on race, color, religion, sex, or national origin, except that such a notice or advertisement may indicate a preference, limitation, specification, or dis- crimination based on religion, sex, or national origin when religion, sex, or national origin is a bona fide occupational qualification for employment.

EQUAL EMPLOYMENT OPPORTUNITY COMMISSION SEC. 2000e-4. [Section 705]. (a) There is hereby created a Commission to be known as the Equal Employment Opportunity Commission, which shall be composed of five members, not more than three of whom shall be members of the same political party. Members of the Commission shall be appointed by the President by and with the advice and consent of the Senate for a term of five years. Any indi- vidual chosen to fill a vacancy shall be appointed only for the unexpired term of the member whom he shall succeed, and all members of the Commission shall continue to serve until their successors are appointed and qualified, except that no such member of the Commission shall continue to serve (1) for more than sixty days when the Congress is in session unless a nomina- tion to fill such vacancy shall have been submitted to the Senate, or (2) after the adjournment sine die of the session of the Senate in which such nomination was submitted. The President shall designate one member to serve as Chairman of the Commission, and one member to serve as Vice Chairman. The Chairman shall be responsible on behalf of the Commission for the administrative operations of the Commission, and, except as provided in subsection (b) of this section, shall appoint, in accordance with the provisions of title 5 [United States Code] governing appointments in the competitive service, such officers, agents, attorneys, administra- tive law judges [hearing examiners], and employees as he deems necessary to assist it in the performance of its functions and to fix their compensation in accordance with the provisions of chapter 51 and subchapter III of chapter 53 of title 5 [United States Code], relating to classifi- cation and General Schedule pay rates: Provided, That assignment, removal, and compensation of administrative law judges [hearing examiners] shall be in accordance with sections 3105, 3344, 5372, and 7521 of title 5 [United States Code]. (b) (1) There shall be a General Counsel of the Commission appointed by the President, by and with the advice and consent of the Senate, for a term of four years. The General Counsel shall have responsibility for the conduct of litigation as provided in sections 2000e-5 and 2000e-6 of this title [sections 706 and 707]. The General Counsel shall have such other duties as the Com- mission may prescribe or as may be provided by law and shall concur with the Chairman of the Commission on the appointment and supervision of regional attorneys. The General Counsel of the Commission on the effective date of this Act shall continue in such position and perform the functions specified in this subsection until a successor is appointed and qualified.

(2) Attorneys appointed under this section may, at the direction of the Commission, appear for and represent the Commission in any case in court, provided that the Attorney General shall conduct all litigation to which the Commission is a party in the Supreme Court pursuant to this subchapter. (c) A vacancy in the Commission shall not impair the right of the remaining members to exer- cise all the powers of the Commission and three members thereof shall constitute a quorum.

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(d) The Commission shall have an official seal which shall be judicially noticed. (e) The Commission shall at the close of each fiscal year report to the Congress and to the President concerning the action it has taken [the names, salaries, and duties of all individuals in its employ] and the moneys it has disbursed. It shall make such further reports on the cause of and means of eliminating discrimination and such recommendations for further legislation as may appear desirable. (f) The principal office of the Commission shall be in or near the District of Columbia, but it may meet or exercise any or all its powers at any other place. The Commission may establish such regional or State offices as it deems necessary to accomplish the purpose of this subchapter. (g) The Commission shall have power-

(1) to cooperate with and, with their consent, utilize regional, State, local, and other agen- cies, both public and private, and individuals;

(2) to pay to witnesses whose depositions are taken or who are summoned before the Com- mission or any of its agents the same witness and mileage fees as are paid to witnesses in the courts of the United States;

(3) to furnish to persons subject to this subchapter such technical assistance as they may request to further their compliance with this subchapter or an order issued thereunder;

(4) upon the request of (i) any employer, whose employees or some of them, or (ii) any labor organization, whose members or some of them, refuse or threaten to refuse to cooperate in effectuating the provisions of this subchapter, to assist in such effectuation by conciliation or such other remedial action as is provided by this subchapter;

(5) to make such technical studies as are appropriate to effectuate the purposes and policies of this subchapter and to make the results of such studies available to the public;

(6) to intervene in a civil action brought under section 2000e-5 of this title [section 706] by an aggrieved party against a respondent other than a government, governmental agency or political subdivision. (h) (1) The Commission shall, in any of its educational or promotional activities, cooperate with other departments and agencies in the performance of such educational and promotional activities.

(2) In exercising its powers under this title, the Commission shall carry out educational and outreach activities (including dissemination of information in languages other than English) targeted to-

(A) individuals who historically have been victims of employment discrimination and have not been equitably served by the Commission; and

(B) individuals on whose behalf the Commission has authority to enforce any other law prohibiting employment discrimination, concerning rights and obligations under this title or such law, as the case may be. (i) All officers, agents, attorneys, and employees of the Commission shall be subject to the provisions of section 7324 of title 5 [section 9 of the Act of August 2, 1939, as amended (the Hatch Act)], notwithstanding any exemption contained in such section. (j) (1) The Commission shall establish a Technical Assistance Training Institute, through which the Commission shall provide technical assistance and training regarding the laws and regulations enforced by the Commission.

(2) An employer or other entity covered under this title shall not be excused from com- pliance with the requirements of this title because of any failure to receive technical assis- tance under this subsection.

(3) There are authorized to be appropriated to carry out this subsection such sums as may be necessary for fiscal year 1992.

ENFORCEMENT PROVISIONS SEC. 2000e-5. [Section 706]. (a) The Commission is empowered, as hereinafter provided, to prevent any person from engag- ing in any unlawful employment practice as set forth in section 2000e-2 or 2000e-3 of this title [section 703 or 704].

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(b) Whenever a charge is filed by or on behalf of a person claiming to be aggrieved, or by a member of the Commission, alleging that an employer, employment agency, labor organization, or joint labor management committee controlling apprenticeship or other training or retraining, including on the job training programs, has engaged in an unlawful employment practice, the Commission shall serve a notice of the charge (including the date, place and circumstances of the alleged unlawful employment practice) on such employer, employment agency, labor organization, or joint labor management committee (hereinafter referred to as the “respondent”) within ten days, and shall make an investigation thereof. Charges shall be in writing under oath or affirmation and shall contain such information and be in such form as the Commission requires. Charges shall not be made public by the Commission. If the Commission determines after such investigation that there is not reasonable cause to believe that the charge is true, it shall dismiss the charge and promptly notify the person claiming to be aggrieved and the respondent of its action. In determining whether reasonable cause exists, the Commission shall accord substantial weight to final findings and orders made by State or local authorities in proceedings commenced under State or local law pursuant to the requirements of subsections (c) and (d) of this section. If the Commission determines after such investigation that there is reasonable cause to believe that the charge is true, the Commission shall endeavor to eliminate any such alleged unlawful employment practice by informal methods of conference, concili- ation, and persuasion. Nothing said or done during and as a part of such informal endeavors may be made public by the Commission, its officers or employees, or used as evidence in a subsequent proceeding without the written consent of the persons concerned. Any person who makes public information in violation of this subsection shall be fined not more than $1,000 or imprisoned for not more than one year, or both. The Commission shall make its determina- tion on reasonable cause as promptly as possible and, so far as practicable, not later than one hundred and twenty days from the filing of the charge or, where applicable under subsection (c) or (d) of this section, from the date upon which the Commission is authorized to take action with respect to the charge. (c) In the case of an alleged unlawful employment practice occurring in a State, or political sub- division of a State, which has a State or local law prohibiting the unlawful employment practice alleged and establishing or authorizing a State or local authority to grant or seek relief from such practice or to institute criminal proceedings with respect thereto upon receiving notice thereof, no charge may be filed under subsection (a) of this section by the person aggrieved before the expiration of sixty days after proceedings have been commenced under the State or local law, unless such proceedings have been earlier terminated, provided that such sixty day period shall be extended to one hundred and twenty days during the first year after the effective date of such State or local law. If any requirement for the commencement of such proceed- ings is imposed by a State or local authority other than a requirement of the filing of a written and signed statement of the facts upon which the proceeding is based, the proceeding shall be deemed to have been commenced for the purposes of this subsection at the time such statement is sent by registered mail to the appropriate State or local authority. (d) In the case of any charge filed by a member of the Commission alleging an unlawful employment practice occurring in a State or political subdivision of a State which has a State or local law prohibiting the practice alleged and establishing or authorizing a State or local author- ity to grant or seek relief from such practice or to institute criminal proceedings with respect thereto upon receiving notice thereof, the Commission shall, before taking any action with respect to such charge, notify the appropriate State or local officials and, upon request, afford them a reasonable time, but not less than sixty days (provided that such sixty day period shall be extended to one hundred and twenty days during the first year after the effective day of such State or local law), unless a shorter period is requested, to act under such State or local law to remedy the practice alleged. (e) (1) A charge under this section shall be filed within one hundred and eighty days after the alleged unlawful employment practice occurred and notice of the charge (including the date, place and circumstances of the alleged unlawful employment practice) shall be served upon the person against whom such charge is made within ten days thereafter, except that in a case

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of an unlawful employment practice with respect to which the person aggrieved has initially instituted proceedings with a State or local agency with authority to grant or seek relief from such practice or to institute criminal proceedings with respect thereto upon receiving notice thereof, such charge shall be filed by or on behalf of the person aggrieved within three hun- dred days after the alleged unlawful employment practice occurred, or within thirty days after receiving notice that the State or local agency has terminated the proceedings under the State or local law, whichever is earlier, and a copy of such charge shall be filed by the Commission with the State or local agency.

(2) For purposes of this section, an unlawful employment practice occurs, with respect to a seniority system that has been adopted for an intentionally discriminatory purpose in violation of this title (whether or not that discriminatory purpose is apparent on the face of the seniority provision), when the seniority system is adopted, when an individual becomes subject to the seniority system, or when a person aggrieved is injured by the application of the seniority system or provision of the system. (f) (1) If within thirty days after a charge is filed with the Commission or within thirty days after expiration of any period of reference under subsection (c) or (d) of this section, the Com- mission has been unable to secure from the respondent a conciliation agreement acceptable to the Commission, the Commission may bring a civil action against any respondent not a gov- ernment, governmental agency, or political subdivision named in the charge. In the case of a respondent which is a government, governmental agency, or political subdivision, if the Com- mission has been unable to secure from the respondent a conciliation agreement acceptable to the Commission, the Commission shall take no further action and shall refer the case to the Attorney General who may bring a civil action against such respondent in the appropriate United States district court. The person or persons aggrieved shall have the right to intervene in a civil action brought by the Commission or the Attorney General in a case involving a gov- ernment, governmental agency, or political subdivision. If a charge filed with the Commission pursuant to subsection (b) of this section, is dismissed by the Commission, or if within one hundred and eighty days from the filing of such charge or the expiration of any period of ref- erence under subsection (c) or (d) of this section, whichever is later, the Commission has not filed a civil action under this section or the Attorney General has not filed a civil action in a case involving a government, governmental agency, or political subdivision, or the Commis- sion has not entered into a conciliation agreement to which the person aggrieved is a party, the Commission, or the Attorney General in a case involving a government, governmental agency, or political subdivision, shall so notify the person aggrieved and within ninety days after the giving of such notice a civil action may be brought against the respondent named in the charge (A) by the person claiming to be aggrieved or (B) if such charge was filed by a member of the Commission, by any person whom the charge alleges was aggrieved by the alleged unlawful employment practice. Upon application by the complainant and in such cir- cumstances as the court may deem just, the court may appoint an attorney for such complain- ant and may authorize the commencement of the action without the payment of fees, costs, or security. Upon timely application, the court may, in its discretion, permit the Commission, or the Attorney General in a case involving a government, governmental agency, or political subdivision, to intervene in such civil action upon certification that the case is of general public importance. Upon request, the court may, in its discretion, stay further proceedings for not more than sixty days pending the termination of State or local proceedings described in subsection (c) or (d) of this section or further efforts of the Commission to obtain voluntary compliance.

(2) Whenever a charge is filed with the Commission and the Commission concludes on the basis of a preliminary investigation that prompt judicial action is necessary to carry out the pur- poses of this Act, the Commission, or the Attorney General in a case involving a government, governmental agency, or political subdivision, may bring an action for appropriate temporary or preliminary relief pending final disposition of such charge. Any temporary restraining order or other order granting preliminary or temporary relief shall be issued in accordance with rule 65 of the Federal Rules of Civil Procedure. It shall be the duty of a court having jurisdiction over

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proceedings under this section to assign cases for hearing at the earliest practicable date and to cause such cases to be in every way expedited.

(3) Each United States district court and each United States court of a place subject to the jurisdiction of the United States shall have jurisdiction of actions brought under this subchap- ter. Such an action may be brought in any judicial district in the State in which the unlawful employment practice is alleged to have been committed, in the judicial district in which the employment records relevant to such practice are maintained and administered, or in the judi- cial district in which the aggrieved person would have worked but for the alleged unlawful employment practice, but if the respondent is not found within any such district, such an action may be brought within the judicial district in which the respondent has his principal office. For purposes of sections 1404 and 1406 of title 28 [of the United States Code], the judicial district in which the respondent has his principal office shall in all cases be considered a district in which the action might have been brought.

(4) It shall be the duty of the chief judge of the district (or in his absence, the acting chief judge) in which the case is pending immediately to designate a judge in such district to hear and determine the case. In the event that no judge in the district is available to hear and determine the case, the chief judge of the district, or the acting chief judge, as the case may be, shall cer- tify this fact to the chief judge of the circuit (or in his absence, the acting chief judge) who shall then designate a district or circuit judge of the circuit to hear and determine the case.

(5) It shall be the duty of the judge designated pursuant to this subsection to assign the case for hearing at the earliest practicable date and to cause the case to be in every way expedited. If such judge has not scheduled the case for trial within one hundred and twenty days after issue has been joined, that judge may appoint a master pursuant to rule 53 of the Federal Rules of Civil Procedure. (g) (1) If the court finds that the respondent has intentionally engaged in or is intentionally engaging in an unlawful employment practice charged in the complaint, the court may enjoin the respondent from engaging in such unlawful employment practice, and order such affirma- tive action as may be appropriate, which may include, but is not limited to, reinstatement or hiring of employees, with or without back pay (payable by the employer, employment agency, or labor organization, as the case may be, responsible for the unlawful employment practice), or any other equitable relief as the court deems appropriate. Back pay liability shall not accrue from a date more than two years prior to the filing of a charge with the Commission. Interim earnings or amounts earnable with reasonable diligence by the person or persons discriminated against shall operate to reduce the back pay otherwise allowable.

(2) (A) No order of the court shall require the admission or reinstatement of an individual as a member of a union, or the hiring, reinstatement, or promotion of an individual as an employee, or the payment to him of any back pay, if such individual was refused admission, suspended, or expelled, or was refused employment or advancement or was suspended or discharged for any reason other than discrimination on account of race, color, religion, sex, or national origin or in violation of section 2000e-3(a) of this title [section 704(a)].

(B) On a claim in which an individual proves a violation under section 2000e-2(m) of this title [section 703(m)] and a respondent demonstrates that the respondent would have taken the same action in the absence of the impermissible motivating factor, the court-

(i) may grant declaratory relief, injunctive relief (except as provided in clause (ii)), and attorney’s fees and costs demonstrated to be directly attributable only to the pursuit of a claim under section 2000e-2(m) of this title [section 703(m)]; and

(ii) shall not award damages or issue an order requiring any admission, reinstatement, hiring, promotion, or payment, described in subparagraph (A). (h) The provisions of chapter 6 of title 29 [the Act entitled “An Act to amend the Judicial Code and to define and limit the jurisdiction of courts sitting in equity, and for other purposes,” approved March 23, 1932 (29 U.S.C. 105-115)] shall not apply with respect to civil actions brought under this section. (i) In any case in which an employer, employment agency, or labor organization fails to comply with an order of a court issued in a civil action brought under this section, the Commission may commence proceedings to compel compliance with such order.

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(j) Any civil action brought under this section and any proceedings brought under subsection (i) of this section shall be subject to appeal as provided in sections 1291 and 1292, title 28 [United States Code]. (k) In any action or proceeding under this subchapter the court, in its discretion, may allow the prevailing party, other than the Commission or the United States, a reasonable attorney’s fee (including expert fees) as part of the costs, and the Commission and the United States shall be liable for costs the same as a private person.

CIVIL ACTIONS BY THE ATTORNEY GENERAL SEC. 2000e-6. [Section 707]. (a) Whenever the Attorney General has reasonable cause to believe that any person or group of persons is engaged in a pattern or practice of resistance to the full enjoyment of any of the rights secured by this subchapter, and that the pattern or practice is of such a nature and is intended to deny the full exercise of the rights herein described, the Attorney General may bring a civil action in the appropriate district court of the United States by filing with it a com- plaint (1) signed by him (or in his absence the Acting Attorney General), (2) setting forth facts pertaining to such pattern or practice, and (3) requesting such relief, including an application for a permanent or temporary injunction, restraining order or other order against the person or persons responsible for such pattern or practice, as he deems necessary to insure the full enjoy- ment of the rights herein described. (b) The district courts of the United States shall have and shall exercise jurisdiction of proceed- ings instituted pursuant to this section, and in any such proceeding the Attorney General may file with the clerk of such court a request that a court of three judges be convened to hear and determine the case. Such request by the Attorney General shall be accompanied by a certifi- cate that, in his opinion, the case is of general public importance. A copy of the certificate and request for a three judge court shall be immediately furnished by such clerk to the chief judge of the circuit (or in his absence, the presiding circuit judge of the circuit) in which the case is pending. Upon receipt of such request it shall be the duty of the chief judge of the circuit or the presiding circuit judge, as the case may be, to designate immediately three judges in such circuit, of whom at least one shall be a circuit judge and another of whom shall be a district judge of the court in which the proceeding was instituted, to hear and determine such case, and it shall be the duty of the judges so designated to assign the case for hearing at the earliest practicable date, to participate in the hearing and determination thereof, and to cause the case to be in every way expedited. An appeal from the final judgment of such court will lie to the Supreme Court.

In the event the Attorney General fails to file such a request in any such proceeding, it shall be the duty of the chief judge of the district (or in his absence, the acting chief judge) in which the case is pending immediately to designate a judge in such district to hear and determine the case. In the event that no judge in the district is available to hear and determine the case, the chief judge of the district, or the acting chief judge, as the case may be, shall certify this fact to the chief judge of the circuit (or in his absence, the acting chief judge) who shall then designate a district or circuit judge of the circuit to hear and determine the case.

It shall be the duty of the judge designated pursuant to this section to assign the case for hearing at the earliest practicable date and to cause the case to be in every way expedited. (c) Effective two years after March 24, 1972 [the date of enactment of the Equal Employment Opportunity Act of 1972], the functions of the Attorney General under this section shall be transferred to the Commission, together with such personnel, property, records, and unexpended balances of appropriations, allocations, and other funds employed, used, held, available, or to be made available in connection with such functions unless the President submits, and neither House of Congress vetoes, a reorganization plan pursuant to chapter 9 of title 5 [United States Code], inconsistent with the provisions of this subsection. The Commission shall carry out such functions in accordance with subsections (d) and (e) of this section.

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(d) Upon the transfer of functions provided for in subsection (c) of this section, in all suits commenced pursuant to this section prior to the date of such transfer, proceedings shall con- tinue without abatement, all court orders and decrees shall remain in effect, and the Commis- sion shall be substituted as a party for the United States of America, the Attorney General, or the Acting Attorney General, as appropriate. (e) Subsequent to March 24, 1972 [the date of enactment of the Equal Employment Opportunity Act of 1972], the Commission shall have authority to investigate and act on a charge of a pattern or practice of discrimination, whether filed by or on behalf of a person claiming to be aggrieved or by a member of the Commission. All such actions shall be conducted in accordance with the procedures set forth in section 2000e-5 of this title [section 706].

EFFECT ON STATE LAWS SEC. 2000e-7. [Section 708]. Nothing in this subchapter shall be deemed to exempt or relieve any person from any liability, duty, penalty, or punishment provided by any present or future law of any State or political subdivision of a State, other than any such law which purports to require or permit the doing of any act which would be an unlawful employment practice under this subchapter.

INVESTIGATIONS, INSPECTIONS, RECORDS, STATE AGENCIES SEC. 2000e-8. [Section 709]. (a) In connection with any investigation of a charge filed under section 2000e-5 of this title [section 706], the Commission or its designated representative shall at all reasonable times have access to, for the purposes of examination, and the right to copy any evidence of any person being investigated or proceeded against that relates to unlawful employment practices covered by this subchapter and is relevant to the charge under investigation. (b) The Commission may cooperate with State and local agencies charged with the adminis- tration of State fair employment practices laws and, with the consent of such agencies, may, for the purpose of carrying out its functions and duties under this subchapter and within the lim- itation of funds appropriated specifically for such purpose, engage in and contribute to the cost of research and other projects of mutual interest undertaken by such agencies, and utilize the services of such agencies and their employees, and, notwithstanding any other provision of law, pay by advance or reimbursement such agencies and their employees for services rendered to assist the Commission in carrying out this subchapter. In furtherance of such cooperative efforts, the Commission may enter into written agreements with such State or local agencies and such agreements may include provisions under which the Commission shall refrain from processing a charge in any cases or class of cases specified in such agreements or under which the Commission shall relieve any person or class of persons in such State or locality from requirements imposed under this section. The Commission shall rescind any such agreement whenever it determines that the agreement no longer serves the interest of effective enforce- ment of this subchapter. (c) Every employer, employment agency, and labor organization subject to this subchapter shall (1) make and keep such records relevant to the determinations of whether unlawful employment practices have been or are being committed, (2) preserve such records for such periods, and (3) make such reports therefrom as the Commission shall prescribe by regulation or order, after public hearing, as reasonable, necessary, or appropriate for the enforcement of this subchapter or the regulations or orders thereunder. The Commission shall, by regulation, require each employer, labor organization, and joint labor management committee subject to this subchapter which controls an apprenticeship or other training program to maintain such records as are reasonably necessary to carry out the purposes of this subchapter, including, but not limited to, a list of applicants who wish to participate in such program, including the chronological order in which applications were received, and to furnish to the Commission

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upon request, a detailed description of the manner in which persons are selected to participate in the apprenticeship or other training program. Any employer, employment agency, labor organization, or joint labor management committee which believes that the application to it of any regulation or order issued under this section would result in undue hardship may apply to the Commission for an exemption from the application of such regulation or order, and, if such application for an exemption is denied, bring a civil action in the United States district court for the district where such records are kept. If the Commission or the court, as the case may be, finds that the application of the regulation or order to the employer, employment agency, or labor organization in question would impose an undue hardship, the Commission or the court, as the case may be, may grant appropriate relief. If any person required to comply with the provisions of this subsection fails or refuses to do so, the United States district court for the district in which such person is found, resides, or transacts business, shall, upon application of the Commission, or the Attorney General in a case involving a government, governmental agency or political subdivision, have jurisdiction to issue to such person an order requiring him to comply. (d) In prescribing requirements pursuant to subsection (c) of this section, the Commission shall consult with other interested State and Federal agencies and shall endeavor to coordinate its requirements with those adopted by such agencies. The Commission shall furnish upon request and without cost to any State or local agency charged with the administration of a fair employ- ment practice law information obtained pursuant to subsection (c) of this section from any employer, employment agency, labor organization, or joint labor management committee sub- ject to the jurisdiction of such agency. Such information shall be furnished on condition that it not be made public by the recipient agency prior to the institution of a proceeding under State or local law involving such information. If this condition is violated by a recipient agency, the Commission may decline to honor subsequent requests pursuant to this subsection. (e) It shall be unlawful for any officer or employee of the Commission to make public in any manner whatever any information obtained by the Commission pursuant to its authority under this section prior to the institution of any proceeding under this subchapter involving such information. Any officer or employee of the Commission who shall make public in any man- ner whatever any information in violation of this subsection shall be guilty, of a misdemeanor and upon conviction thereof, shall be fined not more than $1,000, or imprisoned not more than one year.

INVESTIGATORY POWERS SEC. 2000e-9. [Section 710]. For the purpose of all hearings and investigations conducted by the Commission or its duly authorized agents or agencies, section 161 of title 29 [section 11 of the National Labor Relations Act] shall apply.

POSTING OF NOTICES; PENALTIES SEC. 2000e-10. [Section 711]. (a) Every employer, employment agency, and labor organization, as the case may be, shall post and keep posted in conspicuous places upon its premises where notices to employees, appli- cants for employment, and members are customarily posted a notice to be prepared or approved by the Commission setting forth excerpts, from or, summaries of, the pertinent provisions of this subchapter and information pertinent to the filing of a complaint. (b) A willful violation of this section shall be punishable by a fine of not more than $100 for each separate offense.

VETERANS’ SPECIAL RIGHTS OR PREFERENCE SEC. 2000e-11. [Section 712]. Nothing contained in this subchapter shall be con- strued to repeal or modify any Federal, State, territorial, or local law creating special rights or preference for veterans.

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RULES AND REGULATIONS SEC. 2000e-12. [Section 713]. (a) The Commission shall have authority from time to time to issue, amend, or rescind suit- able procedural regulations to carry out the provisions of this subchapter. Regulations issued under this section shall be in conformity with the standards and limitations of subchapter II of chapter 5 of title 5 [the Administrative Procedure Act]. (b) In any action or proceeding based on any alleged unlawful employment practice, no person shall be subject to any liability or punishment for or on account of (1) the commis- sion by such person of an unlawful employment practice if he pleads and proves that the act or omission complained of was in good faith, in conformity with, and in reliance on any written interpretation or opinion of the Commission, or (2) the failure of such person to publish and file any information required by any provision of this subchapter if he pleads and proves that he failed to publish and file such information in good faith, in conformity with the instructions of the Commission issued under this subchapter regarding the filing of such information. Such a defense, if established, shall be a bar to the action or proceeding, notwithstanding that (A) after such act or omission, such interpretation or opinion is modi- fied or rescinded or is determined by judicial authority to be invalid or of no legal effect, or (B) after publishing or filing the description and annual reports, such publication or filing is determined by judicial authority not to be in conformity with the requirements of this subchapter.

FORCIBLY RESISTING THE COMMISSION OR ITS REPRESENTATIVES SEC. 2000e-13. [Section 714]. The provisions of sections 111 and 1114, title 18 [United States Code], shall apply to officers, agents, and employees of the Commission in the performance of their official duties. Notwithstanding the provisions of sections 111 and 1114 of title 18 [United States Code], whoever in violation of the provisions of section 1114 of such title kills a person while engaged in or on account of the performance of his official functions under this Act shall be punished by imprisonment for any term of years or for life.

TRANSFER OF AUTHORITY [Administration of the duties of the Equal Employment Opportunity Coordinating Council was transferred to the Equal Employment Opportunity Commission effective July 1, 1978, under the President’s Reorganization Plan of 1978.]

EQUAL EMPLOYMENT OPPORTUNITY COORDINATING COUNCIL SEC. 2000e-14. [Section 715]. [There shall be established an Equal Employment Opportunity Coordinating Council (hereinafter referred to in this section as the Council) composed of the Secretary of Labor, the Chairman of the Equal Employment Opportunity Commission, the Attorney General, the Chairman of the United States Civil Service Com- mission, and the Chairman of the United States Civil Rights Commission, or their respective delegates.] The Equal Employment Opportunity Commission [Council] shall have the responsibility for developing and implementing agreements, policies and practices designed to maximize effort, promote efficiency, and eliminate conflict, competition, duplication and inconsistency among the operations, functions and jurisdictions of the various departments, agencies and branches of the Federal Government responsible for the implementation and enforcement of equal employ- ment opportunity legislation, orders, and policies. On or before October 1 [July 1] of each year, the Equal Employment Opportunity Commission [Council] shall transmit to the President and

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to the Congress a report of its activities, together with such recommendations for legislative or administrative changes as it concludes are desirable to further promote the purposes of this section.

EFFECTIVE DATE SEC. 2000e-15. [Section 716]. [(a) This title shall become effective one year after the date of its enactment. (b) Notwithstanding subsection (a), sections of this title other than sections 703, 704, 706, and 707 shall become effective immediately. (c)] The President shall, as soon as feasible after July 2, 1964 [the enactment of this title], con- vene one or more conferences for the purpose of enabling the leaders of groups whose members will be affected by this subchapter to become familiar with the rights afforded and obligations imposed by its provisions, and for the purpose of making plans which will result in the fair and effective administration of this subchapter when all of its provisions become effective. The President shall invite the participation in such conference or conferences of (1) the members of the President’s Committee on Equal Employment Opportunity, (2) the members of the Com- mission on Civil Rights, (3) representatives of State and local agencies engaged in furthering equal employment opportunity, (4) representatives of private agencies engaged in furthering equal employment opportunity, and (5) representatives of employers, labor organizations, and employment agencies who will be subject to this subchapter.

TRANSFER OF AUTHORITY [Enforcement of Section 717 was transferred to the Equal Employment Opportunity Commis- sion from the Civil Service Commission (Office of Personnel Management) effective January 1, 1979 under the President’s Reorganization Plan No. 1 of 1978.]

EMPLOYMENT BY FEDERAL GOVERNMENT SEC. 2000e-16. [Section 717]. (a) All personnel actions affecting employees or applicants for employment (except with regard to aliens employed outside the limits of the United States) in military departments as defined in section 102 of title 5 [United States Code], in executive agencies [other than the General Accounting Office] as defined in section 105 of title 5 [United States Code] (including employ- ees and applicants for employment who are paid from nonappropriated funds), in the United States Postal Service and the Postal Rate Commission, in those units of the Government of the District of Columbia having positions in the competitive service, and in those units of the legislative and judicial branches of the Federal Government having positions in the competitive service, and in the Library of Congress shall be made free from any discrimination based on race, color, religion, sex, or national origin. (b) Except as otherwise provided in this subsection, the Equal Employment Opportunity Com- mission [Civil Service Commission] shall have authority to enforce the provisions of subsection (a) of this section through appropriate remedies, including reinstatement or hiring of employees with or without back pay, as will effectuate the policies of this section, and shall issue such rules, regulations, orders and instructions as it deems necessary and appropriate to carry out its responsibilities under this section. The Equal Employment Opportunity Commission [Civil Service Commission] shall-

(1) be responsible for the annual review and approval of a national and regional equal employment opportunity plan which each department and agency and each appropriate unit referred to in subsection (a) of this section shall submit in order to maintain an affirmative pro- gram of equal employment opportunity for all such employees and applicants for employment;

(2) be responsible for the review and evaluation of the operation of all agency equal employ- ment opportunity programs, periodically obtaining and publishing (on at least a semiannual basis) progress reports from each such department, agency, or unit; and

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(3) consult with and solicit the recommendations of interested individuals, groups, and organizations relating to equal employment opportunity. The head of each such department, agency, or unit shall comply with such rules, regulations, orders, and instructions which shall include a provision that an employee or applicant for employment shall be notified of any final action taken on any complaint of discrimination filed by him thereunder. The plan submitted by each department, agency, and unit shall include, but not be limited to-

(1) provision for the establishment of training and education programs designed to provide a maximum opportunity for employees to advance so as to perform at their highest potential; and

(2) a description of the qualifications in terms of training and experience relating to equal employment opportunity for the principal and operating officials of each such department, agency, or unit responsible for carrying out the equal employment opportunity program and of the allocation of personnel and resources proposed by such department, agency, or unit to carry out its equal employment opportunity program. With respect to employment in the Library of Congress, authorities granted in this subsection to the Equal Employment Opportunity Commission [Civil Service Commission] shall be exer- cised by the Librarian of Congress. (c) Within 90 days of receipt of notice of final action taken by a department, agency, or unit referred to in subsection (a) of this section, or by the Equal Employment Opportunity Commis- sion [Civil Service Commission] upon an appeal from a decision or order of such department, agency, or unit on a complaint of discrimination based on race, color, religion, sex or national origin, brought pursuant to subsection (a) of this section, Executive Order 11478 or any suc- ceeding Executive orders, or after one hundred and eighty days from the filing of the initial charge with the department, agency, or unit or with the Equal Employment Opportunity Com- mission [Civil Service Commission] on appeal from a decision or order of such department, agency, or unit until such time as final action may be taken by a department, agency, or unit, an employee or applicant for employment, if aggrieved by the final disposition of his complaint, or by the failure to take final action on his complaint, may file a civil action as provided in section 2000e-5 of this title [section 706], in which civil action the head of the department, agency, or unit, as appropriate, shall be the defendant. (d) The provisions of section 2000e-5(f) through (k) of this title [section 706(f) through (k)], as applicable, shall govern civil actions brought hereunder, and the same interest to compensate for delay in payment shall be available as in cases involving nonpublic parties. (e) Nothing contained in this Act shall relieve any Government agency or official of its or his primary responsibility to assure nondiscrimination in employment as required by the Constitu- tion and statutes or of its or his responsibilities under Executive Order 11478 relating to equal employment opportunity in the Federal Government.

SPECIAL PROVISIONS WITH RESPECT TO DENIAL, TERMINATION, AND SUSPENSION OF GOVERNMENT CONTRACTS SEC. 2000e-17. [Section 718]. No Government contract, or portion thereof, with any employer, shall be denied, withheld, terminated, or suspended, by any agency or officer of the United States under any equal employment opportunity law or order, where such employer has an affirmative action plan which has previously been accepted by the Government for the same facility within the past twelve months without first according such employer full hearing and adjudication under the provisions of section 554 of title 5 [United States Code], and the following pertinent sections: Provided, That if such employer has deviated substantially from such previously agreed to affirmative action plan, this section shall not apply: Provided further, That for the purposes of this section an affirmative action plan shall be deemed to have been accepted by the Government at the time the appropriate compliance agency has accepted such plan unless within forty five days thereafter the Office of Federal Contract Compliance has disapproved such plan.

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THE CIVIL RIGHTS ACT OF 1991 The U.S. Equal Employment Opportunity Commission.

Title I—Federal Civil Rights Remedies PROHIBITION AGAINST ALL RACIAL DISCRIMINATION IN THE MAKING AND ENFORCEMENT OF CONTRACTS SEC. 101. Section 1977 of the Revised Statutes (42 U.S.C. 1981) is amended-

(1) by inserting “(a)” before “All persons within”; and (2) by adding at the end the following new subsections: “(b) For purposes of this section, the term ‘make and enforce contracts’ includes the making,

performance, modification, and termination of contracts, and the enjoyment of all benefits, privileges, terms, and conditions of the contractual relationship.

“(c) The rights protected by this section are protected against impairment by nongovernmen- tal discrimination and impairment under color of State law.”

DAMAGES IN CASES OF INTENTIONAL DISCRIMINATION SEC. 102. The Revised Statutes are amended by inserting after section 1977 (42 U.S.C. 1981) the following new section: “SEC. 1977A. DAMAGES IN CASES OF INTENTIONAL DISCRIMINATION IN EMPLOY- MENT. [42 U.S.C. 1981a] “(a) Right of Recovery. -

“(1) Civil Rights. - In an action brought by a complaining party under section 706 or 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-5) against a respondent who engaged in unlawful intentional discrimination (not an employment practice that is unlawful because of its disparate impact) prohibited under section 703, 704, or 717 of the Act (42 U.S.C. 2000e-2 or 2000e-3), and provided that the complaining party cannot recover under section 1977 of the Revised Statutes (42 U.S.C. 1981), the complaining party may recover compensatory and punitive dam- ages as allowed in subsection (b), in addition to any relief authorized by section 706(g) of the Civil Rights Act of 1964, from the respondent.

“(2) Disability. - In an action brought by a complaining party under the powers, remedies, and procedures set forth in section 706 or 717 of the Civil Rights Act of 1964 (as provided in section 107(a) of the Americans with Disabilities Act of 1990 (42 U.S.C. 12117 (a)), and sec- tion 505(a)(1) of the Rehabilitation Act of 1973 (29 U.S.C. 794a(a)(1)), respectively) against a respondent who engaged in unlawful intentional discrimination (not an employment practice that is unlawful because of its disparate impact) under section 501 of the Rehabilitation Act of 1973 (29 U.S.C. 791) and the regulations implementing section 501, or who violated the requirements of section 501 of the Act or the regulations implementing section 501 concerning the provision of a reasonable accommodation, or section 102 of the Americans with Disabili- ties Act of 1990 (42 U.S.C. 12112), or committed a violation of section 102(b)(5) of the Act, against an individual, the complaining party may recover compensatory and punitive damages as allowed in subsection (b), in addition to any relief authorized by section 706(g) of the Civil Rights Act of 1964, from the respondent.

“(3) Reasonable Accommodation and Good Faith Effort. - In cases where a discriminatory practice involves the provision of a reasonable accommodation pursuant to section 102(b)(5) of the Americans with Disabilities Act of 1990 or regulations implementing section 501 of the

Appendix D

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Rehabilitation Act of 1973, damages may not be awarded under this section where the covered entity demonstrates good faith efforts, in consultation with the person with the disability who has informed the covered entity that accommodation is needed, to identify and make a reason- able accommodation that would provide such individual with an equally effective opportunity and would not cause an undue hardship on the operation of the business. “(b) Compensatory and Punitive Damages. -

“(1) Determination of punitive damages. - A complaining party may recover punitive dam- ages under this section against a respondent (other than a government, government agency or political subdivision) if the complaining party demonstrates that the respondent engaged in a discriminatory practice or discriminatory practices with malice or with reckless indifference to the federally protected rights of an aggrieved individual.

“(2) Exclusions from compensatory damages. - Compensatory damages awarded under this section shall not include back pay, interest on back pay, or any other type of relief authorized under section 706(g) of the Civil Rights Act of 1964.

“(3) Limitations. - The sum of the amount of compensatory damages awarded under this section for future pecuniary losses, emotional pain, suffering, inconvenience, mental anguish, loss of enjoyment of life, and other nonpecuniary losses, and the amount of punitive damages awarded under this section, shall not exceed, for each complaining party -

“(A) in the case of a respondent who has more than 14 and fewer than 101 employees in each of 20 or more calendar weeks in the current or preceding calendar year, $50,000;

“(B) in the case of a respondent who has more than 100 and fewer than 201 employees in each of 20 or more calendar weeks in the current or preceding calendar year, $100,000; and

“(C) in the case of a respondent who has more than 200 and fewer than 501 employees in each of 20 or more calendar weeks in the current or preceding calendar year, $200,000; and

“(D) in the case of a respondent who has more than 500 employees in each of 20 or more calendar weeks in the current or preceding calendar year, $300,000.

“(4) Construction. - Nothing in this section shall be construed to limit the scope of, or the relief available under, section 1977 of the Revised Statutes (42 U.S.C. 1981). “(c) Jury Trial. - If a complaining party seeks compensatory or punitive damages under this section -

“(1) any party may demand a trial by jury; and “(2) the court shall not inform the jury of the limitations described in subsection (b)(3).

“(d) Definitions. - As used in this section: “(1) Complaining party. - The term ‘complaining party’ means - “(A) in the case of a person seeking to bring an action under subsection (a)(1), the Equal

Employment Opportunity Commission, the Attorney General, or a person who may bring an action or proceeding under title VII of the Civil Rights Act of 1964 (42 U.S.C. 2000e et seq.); or

“(B) in the case of a person seeking to bring an action under subsection (a)(2), the Equal Employment Opportunity Commission, the Attorney General, a person who may bring an action or proceeding under section 505(a)(1) of the Rehabilitation Act of 1973 (29 U.S.C. 794a(a)(1)), or a person who may bring an action or proceeding under title I of the Americans with Disabili- ties Act of 1990 (42 U.S.C. 12101 et seq.).

“(2) Discriminatory practice. - The term ‘discriminatory practice’ means the discrimination described in paragraph (1), or the discrimination or the violation described in paragraph (2), of subsection (a).

ATTORNEY’S FEES [This section amends section 722 of the Revised Statutes (42 U.S.C. 1988) by adding a refer- ence to section 102 of the Civil Rights Act of 1991 to the list of civil rights actions in which rea- sonable attorney’s fees may be awarded to the prevailing party, other than the United States.]

SEC. 103. The last sentence of section 722 of the Revised Statutes (42 U.S.C. 1988) is amended by inserting “,1977A” after “1977”.

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DEFINITIONS SEC. 104. [This section amends section 701 of the Civil Rights Act of 1964 (42 U.S.C. 2000e) by adding the following new subsections: (l) “complaining party,” (m) “demonstrates,” and (n) “respondent”.]

BURDEN OF PROOF IN DISPARATE IMPACT CASES SEC. 105. (a) [This subsection amends section 703 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2) by adding a new subsection (k), on the burden of proof in disparate impact cases.] (b) No statements other than the interpretive memorandum appearing at Vol. 137 Congressional Record S 15276 (daily ed. Oct. 25, 1991) shall be considered legislative history of, or relied upon in any way as legislative history in construing or applying, any provision of this Act that relates to Wards Cove - Business necessity/cumulation/alternative business practice. [42 U.S.C. 1981 note]

PROHIBITION AGAINST DISCRIMINATORY USE OF TEST SCORES SEC. 106. [This section amends section 703 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2) by adding a new subsection (l), on the prohibition against discriminatory use of test scores.]

CLARIFYING PROHIBITION AGAINST IMPERMISSIBLE CONSIDERATION OF RACE, COLOR, RELIGION, SEX, OR NATIONAL ORIGIN IN EMPLOYMENT PRACTICES SEC. 107. (a) In general. [This subsection amends section 703 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2) by adding a new subsection (m), clarifying the prohibition against consideration of race, color, religion, sex, or national origin in employment practices.] (b) Enforcement provisions. [This subsection amends section 706(g) of the Civil Rights Act of 1964 (42 U.S.C. 2000e-5(g)) by renumbering existing subsection (g), and adding at the end a new subparagraph (B) to provide a limitation on available relief in “mixed motive” cases (where the employer demonstrates it would have made the same decision in the absence of discrimination).]

FACILITATING PROMPT AND ORDERLY RESOLUTION OF CHALLENGES TO EMPLOYMENT PRACTICES IMPLEMENTING LITIGATED OR CONSENT JUDGMENTS OR ORDERS SEC. 108. [This section amends section 703 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-2) by adding a new subsection (n), on the resolution of challenges to employment prac- tices implementing litigated or consent judgments or orders.]

PROTECTION OF EXTRATERRITORIAL EMPLOYMENT SEC. 109. (a) Definition of Employee. [This subsection amends the definition of “employee” in section 701(f) of the Civil Rights Act of 1964 (42 U.S.C. 2000e(f)) and section 101(4) of the Americans with Disabilities Act of 1990 (42 U.S.C. 12111(4)) by adding a sentence to the end of each defi- nition to include U.S. citizens employed abroad within the laws’ protections.]

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(b) Exemption. [This subsection amends section 702 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-1) by adding new subsections (b) (on compliance with the statute if violative of foreign law) and (c) (on the control of a corporation incorporated in a foreign country). This subsection similarly amends section 102 of the Americans with Disabilities Act of 1990 (42 U.S.C. 12112) by relettering the existing subsections and adding a new subsection (c) “Covered Entities in Foreign Countries.”] (c) Application of Amendments. - The amendments made by this section shall not apply with respect to conduct occurring before the date of the enactment of this Act. [42 U.S.C. 2000e note]

TECHNICAL ASSISTANCE TRAINING INSTITUTE SEC. 110. (a) Technical Assistance. [This subsection amends section 705 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-4) by adding a new subsection (j), establishing the Technical Assistance Training Institute.] (b) Effective Date. - The amendment made by this section shall take effect on the date of enact- ment of this Act. [42 U.S.C. 2000e-4 note]

EDUCATION AND OUTREACH SEC. 111. [This section amends section 705(h) of the Civil Rights Act of 1964 (42 U.S.C. 2000e-4(h)) by renumbering the existing subsection and adding at the end a paragraph requir- ing the EEOC to engage in certain educational and outreach activities.]

EXPANSION OF RIGHT TO CHALLENGE DISCRIMINATORY SENIORITY SYSTEMS SEC. 112. [This section amends section 706(e) of the Civil Rights Act of 1964 (42 U.S.C. 2000e-5(e)) by renumbering the subsection and adding at the end a paragraph to expand the right of claimants to challenge discriminatory seniority systems.]

AUTHORIZING AWARD OF EXPERT FEES SEC. 113. (a) Revised Statutes. - Section 722 of the Revised Statutes is amended-

(1) by designating the first and second sentences as subsections (a) and (b), respectively, and indenting accordingly; and

(2) by adding at the end the following new subsection: “(c) In awarding an attorney’s fee under subsection (b) in any action or proceeding to enforce

a provision of section 1977 or 1977A of the Revised Statutes, the court, in its discretion, may include expert fees as part of the attorney’s fee.” [42 U.S.C. 1988] (b) Civil Rights Act of 1964. [This section amends section 706(k) of the Civil Rights Act of 1964 (42 U.S.C. 2000e-5(k)) to provide for recovery of expert fees as part of an attorney’s fees award.]

PROVIDING FOR INTEREST AND EXTENDING THE STATUTE OF LIMITATIONS IN ACTIONS AGAINST THE FEDERAL GOVERNMENT SEC. 114. [This section amends section 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-16) by extending the time for federal employees or applicants to file a civil action from 30 to 90 days (from receipt of notice of final action taken by a department, agency or unit), and allowing federal employees or applicants the same interest to compensate for delay in pay- ments as is available in cases involving nonpublic parties.]

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NOTICE OF LIMITATIONS PERIOD UNDER THE AGE DISCRIMINATION IN EMPLOYMENT ACT OF 1967 SEC. 115. [This section amends section 7(e) of the Age Discrimination in Employment Act of 1967 (ADEA) (29 U.S.C. 626(e)) by eliminating the two- and three-year statute of limitations and making ADEA suit-filing requirements the same as those under Title VII, and requiring the EEOC to provide notice to charging parties upon termination of the proceedings.]

LAWFUL, COURT-ORDERED REMEDIES, AFFIRMATIVE ACTION, AND CONCILIATION AGREEMENTS NOT AFFECTED SEC. 116 [42 U.S.C. 1981 note]. Nothing in the amendments made by this title shall be construed to affect court-ordered remedies, affirmative action, or conciliation agree- ments, that are in accordance with the law.

COVERAGE OF HOUSE OF REPRESENTATIVES AND THE AGENCIES OF THE LEGISLATIVE BRANCH SEC. 117. (a) Coverage of the House of Representatives. [This subsection extends the rights and protec- tions of Title VII of the Civil Rights Act of 1964, as amended, to employees of the U.S. House of Representatives. Procedures for processing discrimination complaints are handled internally by the House, not by the EEOC.] [2 U.S.C. 60 l] (b) Instrumentalities of Congress. [This subsection extends the rights and protections of the Civil Rights Act of 1991 and Title VII of the Civil Rights Act of 1964, as amended, to “Instru- mentalities of Congress,” which are defined to include: the Architect of the Capitol, the Con- gressional Budget Office, the General Accounting Office, the Government Printing Office, the Office of Technology Assessment, and the United States Botanic Garden. Each agency is to establish its own remedies and procedures for enforcement.]

ALTERNATIVE MEANS OF DISPUTE RESOLUTION SEC. 118 [42 U.S.C. 1981 note]. Where appropriate and to the extent authorized by law, the use of alternative means of dispute resolution, including settlement negotiations, conciliation, facilitation, mediation, fact finding, minitrials, and arbitration, is encouraged to resolve disputes arising under the Acts or provisions of Federal law amended by this title.

Title II—Glass Ceiling [This title sets up a “Glass Ceiling Commission” to focus attention on, and complete a study relating to, the existence of artificial barriers to the advancement of women and minorities in the workplace, and to make recommendations for overcoming such barriers. The Commission is to be composed of 21 members, with the Secretary of Labor serving as the Chairperson of the Commission. This title does not directly impose any responsibilities or obligations on the EEOC except to provide information and technical assistance as requested by the new Commission.] [42 U.S.C. 2000e note]

Title III—Government Employee Rights GOVERNMENT EMPLOYEE RIGHTS ACT OF 1991 SEC. 301 [2 U.S.C. 1201]. (a) Short title. - This title may be cited as the “Government Employee Rights Act of 1991”. (b) Purpose. - The purpose of this title is to provide procedures to protect the right of Senate and other government employees, with respect to their public employment, to be free of discrimina- tion on the basis of race, color, religion, sex, national origin, age, or disability.

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(c) Definitions. - For purposes of this title: (1) Senate employee. - The term “Senate employee” or “employee” means - (A) any employee whose pay is disbursed by the Secretary of the Senate; (B) any employee of the Architect of the Capitol who is assigned to the Senate Restaurants

or to the Superintendent of the Senate Office Buildings; (C) any applicant for a position that will last 90 days or more and that is to be occupied by

an individual described in subparagraph (A) or (B); or (D) any individual who was formerly an employee described in subparagraph (A) or (B) and

whose claim of a violation arises out of the individual’s Senate employment. (2) Head of employing office. - The term “head of employing office” means the individual

who has final authority to appoint, hire, discharge, and set the terms, conditions or privileges of the Senate employment of an employee.

(3) Violation. - The term “violation” means a practice that violates section 302 of this title.

DISCRIMINATORY PRACTICES PROHIBITED SEC. 302 [2 U.S.C. 1202]. [Sections 320 and 321 (which protect Presidential appoin- tees and previously exempt state employees who may file complaints of discrimination with EEOC under this title) refer to the rights, protections and remedies of this section and section 307(h).] All personnel actions affecting employees of the Senate shall be made free from any discrimi- nation based on -

(1) race, color, religion, sex, or national origin, within the meaning of section 717 of the Civil Rights Act of 1964 (42 U.S.C. 2000e-16);

(2) age, within the meaning of section 15 of the Age Discrimination in Employment Act of 1967 (29 U.S.C. 633a); or

(3) handicap or disability, within the meaning of section 501 of the Rehabilitation Act of 1973 (29 U.S.C. 791) and sections 102–104 of the Americans with Disabilities Act of 1990 (42 U.S.C. 12112-14). [SECTIONS 303 THROUGH 306: Section 303 (2 U.S.C. 1203) establishes the Office of Senate Fair Employment Practices, which will administer the procedures set forth in sections 304 through 307. Section 304 (2 U.S.C. 1204) outlines the four-step procedure described in Sections 305 through 309 for consideration of alleged violations. Section 305 (2 U.S.C. 1205) describes the Step I counseling procedures. Section 306 (2 U.S.C. 1206) describes the Step II mediation process. Section 307 (2 U.S.C. 1207), described fully below, sets forth the formal complaint and hearing procedures.]

STEP I I I : FORMAL COMPLAINT AND HEARING SEC. 307 [2 U.S.C. 1207]. [SECTION 307, SUBSECTIONS (a) THROUGH (g), AND (i): Subsections (a) through (g), and (i) of Section 307 describe the process from the formal complaint through the hearing stage.] [Sections 320 and 321 (which protect Presidential appointees and previously exempt state employees who may file complaints of discrimination with EEOC under this title) refer to the rights, protections and remedies of section 302 and the following subsection.] (h) Remedies. - If the hearing board determines that a violation has occurred, it shall order such remedies as would be appropriate if awarded under section 706 (g) and (k) of the Civil Rights Act of 1964 (42 U.S.C. 2000e-5 (g) and (k)), and may also order the award of such compensa- tory damages as would be appropriate if awarded under section 1977 and section 1977A (a) and (b)(2) of the Revised Statutes (42 U.S.C. 1981 and 1981A (a) and (b)(2)). In the case of a determination that a violation based on age has occurred, the hearing board shall order such remedies as would be appropriate if awarded under section 15(c) of the Age Discrimination in Employment Act of 1967 (29 U.S.C. 633a(c)). Any order requiring the payment of money must be approved by a Senate resolution reported by the Committee on Rules and Administration. The hearing board shall have no authority to award punitive damages.

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[SECTIONS 308 THROUGH 313: Section 308 (2 U.S.C. 1208) describes the procedures by which a Senate employee or head of an employing office may request a review by the Select Committee on Ethics of a decision issued under Section 307. Section 309 (2 U.S.C. 1209) describes the circumstances under which a Senate employee or Member of the Senate may petition for a review by the United States Court of Appeals for the Federal Circuit. Section 310 (2 U.S.C. 1210) describes the procedures by which a complaint may be resolved. Section 311 (2 U.S.C. 1211) enumerates reimbursable costs of attending hearings. Section 312 (2 U.S.C. 1212) prohibits intimidation or reprisal against any employee because of the exercise of a right under this title. Section 313 (2 U.S.C. 1213) outlines confidentiality requirements for counseling, mediation, hearings, final decisions, and records.]

EXERCISE OF RULEMAKING POWER SEC. 314 [2 U.S.C. 1214]. The provisions of this title, except for sections 309, 320, 321, and 322, are enacted by the Senate as an exercise of the rulemaking power of the Senate, with full recognition of the right of the Senate to change its rules, in the same manner, and to the same extent, as in the case of any other rule of the Senate. Notwithstanding any other provi- sion of law, except as provided in section 309, enforcement and adjudication with respect to the discriminatory practices prohibited by section 302, and arising out of Senate employment, shall be within the exclusive jurisdiction of the United States Senate.

TECHNICAL AND CONFORMING AMENDMENTS SEC. 315. [This section makes technical and conforming amendments to section 509 of the Americans with Disabilities Act of 1990 (ADA) (42 U.S.C. 12209) with respect to Senate employees.] [SECTIONS 316 THROUGH 319: Section 316 (2 U.S.C. 1215) states that the consideration of political affiliation, domicile, and political compatibility with the employing office in an employment decision shall not be considered a violation of this title. Section 317 (2 U.S.C. 1216) states that a Senate employee may not commence a judicial proceeding to redress a prohibited discriminatory practice, except as provided in this title. Sec. 318 (2 U.S.C. 1217) expresses the Senate’s view that legislation should be enacted to provide the same or compa- rable rights and remedies as are provided under this title to Congressional employees lacking such rights and remedies. Section 319 (2 U.S.C. 1218) reaffirms the Senate’s commitment to Rule XLII of the Standing Rules of the Senate.]

COVERAGE OF PRESIDENTIAL APPOINTEES SEC. 320 [2 U.S.C. 1219]. (a) In General. -

(1) Application. - The rights, protections, and remedies provided pursuant to section 302 and 307(h) of this title shall apply with respect to employment of Presidential appointees.

(2) Enforcement by administrative action. - Any Presidential appointee may file a complaint alleging a violation, not later than 180 days after the occurrence of the alleged violation, with the Equal Employment Opportunity Commission, or such other entity as is designated by the President by Executive Order, which, in accordance with the principles and procedures set forth in sections 554 through 557 of title 5, United States Code, shall determine whether a violation has occurred and shall set forth its determination in a final order. If the Equal Employment Opportunity Commission, or such other entity as is designated by the President pursuant to this section, determines that a violation has occurred, the final order shall also provide for appropri- ate relief.

(3) Judicial review. - (A) In general. - Any party aggrieved by a final order under paragraph (2) may petition for

review by the United States Court of Appeals for the Federal Circuit.

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(B) Law applicable. - Chapter 158 of title 28, United States Code, shall apply to a review under this section except that the Equal Employment Opportunity Commission or such other entity as the President may designate under paragraph (2) shall be an “agency” as that term is used in chapter 158 of title 28, United States Code.

(C) Standard of review. - To the extent necessary to decision and when presented, the review- ing court shall decide all relevant questions of law and interpret constitutional and statutory provisions. The court shall set aside a final order under paragraph (2) if it is determined that the order was -

(i) arbitrary, capricious, an abuse of discretion, or otherwise not consistent with law; (ii) not made consistent with required procedures; or (iii) unsupported by substantial evidence. In making the foregoing determinations, the court shall review the whole record or those

parts of it cited by a party, and due account shall be taken of the rule of prejudicial error. (D) Attorney’s fees. - If the presidential appointee is the prevailing party in a proceeding

under this section, attorney’s fees may be allowed by the court in accordance with the standards prescribed under section 706(k) of the Civil Rights Act of 1964 (42 U.S.C. 2000e-5(k)). (b) Presidential appointee. - For purposes of this section, the term “Presidential appointee” means any officer or employee, or an applicant seeking to become an officer or employee, in any unit of the Executive Branch, including the Executive Office of the President, whether appointed by the President or by any other appointing authority in the Executive Branch, who is not already entitled to bring an action under any of the statutes referred to in section 302 but does not include any individual -

(1) whose appointment is made by and with the advice and consent of the Senate; (2) who is appointed to an advisory committee, as defined in section 3(2) of the Federal

Advisory Committee Act (5 U.S.C. App.); or (3) who is a member of the uniformed services.

COVERAGE OF PREVIOUSLY EXEMPT STATE EMPLOYEES SEC. 321 [2 U.S.C. 1220]. (a) Application. - The rights, protections, and remedies provided pursuant to section 302 and 307(h) of this title shall apply with respect to employment of any individual chosen or appointed, by a person elected to public office in any State or political subdivision of any State by the qualified voters thereof -

(1) to be a member of the elected official’s personal staff; (2) to serve the elected official on the policymaking level; or (3) to serve the elected official as an immediate advisor with respect to the exercise of the

constitutional or legal powers of the office. (b) Enforcement by administrative action. -

(1) In general. - Any individual referred to in subsection (a) may file a complaint alleg- ing a violation, not later than 180 days after the occurrence of the alleged violation, with the Equal Employment Opportunity Commission, which, in accordance with the principles and procedures set forth in sections 554 through 557 of title 5, United States Code, shall deter- mine whether a violation has occurred and shall set forth its determination in a final order. If the Equal Employment Opportunity Commission determines that a violation has occurred, the final order shall also provide for appropriate relief.

(2) Referral to state and local authorities. - (A) Application. - Section 706(d) of the Civil Rights Act of 1964 (42 U.S.C. 2000e-5(d))

shall apply with respect to any proceeding under this section. (B) Definition. - For purposes of the application described in subparagraph (A), the term

“any charge filed by a member of the Commission alleging an unlawful employment practice” means a complaint filed under this section. (c) Judicial review. - Any party aggrieved by a final order under subsection (b) may obtain a review of such order under chapter 158 of title 28, United States Code. For the purpose of this

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review, the Equal Employment Opportunity Commission shall be an “agency” as that term is used in chapter 158 of title 28, United States Code. (d) Standard of review. - To the extent necessary to decision and when presented, the review- ing court shall decide all relevant questions of law and interpret constitutional and statutory provisions. The court shall set aside a final order under subsection (b) if it is determined that the order was -

(1) arbitrary, capricious, an abuse of discretion, or otherwise not consistent with law; (2) not made consistent with required procedures; or (3) unsupported by substantial evidence.

In making the foregoing determinations, the court shall review the whole record or those parts of it cited by a party, and due account shall be taken of the rule of prejudicial error. (e) Attorney’s fees. - If the individual referred to in subsection (a) is the prevailing party in a proceeding under this subsection, attorney’s fees may be allowed by the court in accordance with the standards prescribed under section 706(k) of the Civil Rights Act of 1964 (42 U.S.C. 2000e-5(k)).

SEVERABILITY SEC. 322 [2 U.S.C. 1221]. Notwithstanding section 401 of this Act, if any provision of section 309 or 320(a)(3) is invalidated, both sections 309 and 320(a)(3) shall have no force and effect.

PAYMENTS BY THE PRESIDENT OR A MEMBER OF THE SENATE SEC. 323 [2 U.S.C. 1222]. The President or a Member of the Senate shall reimburse the appropriate Federal account for any payment made on his or her behalf out of such account for a violation committed under the provisions of this title by the President or Member of the Senate not later than 60 days after the payment is made.

REPORTS OF SENATE COMMITTEES SEC. 324 [2 U.S.C. 1223]. (a) Each report accompanying a bill or joint resolution of a public character reported by any committee of the Senate (except the Committee on Appropriations and the Committee on the Budget) shall contain a listing of the provisions of the bill or joint resolution that apply to Congress and an evaluation of the impact of such provisions on Congress. (b) The provisions of this section are enacted by the Senate as an exercise of the rulemaking power of the Senate, with full recognition of the right of the Senate to change its rules, in the same manner, and to the same extent, as in the case of any other rule of the Senate.

INTERVENTION AND EXPEDITED REVIEW OF CERTAIN APPEALS SEC. 325 [2 U.S.C. 1224]. (a) Intervention. - Because of the constitutional issues that may be raised by section 309 and section 320, any Member of the Senate may intervene as a matter of right in any proceeding under section 309 for the sole purpose of determining the constitutionality of such section. (b) Threshold Matter. - In any proceeding under section 309 or section 320, the United States Court of Appeals for the Federal Circuit shall determine any issue presented concerning the constitutionality of such section as a threshold matter. (c) Appeal. -

(1) In general. - An appeal may be taken directly to the Supreme Court of the United States from any interlocutory or final judgment, decree, or order issued by the United States Court of Appeals for the Federal Circuit ruling upon the constitutionality of section 309 or 320.

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(2) Jurisdiction. - The Supreme Court shall, if it has not previously ruled on the question, accept jurisdiction over the appeal referred to in paragraph (1), advance the appeal on the docket and expedite the appeal to the greatest extent possible.

Title IV—General Provisions SEVERABILITY SEC. 401 [42 U.S.C. 1981 NOTE]. If any provision of this Act, or an amendment made by this Act, or the application of such provision to any person or circumstances is held to be invalid, the remainder of this Act and the amendments made by this Act, and the application of such provision to other persons and circumstances, shall not be affected.

EFFECTIVE DATE SEC. 402 [42 U.S.C. 1981 NOTE]. (a) In General. - Except as otherwise specifically provided, this Act and the amendments made by this Act shall take effect upon enactment. (b) Certain Disparate Impact Cases. Notwithstanding any other provision of this Act, nothing in this Act shall apply to any disparate impact case for which a complaint was filed before March 1, 1975, and for which an initial decision was rendered after October 30, 1983.

Approved November 21, 1991.

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1

PA R

T 1

  The Legal Environm

ent of B usiness

An Introduction to Dynamic Business Law 1

1 What is business law?

2 How does business law relate to business education?

3 What are the purposes of law?

4 What are alternative ways to classify the law?

5 What are the sources of the law?

6 What are the various schools of jurisprudence?

C H A P T E R

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

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This book is for future business managers, especially those who wish to be leaders. The preparation for that career requires, in part, an awareness of the legal issues arising in business. Businesses need to finance capital growth, purchase inputs, and hire and develop employees. They must sell to consumers, please owners, and comply with government rules. All these activities are full of potential legal conflicts. Appendix 1A explains the role of critical thinking in resolving these conflicts.

Business law consists of the enforceable rules of conduct that govern commercial rela- tionships. For example, a firm is required by law to obey the antitrust laws when it con- siders merging with another firm. In other words, buyers and sellers interact in market exchanges within the rules that specify the boundaries of legal business behavior. Consti- tutions, legislatures, regulatory bodies, and courts spell out what market participants may and may not legally do.

Business activities must follow legal guidelines. All contracts, employment decisions, and payments to a supplier are constrained and protected by business law. Each of the six functional areas of business—management, production and transportation, marketing, research and development, accounting and finance, and human resource management— sits on a foundation of business law, as Exhibit 1-1 illustrates.

Law and Its Purposes As individuals, few of us can impose rules on others, but a majority of citizens in a democ- racy can agree to permit certain authorities to make and enforce rules of behavior in their community. These rules are the law , and they are enforceable in the courts the community maintains. Exhibit 1-2 lists just a few of the many purposes fulfilled by the law.

Each is important, but taken together they remind us why we are proud to say we are a society of laws. The respect we give the law as a source of authority is in part our recog- nition that in its absence, we would rely solely on the goodwill and dependability of one another. Most of us greatly prefer the law.

Classification of the Law There are many ways of dividing laws into different groups. Some include national ver- sus international law, federal versus state law, and public versus private law. Private law regulates disputes between private individuals or groups. If a store owner is delinquent in paying rent to the landlord, the resulting dispute is governed by private law. Public law controls disputes between private individuals or groups and their government. If a store dumps waste behind its building in violation of local, state, or federal environmental regu- lations, public law will resolve the dispute.

Another distinction we make is between civil and criminal law. (See Exhibit 1-3 .) Civil law delineates the rights and responsibilities implied in relationships between persons and between persons and their government. It also identifies the remedies available when someone’s rights are violated. For example, in 1993 the restaurant chain Jack-In-the-Box was ordered to pay civil damages after a two-year-old child died of food poisoning and several other people became ill from eating meat tainted with E. coli bacteria.

Criminal law, in contrast, regulates incidents in which someone commits an act against the public as a whole, such as by conducting insider trading on the stock exchange. Insider trading occurs when an individual uses insider, or secret, company information to increase her or his own finances or those of family or friends. Several years ago an IBM secretary allegedly told her husband, who in turn told several other people, that the company was

LO1

What is business law?

LO2

How does business law relate to business education?

LO4

What are alternative ways to classify the law?

LO3

What are the purposes of law?

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Chapter 1 An Introduction to Dynamic Business Law 3

Exhibit 1-1 Business Law and the Six Functional Areas of Business

FUNCTIONAL AREA OF BUSINESS RELEVANT AREAS OF BUSINESS LAW

Corporate management International and comparative law

White-collar crime

Contracts

Corporate law

Antitrust law

Administrative law

Agency law

Insurance law

Employment law

Production and transportation Tort law

Contracts

Environmental law

Consumer law

Marketing Tort law

Contracts

Antitrust law

Consumer law

Intellectual property

Research and development Product liability

Intellectual property

Property law

Consumer law

Accounting and finance Liability of accountants

Contracts

Negotiable instruments and banking

Bankruptcy

White-collar crime

Human resource management Agency law

Contracts

Employment and labor law

Employment discrimination

Exhibit 1-2 Purposes of the Law • Providing order such that one can depend on a promise or an expectation of obligations.

• Serving as an alternative to fighting.

• Facilitating a sense that change is possible, but only after a rational consideration of options.

• Encouraging social justice.

• Guaranteeing personal freedoms.

• Serving as a moral guide by indicating minimal expectations of citizens and organizations.

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going to take over operations of Lotus Development. The leaked information spread among a number of individuals, 25 of whom bought stock that increased greatly in value following IBM’s public announcement of the takeover. The Securities and Exchange Commission filed charges against them for creating an unfair trading environment for the public. Criminal law cases are prosecuted not by individuals but by the state, federal, or local government.

While some new laws have been adopted to regulate the kinds of activities businesses can now conduct online, cyberlaw is based primarily on existing laws. Laws governing contracts, for instance, are essentially the same in all situations, yet adaptations are nec- essary because contracts can now be made and signed online through retailers such as Amazon and eBay. Activities by companies such as Napster and YouTube have raised the question of whether and when the copying of certain intellectual property, such as music and video, constitutes theft.

Exhibit 1-3 Civil versus Criminal Law

Civil v. Criminal Law

Civil Law

Regulates the rights and responsibilities implied in relationships between people and between people and their government   

Civil cases involve either two individuals or two organizations

Defendant must be found guilty by a preponderance of evidence

Guilty defendant of a civil case is never incarcerated. Typically if defendant is  found guilty, the victim receives some sort of compensation

Criminal Law

Regulates incidents in which an individual or organization that commits an act against  the public

Criminal cases usually involve the person who is suspected of committing a crime and the public, such as state or federal government 

Defendant must be found guilty beyond all reasonable doubt 

Guilty defendant of criminal case could be incarcerated or be required to pay a fine 

Both regulate  the behavior  of individuals  for the same purpose 

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Chapter 1 An Introduction to Dynamic Business Law 5

Sources of Business Law How is law created, and where do we look to find the laws? The sources of law are dis- cussed below and summarized in Exhibit 1-4 .

CONSTITUTIONS The United States Constitution and the constitution of each state establish the fundamental principles and rules by which the United States and the individual states are governed. The term constitutional law refers to the general limits and powers of these governments as stated in their written constitutions. The U.S. Constitution is the supreme law of the land, the foundation for all laws in the United States. It is the primary authority to study when trying to identify the relationship between business organizations and government.

STATUTES The assortment of statutes, or rules and regulations put forth by legislatures, is what we call statutory law. These legislative acts are written into the United States Code when they are passed by Congress or into the appropriate state codes when they are enacted by state legislatures. The codes are a collection of all the laws in one convenient location.

LO5

What are the sources of the law?

Exhibit 1-4 Sources of Law Constitutional law A collection of fundamental rules and regulations concerning the power

and limits of governments as well as the relationships between the levels of government. Constitutional laws are usually stated in the form of a written constitution, and each level of government has its set of consti- tutional law, with the highest level (federal) being the foundation for the lower levels.

Statutory law A collection of rules and regulations put forth by legislating bodies; considered the primary law under the constitution. Under state govern- ment, these laws or statutes are typically grouped by subject matter and referred to as codes. Under the federal government, these laws are organized by subject-matter titles, under the United States Code. Under local government, these laws are usually within the city and county ordinances.

Administrative law A collection of rules and regulations put forth by agencies of executive bodies of government. Each level of government has dozens of adminis- trative agencies that are responsible for particular areas of government function, and administrative law consists of the decisions made by these agencies.

Common law A collection of judicial interpretations put forth by judicial bodies; also referred to as case law. This source is considered law unless later statu- tory law revokes the interpretation. When deciding a case, courts will use current law as well as past decisions in similar cases to reach a decision, or, in other words, they obey the principle of stare decisis.

Treaty A legally binding agreement, similar to a contract, between two or more nations or international organizations.

Executive order An order by the head of the executive governing body, such as the presi- dent or state governor, that either implements a new law or interprets existing law.

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Business managers must also be familiar with the local city and county ordinances that govern matters not covered by federal or state codes. These ordinances address important business considerations such as local taxes, environmental standards, zoning, and building codes. If you wish to open a Krispy Kreme franchise in Santa Fe, New Mexico, you must follow local guidelines regarding where you may build your store, the materials you may use, and the state minimum wage you must pay employees making donuts. The regulations will be different if you wish to open your franchise in Toledo, Ohio, or Seattle, Washington.

While they are not a source of law in the same sense as constitutions and statutory law, model or uniform laws serve as a basis for some statutory law at the state level. Business activity is made more difficult when laws vary from state to state. To prevent such problems, a group of legal scholars and lawyers formed the National Conference of Commissioners on Uniform State Laws (NCC). The NCC regularly urges states to enact model laws to provide greater uniformity. The response is entirely in the hands of the state legislatures. They can ignore a suggestion or adopt part or all of the proposed model law.

The proposals of the NCC, while not laws themselves, have been adopted on more than 200 occasions by state legislatures. The NCC is an especially important influence on busi- ness law. Paired with the publications of the American Law Institute, it became the source of the Uniform Commercial Code (UCC). The UCC is a body of law so significant for business activities that it will be the focus of intensive study in several chapters of this text. The UCC laws include sales laws and other regulations affecting commerce, such as bank deposits and collections, title documents, and warranties. For example, these laws govern the different types of warranties that companies such as Microsoft, Sony, and Honda pro- vide with their products.

CASES Constitutions, legislatures, and administrative agencies encourage certain behaviors and prevent others. But laws are seldom self-explanatory and often require interpretation. Case law, also called common law, is the collection of legal interpretations made by judges. These interpretations are law unless revoked later by new statutory law.

Case law is especially significant for businesses that operate in multiple legal jurisdic- tions. Courts in two different business locations may interpret similarly worded statutes differently.

Courts issue judicial decisions that often include interpretations of statutes and adminis- trative regulations, as well as the reasoning they used to arrive at a decision. Such reasoning depends heavily on precedent, past decisions in similar cases that guide later decisions, thereby providing greater stability and predictability to the law.

Business managers must pay attention to changes in the law and cases in which new precedents are set and take them into account when making business decisions. After a woman was severely burned by very hot coffee, McDonald’s was found negligent for fail- ing to provide a warning label on its hot-beverage cups. Now many retailers provide warn- ing labels on their beverage cups because of the precedent set by this case.

When courts rely on precedent, they are obeying the principle of stare decisis (“stand- ing by their decision”), in which rulings made in higher courts become binding precedent for lower courts. When an issue is brought before a state court, the court will determine whether the state supreme court has made a decision on a similar issue, which creates a binding precedent or pattern of law the lower court must follow. If there is no binding deci- sion, both state courts need to look for other rulings on similar cases.

They are not bound by each other’s decisions and might decide differently on the same issue. Decisions in lower courts can be appealed to the state appeals court, however, and

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Chapter 1 An Introduction to Dynamic Business Law 7

the appeals court’s decision can be appealed to the state supreme court. If the state supreme court rules on the case, its decision is binding for the state in that and future cases but does not affect earlier decisions made by state courts.

Perhaps the most well-known case associated with stare decisis is Roe v. Wade. 1 This landmark case, decided in 1973, made a decision on the issue of abortion. The U.S. Supreme Court decided that until a fetus is “viable,” a woman may terminate her preg- nancy for any reason. The Court went on to define viable as the ability of the fetus “to live outside the mother’s womb, albeit with artificial aid.” The Court added that such a capabil- ity could occur around 24 weeks, although usually around 7 months. The decision in Roe v. Wade has been upheld in cases since. The precedent still stands today, despite attempts to overturn it. In 1992, Planned Parenthood of Southeastern Pennsylvania v. Casey 2 used the decision to determine that a woman has a constitutional right to have an abortion, although the standard for restricting abortions was lowered.

Another case that has been used in accordance with stare decisis as a binding precedent is Brown v. Board of Education, 3 which abolished discriminatory policies for individu- als of different racial backgrounds. In Regents of the University of California v. Bakke, 4 the plaintiff, a white male, had applied to the University of California at Davis medical school two years in a row and been denied admittance. He alleged the admissions process was discriminatory because 16 of 100 slots were reserved for members of minority races. The U.S. Supreme Court found the school’s admissions policy was not lawful, referencing Brown and stating that the basic principle behind it and similar cases was that individu- als could not be excluded on the basis of race or ethnicity. The Court wrote, “Preferring members of any one group for no reason other than race or ethnic origin is discrimination for its own sake.”

Another U.S. Supreme Court case that relied in part on Brown v. Board of Education was Wygant v. Jackson Board of Education. 5 The Board of Education and teachers’ union in Jackson, Michigan, had agreed that if teachers were laid off, those with more senior- ity would be retained and the minority teachers’ percentage of the layoffs would not be higher than their percentage of all teachers employed by the school district at the time of the layoffs. When layoffs did occur, nonminority teachers were laid off and minority teach- ers with less seniority were retained. The nonminority teachers sued. When the case was brought before the Supreme Court, the Court ruled that the layoff policy was not lawful because “[c]arried to the logical extreme, the idea that black students are better off with black teachers could lead to the very system the Court rejected in Brown v. Board of Edu- cation. ” Again in accordance with Brown, the Court ruled that singling people out on the basis of race was not lawful.

However, the case Plessy v. Ferguson 6 is an interesting circumstance in regard to stare decisis. In this case, the court decided that separate accommodations for blacks and whites was acceptable as long as such separation was “separate but equal.” This case essentially made the legal acknowledgment of a difference between blacks and whites, and different treatment, acceptable. Interestingly, in 1954, Brown v. Board of Education did not follow the precedent established by Plessy v. Ferguson. In fact, the ruling established in Plessy was overturned. The Supreme Court determined that segregation of blacks and whites

1 410 U.S. 113 (1973).

2 505 U.S. 833 (1992).

3 347 U.S. 483 (1954).

4 438 U.S. 265 (1978).

5 476 U.S. 267 (1986).

6 163 U.S. 537 (1896).

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violated the equal protection clause of the Fourteenth Amendment of the Constitution. Thus, the court overturned the precedent and created a new one, one that has been used in decisions made by courts ever since.

Just as state statutes have been strongly influenced by the suggestions of the NCC, common law evolves with the assistance of a mechanism called Restatements of the Law. These are summaries of the common law rules in a particular area of the law that have been enacted by most states. The American Law Institute prepares these Restatements for con- tracts, agency, property, torts, and many other areas of law that affect business decisions. While the Restatements are not themselves a source of business law, judges frequently use them to guide their interpretations in a particular case.

In addition to the Restatements, many influences are at work in the minds of judges when they interpret constitutions, statutes, and regulations. Their own values and social backgrounds function as lights and shadows, moving the judges toward particular legal decisions.

Courts in one jurisdiction need not obey precedents in other jurisdictions, but they may be influenced by them. At least two current Supreme Court justices are using law in other countries as a basis for rethinking certain laws in the United States. The logic of this reli- ance on precedent is based on respect for those who have already wrestled with the issue and provided us guidance with their earlier decision.

ADMINISTRATIVE LAW Constitutions and statutes never cover all the detailed rules that affect relationships between government and business. The federal, state, and local governments have doz- ens of administrative agencies whose task is to perform a particular government function. For example, the Environmental Protection Agency (EPA) has broad responsibilities to enforce federal statutes in the area of environmental protection. The Occupational Safety and Health Administration (OSHA) oversees health and workplace safety and makes sure working conditions are not hazardous. In 1994, OSHA settled a complaint that United Par- cel Service (UPS) was not providing adequate safety measures and equipment for workers who handled hazardous waste by making sure UPS adapted its practices to follow federal safety guidelines.

Administrative law is the collection of rules and decisions made by all these agencies. Just glance at Exhibit 1-5 to get a sense of the scope of a few of the major federal admin- istrative agencies.

TREATIES A treaty is a binding agreement between two states or international organizations. It may be an international agreement, a covenant, an exchange of letters, a convention, or proto- cols. In the United States, a treaty is generally negotiated by the executive branch. To be binding, it must then be approved by two-thirds of the Senate.

A treaty is similar to a contract in two important ways. Both treaties and contracts are attempts by parties to determine rights and obligations among themselves, and when a party fails to obey a treaty or a contract, international law imposes liability on it.

EXECUTIVE ORDERS The president and state governors can issue directives requiring that officials in the execu- tive branch perform their functions in a particular manner. The Code of Federal Regu- lations (CFR) contains all the executive orders created by the president. (It is online at

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www.gpoaccess.gov/cfr/index.html .) Presidents claim the power to issue such orders on the basis of their Article II, Section 1, constitutional power to “take care that the laws be faithfully executed.” President George W. Bush issued 284 executive orders during the eight years of his presidency.

An especially controversial executive order is Order 9066, issued by President Franklin Roosevelt during World War II, which sent Japanese-Americans on the West Coast, as well as thousands of Italian-American and German-American families, to internment camps for the duration of the war.

Exhibit 1-6 summarizes the various locations where you can find particular laws.

SCHOOLS OF JURISPRUDENCE When legislators or courts make law, they do so guided by certain habits of mind and specific beliefs about human nature. Beliefs are deeply rooted within a person’s emotions and habits, and thus they are sure to guide one’s opinions and decisions. Such beliefs may be commonly held and thus create various larger schools of thought. Once one determines what schools of thought influence certain types of decisions and opinions, one is sure to better understand such decisions. This section briefly describes several of the more com- mon guides to legal interpretation.

Natural Law. The term natural law describes certain ethical laws and principles believed to be morally right and “above” the laws devised by humans. Under natural law individuals have not only basic human rights but also the freedom to disobey a law enacted

Exhibit 1-5 Major Federal Administrative Agencies

INDEPENDENT AGENCIES EXECUTIVE AGENCIES

• Commodity Futures Trading Commission (CFTC) http://www.cftc.gov/

• Consumer Product Safety Commission (CPSC) http://www.cpsc.gov/

• Equal Employment Opportunity Commission (EEOC)http://www.eeoc.gov/

• Federal Trade Commission (FTC) http://www.ftc.gov/

• Federal Communications Commission (FCC) http://www.fcc.gov/

• National Labor Relations Board (NLRB) http://www.nlrb.gov/

• National Transportation Safety Board (NTSB) http://www.ntsb.gov/

• Nuclear Regulatory Commission (NRC) http://www.nrc.gov/

• Securities and Exchange Commission (SEC) http://www.sec.gov/

• Federal Deposit Insurance Corporation (FDIC) http://www.fdic.gov/

• Occupational Safety and Health Administration (OSHA) http://www.osha.gov/

• General Services Administration (GSA) http://www.gsa.gov/

• National Aeronautics and Space Administration (NASA) http://www.nasa.gov/

• Small Business Administration (SBA) http://www.sba.gov

• U.S. Agency for International Development (USAID) http://www.usaid.gov/

• National Science Foundation (NSF) http://www.nsf.gov/

• Veterans Administration (VA) http://www.va.gov/

• Office of Personnel Management (OPM) http://www.opm.gov/

LO6

What are the various schools of

jurisprudence?

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by people if their conscience goes against it and they believe it is wrong. Dow Chemical wants its suppliers to conform to U.S. environmental and labor laws, not just the local laws in the supplier’s country, where regulations may not be as stringent. This policy reflects the beliefs that people have a right to be treated fairly in their jobs and a right as human beings to have a clean environment.

Legal Positivism. The concept of legal positivism sees our proper role as obedience to duly authorized law. That law is quite distinct from morality, and moral questions about the law should not interfere with our inclination to obey it. A judge with leanings in the direction of legal positivism might write that she is deciding to enforce the law in question but that her decision does not necessarily mean she sees the law as the morally correct rule.

Identification with the Vulnerable. Closely linked to pursuing legal change through natural law is pursuing change through identification with the vulnerable, on the grounds that some higher law or body of moral principles connects all of us in the human commu- nity. Some members of our society are able to take care of themselves in terms of most life situations. Others, especially the ill, children, the aged, the disabled, and the poor, require assistance to meet their fundamental needs of life, health, and education.

This guide to legal change is tied closely to the pursuit of fairness, a “level playing field,” in our society. We might look at a particular employment contract and feel out- rage that “it is just not fair.” That outrage can be a stimulus for legal change. Minimum- wage laws reflect the belief that workers should receive a minimum hourly wage and that employers should not be allowed to pay them less.

Historical School: Tradition. One of the guidelines most often used for shaping the law is tradition, or custom. Stare decisis is rooted in this historical school. When we follow tradition, instead of reinventing the wheel we link our behavior to the behavior of those who faced similar problems in earlier periods. We assume past practice was the prod- uct of careful thought.

Exhibit 1-6 Where to Locate the Law

Source by Level of Government

TYPE OF LAW FEDERAL STATE LOCAL

Statutes United States Code (USC) United States Code Annotated (USCA) United States Statutes at Large

State code Municipal ordinances

Administrative law

Code of Federal Regulations (CFR) Federal Register

State administrative code

Municipality administrative regulations

Common law United States Reports (U.S.) United States Supreme Court Reporter (S. Ct.) Federal Reporter (F. F.2d) Federal Supplement (F.Supp.)

Regional reporters State reporters

Check the clerk’s office at the local courthouse

Executive order Title 3 of Code of Federal Regulations Codification of Presidential Proclamations and Executive Orders

See state government Web site

n/a

Treaty See http://www.asil.org/treaty1.cfm n/a n/a

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Legal Realism. Legal realism is based on the idea that, when ruling on a case, judges need to consider more than just the law; they also weigh factors such as social and economic conditions, since legal guidelines were designed by humans and exist in an ever-changing environment. Judges who follow this school of thought are more likely to depart from past court decisions to account for the fact that our society is constantly shift- ing and evolving. They believe the law can never be enforced with complete consistency and argue that because judges are human, they will bring different methods of reasoning to very similar cases.

One law enacted to reflect social changes is the Family and Medical Leave Act. This act mandates that businesses employing more than 50 people provide their workers with up to 12 weeks’ unpaid leave every year to take care of family-related affairs, including caring for oneself or ill parents and adopting or having a child. The law also protects pregnant women who take time off work, as their employers must provide them with the same pay and the same or an equivalent job when they return to work. More mothers are working outside the home, and more women are returning to work soon after they have a child. The act protects them against some types of discrimination that might occur after they return.

Cost-Benefit Analysis. Suppose we could attach a monetary figure to the benefits of a particular law or legal decision. We would next need to examine all its costs and place a monetary value on it. If we possessed these figures, we could use cost-benefit analysis as a guide to legal change, choosing the alternatives that maximized benefits and minimized costs.

This approach is tied closely to the pursuit of efficiency. If the law to be applied yields more benefits than costs, then we have saved resources that we can, in turn, use to obtain more goods and services. Our economy is thus more efficient because it produces more with less.

Polluted land is an economic loss as it cannot be used for farming or recreation. Pol- luted water can be toxic for fish and cannot be used for drinking. Polluted air can cause health problems and result in higher health care costs. While complying with EPA pollu- tion controls may cost companies more initially, the price of environmental cleanup and lost productivity in the economy as a whole may be even greater.

Global and Comparative Law Advances in technology and transportation make trade with other countries far easier today than in the past. Boeing Co. can make hundreds of components for the same airliner all over the world and then assemble them in the United States. An antique store can operate in Poughkeepsie but sell to customers in Moscow or Taipei through a Web site.

This ease in trade means business managers must be familiar with laws that regulate business practices between nations. The United States has entered into trade agreements, such as the North American Free Trade Agreement (NAFTA) with Canada and Mexico and the General Agreement on Tariffs and Trade (GATT) with about 150 other countries, that help establish the conditions of global trade.

Future managers should also understand comparative law, which studies and compares the laws in different countries. The European Union (EU) regulates taxes on Internet sales and the amount of pollution firms can release differently than does the U.S. government. Companies doing business in the EU must take these standards into account. The Chi- nese government does not want its citizens to have access to certain information and Web sites. To do business there, Google had to conform to Chinese standards by restricting the content of searches performed on Google.cn. Some felt that by thus restricting access to information, Google had violated its own mission statement to “do no evil.”

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12 Part 1 The Legal Environment of Business

Business law tells managers the basic rules of the business game. Play any game with- out having first studied the rules, and you will probably fail. But unlike an ordinary game, business has a rule book that is changing dynamically. So modern business managers must have an ongoing fascination with the law to function effectively.

administrative law 8

business law 2

case law 6

civil law 2

common law 6

constitutional law 5

cost-benefit analysis 11

criminal law 2

cyberlaw 4

identification with the vulnerable 10

legal positivism 10

legal realism 11

model (uniform) laws 6

natural law 9

precedent 6

private law 2

public law 2

Restatements of the Law 8

stare decisis 6

statutory law 5

treaty 8

Key Terms

Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

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Success in business requires the development of critical-thinking skills —the ability to understand the structure of what someone is saying and then apply a set of criteria to evalu- ate its worth. In other words, businesspeople need to be able to sort sense from nonsense by developing critical attitudes and abilities. There is no better context in which to develop these skills than the study of the laws that affect business.

Legal reasoning is like other kinds of reasoning in some ways. The stimulus that gets us thinking is an issue, stated as a question that requires us to do something, to think about answers.

We may be interested in such issues as the following:

• When are union organizers permitted under the National Labor Relations Act to tres- pass on an employer’s property?

• Do tobacco manufacturers have liability for the deaths of smokers?

• Must a business fulfill a contract with an unlicensed contractor in a state requiring that all contractors be licensed?

These questions have several potential answers, but which best accomplishes a particu- lar business objective? Which is consistent with the law? Here is where critical thinking is essential to business success. Some answers can get the decision maker into trouble; others will advance the intended purpose. Each answer is called a conclusion.

Business firms are both consumers of and contributors to legal conclusions. As they learn about and react to decisions or conclusions made by courts, businesspeople can respond in two ways:

1. Understand the conclusions in the case, and use this understanding as a guide for future business decisions.

2. Make judgments about the quality of the conclusions.

This book encourages you to do both. Critical thinking is active; it challenges each of us to form judgments about the quality of the link between a set of reasons and the conclusion derived from them. In particular, we will be focusing on the link between a court’s reasons and its conclusions.

The following structure for critical thinking is a thoroughly tested method used by suc- cessful market decision makers. Every time you read a case, try to follow it.

1. Find the facts.

Here we are looking for the most basic building blocks in a legal decision or argument. They provide the environment or context in which the legal issue is to be resolved. Cer- tain events occurred; certain actions were or were not taken; particular persons behaved or failed to behave in specific ways. We always want to know, What happened in this case?

2. Look for the issue.

The issue is the question that caused the lawyers and their clients to enter the legal system.

3. Identify the judge’s reasons and conclusion.

We want a world rich with opinions so that we can have a broad field of choice. But we should agree with only those legal opinions that have convincing reasons supporting the

Appendix 1A Critical Thinking and Business Law

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14 Part 1 The Legal Environment of Business

conclusion. Asking “Why?” is our respectful way of saying, “I want to believe you, but you have an obligation to help me by sharing the reasons for your conclusion.”

4. Locate in the decision the rules of law that govern the judge’s reasoning.

Judges cannot offer just any reasoning that they please. They must always look back over their shoulders at the laws and previous court decisions that together provide an anchor for current and future decisions. What makes legal reasoning so complex is that statutes and legal findings are never crystal clear. They may seem very clear, but judges and businesspeople have room for interpretive flexibility in their reasoning.

5. Apply critical thinking to the reasoning.

A judge’s reasoning, once we have laid it out by following the steps discussed here, is a message we may either accept or reject. Critical thinking in the legal context consists of examining the legal opinion in search of potential problems in the reasoning.

One of the most exciting things about our legal system is its potential for change. Here is a small sample of some especially useful critical-thinking tools for business managers when thinking about business law:

• Look for potential ambiguity in the reasoning. Ambiguity is a lack of clarity in a word or phrase. Many words have multiple meanings; until we know the intended one, we cannot tell whether we agree or disagree with the reasoning.

• Ask whether the analogies used in the decision are strong. When judges follow prec- edents, they are saying the facts in the precedent and those in the case at hand are so similar that it makes sense to apply the same rule of law in both. Are there key differ- ences in the facts that raise questions about the quality of that analogy?

• Check the quality of the judge’s reasoning. Is the judge’s supporting evidence both abundant enough and reliable enough that we should agree with the reasoning?

• Think about the extent to which missing information prevents you from being totally confident about the judge’s reasoning. Is there information you would need to have before making up your mind?

• Consider the possibility of rival causes. When the judge claims one action caused another, think about whether some alternative cause may have been responsible.

Working through these steps accomplishes several things. First, walking through this process familiarizes you at a deeper level with what the judge is saying. You have to wres- tle with the judge’s logic and use of evidence to complete the critical-thinking activity. Second, the critical thinking provides a sense that the law evolves as we put together the strengths and weaknesses of previous thinking by judges and legal scholars. Most impor- tantly, critical thinking enables us to practice interacting with the law, always with an eye to considering ways to improve our legal system.

This chapter has enabled you to understand several important things. First, you should now be acquainted with what business law is and how business law and business education are intertwined. Second, you should understand the purposes of law, be acquainted with different kinds of law, and have a basic understanding of how different courts and agencies cooperate with one another. You should also now know about the interplay between case law and stare decisis, or binding precedent. You should also be able to pinpoint where vari- ous kinds of laws come from.

More importantly, however, you should realize that all of our courts and legal docu- ments are thought to be just and that justice is an idea based on other ideas. Different schools of thought arise from deep-rooted, commonly held beliefs, and these schools guide decisions about what is fair and just and why. Finally, you should be able to critically

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Chapter 1 An Introduction to Dynamic Business Law 15

evaluate a judge’s or court’s opinion. Only by doing so can you sort through the logic of the decision and pinpoint all the factors that went into the decision, including not only precedent and case law but the perspective flowing from schools of legal thought, rooted in personal beliefs and opinions.

critical-thinking skills 13

Key Terms

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Th

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ga l E

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of B

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  PA

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1

1 What are business ethics and the social responsibility of business?

2 How are business law and business ethics related?

3 How can we use the WPH framework for ethical business decisions?

Business Ethics 2 C H A P T E R

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

CASE OPENER Chinese Factories and Toxic Toothpaste

The Chinese export industry is highly competitive, with each manufacturer continuously seeking to cut costs, even if by only one-half of 1 percent. In May 2007, the interna- tional community expressed its dismay at the manufacturers’ latest cost-cutting technique: replacing glycerin with diethylene glycol. Glycerin is a harmless thickening agent. Dieth- ylene glycol is a poisonous thickening agent used to make antifreeze. The end product exported from China was poisonous toothpaste, none of which was labeled to indicate that the products contained diethylene glycol.

When the poisonous chemical was found in Chinese toothpaste, the FDA issued a warning, telling consumers to discard all Chinese toothpaste as a precaution. The Chinese government responded by telling consumers that the FDA warning was unscientific and unjustified. In 2000, a Chinese study had found that toothpaste containing diethylene gly- col was harmless if the chemical concentration was below 15.6 percent. The contaminated toothpaste found in America contained diethylene glycol in concentrations of 3 to 5 per- cent. The FDA warned that diethylene glycol was unsafe in any concentration, particularly for children, as well as individuals with liver and kidney illnesses.

In July 2007, due to growing international concern about the safety of Chinese tooth- paste, the Chinese government banned all manufacturers from using diethylene glycol in toothpaste. Investigators believed that the toothpaste originated from two small man- ufacturers in the Danyang coastal region, although the manufacturers denied fault. The

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To see how ethics relates to accounting, please see the Connecting to the Core activity on the text Web site at www.mhhe.com/kubasek2e.

17

contaminated toothpaste was found in at least seven countries, including the United States. As of the writing of this book, there had been no confirmed illnesses or deaths due to use of the contaminated toothpaste.

1. If you were one of the small Chinese manufacturers of toothpaste, would you be will- ing to substitute diethylene glycol for glycerin?

2. If you were manufacturing toothpaste and decided to substitute diethylene glycol for glycerin, would you consider it your ethical obligation to list diethylene glycol as an ingredient in your toothpaste?

The Wrap-Up at the end of the chapter will answer these questions.

What a business manager in the situation described in the opening scenario should do is not altogether clear. Ethical conversation is less about finding the one and only right thing to do than it is about finding the better thing to do. Whatever you choose to do, some stakeholders will be hurt and others will benefit.

This chapter provides some assistance for thinking systematically about issues of right and wrong in business conduct. Initially, we need to sort through the meaning of key terms like business ethics and social responsibility. Then, because it is helpful to have a useful approach to ethical decision making, we provide a practical method by which future business managers can think more carefully about the ethical dilemmas they will face during their careers.

Business Ethics and Social Responsibility Ethics is the study and practice of decisions about what is good, or right. Ethics guides us when we are wondering what we should be doing in a particular situation. Business eth- ics is the application of ethics to the special problems and opportunities experienced by businesspeople. For example, as a business manager, you might someday decide what is best for a company, such as one of those Chinese toothpaste manufacturers described in the Case Opener. Is the company doing the right thing when it attempts to reduce the costs of production by substituting diethylene glycol for glycerin?

Such questions present businesses with ethical choices, each of which has advantages and disadvantages. An ethical dilemma is a problem about what a firm should do for which no clear, right decision is available. Reasonable people can expect to disagree about optimal solutions to ethical dilemmas.

For example, imagine yourself in the position of a business manager at Wells Fargo Bank. You know that providing bank accounts for customers has costs attached to it. You want to cover those costs by charging the customers the cost of their checking accounts. By doing so, you can preserve the bank’s rev- enue for shareholders and employees of Wells Fargo. So far, the decision seems simple. But an ethical dilemma soon appears.

You learn from recent government reports that 12 million families cannot afford to have bank accounts when they are charged a fee to maintain one. You want to do the right thing in this situation. But what would that be? The study of business ethics can help you resolve this dilemma by suggesting approaches you can use that will show respect for others while maintaining a healthy business enterprise.

Making these decisions would be much easier if managers could focus only on the impact of decisions on the firm. If, for example, a firm had as its only objective the

LO1

What are business ethics and the social

responsibility of business?

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18 Part 1 The Legal Environment of Business

maximization of profits, the “right thing” to do would be the option that had the largest positive impact on the firm’s profits.

But businesses operate in a community. Communities have expectations for behavior of individuals, groups, and businesses. Different communities have different expectations of businesses. Trying to identify what those expectations are and deciding whether to fulfill them complicate business ethics. The community often expects firms to do much more for it than just provide a useful good or service at a reasonable price. For example, a com- munity may expect firms to resist paying bribes, even when the payment of such fees is an ordinary cost of doing business in certain global settings. The social responsibility of business consists of the expectations that the community imposes on firms doing business inside its borders. These expectations must be honored to a certain extent, even when a firm wishes to ignore them, because firms are always subject to the implicit threat that leg- islation will impose social obligations on them. So, if the community expects businesses to obey certain standards of fairness even when the standards interfere with profit maximiza- tion, firms that choose to ignore that expectation do so at their peril. See Exhibit 2-1 for a brief look at General Electric’s approach to social responsibility.

Consider also the 2008 financial meltdown that resulted when Wall Street investors traded packages of faulty mortgages. Fannie Mae, a government-sponsored company, was in the business of buying, selling, and guaranteeing high-risk mortgages in an effort to make mortgages more affordable for the American people. When borrowers defaulted on their mortgages, Fannie Mae was obligated to pay the balance. Financial advisers warned the company that it was assuming too much risk (guaranteeing more than $270 billion in loans to risky borrowers between 2005 and 2008), but the company continued to buy high-risk mortgages in an effort to keep up with the current market trends. As Wall Street began trading more and more high-risk mortgages, and more borrowers began defaulting on those mortgages, Fannie Mae faced a crisis. In September 2008, the federal government spent $200 billion to rescue Fannie Mae and its counterpart Freddie Mac from their risky investment decisions. Fannie Mae had not only failed in its profit-oriented goals but also failed in its attempts to make mortgages more affordable for Americans, engaging instead in irresponsible behaviors that cost taxpayers billions of dollars.

Exhibit 2-1 Good Citizenship and Profits

Given the number of corporate accounting scandals that have been revealed in the past few years, many corporations are making a point of assuring their investors that their corporate goals are not focused solely on profit. As investors lost millions of dollars during the collapse of companies such as WorldCom and Enron, some corporations have been placing increased emphasis on promoting them- selves not only as profitable but as conscientious and ethical.

For example, the following three statements that compose GE’s Citizenship Framework seek to assure current and potential investors that the company is dedicated to both stock performance and company integrity.

GE’s Citizenship Framework 1. Strong economic performance and stakeholder impact.

2. Rigorous compliance with fundamental accounting and legal requirements.

3. Going beyond compliance by supporting ethical actions.

In linking performance and integrity, the company endeavors to pair high profits and compliance with government ethics regulations, promoting itself as a company that is worthy of investment and will be honest with shareholders. Whereas in years past companies may have focused solely on their profitability in an attempt to gain new investors, today many business managers realize that corporate honesty has become just as important to those who are seeking to buy stock.

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Chapter 2 Business Ethics 19

Business Law and Business Ethics Before business managers consider the social responsibilities of firms in their communi- ties, they need to gather all the relevant facts.

The Chinese manufacturers’ decision to substitute diethylene glycol for glycerin depends on a huge array of facts: alternative costs of production, competition among man- ufacturers, the legal and regulatory framework in each relevant country, and the social responsibilities of the manufacturers, just to name a few. But experienced managers know that assembling the facts is just the beginning of a thoughtful business decision. Next, it makes sense to ask, Is it legal to go forward with this decision?

The legality of the decision is the minimal standard that must be met. But the exis- tence of that minimum standard is essential for the development of business ethics. To make this point, let’s take a look at the growing practice of bribery in the absence of such legal standards. In some countries businesses must pay bribes to receive legitimate supplies. Though the businessperson may be morally opposed to paying the bribes, the supplies are necessary to stay in business and there may be no other means of obtaining them.

Thus, multinational companies face an ethical dilemma: They must decide whether to pay bribes or find alternative sources of supplies. For instance, when McDonald’s opened its doors in Moscow, it made arrangements to receive its supplies from foreign providers. These arrangements ensured that the franchise did not have to engage in questionable busi- ness practices.

Regardless of the ethical and legal implications, there are still multinational corpora- tions that choose to use bribes as a means of doing business in foreign markets. For exam- ple, in December 2008, multinational giant Siemens AG was ordered to pay the largest Foreign Corrupt Practices Act (FCPA) fine in history after admitting to acts of bribery worldwide. The company had been using off-the-book slush funds, middlemen posing as agents or company consultants, and even money-filled briefcases to bribe government offi- cials and secure contracts overseas. An FBI agent involved in the Siemens investigation went so far as to say that executives for Siemens used bribery as “standard operating pro- cedure” and “a business strategy.” As a result, $1.6 billion later, Siemens AG is now forced to restructure itself to do business ethically and legally.

Future business professionals ought to consider not just the moral and monetary costs of engaging in unethical business practices but also the cost of lost business. A tarnished reputation could mean losing contracts, sales, and partnerships in the future.

Look at Case 2-1 as an exercise in comparing what is legal with what is ethical. Busi- ness law affects ethics because it provides a floor for managerial ethics. At a minimum, ethics requires a presumption in favor of obedience to law. As you review the Kipps case, consider the relationship between law and ethics.

LO2

How are business law and business ethics

related?

Several universities actively recruited Kyle Kipps, a tal- ented football player in southern Louisiana, in 1996 and 1997. Kyle’s father, Rexford Kipps, was an assistant foot- ball coach at the University of Southwestern Louisiana

(USL) for eleven years. In March 1996, Nelson Stokley, USL’s head football coach, told Rexford Kipps that Kyle was to attend either USL or a college or university outside of Louisiana. When Kyle notified Stokley that he had orally

REXFORD KIPPS ET AL. v. JAMES CAILLER ET AL. U.S. COURT OF APPEALS, FIFTH CIRCUIT 197 F.3D 765 (1999)

CASE 2-1

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[continued]

committed to play at Louisiana State University (LSU) on a football scholarship, Stokley told Rexford Kipps to for- bid his son to play football for LSU. Rexford Kipps argued that he could not and would not force his son to refuse to play for LSU. Consequently, Stokley terminated Kipps’s employment with LSU. Both Nelson Schexnayder, Jr., USL Director of Athletics, and Ray Authement, President of USL, approved Kipps’s termination. The President of the Board of Trustees, James Caillier, also approved Kipps’s termination.

Rexford Kipps brought constitutional and state law claims against defendants Caillier, Schexnayder, Authe- ment, and Stokley. These defendants filed for summary judgment, arguing that the at-will employment status of Kipps precluded any wrongful termination action. Fur- thermore, they claimed that they were entitled to qualified immunity and Kipps’s termination was justified because Kyle’s choice would affect USL’s ability to recruit athletes. The district court granted Stokley, Schexnayder, and Authe- ment’s motion for summary judgment on qualified immu- nity grounds. Kipps appealed to the U.S. Court of Appeals, 5th District.

JUDGE PARKER: Public officials acting within the scope of their official duties are shielded from civil liability by the qualified immunity doctrine. Government officials are enti- tled to qualified immunity “insofar as their conduct does not violate clearly established statutory or constitutional rights of which a reasonable person would have known.”

In order to establish that the defendants are not enti- tled to qualified immunity, plaintiffs must satisfy a three- part test. First, “[a] court evaluating a claim of qualified immunity must first determine whether the plaintiff has alleged the deprivation of a constitutional right at all.”

Second, the court must “determine whether that right was clearly established at the time of the alleged violation.” Finally, the court “must determine whether the record shows that the violation occurred, or at least gives rise to a genuine issue of material fact as to whether the defen- dant actually engaged in the conduct that violated the clearly-established right.” If it is determined that the offi- cial’s conduct was unconstitutional, then the court must decide whether the conduct was nonetheless “objectively reasonable.”

Assuming arguendo that defendants violated Kipps’s clearly established constitutional liberty interest in familial association, the resolution of this issue turns on whether the defendants’ actions were “objectively reasonable.” Because we find that defendants’ actions were objectively reason- able, we affirm the district court’s dismissal of Kipps’s 1983 claim on the basis of qualified immunity.

Even if defendants violated Kipps’s clearly established constitutional right, they are still entitled to qualified immu- nity if their actions were objectively reasonable.  .  .  . The record indicates that Kipps was fired because his son chose to play football for a Louisiana school other than USL. Notwithstanding the defendants’ subjective motivation and belief as to the lawfulness of their conduct, we find the defendants’ motivation for terminating Kipps was objec- tively reasonable. Defendants’ motivation, according to the record in this case, was to mitigate the damage that Kyle’s attendance at LSU as opposed to USL would have on alumni relations and recruiting efforts.

The summary judgment record of this appeal contains no facts upon which we could find that defendants’ actions were objectively unreasonable.

AFFIRMED.

What reasons did the judge offer to support his decision that Kipps’s termination was legal? Which facts in the case are most important in your mind when evaluating the reasoning?

Identify various meanings of the phrase “objectively reason- able.” Which meaning do you think the court is using? Is it clear? How does this affect the validity of the argument given by Judge Parker?

ETHICAL DECISION MAKING CRITICAL THINKING

The Kipps case provides a snapshot of the complexity of the link between ethics and the law. Do you believe that some view of what it means to do the right thing is responsible for the legal decision in this case?

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Chapter 2 Business Ethics 21

As the Kipps case demonstrates, business managers must sometimes decide whether to hire and fire particular employees. Their decisions will be guided by legal rules that have both ethical foundations and implications for needed legal reform.

In addition, the definition of business ethics refers to standards of business conduct. It does not result in a set of correct decisions. Business ethics can improve business decisions by serving as a reminder not to choose the first business option that comes to mind or the one that enriches us in the short run. But business ethics can never produce a list of correct business decisions that all ethical businesses will make.

Well-managed firms try to provide ethical leadership by establishing codes of ethics for the firm. For example, Exhibit 2-2 addresses the attempt by General Motors, a major automobile maker, to make a statement about the importance of business ethics to its firm. Notice, however, that this corporate code can never do more than provide guidance. The complications associated with managerial decisions do not permit any ethical guide to provide definitive lists of right and wrong decisions.

At the same time that business ethics guides decisions within firms, ethics helps guide the law. Law and business ethics serve as an interactive system—informing and assessing each other. For example, our ethical inclination to encourage trust, depend- ability, and efficiency in market exchanges shapes many of our business laws. See Exhibit 2-3 , for instance. The principles of contract law facilitate market exchanges and trade because the parties to an exchange can count on the enforceability of agreements. Legal rules that govern the exchange have been shaped in large part by our sense of commercial ethics.

Of course, different ethical understandings prevail in different countries. Thus, ethi- cal conceptions shape business law and business relationships uniquely in each country. Increasingly, business leaders require sensitivity to the differences in legal guidelines in the various countries in which they operate. These differences are based on some- what different understandings of ethical behavior among businesspeople in diverse countries.

Exhibit 2-2 Ethical Business Practices General Motors’

Code of Business Conduct

The foundation for all conduct by GM and its employees is one of our core values: Integrity. Integrity is essential to achieving our vision of becoming the world leader in transportation products and services, earning the enthusiasm of our customers, working together as a team, innovating, and continuously improving. We call this Winning With Integrity.

These Guidelines are designed to help GM and its employees understand and meet fundamental obligations that are vital to our success. Some of those obligations are legal duties. They are estab- lished by the laws, regulations, and court rulings applicable to our business. Other obligations result from policies GM establishes to make sure our actions align with our core values and cultural priori- ties. Compliance with both types of obligation—our legal duties and our internal policies—is vital to our goal of winning with integrity.

Employees who violate these guidelines may be subject to disciplinary action which, in the judg- ment of management, is appropriate to the nature of the violation and which may include termination of employment. Employees may also be subject to civil and criminal penalties if the law has been violated.

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Business Gifts and Favors in China

In China, the practice of using guanxi has become an integral part of doing business for firms already located in the country and for those interested in entering the Chinese market. Guanxi, which refers to a sort of relationship building, is an intricate system of interpersonal networks woven together by social ties. The concept of guanxi is important to individuals involved in business because having good guanxi means having connections that can assist you in getting things that may normally be out of reach to you or your business. The rules and regulations in China can be burdensome, but the right guanxi, or connections, can make many processes much easier. The guanxi system is built on reciprocity, and if some- one does a favor for you, you’ll be expected to return that favor in the future. A favor could technically be any number of things, from access to partnerships, contacts, and government officials to spe- cial consideration or useful information.

The process of creating and maintaining guanxi may seem somewhat taboo to westerners because businesses in the United States often have strict rules about accepting gifts, doing favors

COMPARING THE LAW OF OTHER COUNTRIES

and offering preferential treatment or consideration to clients. However, Dan Mintz, a Brooklyn native with no college degree, who is now the CEO of one of the largest advertising agencies in China, claims guanxi is a necessity when doing business in China. After moving to Beijing with no contacts and little experience, Mintz established his own business (Dynamic Marking Group) with two Chinese partners, Peter Xiao and Wu Bing. Both Xiao and Bing had extensive guanxi, networks that extended into high lev- els of Chinese government and banking. The trio spent their time targeting potential clients, delivering gifts, and hosting dinners as means to strengthen their guanxi and improve their business opportunities. Through their hard work and strong guanxi Mintz, Xiao, and Bing were eventually able to secure deals with some of the biggest brands in the world: Budweiser, Kraft, Audi, Volkswa- gen, and Nike.

Exhibit 2-3 Enron, WorldCom, and Shifts in Business Regulation

During the past several years, ethics violations have been uncovered in the accounting practices of a number of large companies. Enron and WorldCom were two of the perpetrators in these scandals. Both companies failed to report or record billions of dollars in profit losses, which resulted in stock- holders’ believing that the companies were in a much better financial state than actually was the case.

Enron’s tangled web involved the company’s creating multiple subsidiaries and related companies. These businesses were often treated as companies independent of Enron and not shown on the accounting books. Enron used the subsidiaries to conceal debts and losses in a very complex fraud scheme. When the company went bankrupt, employees who had based their retirement plans around Enron stock lost almost everything. Additionally, Enron auditor Arthur Andersen was found guilty of shredding documents about Enron’s audits.

In June 2002, shortly after the Enron bankruptcy was announced, WorldCom revealed that it also had engaged in unethical accounting practices. WorldCom’s violations included counting profits twice and concealing billions of dollars in expenses when making reports to the SEC. The company thereby made itself appear profitable when it was actually losing money. In total, WorldCom had more than $7 billion in misreported debt.

These two cases, among others, left investors understandably concerned about the truthfulness of individuals who were in charge of operating large corporations. Those in charge of these companies had been awarded million-dollar bonuses while completely disregarding stockholders and employees, who lost millions of dollars when the companies collapsed.

The revelations of Enron and WorldCom suggested quite blatantly that the business world could not be allowed to regulate itself ethically. Their downfall in part led to many federal regulations designed to promote truthfulness and ethical practices among business managers. In this new business envi- ronment, there is a much greater degree of government oversight to ensure that companies maintain high standards of ethical behavior. Companies are required to make their accounting records far more transparent, to satisfy not only the federal government but their understandably wary investors.

Source: Flora F. Gu, Kineta Hung, and David K. Tse, “When Does Guanxi Matter? Issues of Capitalization and Its Dark Sides,” Journal of Marketing 72 (July 2008), pp. 12–28;

www.fastcompany.com/magazine/104/open_mintz.html?page = 0%2C0; and

www.chinasuccessstories.com/2008/02/07/dmg-chinese-advertising/.

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Chapter 2 Business Ethics 23

As we mentioned above, business ethics does not yield one “correct” decision. So how are business managers to chart their way through the ethical decision-making process? One source of assistance consists of the general theories and schools of thought about eth- ics. Each ethical system provides a method for resolving ethical dilemmas by examining duties, consequences, virtues, justice, and so on. A detailed look at each of these ethical systems can be found in Appendix 2A.

In the interest of providing future business managers with a practical approach to business ethics that they can use, we suggest a three-step approach: the WPH process of ethical decision making. This approach offers future business managers some ethical guidelines, or practical steps, that provide a dependable stimulus to ethical reasoning in a business context. Appendix 2A provides the theoretical basis for the WPH approach used in this book.

The WPH Framework for Business Ethics A useful set of ethical guidelines requires recognition that managerial decisions must meet the following primary criteria:

• The decisions affect particular groups of stakeholders in the operations of the firm. The pertinent question is thus, Whom would this decision affect?

• The decisions are made in pursuit of a particular purpose. Business decisions are instruments toward an ethical end.

• The decisions must meet the standards of action-oriented business behavior. Managers need a doable set of guidelines for how to make ethical decisions.

The remainder of this chapter explains and illustrates this framework. See Exhibit 2-4 for a summary of the key WPH elements.

LO3

How can we use the WPH framework for ethi- cal business decisions?

Exhibit 2-4 The WPH Process of Ethical Decision Making

1. W—WHO (Stakeholders): Consumers

Owners or investors

Management

Employees

Community

Future generations

2. P—PURPOSE (Values): Freedom

Security

Justice

Efficiency

3. H—HOW (Guidelines): Public disclosure

Universalization

Golden Rule

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WHO ARE THE RELEVANT STAKEHOLDERS? The stakeholders of a firm are the many groups of people affected by the firm’s decisions. Any given managerial decision affects, in varying degrees, the following stakeholders:

1. Owners or shareholders.

2. Employees.

3. Customers.

4. Management.

5. The general community where the firm operates.

6. Future generations.

Exhibit 2-5 gives a portrait of General Mills’ commitments to its primary stakehold- ers and demonstrates that General Mills is aware of the people involved in its various decisions.

When you consider the relevant stakeholders, try to go beyond the obvious. In the Case Nugget, Maria’s encounter with her company’s vice president clearly highlights certain common interests of management and its employees. However, a useful exercise for all of us is to force ourselves to think more broadly about additional stakeholders who may be affected just as much in the long run. Then we will be less likely to make decisions that have unintended negative ethical impacts.

Maria’s ethical dilemma is complex. Many of the issues in the dilemma pertain to her career and the welfare of her firm. But consider the many stakeholders whose interests

Exhibit 2-5 Commitments to General Mills’ Stakeholders

We share a common purpose and a common responsibility with our stakeholders. We want them to know that they can depend on us—and that they can trust us. We know too that we must depend on them. We want every stakeholder of General Mills to feel they are part of something special.

Our Consumers Our consumers trust General Mills to deliver quality and value when they are shopping for the most important people in their lives—their families.

Our Customers Our customers trust General Mills to deliver quality and value for their customers—the consumers of our products—and they look to us to help them grow.

Our Partners We treat our suppliers, vendors, and other partners with respect—conducting ourselves with integrity in every aspect of every relationship.

Our Team We are diverse, talented, committed individuals of integrity—constantly learning and growing and contributing to our communities.

Our Shareholders Our shareholders trust General Mills to deliver superior performance and superior total investment returns.

Our Communities We are committed to making a positive difference in people’s lives by making a positive difference in our communities.

www.generalmills.com/corporate/commitment/stakeholders.aspx (accessed October 30, 2008).

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were not introduced into the conversation. When we overlook important, relevant stake- holders, we are ignoring a significant component of ethical reasoning.

Consider the negative impact that results when a firm fails to show adequate respect for a major stakeholder. On December 3, 1984, a horrible catastrophe occurred at a chemical plant in Bhopal, India. The plant was a subsidiary of Union Carbide. Dam- age to some equipment resulted in the emission of a deadly gas, methyl isocyanate, into the atmosphere. The emission of the gas caused injuries to more than 200,000 workers and other people in the neighborhood of the chemical plant. Several thousand people died.

Many factors, including worker error, faulty management decisions, equipment failures, and poor safety standards combined to cause the accident. Union Carbide was accused of not demanding the same rigorous safety standards in India as it had in the United States. Citizens of both India and the United States demanded that the corporation be held respon- sible for its evident neglect of safety. Union Carbide argued that it could not operate the plant if it were required to obey rigid Indian safety standards and that the economic ben- efits of the plant to India outweighed the risks of not following these standards. After years of litigation in both U.S. and Indian courts, Union Carbide was eventually ordered to monetarily compensate the victims of the accident. Among other factors, Union Carbide’s failure to respect the interests of a major stakeholder resulted in a disaster for the firm and for the community.

After we consider stakeholders, the next step in the WPH framework is to con- sider the purpose of business decisions. In the next section, we look first at the parties involved, and then we explore the purposes that bring these various parties together in a common effort.

WHAT ARE THE ULTIMATE PURPOSES OF THE DECISION? When we think about the ultimate reason or purpose for why we make decisions in a busi- ness firm, we turn to the basic unit of business ethics—values. Values are positive abstrac- tions that capture our sense of what is good or desirable. They are ideas that underlie

The Many Stakeholders in a Business Decision

Maria Lopez

Maria recently became the purchasing manager of a small lawn- mower manufacturing firm. She is excited about the opportunity to demonstrate her abilities in this new responsibility. She is very aware that several others in the firm are watching her closely because they do not believe she deserves the purchasing manager position.

Her new job at the firm requires that she interact with several senior managers and leaders. One vice president in particular, Brian O’Malley, is someone she admires because he has earned the respect of the CEO on the basis of his success at making profits for the firm. Again and again, he just seems to know how to discover

HYPOTHETICAL CASE NUGGET

and take advantage of competitive opportunities that end up paying off royally for the firm.

Maria’s first responsibility is to buy the motors for the assembly line. The motors constitute 30 percent of the total construction cost of the lawn mowers. Consequently, even a small error on Maria’s part would have huge implications for the firm’s profitability. The bids from the motor suppliers are required to be secret in order to maximize competition among the suppliers. The bids are due at 5 p.m. today.

At 3 p.m., Maria accidentally sees Brian returning the submitted bids to the locked safe where they are to be stored, according to company policy, until all bids have been submitted at 5 p.m. Then at 4:45 p.m., she notices a postal delivery of a bid from Stein’s Motor Company. Her head buzzes as it hits her that Stein’s presi- dent is one of Brian O’Malley’s cousins.

She has no idea what to do. However, she knows she has to decide quickly.

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26 Part 1 The Legal Environment of Business

conversations about business ethics. We derive our ethics from the interplay of values. Values represent our understanding of the purposes we will fulfill by making particular decisions.

For example, we value honesty. We want to live in communities where the trust that we associate with honesty prevails in our negotiations with one another. Business depends on the maintenance of a high degree of trust. No contract can protect us completely against every possible contingency. So we need some element of trust in one another when we buy and sell.

When that trust is lacking, businesses fall apart. Between January and October 2008, more than 400 people were arrested for mortgage-fraud-related crimes. One of the people arrested was Wayne Puff, who started the business New Jersey Affordable Homes. Over the course of a decade, Puff solicited more than $123 million from investors, who did not know that Puff was running a Ponzi scheme. Puff was using money from later investors to pay “returns” to earlier investors, thereby fooling people into believing his business was profitable. All the while, Puff and his associates were committing mortgage fraud to main- tain the appearance of their business scheme.

If we think about the definition of values for a moment, we realize two things immedi- ately. First, there are a huge number of values that pull and push our decisions. For exam- ple, Puff may have thought of honesty as an important value, but perhaps his desire for personal success weighed more heavily on his decision making than the need for honesty did. Second, to state that a value is important in a particular situation is to start a conversa- tion about what is meant by that particular value. For example, some people may consider success a measure of one’s character, whereas one may presume from Puff’s actions that his definition of success was largely based on financial achievement.

To help make WPH useful to you as a manager, Exhibit 2-6 outlines an efficient way to apply this second step in the WPH framework. The exhibit identifies four of the most important values influencing business ethics and presents alternative meanings for each.

Exhibit 2-6 Primary Values and Business Ethics

VALUE ALTERNATIVE MEANINGS

Freedom 1. To act without restriction from rules imposed by others.

2. To possess the capacity or resources to act as one wishes.

3. To escape the cares and demands of this world entirely.

Security 1. To possess a large-enough supply of goods and services to meet basic needs.

2. To be safe from those wising to interfere with your property rights.

3. To achieve the psychological condition of self-confidence to such an extent that risks are welcome.

Justice 1. To receive the products of your labor.

2. To treat all humans identically, regardless of race, class, gender, age, and sexual preference.

3. To provide resources in proportion to need.

4. To possess anything that someone else is willing to grant you.

Efficiency 1. To maximize the amount of wealth in society.

2. To get the most from a particular output.

3. To minimize costs.

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Chapter 2 Business Ethics 27

Exhibit 2-6 should not only help clarify the importance of values in your own mind but also enable you to question others who claim to be acting in an ethical fashion.

For instance, a manager might be deciding whether to fire an employee whose performance is less than impressive. In making this decision, the manager explores alternative visions of key values such as justice and efficiency and then makes choices about which action to take. Values and their alternative meanings are often the foundation for different ethical decisions.

To avoid ambiguity, many companies summarize their values in brief statements. Nortel Networks’ statement of core values, shown in Exhibit 2-7 , identifies for Nortel’s stake- holders which positive abstractions guide its business decisions.

HOW DO WE MAKE ETHICAL DECISIONS? Making ethical decisions has always been one of our most confusing and important human challenges. In the process of meeting this challenge, we have discovered a few general, ethical guidelines to assist us. An ethical guideline provides one path to ethical conduct. Notice that all three ethical guidelines below reflect a central principle of business ethics: consideration for stakeholders.

The Golden Rule. The idea that we should interact with other people in a manner consistent with the way we would like them to interact with us has deep historical roots. Both Confucius and Aristotle suggested versions of that identical guideline. One scholar has identified six ways the Golden Rule can be interpreted:

1. Do to others as you want them to gratify you.

2. Be considerate of others’ feelings as you want them to be considerate of yours.

3. Treat others as persons of rational dignity like you.

Exhibit 2-7 Core Values: A Guide to Ethical Business Practice

NORTEL NETWORKS’ CORE VALUES

1. We create superior value for our customers.

2. We work to provide shareholder value.

3. Our people are our strength.

4. We share one vision. We are one team.

5. We have only one standard—excellence.

6. We embrace change and reward innovation.

7. We fulfill our commitments and act with integrity.

New ways of organizing people and work within the corporation are giving each of us more decision- making responsibility. Given the complexity and constantly changing nature of our work and our world, no book of hard-and-fast rules—however long and detailed—could ever adequately cover all the dilemmas people face. In this context, every Nortel Networks’ employee is asked to take leadership in ethical decision making.

In most situations, our personal values and honesty will guide us to the right decision. But in our capacity as employees and representatives of Nortel Networks, we must also always consider how our actions affect the integrity and credibility of the corporation as a whole. Our business ethics must reflect the standard of conduct outlined in this document—a standard grounded in the corporation’s values and governing Nortel Networks’ relationships with all stakeholders.

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28 Part 1 The Legal Environment of Business

4. Extend brotherly or sisterly love to others, as you would want them to do to you.

5. Treat others according to moral insight, as you would have others treat you.

6. Do to others as God wants you to do to them.

Regardless of the version of the Golden Rule we use, this guideline urges us to be aware that other people—their rights and needs—matter.

Let’s return to the ethical problem outlined at the beginning of this chapter. Using the Golden Rule as your ethical guideline, how would you behave? Would you hide the infor- mation about the chemicals used to make your toothpaste, or would you disclose the infor- mation? Put yourself in the consumer’s position. As a consumer, would you want to know that your toothpaste contained a potentially toxic chemical? Are there other stakeholders in the organization whose interests should be the focus of your application of the Golden Rule? The focus on others that is the foundation of the Golden Rule is also clearly reflected in a second ethical guideline: the public disclosure test.

Public Disclosure Test. Applying what you have learned to the ethical dilemma faced by the Chinese toothpaste manufacturers, suppose you decide to ignore the com- plaints about the use of diethylene glycol instead of glycerin. Now suppose that your deci- sion to ignore the complaints is printed in the newspaper. How would the public react? How would you feel about the public’s having full knowledge of what you intend to do?

We tend to care about what others think about us as ethical agents. Stop for a moment and think of corporations that failed to apply the public disclosure test and generated nega- tive reactions as a result. For example, in July 2006, a company named Trafigura attempted to dump waste from one of its ships at a port in Holland. The ship initially reported that it was dumping “regular slops,” or wastewater from the ship’s hold, and agreed to pay $15,000.

As the port’s workers began to empty the waste, they noticed that the waste had an unusual consistency and smell. Upon testing, the workers discovered that the waste was toxic and would cost $300,000 to treat and dispose of properly. Trafigura refused to pay, insisting that the waste was not toxic.

Trafigura had its waste reloaded onto the ship and left without paying to dispose of any of the waste. The ship then headed toward Africa, where Trafigura had reportedly found a company capable of disposing the waste. The disposal company, called Tommy, was allegedly a shell corporation created by Trafigura specifically for this job. Tommy charged Trafigura a mere $20,000 to dispose of the toxic waste. The waste was pumped from the ship into trucks that drove into Abidjan, an extremely poor part of the Ivory Coast, where the waste was dumped in 18 different residential areas during the night. The waste was not treated in any way.

Over the course of the following days, people throughout Abidjan suffered from head- aches, nausea, open sores on their skin, and even death. At least 10 people died from exposure to the toxic waste, and tens of thousands of people were injured. When the inter- national community heard that tons of toxic waste had been dumped in impoverished resi- dential areas, the outcry was noticeable.

Trafigura disclaimed all blame, saying first that the waste was not toxic and second that the company at fault was Tommy, the company that physically dumped the waste in Abidjan. As a result of the companies’ actions, criminal charges were filed against some of the key players. In October 2008, the Nigerian man who hired the trucks that dumped the waste was sentenced to 20 years in prison, and an Ivorian port official was sentenced to 5 years in prison. Seven other port and government officials were acquitted at trial.

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Chapter 2 Business Ethics 29

In February 2007, Trafigura agreed to pay $200 million to the Ivory Coast govern- ment, although the company stated that the settlement was not an admission of guilt. Trafigura claimed that the money would help pay for medical care for the tens of thou- sands of injured people and also help with the cleanup of the waste. Trafigura would likely have behaved differently had it considered the public disclosure test before paying to dump toxic waste in Abidjan. The company may have realized that the international community would be outraged by Trafigura’s disregard for the well-being of tens of thou- sands of people, and the company may even have considered that its decision would cost far more money than it would save. Presumably, Trafigura would have chosen a different waste disposal option, one that would have saved its reputation, its money, and the lives of others.

Another way to think of the public disclosure test is to view it as a ray of sun- light that makes our actions visible, rather than obscured. As Exhibit 2-8 suggests, the issue of transparency of behavior is often seen as a method of improving ethical behavior. The public disclosure test is sometimes called the “television test,” for it requires us to imagine that our actions are being broadcast on national television. The premise behind the public disclosure test is that ethics is hard work, labor that we might resist if we did not have frequent reminders that we live in a community. As a member of a community, our self-concept is tied, at least in part, to how that com- munity perceives us.

Universalization Test. A third general guideline shares with the other two a focus on the “other”—the stakeholders whom our actions affect. Before we act, the universal- ization test asks us to consider what the world would be like were our decision copied by everyone else. Applying the universalization test causes us to wonder aloud: “Is what I am about to do the kind of action that, were others to follow my example, makes the world a better place for me and those I love?”

Exhibit 2-8 A Mandate for Ethical Behavior

THE SARBANES-OXLEY ACT

The Corporate and Criminal Fraud Accountability Act, also known as the Sarbanes-Oxley Act, was signed by President Bush in 2002 in the wake of several corporate accounting scandals. The act is intended to promote high ethical standards among business managers and employees through a series of stringent requirements and controls that regulate several different facets of corporate operation.

Among other things, the act created the Public Company Accounting Oversight Board. This board is responsible for ensuring that auditors and public accounting firms compile accurate and truthful financial reports for the companies they audit. The act also requires that companies devise a system that allows employees to report suspicions of unethical behavior within the company. The act also protects these whistle-blowers from being fired or from retaliation by their employer for reporting a possible problem within the company.

Additionally, the chief executive officer (CEO) or chief financial officer (CFO) must personally vouch that the company’s financial statements are correct, meet all SEC requirements for disclosure, and represent company finances accurately. The act provides for very harsh penalties in the case of viola- tions. If the CEO or CFO knows that the company’s financial reports are incorrect but claims they are truthful, or if he or she destroys or changes financial documents, the imposed fine can run into the millions of dollars.

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Chinese Toothpaste Manufacturers Chinese toothpaste manufacturers, as well as other firms, affect the lives of many stake- holders in many countries. The manufacturers’ owners, workers, and customers are perhaps the most obvious stakeholders in decisions the manufacturers make about their production, labeling, and distribution policies. It is clear that the manufacturers’ decisions have poten- tially deadly consequences for customers who use the contaminated toothpaste, but the manufacturers’ decisions may also affect the business climate among other manufacturers, which may be tempted to engage in similarly questionable business practices to cut costs. All of the manufacturers’ decisions have ethical implications.

What those decisions are can be guided by an appreciation of the conflicting values that lie under the surface when we make decisions that affect others. The WPH system of ethical decision making stimulates the Chinese toothpaste manufacturers and similar companies to ask questions about their behavior that highlight their possible effects on the community.

All of us would probably agree that the manufacturers have a responsibility to try to be sustainable business enterprises. Toward that end, profits are essential. But production practices that cut costs may not be an effective way to make long-run profits because the multiple stakeholders disagree about the benefits of such practices. While the Chinese gov- ernment initially defended the manufacturers by reporting that diethylene glycol was not dangerous in low concentrations, the international outrage resulting from the discovery of the contaminated toothpaste caused even the Chinese government to ban the manufactur- ers from using diethylene glycol in toothpaste. By failing to disclose their use of diethyl- ene glycol, the manufacturers lost credibility among international consumers, substantially damaging their ability to be competitive and successful business firms.

CASE OPENER WRAP-UP

E-COMMERCE AND THE LAW

Computer Use and Ethics

The use of computers to store and transfer important business information has resulted in a new set of ethical concerns. How private is the computer screen? Are companies allowed to collect information about their customers? Who owns the information cus- tomers give to e-businesses? E-commerce law is gradually adjust- ing to such questions. But as the beginning of this chapter pointed out, knowing the law is just the first step in discovering ethical business decisions.

One case that considered questions related to e-commerce and privacy involved Toysmart.com and its privacy policy. In 2000, the Federal Trade Commission (FTC) filed a complaint against

Toysmart.com, charging the online retailer with selling customer lists despite earlier privacy statements that its customers’ personal data would never be shared with a third party. The customer lists were included as assets to be sold as part of the company’s bank- ruptcy proceedings. The FTC issued a settlement with Toysmart.com allowing the lists to be sold as long as (1) the sale occurred before July 2001, (2) the lists would be sold to a family-oriented company, and (3) the buyer would agree to abide by the original Toysmart. com privacy policy. After the FTC imposed these restrictions, the end result was that customers’ personal information was not sold.

The Toysmart.com case makes it clear that, for both ethical and legal reasons, companies that adopt a privacy policy need to think that policy through before announcing it to customers.

In summary, business managers can apply the WPH approach to most ethical dilemmas. The WPH framework provides a practical process suited to the frequently complex ethical dilemmas that business managers must address quickly in today’s society.

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Chapter 2 Business Ethics 31 Chapter 2 Business Ethics 31

Business Ethics and Social Responsibility

Business Law and Business Ethics

The WPH Framework for Business Ethics

business ethics 17

ethical dilemma 17

ethical guidelines 23

ethics 17

social responsibility of business 18

stakeholders 24

values 25

WPH process of ethical decision making 23

Key Terms

Business ethics is the application of ethics to the special problems and opportunities experienced by businesspeople.

The social responsibility of business consists of the expectations that the community imposes on firms doing business with its citizens.

Business ethics builds on business law. The law both affects and is affected by evolving ethical patterns. But business law provides only a floor for business ethics, telling business leaders the minimally acceptable course of action.

Who are the relevant stakeholders? This question determines which interests (consumers, employees, managers, owners) are being pushed and prodded. What are the ultimate purposes of the decision? This question determines which values (freedom, efficiency, security, and justice) are being upheld by the decision.

How do we make ethical decisions? This question leads us to apply general ethical guidelines:

• Golden Rule: Do unto others as you would have them do unto you.

• Public disclosure test: If the public knew about this decision, how would you decide?

• Universalization test: What would the world be like were our decision copied by everyone else.

Summary of Key Topics

Sarbanes-Oxley Act of 2002

Point / Counterpoint

Are the Costs Associated with the Sarbanes-Oxley Act Reason for Reform?

NO YES

Corporate and accounting scandals, such as Enron, were the reason the Sarbanes-Oxley Act of 2002 was drafted. The act promotes honesty and accountability in financial reporting, thus bringing increased security to investors. For example, corporations must now ensure the segrega- tion of all duties related to accounting procedures.

Corporations need incentives to remain or go public. The Sarbanes-Oxley Act of 2002 is not an incentive. Although there may have been ample motivation for the develop- ment of an act that addresses accounting scandals, the costs associated with Sarbanes-Oxley are much too high. Simply purchasing and learning to use the materials needed for compliance with the act would cost approxi- mately $3.5 million.

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Although critics assert that the financial burden asso- ciated with the act is reason for reform, the compliance costs about which they speak are beginning to fall as indi- viduals become familiar with the new systems. In addi- tion, the Dow Jones Industrial Average is rising as a result of increased investor confidence. This confidence is the direct result of the requirement that corporations disclose information and allow for investigations by the Public Company Accounting Oversight Board.

Since the passing of the Sarbanes-Oxley Act, there have not been any known major accounting scandals. Without public disclosure, corporations would have little incentive to engage in rigorous evaluation of their own accounting practices. By forcing corporations to disclose information, they are being held to higher ethical standards than they were previously.

Those who argue that the act should not be reformed often focus on the idea that every corporation is now being held to the same standards. However, as a result of the substantial economic costs associated with implementa- tion of the guidelines, smaller businesses that would like to go public are forced to remain private to avoid the costs. Among small businesses that are already public, many are not able to gather the resources necessary to comply with the act.

In addition to the costs associated with the act, cor- porations are now monitored by commissions that are appointed rather than elected. These commissions lack the accountability that is necessary to make decisions about how to regulate, tax, and punish companies and individu- als that may violate the provisions of the act. Thus, the act as it is currently written does not provide an equal opportu- nity to all corporations and businesses.

1. How do business ethics and business law interact with each other? Is one highly ethical and the other less ethical?

2. If business ethics does not offer guidance about what is always the right thing to do, is one behavior as good as the next?

3. How does the WPH approach to ethics approach an ethical problem?

4. Jarold Daniel Friedman worked as a temporary computer contractor for a pharmaceutical ware- house. The warehouse offered him a permanent position, but the warehouse required that he get a mumps vaccine, grown in chicken embryos, as a condition of his permanent employment. Friedman, a vegan, believed that the vaccination would violate his religious beliefs and declined to be vaccinated. As a result, the warehouse withdrew its offer of employment. Friedman claimed that the warehouse discriminated against him on the basis of religion. Do you agree with Friedman? Do employers have a duty to respect the beliefs of their employees? If so, what happens when that duty conflicts with employers’ duty to provide a safe and healthy work environment? [ Friedman v. Southern California Permanente Medical Group, 102 Cal. App. 4th 39 (2002).]

5. Jennifer Erickson sued her employer, Bartell Drug Company, contending that its decision not to cover prescription contraceptives under its employee pre- scription drug plan constituted sex discrimination. Bartell argued that its decision was not sex discrim- ination because contraceptives were preventive, were voluntary, and did not treat an illness. With whom do you agree? Why? What values did you use to reach your conclusion? [ Erickson v. Bartell Drug Co., 141 F. Supp. 2d 1266 (2001).]

6. Entertainment Network, Inc. (ENI), a business that provided news, entertainment, and information via the Internet, sued government officials who pro- hibited the company from filming the execution of Oklahoma City bomber Timothy McVeigh and sell- ing the footage of the execution online. The gov- ernment officials argued that a Justice Department regulation prohibiting audio and visual recording devices at federal executions applied in the case at hand. ENI, however, argued that the regulation vio- lated the company’s First Amendment right to free speech. How do you think the court should have ruled in this case? Do you think ENI might have altered its decision to broadcast the execution if it had applied the Golden Rule? [ Entm’t Network, Inc. v. Lappin, 134 F. Supp. 2d 1002 (2001).]

Questions & Problems

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7. Ernest Price went to a doctor in 1997, seeking Oxycontin to treat pain related to sickle cell ane- mia. Between November 1999 and October 2000, Price sought Oxycontin prescriptions from at least ten different doctors at ten different clinics in two cities, filling the prescriptions at seven pharmacies in three cities. The doctors were notified of Price’s medication-seeking behavior, and the doctors dis- continued Price’s treatment. Price then filed suit, claiming his doctors, pharmacies, and the pharma- ceutical companies that manufactured Oxycontin had breached their duty by failing to adequately warn Price of the addictive nature of Oxycontin. How do you think the court responded to Price’s claims? Think about all the stakeholders involved in such a case; how would those parties be affected by a ruling in favor of Price? In favor of the doc- tors and pharmaceutical companies? [ Ernest Price v. The Purdue Pharma Co., 920 So. 2d 479; 2006 Miss. LEXIS 67 (2006).]

8. Javier Galindo, the husband of Richard Clark’s housekeeper, was sitting in his car, parked in the driveway of Clark’s house, waiting to pick up his wife. While he was waiting, a leaning 80-foot tree located on an adjacent property fell on Galindo’s car and killed him. Galindo’s wife sued Clark, alleging that Clark was liable for failing to notify Galindo about the danger posed by the leaning tree. Do you think that Clark had a legal responsibility to tell Galindo about the tree? Do you think Clark had an ethical responsibility to tell Galindo about the tree? Why might the answer to these questions be different? [ Galindo v. Town of Clarkstown, 2 N.Y.3d 633 (2004).]

9. Doctors diagnosed Leo Guilbeault with lung cancer. He had been smoking the same brand, Camel cigarettes, since 1951. Guilbeault filed a complaint against the manufacturer of Camel cigarettes, R. J. Reynolds Tobacco Co. According to Guilbeault,

Reynolds failed to adequately warn consumers about the dangers of smoking. Prior to 1970, Camel cigarettes were sold without a warning label. After the Labeling Act of 1966, Reynolds began to put warning labels on packages of cigarettes. Guilbeault believes that Reynolds knew about the adverse health consequences of smoking before 1970 and, therefore, that Reynolds had a duty to warn consumers of these consequences. Do you agree with his argument? Should Reynolds have warned consumers earlier? [ Guilbeault v. R. J. Reynolds Tobacco Co., 44 Fed. R. Serv. 3d 124 (1999).]

10. Brazos Higher Education Service Corporation, Inc., was a nonprofit student loan company. Brazos allowed one of its employees to store customers’ personal financial information on a laptop with an unencrypted hard drive. The laptop was subsequently stolen from the employee’s home during a robbery. Brazos had no way of knowing which customers’ information was contained on the laptop’s hard drive or whether the information would be accessed by a third party. As a precaution, Brazos notified all of its customers that their information may have been accessed by a third party and offered each customer six months of identity-theft monitoring. One customer, Guin, brought suit against Brazos for negligence, claiming that Brazos had failed to adequately protect his financial information, thereby causing Guin harm. Guin’s information was never accessed by a third party, and Guin never suffered identity theft. How might other businesses be affected if Guin’s lawsuit succeeded? Do you think Brazos was wrong to store its customers’ financial information on an unencrypted laptop hard drive? [ Stacy Lawton Guin v. Brazos Higher Education Service Corporation, Inc., 2006 U.S. Dist. LEXIS 4846 (2006).]

Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

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Appendix 2A Theories of Business Ethics

Ethical Relativism and Situational Ethics An ethical school of thought that may seem appealing on the surface is ethical relativ- ism. Ethical relativism is a theory of ethics that denies the existence of objective moral standards. Rather, according to ethical relativism, individuals must evaluate actions on the basis of what they feel is best for themselves. Ethical relativism holds that when two indi- viduals disagree over a question about morality, both individuals are correct because no objective standard exists to evaluate their actions. Instead, morality is relative, and thus no one can criticize another’s behavior as immoral. Many people find ethical relativism attrac- tive because it promotes tolerance.

Ethical relativism may appear attractive at first glance, but very few people are willing to accept the logical conclusions of this theory. For example, ethical relativism requires that we see murder as a moral action as long as the murderer believes that the action is best for himself or herself. Once a person accepts the appropriateness of criticizing behavior in some situations, the person has rejected ethical relativism and must develop a more com- plex ethical theory.

Situational ethics is a theory that at first appears similar to ethical relativism but is actually substantially different. Like ethical relativism, situational ethics requires that we evaluate the morality of an action by imagining ourselves in the position of the person facing the ethical dilemma. But unlike ethical relativism, situational ethics allows us to judge other people’s actions. In other words, situational ethics holds that once we put ourselves in another person’s shoes, we can evaluate whether that person’s action was ethical.

While situational ethics provides a useful rule of thumb to use when thinking about the ethical decision-making process, it does not offer specific-enough criteria to be use- ful in many real-world situations. Once we imagine ourselves in the position of a person facing an ethical dilemma, situational ethics does not tell us how to evaluate that person’s actions. An alternative school of ethical thought, however, provides a much more judgmen- tal approach to ethical dilemmas.

Absolutism Absolutism, or ethical fundamentalism, requires that individuals defer to a set of rules to guide them in the ethical decision-making process. Unlike ethical relativ- ism and situational ethics, absolutism holds that whether an action is moral does not depend on the perspective of the person facing the ethical dilemma. Rather, whether an action is moral depends on whether the action conforms to the given set of ethical rules.

Of course, people disagree about which set of rules to follow. Why should we accept and act on any one absolutist set of rules? Absolutism cannot tell us, for example, why we ought to follow the doctrines set forth in the Koran and not Hindu doctrines.

Moreover, the unquestionable nature of the rules in most absolutist repositories seems overly inflexible when applied to different situations. For instance, “Thou shalt not kill” seems to be an absolute rule, but, in practice, killing in self-defense seems to be an accept- able exception to this rule.

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Chapter 2 Business Ethics 35

Consequentialism In contrast to absolutism, consequentialism does not provide a rigid set of rules to fol- low regardless of the situation. Rather, as the word consequentialism suggests, this ethi- cal approach “depends on the consequences.” Consequentialism is a general approach to ethical dilemmas that requires that we inquire about the consequences to relevant people of our making a particular decision.

Utilitarianism is one form of consequentialism that business managers may find useful. Like many consequentialist theories of ethics, utilitarianism urges managers to take those actions that provide the greatest pleasure after having subtracted the pain or harm associ- ated with the action in question.

Utilitarianism has two main branches: act utilitarianism and rule utilitarianism. Act utilitarianism tells business managers to examine all the potential actions in each situ- ation and choose the action that yields the greatest amount of pleasure over pain for all involved. For example, according to act utilitarianism, a business manager who deceives an employee may be acting morally if the act of deception maximizes pleasure over pain for everyone involved.

Rule utilitarians, on the other hand, see great potential for the abuse of act utili- tarianism. Instead of advocating the maximization of pleasure over pain in each indi- vidual situation, rule utilitarianism holds that general rules that on balance produce the greatest amount of pleasure for all involved should be established and followed in each situation. Thus, even if the business manager’s decision to deceive an employee maximizes pleasure over pain in a given situation, the act probably would not be consis- tent with rule utilitarianism because deception does not generally produce the greatest satisfaction.

Rule utilitarianism underlies many laws in the United States. For example, labor laws prohibit employers from hiring children to do manufacturing work, even though in some situations the transaction would maximize pleasure over pain.

One form of utilitarianism commonly applied by firms and government is cost-benefit analysis. When a business makes decisions based on cost-benefit analysis, it is compar- ing the pleasure and pain of its optional choices, as that pleasure and pain are measured in monetary terms.

As we have shown, consequentialism is not altogether helpful because of the extreme difficulty in making the required calculations about consequences. Another issue raises an important additional objection to consequentialist thinking: Where does the impor- tant social value of justice fit into consequentialist reasoning? Many business decisions could be beneficial in their consequences for a majority of the population, but is it fair to require that a few be harmed so that the majority can be improved? Consequentialism does not provide definite answers to these questions, but an alternative ethical theory does.

Deontology Deontology is an alternative theoretical approach to consequentialism. When you see references to Kantian ethics , the analysis that follows the reference will be a discussion of the most famous of the deontological approaches to business ethics. Unlike a per- son espousing consequentialism, a person using a deontological approach will not see

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36 Part 1 The Legal Environment of Business

the relevance of making a list of harms and benefits that result from a particular deci- sion. Instead, deontology consists of acting on the basis of the recognition that certain actions are right or wrong, regardless of their consequences. For example, a business leader might consider it wrong to terminate a person whose spouse has terminal cancer because a firm has an obligation to support its employees when they are vulnerable, period.

But how are business managers to decide whether an action is right or wrong? The German deontological philosopher Immanuel Kant proposed the categorical imperative to determine whether an action is right. According to the categorical imperative, an action is moral only if it would be consistent for everyone in society to act in the same way. Thus, for example, applying the categorical imperative would lead you to conclude that you should not cheat on a drug test, because if everyone acted in the same way, the drug test would be meaningless.

From the deontological viewpoint, the duties or obligations that we owe one another as humans are much more ethically significant than are measurements of the impacts of business decisions. For example, a person using a deontological theory of ethics may see any business behavior that violates our duty of trust as being wrong. To sell a car that one knows will probably not be usable after four years is, from this perspec- tive, unethical. No set of positive consequences that might flow from the production decision can overcome the certainty of the deontological recognition that the sale is wrong.

The duties that we owe others imply that human beings have fundamental rights based on the dignity of each individual. This principle of rights asserts that whether a business decision is ethical depends on how the decision affects the rights of all involved. This principle is foundational to Western culture: the Declaration of Indepen- dence, for example, asserts that everyone has the right to “life, liberty, and the pursuit of happiness.”

But just as consequentialism is incredibly complicated, deontology is difficult to apply because people disagree about what duties we owe to one another and which duties are more important than others when they conflict. For example, imagine the dilemma of a scientist working for a tobacco firm who discovers that cigarettes are car- cinogenic. She owes a duty of trust to her employer, but she also has a conflicting duty to the community to do no harm. Where would a business manager find a list of relevant duties under the deontological framework, and why should we accept and act on any particular list?

In addition, as with absolutism, the absolute nature of many deontological lists of duties and rights seems overly rigid when applied to a wide variety of contexts. For instance, saying that we owe a duty to respect human life sounds absolute. In application, however, we might be forced to harm one life to preserve other life. An alternative theory of ethics, called virtue ethics, avoids this rigidity problem by providing us with abstract goals to pursue continually.

Virtue Ethics Virtue ethics is an ethical system in which the development of virtues, or positive char- acter traits such as courage, justice, and truthfulness, is the basis for morality. A morally excellent (and thus good) person develops virtues and distinguishes them from vices, or negative character traits, such as cowardice and vanity. This development of virtues occurs

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Chapter 2 Business Ethics 37

through practice. Virtues are the habits of mind that move us toward excellence, the good life, or human flourishing.

As a guide to business ethics, virtue ethics requires that managers act in such a way that they will increase their contributions to the good life. Virtue ethics tells them to follow the character traits that, upon introspective reflection, they see as consistent with virtue. Iden- tifying the relevant virtues and vices requires reasoning about the kind of human behavior that moves us toward the good, successful, or happy life.

A difficulty with the application of virtue ethics is the lack of agreement about the meaning of “the good life.” Without that agreement, we are not able to agree about what types of behavior are consistent with our achievement of that goal. Even so, virtue ethics is useful in reminding us that ethics is grounded in a sense of what it means to be virtuous— we need some moral beacon to call us toward a more morally excellent condition. An alternative theory of business ethics, the ethics of care, offers a clear conception of what is virtuous.

Ethics of Care The ethics of care holds that the right course of action is the option most consistent with the building and maintaining of human relationships. Those who adhere to an ethic of care argue that traditional moral hierarchies ignore an important element of life: relationships. Care for the nurturing of our many relationships serves as a reminder of the importance of responsibility to others.

According to someone who adheres to an ethic of care, when one person cares for another person, the first person is acting morally. When other ethical theories emphasize different moral dimensions as a basis for resolving ethical dilemmas, they rarely consider the harm they might do to relationships; thus, from the perspective of the ethics of care, alternative theories of business ethics often encourage unethical behavior.

Ethics-of-care theorists argue that when one individual, the caregiver, meets the needs of one other person, the cared-for party, the caregiver is actually helping to meet the needs of all the individuals who fall within the cared-for party’s web of care. Thus, by specifically helping one other individual, the caregiver is assisting numerous people.

The strength of this theoretical approach is that it focuses on the basis of ethics in gen- eral: the significance of the interests of other people. The urging to care for relationships speaks to the fundamental basis of why we are concerned about ethics in the first place. Most of us do not need any encouragement to think about how a decision will affect us personally. But ethical reasoning requires that we weigh the impact of decisions on the larger community.

Let’s examine how these ethical theories are applied in real-world firms. Exhibit 2A-1 is an abridged version of the Johnson & Johnson Credo, or statement of shared corporate values. General Robert Wood Johnson, who guided Johnson & Johnson from a small, family-owned business to a worldwide enterprise, believed the corporation had social responsibilities beyond the manufacturing and marketing of products. In 1943, he wrote and published the Johnson & Johnson Credo, a document outlining those respon- sibilities. Does the credo depend more on ethical relativism, situational ethics, absolut- ism, consequentialism, deontology, virtue ethics, or the ethics of care for its ethical vision?

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Exhibit 2A-1 Johnson & Johnson’s Credo The Credo

We believe our first responsibility is to the doctors, nurses and patients, to mothers and fathers and all others who use our products and services. In meeting their needs everything we do must be of high quality. We must constantly strive to reduce our costs in order to maintain reasonable prices. Custom- ers’ orders must be serviced promptly and accurately. Our suppliers and distributors must have an opportunity to make a fair profit.

We are responsible to our employees, the men and women who work with us throughout the world. Everyone must be considered as an individual. We must respect their dignity and recog- nize their merit. They must have a sense of security in their jobs. Compensation must be fair and adequate, and working conditions clean, orderly and safe. We must be mindful of ways to help our employees fulfill their family responsibilities. Employees must feel free to make suggestions and complaints. There must be equal opportunity for employment, development and advancement for those qualified. We must provide competent management, and their actions must be just and ethical.

We are responsible to the communities in which we live and work and to the world community as well. We must be good citizens—support good works and charities and bear our fair share of taxes. We must encourage civic improvements and better health and education. We must maintain in good order the property we are privileged to use, protecting the environment and natural resources.

Our final responsibility is to our stockholders. Business must make a sound profit. We must experi- ment with new ideas. Research must be carried on, innovative programs developed and mistakes paid for. New equipment must be purchased, new facilities provided and new products launched. Reserves must be created to provide for adverse times. When we operate according to these principles, the stockholders should realize a fair return. Used with permission of Johnson & Johnson.

Exhibit 2A-2 At a Glance Theories of Business Ethics

ETHICAL APPROACH DESCRIPTION

Ethical relativism Asserts that morality is relative.

Situational ethics Requires that when we evaluate whether an action is ethical, we imagine ourselves in the position of the person facing the ethical dilemma.

Consequentialism Considers the consequences (i.e., harms and benefits) of making a particular decision.

Deontology Recognizes certain actions as right or wrong regardless of the consequences.

Virtue ethics Encourages individuals to develop virtues (e.g., courage and truthfulness) that guide behavior.

Ethics of care Holds that ethical behavior is determined by actions that care for and maintain human relationships.

Exhibit 2A-2 summarizes the ethical theories discussed in this appendix.

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Chapter 2 Business Ethics 39

absolutism 34

act utilitarianism 35

categorical imperative 36

consequentialism 35

cost-benefit analysis 35

deontology 36

ethical relativism 34

ethics of care 37

principle of rights 36

rule utilitarianism 35

situational ethics 34

utilitarianism 35

virtue ethics 36

Key Terms

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1 What are the different types of jurisdiction a court must have before it can render a binding decision in a case?

2 What is venue?

3 How is our dual court system structured?

4 What are the threshold requirements that must be met before a court will hear a case?

5 What are the steps in civil litigation?

The U.S. Legal System 3 C H A P T E R

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

CASE OPENER Questionable Jurisdiction over Caterpillar

James Lewis, a resident of Kentucky, sustained an injury while operating a Caterpillar bulldozer. He filed suit against Caterpillar, a company incorporated in Delaware but with its principal place of business in Illinois. Lewis also filed suit against the supplier of the bulldozer, Whayne Supply Company, whose principal place of business was Kentucky. Lewis filed his case in a Kentucky state court, alleging defective manufacture, negligence, failure to warn, and breach of warranty. Lewis and Whayne Supply Company agreed to settle out of court. Caterpillar then filed a motion to exercise its right of removal (its right to move the case from the state to the federal court system), arguing that the federal court had jurisdiction over the case because Caterpillar and Lewis were from different states. Lewis disagreed with Caterpillar’s contention, claiming that because he had not completed his settlement with Whayne, the case still included a defendant (Whayne) from Lewis’s state, Kentucky. Thus, Lewis argued, federal courts did not have jurisdiction over the case.

The court agreed with Caterpillar’s argument and moved the case to a federal district court. Shortly thereafter, Lewis and Whayne finalized their settlement agreement, and the district court dismissed Whayne from the lawsuit. The federal district court granted

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Caterpillar a favorable judgment. Lewis, however, appealed the district court’s decision, renewing his argument that the district court did not have jurisdiction over the case. The court of appeals agreed with Lewis, holding that because Whayne was a defendant in the case at the time that Caterpillar moved the case from state to federal court, the diversity of citizenship necessary to give the federal court jurisdiction over the case was absent. Thus, a state court should have resolved the dispute. Consequently, the appellate court vacated the district court’s decision. Caterpillar then appealed to the U.S. Supreme Court.

1. What factors determine whether the state or federal court system hears a case?

2. If you were a businessperson with Caterpillar, why might you prefer a federal court to hear the dispute with Lewis instead of a state court?

The Wrap-Up at the end of the chapter will answer these questions.

As the opening scenario illustrates, when a dispute arises, parties in this country do not simply “go to court.” They often must choose between federal and state court systems. This chapter examines these systems, as well as the trial procedures that apply in civil cases.

Jurisdiction The word jurisdiction comes from the Latin terms juris, meaning “law,” and diction, meaning “to speak.” A useful way to understand jurisdiction is to think of it as referring to courts’ power to hear cases and render decisions that bind the parties before them. A court must have several types of jurisdiction to decide any particular case.

ORIGINAL VERSUS APPELLATE JURISDICTION Trial courts, or courts of original jurisdiction, have the power to hear and decide cases when they first enter the legal system. In these courts, the parties present evidence and call witnesses to testify. Most state court systems refer to trial courts as courts of common pleas or county courts. The federal system calls them district courts.

Courts of appellate jurisdiction, or appellate courts, have the power to review previous judicial decisions to determine whether trial courts erred in their decisions. Appellate courts do not hold trials. Rather, appellate judges review transcripts of trial court proceedings and occasionally consider additional oral and written arguments from each party.

Appellate courts handle primarily questions of law, not questions of fact. A question of law is an issue concerning the interpretation or application of a law. In contrast, a ques- tion of fact is a question about an event or characteristic in a case. For example, whether a student yelled racial slurs on a college campus is a question of fact. On the other hand, whether the First Amendment protects the student’s right to utter racial slurs is a question of law.

Only judges can decide questions of law. Questions of fact are determined in the trial court. In a bench trial (a trial with no jury), the judge decides questions of fact; in a jury trial, the jury decides questions of fact. Appellate courts can, however, overrule trial courts’ decisions on questions of fact, but only when the trial court’s finding was clearly erroneous or when no trial evidence supports the trial court’s finding.

LO1

What are the different types of jurisdiction a

court must have before it can render a binding

decision in a case?

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To read more about how the choice of where to incorporate relates to juris-

diction, please see the Connecting to the Core activity on the text Web site

at www.mhhe.com/kubasek2e.

42 Part 1 The Legal Environment of Business

Legal Principle: The court in which a case is first heard is called the court of original jurisdiction, and the court to which a decision made by that court is appealed is called the court of appellate jurisdiction.

JURISDICTION OVER PERSONS AND PROPERTY In personam jurisdiction (literally, “jurisdiction over the person”) is a court’s power to render a decision affecting the rights of the specific persons before the court. Generally, a court’s power to exercise in personam jurisdiction extends only over a specific geographic region. In the state court system, a court’s in personam jurisdiction usually extends to the state’s borders. In the federal system, on the other hand, each court’s jurisdiction extends across its geographic district.

A court acquires in personam jurisdiction over a person (the plaintiff ) when she files a lawsuit with the court. The court acquires jurisdiction over the person the plaintiff is suing (the defendant ) when it gives him a copy of the complaint and a summons. The complaint specifies the factual and legal basis for the lawsuit and the relief the plaintiff seeks. The summons is a court order that notifies the defendant of the lawsuit and explains how and when to respond to the complaint.

Service of process is the procedure by which courts present these documents to defen- dants. Traditionally, courts use personal service: An officer of the court hands the sum- mons and complaint to the defendant. Recently, however, courts have employed other methods of service, including residential service, in which a court representative leaves the summons and complaint with a responsible adult at the defendant’s home, and service by certified or ordinary mail.

There has even been one case in which a court of appeals upheld service of process by e-mail to be appropriate. The facts of the case, however, created an unusual situation in which no other means of service was really possible. Rio Properties, Inc., operators of the Rio All Suites Resort Casino in Las Vegas, Nevada, decided to put some of its gaming activities on the Internet and discovered that a Costa Rican company, Rio International Interlink (RII), was operating an online, international sports book that allegedly infringed on Rio Properties’ registered trademark. When the court attempted to serve RII at its U.S. address, the court found that it was only an address for an international courier that was not authorized to accept service on behalf of the company, and the court could not find any address for the company in Costa Rico. Rio Properties then filed a motion for alternative service of process with the court for permission to serve RII via its e-mail address, and the motion was granted by the district court. The court of appeals upheld the validity of the district court’s order, noting that the Constitution does not require any specific means of service, only a means of service “reasonably calculated to provide notice and an opportu- nity to respond.” 1 Because the method seemed to be the method of service most likely to reach RII, the court found that it clearly met the standard.

If the defendant is a corporation, courts generally serve either the president of the corporation or an agent that the corporation has appointed to receive service. Most states require that corporations appoint an agent for service when they incorporate. Corporations are subject to in personam jurisdiction in three locations: the state of their incorporation, the location of their main offices, and the geographic areas in which they conduct business.

Courts have in personam jurisdiction only over persons within a specific geographic region. In the past, a state court could not acquire in personam

1 Rio Properties, Inc. v. Rio International Interlink, 284 F.3d 1007 (2002).

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jurisdiction over out-of-state defendants unless it served the defendants within the court’s home state. Thus, defendants who injured plaintiffs could evade legal action by leaving the state and remaining outside its borders. To alleviate this problem, most states have enacted long-arm statutes, which enable the court to serve defendants outside the state as long as the defendant has sufficient minimum contacts within the state and it seems fair to assert long-arm jurisdiction over him or her. The U.S. Supreme Court established this “minimum- contacts” standard in the 1945 case International Shoe Co. v. State of Washington. 2

Each state has its own minimum-contact requirements, but most state statutes hold that acts like committing a tort or doing business in the state are sufficient to allow the state to serve a defendant. In the opening scenario, the company sold products in Kentucky, and its products caused an injury in that state. These two facts were sufficient minimum con- tacts to allow the Kentucky court to serve Caterpillar, even though it was an out-of-state company. Compare the facts of the Caterpillar case to those in the Case Nugget, where the court found that the contacts were sufficient to give the court jurisdiction over the out-of- state resident, even when the primary contact in the state was over the telephone.

In contrast to the situations in the Case Nugget and in the opening scenario, the Florida appellate court did not find minimum contacts with that state to enable a foreign cor- poration to sue Columbia University, located in New York City, for a tort that allegedly occurred in New York. The court found that the fact that Columbia had alumni associa- tions in Florida, owned some interactive classrooms in that state, and offered some online classes to residents did not constitute sufficient minimum contacts for a lawsuit in which none of the tortuous acts were alleged to have occurred in the state. 3

If a defendant has property in a state, a plaintiff may file suit against the defendant’s property instead of the owner. For example, suppose a Utah resident had not paid prop- erty taxes on a piece of land she owned in Idaho. Idaho courts have in rem jurisdiction (Latin for “jurisdiction over the thing”) over the property. Thus, an Idaho state court has the power to seize the property and sell it to pay the property taxes in an in rem proceeding.

Courts can also gain quasi in rem jurisdiction, or attachment jurisdiction, over a defen- dant’s property unrelated to the plaintiff’s claim. For example, suppose Charlie, a Massa- chusetts resident, ran a red light while he was vacationing in California and collided with

2 326 U.S. 310.

3 Trustees of Columbia University v. Ocean World, SA, 2009 WL 1212229, Ct. App. Fla.

A Question of Minimum Contacts

Jones v. Williams

Jones lived in California, and for four years received weekly psy- chotherapy and dream counseling over the telephone from Wil- liams, a licensed therapist living in New Mexico. Williams made several trips to California at Jones’s request to provide additional treatment. For one year, Jones also received shamanic counseling over the phone from Williams’s wife, Ritzman. Jones ceased treat- ment and sued Williams and Ritzman for medical malpractice in California. The defendants moved to have the complaint dismissed for lack of personal jurisdiction.

In examining the facts of the case, the court found that the defendants had sufficient contacts for establishing specific

CASE NUGGET

jurisdiction with respect to a medical malpractice case arising out of their treatment of Jones. The court said that sufficient contacts existed for in personam jurisdiction in a specific case when (1) the nonresident defendant purposefully availed him- self of the privilege of conducting activities in the forum state by some affirmative act or conduct; (2) the plaintiff’s claim arises out of or results from the defendant’s forum-related activities; and (3) the exercise of jurisdiction is reasonable. In this case, the defendants engaged in counseling in the state, both in per- son and via the telephone; the lawsuit arose out of the counsel- ing that occurred in that state; and the defendants should have recognized that in light of their providing services in that state they would be subject to suit there for activities arising from providing that service.

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Jessica’s car. Suppose further that Jessica suffered extensive injuries from the accident and successfully sued Charlie for $200,000 in a California state court. The California court can exercise quasi in rem jurisdiction over Charlie’s California vacation home by seizing it, selling it, and transferring $200,000 to Jessica to satisfy her judgment against Charlie. If Charlie’s vacation home is worth more than $200,000, however, the court must return the excess proceeds to Charlie.

SUBJECT-MATTER JURISDICTION Subject-matter jurisdiction is a court’s power to hear certain kinds of cases. Most indus- trialized countries have a single court system, with courts that have the power to hear both national law cases and local law cases. In contrast, the United States has both a state and a federal court system. Subject-matter jurisdiction determines which court system may hear a particular case. Cases may fall under state jurisdiction, exclusive federal jurisdiction, or concurrent jurisdiction. Exhibit 3-1 illustrates the subject-matter-jurisdiction divisions.

Exclusive Federal Jurisdiction. The federal court system has exclusive jurisdiction over very few cases: admiralty cases, bankruptcy cases, federal criminal prosecutions, lawsuits in which one state sues another state, claims against the United States, and cases involving federal copyrights, patents, or trademarks. Additionally, federal courts have exclusive juris- diction over claims arising under federal statutes that specify exclusive federal jurisdiction.

State Jurisdiction. The state court system has a broad range of jurisdiction; state courts have the power to hear all cases not within the exclusive jurisdiction of the federal court system. State courts also have exclusive jurisdiction over certain cases, such as cases concerning adoption and divorce. Most cases, therefore, fall under state court jurisdiction.

The Caterpillar case fell under state court jurisdiction because its subject matter— product liability and negligence—did not place the case under the exclusive jurisdiction of the federal court system.

Concurrent Federal Jurisdiction. Concurrent federal jurisdiction means that both state and federal courts have jurisdiction over a case. Concurrent jurisdiction covers

* 952 F. Supp. 1119, 1124 (W.D. Pa. 1997).

E-COMMERCE AND THE LAW

The Sliding-Scale Standard for Internet Transactions

Does a business that has Internet contact with a plaintiff in a dif- ferent state satisfy the minimum-contacts standard? Anyone who engages in transactions over the Internet should be concerned about this question.

A federal district court established the following “sliding-scale” standard in the 1997 case Zippo Mfg. Co. v. Zippo Dot Com, Inc.: *

[T]he likelihood that personal jurisdiction can be constitution- ally exercised is directly proportionate to the nature and quality of commercial activity that an entity conducts over the Internet. This sliding scale is consistent with well developed personal jurisdiction principles.

At one end of the spectrum are situations in which a defen- dant clearly does business over the Internet. If the defendant enters

into contracts with residents of a foreign jurisdiction that involve the knowing and repeated transmission of computer files over the Internet, personal jurisdiction is proper.

At the opposite end are situations in which a defendant has simply posted information on an Internet Web site that is acces- sible to users in foreign jurisdictions. A passive Web site that does little more than make information available to those who are interested in it is not grounds for the exercise of personal jurisdiction.

The middle ground is occupied by interactive Web sites at which a user can exchange information with the host computer. In such cases, the exercise of jurisdiction is determined by examining the level of interactivity and commercial nature of the exchange of information that occurs on the Web site.

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two types of cases: federal-question and diversity-of-citizenship cases. Federal-question cases require an interpretation of the United States Constitution, a federal statute, or a federal treaty. For example, suppose a plaintiff alleges that a Florida campaign financing law violates his First Amendment free speech rights. Because this case raises a federal question, it falls under concurrent jurisdiction, and both state and federal courts have the power to hear it.

A diversity-of-citizenship case must satisfy two conditions: (1) The plaintiff(s) does (do) not reside in the same state as the defendant(s), and (2) the controversy concerns an amount in excess of $75,000. Courts use the location of a party’s residence to determine whether diversity of citizenship exists. Most federal court cases are based on diversity of citizenship.

A business may reside in two states: the state of its incorporation and the state of its principal place of business. Thus, in the opening scenario, Caterpillar was a resident of Delaware, the state where it incorporated, and of Illinois, the state of its primary place of business.

Diversity must be complete, however, for a case to fall under concurrent jurisdiction. In the Caterpillar case, Lewis argued that diversity was not complete because both he and the supply company, the second defendant he originally sued, were residents of Kentucky. The appellate court agreed with his argument and overturned the district court’s decision because the district court lacked subject-matter jurisdiction.

Legal Principle: Concurrent jurisdiction exists whenever there is a federal ques- tion or diversity of citizenship and at least $75,000 at issue.

When a case falls under concurrent jurisdiction, the plaintiff initially chooses which court will hear the case by filing in whichever court system the plaintiff wishes the case to be heard in. If a plaintiff files the case in a state court, however, the defendant has a right of removal. This right entitles the defendant to transfer the case to the federal court system. Thus, either party to a case involving concurrent jurisdiction has the ability to ensure that the case will be heard in the federal court system: The plaintiff can file the case in federal court initially, or the defendant can transfer the case to federal court by exercising her right of removal if the case is initially filed in state court. In the opening scenario, Caterpillar exer- cised its right of removal, and the state trial court moved the case to a federal district court.

The issue of subject-matter jurisdiction often arises when the parties to a lawsuit dis- agree about whether to try the case in state or federal court, as Case 3-1 illustrates.

Exhibit 3-1 Subject-Matter- Jurisdiction Divisions Exclusive Federal Jurisdiction

- Admiralty cases - Bankruptcy cases - Federal criminal prosecutions - Cases in which one state sues another state - Claims against the United States - Federal patent, trademark, and copyright claims - Other claims involving federal statutes that specify exclusive federal jurisdiction

Concurrent Federal

Jurisdiction - Federal-question cases - Diversity-of- citizenship cases

State Jurisdiction

- All cases not falling under exclusive federal jurisdiction

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CASE 3-1 WACHOVIA BANK, N. A. V. SCHMIDT UNITED STATES SUPREME COURT 126 S. CT. 941 (2006)

Petitioner Wachovia Bank, National Association (Wachovia), is a national banking association with its designated main office in North Carolina and branch offices in many states, including South Carolina. Plaintiff-respondent Schmidt and other South Carolina citizens sued Wachovia in a South Carolina state court for fraudulently inducing them to par- ticipate in an illegitimate tax shelter. Shortly thereafter, Wachovia filed a petition in Federal District Court, seek- ing to compel arbitration of the dispute. As the sole basis for federal-court jurisdiction, Wachovia claimed there was diversity of citizenship between the parties.

The District Court denied Wachovia’s petition on the merits. On appeal, the Fourth Circuit determined that the District Court lacked subject-matter jurisdiction over the action, vacated the judgment, and instructed the District Court to dismiss the case. The appeals court observed that for diversity purposes, Wachovia is a citizen of “the States in which they are respectively located.” Therefore the appel- late court found Wachovia to be “located” in, and therefore a “citizen” of, every State in which it maintains a branch office. Thus, Wachovia’s South Carolina branch operations rendered it a citizen of that State. Given the South Carolina citizenship of the opposing parties, the court concluded that the matter could not be adjudicated in federal court.

Wachovia appealed to the United States Supreme Court.

JUSTICE GINSBURG: This case concerns the citizen- ship, for purposes of federal-court diversity jurisdiction, of national banks, i.e., corporate entities chartered not by any State, but by the Comptroller of the Currency of the U.S. Treasury. Congress empowered federal district courts to adjudicate civil actions between citizens of different States where the amount in controversy exceeds $75,000.

A business organized as a corporation, for diversity juris- diction purposes, is deemed to be a citizen of any State by which it has been incorporated and, since 1958, also of the State where it has its principal place of business. State banks, usually chartered as corporate bodies by a particu- lar State, ordinarily fit comfortably within this prescrip- tion. Federally chartered national banks do not, for they are not incorporated by “any State.” For diversity jurisdiction purposes, therefore, Congress has discretely provided that national banks “shall . . . be deemed citizens of the States in which they are respectively located.”

The question presented turns on the meaning, in § 1348’s context, of the word “located.” Does it signal, as the peti- tioning national bank and the United States, as amicus cur- iae, urge, that the bank’s citizenship is determined by the place designated in the bank’s articles of association as the location of its main office? Or does it mean, in addition, as respondents urge and the Court of Appeals held, that a national bank is a citizen of every State in which it maintains a branch.

Recognizing that “located” is not a word of enduring rigidity, but one that gains its precise meaning from con- text, we hold that a national bank, for § 1348 purposes, is a citizen of the State in which its main office, as set forth in its articles of association, is located. Were we to hold, as the Court of Appeals did, that a national bank is additionally a citizen of every State in which it has estab- lished a branch, the access of a federally chartered bank to a federal forum would be drastically curtailed in com- parison to the access afforded state banks and other state- incorporated entities. Congress, we are satisfied, created no such anomaly.

REVERSED in favor of Wachovia.

What guideline does Justice Ginsburg provide for determin- ing which alternative interpretation of a word is the most appropriate in a certain context? In other words, what did she suggest as a guideline for sorting out solutions to ambiguity?

ETHICAL DECISION MAKING CRITICAL THINKING

What is the ethical problem suggested by this case?

Why does it matter who has jurisdiction in a case like this one?

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Chapter 3 The U.S. Legal System 47

While the question of which court system will hear a case is a matter that we think of as arising once a dispute has occurred, sometimes companies’ decisions about where to locate are influenced by their knowledge about the court system in a state they are considering. And some organizations actually encourage companies to take a state’s court system into account. As you already know, companies take into account the laws of the states where they are considering locating and doing business. Another factor some businesses consider is whether a state’s courts seem hospitable to businesses. The American Tort Reform Asso- ciation (ATRA), a national organization based in Washington, D.C., attempts to eliminate some of the “legal guesswork” for businesses by creating a list of the nation’s top “Judicial Hellholes” each year. ATRA identifies its top hellholes as places where the law is applied in an “inequitable manner, generally against defendants in civil lawsuits.” 4 One state in particular, West Virginia, continues to top the ATRA charts and has been named the num- ber-one Judicial Hellhole in the United States for both 2007 and 2008. ATRA mentions that one of West Virginia’s major legal shortcomings is that it happens to be only one of two states in the country that does not “guarantee the right to appeal a civil verdict.” 5

Also crippling West Virginia’s ability to offer a favorable business environment is its reputation as being a lawsuit- and plaintiff-friendly state. For example, a judge in West Virginia recently ordered the DuPont company to pay $196 million in punative damages and $55 million for site cleanup and to commit $130 million to medical monitoring and testing after several West Virginia citizens filed suit against the company, claiming one of its plants contaminated their city and posed serious health risks, even though at the time of the verdict none of the residents were ill or showed health effects. High-profile and high- award cases like the DuPont case, coupled with an arguably flawed judicial system, could be enough to deter businesses from locating in West Virginia in the future. The DuPont case demonstrates that, as with any business decision, the costs and benefits of doing busi- ness in a particular state and legal climate need to be evaluated before moving forward.

Venue Once a case is in the proper court system, venue determines which trial court in the system will hear the case. Venue is a matter of geographic location determined by each state’s statutes. Usually, the trial court where the defendant resides is the appropriate venue. If a case involves property, the trial court where the property is located is also an appropriate venue. Finally, if the focus of the case is a particular incident, the trial court where the dispute occurred is an appropriate venue. The plaintiff initially chooses from among the appropriate venues when she files the case.

If the location of the court where the plaintiff filed the case is an inconvenience to the defendant or if the defendant believes it will be difficult to select an unbiased jury in that venue, he may request that the judge move the case by filing a motion for a change of venue. The judge has the discretion to grant or deny the motion.

For example, one particular reason a defendant might choose to request a change of venue is negative pretrial publicity. In May 2008, Sholom Rubashkin, the manager of the nation’s largest kosher slaughterhouse, was arrested in an immigration raid, and he now faces roughly 100 charges ranging from document fraud and identity theft to child-labor and minimum-wage violations. The scale of the raid, which led to the arrest of approxi- mately 400 of Rubashkin’s employees, and the severity of Rubashkin’s charges attracted national media attention. Fearing that he would not be able to receive a fair trial or an

4 www.atra.org/reports/hellholes/. 5 Ibid.

LO2

What is venue?

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48 Part 1 The Legal Environment of Business

unbiased jury, 6 Rubashkin filed a request to have his trial moved from Iowa to either Minneapolis or Chicago. A federal district court judge disagreed with Rubashkin, and denied his initial request for a new venue. However, the judge did acknowledge that pub- licity may increase even more as the trial draws near and mentioned that she may allow Rubashkin to renew his argument for a new venue at that time.

Legal Principle: Venue is appropriate in the county where the defendant resides or where the incident took place over which the lawsuit arose.

The Structure of the Court System The U.S. legal system has two parallel court structures: a federal system and a state sys- tem. Once a plaintiff files a case in one of the systems, the case remains in that system throughout the appeals process. The only exception to this rule occurs when a party to a lawsuit appeals the decision of a state supreme court to the U.S. Supreme Court.

THE FEDERAL COURT SYSTEM The federal court system derives its power from Article III, Section 2, of the U.S. Constitu- tion and consists of three main levels: trial courts, intermediate appellate courts, and the court of last resort. Exhibit 3-2 illustrates this system.

Federal Trial Courts. In the federal court system, the trial courts, or courts of origi- nal jurisdiction, are U.S. district courts. The United States has 94 districts; each district has at least one trial court of general jurisdiction. Courts of general jurisdiction have the power to hear a wide range of cases and can grant almost any type of remedy. Almost every case in the federal system begins in one of these courts.

A small number of cases, however, do not begin in trial courts of general jurisdiction. For cases concerning certain subject matter, Congress has established special trial courts of limited jurisdiction. The types of cases for which Congress has established these special trial courts include bankruptcy cases, claims against the U.S. government, international trade and customs cases, and disputes over certain tax deficiencies.

6 www.nytimes.com/2008/10/31/us/31immig.html?hp; and seattletimes.nwsource.com/html/businesstechnology/2008881497_ apkosherslaughterhousetrial.html.

Exhibit 3-2 The Federal Court System

U.S. Supreme Court

Court of Appeals for the Federal Circuit

United States Tax Court

United States Court of

Federal Claims

Patents and Trademarks

Office

Court of International

Trade

United States Court of

Appeals for Veterans Claims

United States District Courts

(94)

Administrative Tribunals (FTC,

SEC, etc.)

United States Tax Court

Bankruptcy Courts

United States Circuit Courts

of Appeals (12)

LO3

How is our dual court system structured?

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Chapter 3 The U.S. Legal System 49

In an extremely limited number of cases, the U.S. Supreme Court functions as a trial court of limited jurisdiction. These cases include controversies between states and lawsuits against foreign ambassadors.

Intermediate Courts of Appeal. The U.S. circuit courts of appeal make up the second level of courts in the federal system. The United States has 12 circuits, including a circuit for the District of Columbia. Each circuit court hears appeals from district courts in its geographic area. Additionally, a federal circuit court of appeals hears appeals from gov- ernment administrative agencies. Exhibit 3-3 illustrates the geographic circuit divisions.

The Court of Last Resort. The U.S. Supreme Court is the final appellate court in the federal system. Nine justices, who have lifetime appointments, make up the high court. Exhibit 3-4 shows the nine justices on the U.S. Supreme Court in 2010.

The U.S. Supreme Court hears appeals of cases from the court of last resort in a state system. The Court will not, however, hear cases considering questions of pure state law. The Court also functions as a trial court in rare occasions. The structure and functioning of the U.S. Supreme Court system differ from those of similar courts in other countries, as the Comparing the Law of Other Countries box illustrates.

STATE COURT SYSTEMS No uniform state court structure exists because each state has devised its own court system. Most states, however, have a structure similar to the federal court system’s structure.

Exhibit 3-3 The Circuits of the Federal Court System

Western WA

OR

NV

CA

AK

MP GU HI

AZ

UT

ID

MT ND

SD

NE

KS

OK

TX LA MS

AR

AL GA

SC

FL

PR

TN

KY

IL

IA

MN

WI MI

NC

IN OH

PA

VA WV

MA

ME NH

VT

RI

CT

NJ

DE

MD

DC

FED

NY

VI

MO

WY

CO

NM

9

10

8

5 11

4

6 7

3

2 1

Eastern

Eastern

Northern

Eastern

Eastern

Eastern

Eastern

Eastern

Eastern

Eastern

Eastern

Eastern

Eastern

Eastern

Eastern

Middle

Middle

Middle

Middle

Middle Middle

Middle

Eastern

Northern Northern Northern

Northern

Northern

Northern Northern

Northern

Northern

Northern

Northern

Northern

Central

Southern

Western

Western

Western

Western

Western

Western

WesternWestern

Western

Western

Southern

Western

Western

Southern

Southern

Central

Southern

Southern

Southern

Southern

Southern Southern

Southern

Southern

Southern

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State Trial Courts. In state court systems, most cases begin in a trial court of general jurisdiction. As in the federal system, state trial courts of general jurisdiction have the power to hear all cases over which the state court system has jurisdiction except those cases for which the state has established special trial courts of limited jurisdiction. Most states have a trial court of general jurisdiction in each county. The names of these courts

Exhibit 3-4 U.S. Supreme Court Justices, 2010

Associate Justice

Antonin Scalia Appointed in 1984 by

President Reagan

Chief Justice

Ruth Bader Ginsburg Appointed in 1993 by

President Clinton

Stephen G. Breyer Appointed in 1994 by

President Clinton

Appointed in 2009 by President Barack Obama

Associate Justice

John G. Roberts Appointed in 2005 by President G.W. Bush

Associate Justice

Anthony M. Kennedy Appointed in 1988 by President G.H.W. Bush

Associate Justice

Associate JusticeAssociate Justice Associate Justice

Samuel Alito Appointed in 2006 by President G.W. Bush

Clarence Thomas Appointed in 1991 by President G.H.W. Bush

Associate Justice

Elena Kagan Appointed in 2010 by

President Barack Obama

Sonia Sotomayor

The Supreme Court in Japan

The supreme court of Japan, located in Tokyo, consists of 15 justices, including one chief justice. Because the justices ascend from lower courts, they are usually at least 60 years old. The full bench of the supreme court does not hear every appealed case. Rather, a petit (small) bench of five justices first hears each case to

COMPARING THE LAW OF OTHER COUNTRIES

determine whether to transfer the case to a hearing before the full bench. The petit court transfers a case to the full bench if it believes that the appellant can prove that the law or decision in question is unconstitutional. Because proving the unconstitutionality of a law is extremely difficult, the full bench generally hears fewer than 10 cases annually.

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vary by state, but most states refer to them as courts of common pleas or county courts. In some states, these courts have specialized divisions: domestic relations, probate, and so on.

Most states also have trial courts of limited jurisdiction. Usually, these courts can grant only certain remedies. For example, small claims courts, a common type of court of limited jurisdiction in most states, may not grant damage awards larger than a specified amount. Other courts of limited jurisdiction have the power to hear only certain types of cases. For example, probate courts hear only cases about asset and obligation transfers after an indi- vidual’s death.

Intermediate Courts of Appeal. Intermediate courts of appeal, analogous to fed- eral circuit courts of appeal, exist in approximately half the states. These courts usually have broad jurisdiction, hearing appeals from courts of general and limited jurisdictions, as well as from state administrative agencies. The names of these courts also vary by state, but most states call them courts of appeal or superior courts.

Courts of Last Resort. Appeals from the state intermediate courts of appeal lead cases to the state court of last resort. Most states call this court the supreme court, although some states refer to it as the court of appeals. Because approximately half the states lack intermediate courts of appeal, appeals from trial courts in these states go directly to the state court of last resort.

Threshold Requirements Before a case makes it to court, it must meet three threshold requirements. These require- ments ensure that courts hear only cases that genuinely require adjudication. The three requirements are standing, case or controversy, and ripeness.

STANDING A person who has the legal right to bring an action in court has standing (or standing to sue ). For a person to have standing, the outcome of a case must personally affect him or her. For example, if you hire a landscaper to mow your lawn every week and she fails to show up every other week, you have standing to sue your landscaper. But if your friend hired the landscaper to mow his lawn, you lack the standing to sue on your friend’s behalf because you do not have a personal stake in the outcome of the case. The American legal system requires that a plaintiff have a personal stake in the outcome of the case because, the theory goes, the plaintiff’s personal stake stimulates her to present the best possible case.

Standing requirements are subject to frequent litigation when citizen groups sue to enforce environmental laws. For example, the standing of the plaintiff, Friends of the Earth (FOE), was a central issue in the 2000 U.S. Supreme Court case FOE v. Laidlaw Envi- ronmental Services. 7 In the case, FOE filed a lawsuit against Laidlaw, alleging that it had violated the Clean Water Act by discharging excessive amounts of pollutants into a river.

Writing for the majority, Justice Ginsburg cited three factors plaintiffs need for stand- ing: (1) The plaintiff must have an injury in fact that is concrete and actual or imminent; (2) the injury must be fairly traceable to the challenged action of the defendant; and (3) it must be likely that the injury will be redressed by a favorable decision. 8 In applying those criteria to the Laidlaw case, the Supreme Court found that FOE members’ testimony

7 120 S. Ct. 923 (2000).

8 Ibid.

LO4

What are the threshold requirements that must

be met before a court will hear a case?

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that they were afraid to fish and swim in a river they previously enjoyed satisfied the first two criteria. The Court held that although the FOE members would not directly receive money from a penalty against Laidlaw, they would benefit because the penalties would deter Laidlaw and other companies from polluting the river in the future. 9 The Court ruled in FOE’s favor and assessed Laidlaw a $405,800 penalty payable to the U.S. Treasury.

CASE OR CONTROVERSY The case or controversy (or justiciable controversy ) requirement ensures that courts do not render advisory opinions. Three criteria are necessary for a case or controversy to exist. First, the relationship between the plaintiff and the defendant must be adverse. Second, actual or threatened actions of at least one of the parties must give rise to an actual legal dispute. Third, courts must have the ability to render a decision that will resolve the dis- pute. In other words, courts can give final judgments that solve existing problems; they cannot provide rulings about hypothetical situations.

RIPENESS The case or controversy requirement is closely linked to the ripeness requirement. A case is ripe if a judge’s decision is capable of affecting the parties immediately. Usually the issue of ripeness arises when one party claims that the case is moot—in other words, there is no point in the court’s hearing the case because no judgment can affect the situation between the parties.

In the Laidlaw case cited previously, Laidlaw also argued that the case was moot because by the time the case went to trial, the company had complied with the requirements of its discharge permits. Thus, Laidlaw argued, the only remedy left to the courts—a penalty Laidlaw must pay to the government—would not affect the plaintiffs. The Supreme Court disagreed, ruling that the fact that a defendant voluntarily ceases a practice once litigation has commenced does not deprive a federal court of its power to determine the legality of the practice, because such a ruling would leave the defendant free to return to his old unlawful practices. Thus, the Court found the case was not moot because imposing a pen- alty on the defendant would have an important deterrent effect. 10

Legal Principle: Before a case can be heard, it must meet the three threshold requirements of standing, case or controversy, and ripeness.

Steps in Civil Litigation The U.S. litigation system is an adversary system: a neutral fact finder—a judge or jury— hears evidence and arguments that opposing sides present and then decides the case on the basis of the facts and law. Strict rules govern the types of evidence fact finders may con- sider. Theoretically, fact finders make informed and impartial rulings because each party has an incentive to find all relevant evidence and make the strongest possible arguments on behalf of her or his position.

Critics of the adversary system, however, point out several drawbacks: the time and expense each lawsuit requires, the damage a suit may cause to the litigating parties’ relation- ship, and the unfair advantage to those with wealth and experience using the court system.

9 Ibid.

10 Ibid.

LO5

What are the steps in civil litigation?

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THE PRETRIAL STAGE The rules of civil procedure govern civil case proceedings. The Federal Rules of Civil Procedure apply in all federal courts. Each state has its own set of rules, but most states’ rules are very similar to the Federal Rules of Civil Procedure. In addi- tion, each court usually has its own set of local court rules.

Informal Negotiations. The initial attempt to resolve a business dispute is usually informal: a discussion or nego- tiation among the parties to try to find a solution. If the par- ties are unable to resolve their dispute, one party often seeks an attorney’s advice. Together, the attorney and client may be able to resolve the dispute informally with the other party.

Pleadings. The first formal stage of a lawsuit is the plead- ing stage. The plaintiff’s attorney initiates a lawsuit by filing a complaint in the appropriate court. The complaint states the names of the parties to the action, the basis for the court’s subject-matter jurisdiction, the facts on which the plaintiff bases his claim, and the relief the plaintiff seeks. The pleadings prevent surprises at trial; they allow attorneys to prepare arguments to counter the other side’s claims. Exhibit 3-5 shows a typical complaint.

Service of Process. To obtain in personam jurisdiction over a defendant and to satisfy due process, a court must notify the defendant of the pending lawsuit. Service of process occurs when the defendant is given a copy of the complaint and summons by a process server or by certified or ordinary mail.

The complaint explains the basis of the lawsuit to the defendant. The summons tells the defendant that if he or she does not respond to the lawsuit within a certain period of time, the plaintiff will receive a default judgment. A default judgment is a judgment in favor of the plaintiff that occurs when the defendant fails to answer the complaint and the plaintiff’s complaint alleges facts that would support such a judgment.

Defendant’s Response. The defendant responds to the complaint with an answer. In this document, the defendant denies, affirms, or claims no knowledge of the accuracy of the plaintiff’s allegations.

A defendant uses an affirmative defense when her or his answer admits that the facts contained in the complaint are accurate but also includes additional facts that justify the defendant’s actions and provide a legally sound reason to deny relief to the plaintiff. For example, if a woman sued a man for battery because he punched her in the face, he might claim that he hit her only because she aimed a gun at him and threatened to shoot. His claim that he was acting in self-defense is an affirmative defense.

If the defendant plans to raise an affirmative defense, he must raise it in his answer to give the plaintiff adequate notice. If he fails to raise an affirmative defense in the answer, the judge will likely not allow him to raise it during the trial.

Upon receiving the complaint, if the defendant believes that even though all the plain- tiff’s factual allegations are true, the law does not entitle the plaintiff to a favorable judg- ment, the defendant may file a motion to dismiss, or demurrer. (A motion is a request by a party for the court to do something; in this instance, the request is to dismiss the case.)

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In deciding whether to grant a motion to dismiss, a judge accepts the facts as stated by the plaintiff and rules on the legal issues in the case. Judges generally grant a motion to dis- miss only when it appears beyond a doubt that the plaintiff cannot prove any set of facts to justify granting the judgment she seeks.

If the defendant believes he has a claim against the plaintiff, he includes this counterclaim with the answer. As Exhibit 3-6 shows, the form of a counterclaim is identi- cal to the form of a complaint. The defendant states the facts supporting his claim and asks for relief.

If the defendant files a counterclaim, the plaintiff generally files a reply. A reply is an answer to a counterclaim. In the reply, the plaintiff admits, denies, or claims a lack of

THE COURT OF COMMON PLEAS OF CLARK COUNTY, NEVADA

Bob Lyons and Sue Lyons, Plaintiffs

v.

Christine Collins, Defendant

COMPLAINT FOR NEGLIGENCE

Case No.

Now come the plaintiffs, Bob Lyons and Sue Lyons, and, for their complaint, allege as follows:

1. Plaintiffs, Bob Lyons and Sue Lyons, both of 825 Havercamp Street, are citizens of Clark County, in the state of Nevada, and defendant, Christine Collins, 947 Rainbow Ave., is a citizen of Clark County in the state of Nevada.

2. On May 1, 2001, the Defendant built a wooden hanging bridge across a stream that runs through the plaintiffs’ property at 825 Havercamp Street.

3. Defendant negligently used ropes in the construction of the bridge that were not thick enough to sustain human traffic on the bridge.

4. At approximately 4:00 p.m., on May 20, 2001, the plaintiffs were attempting to carry a box of landscaping stones across the bridge when the ropes broke, and the bridge collapsed, causing plaintiffs to fall seven feet into the stream.

5. As a result of the fall, plaintiff, Bob Lyons, suffered a broken arm, a broken leg, and a skull frac- ture, incurring $160,000 in medical expenses.

6. As a result of the fall, plaintiff, Sue Lyons, suffered two broken cervical vertebrae, and a skull fracture, incurring $300,000 in medical expenses.

7. As a result of the fall, the landscaping stones, which had cost $1,200, were destroyed.

8. As a result of the foregoing injuries, plaintiff, Bob Lyons, was required to miss eight weeks of work, resulting in a loss of $2,400 in wages.

9. As a result of the foregoing injuries, plaintiff, Sue Lyons, was required to miss twelve weeks of work, resulting in a loss of $3,600 in wages.

WHEREFORE, Plaintiffs demand judgment in the amount of $467,200, plus costs of this action.

Harlon Elliot

Attorney for Plaintiff

824 Sahara Ave.

Las Vegas, Nevada 89117

JURY DEMAND

Plaintiff demands a trial by jury in this matter.

Exhibit 3-5 Typical Complaint

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Chapter 3 The U.S. Legal System 55

knowledge as to the accuracy of the facts of the defendant’s counterclaim. If the plaintiff plans to use an affirmative defense, she must raise it in the reply.

Pretrial Motions. The early pleadings establish the legal and factual issues of the case. After the pleadings, the plaintiff or defendant may file a motion to conclude the case early, eliminate some claims, or gain some advantage. A party may move, or request, that the court do almost anything pertaining to the case. For example, if the plaintiff files a suit about the right to a piece of property, she may move that the court prohibit the cur- rent possessor of the land from selling it. Courts may grant or deny such motions at their discretion.

When a party files a motion with the court, the court sends a copy to the opposing attorney, who may respond to the motion, usually by requesting that the judge deny the motion. In many cases, the judge rules on the motion immediately. In other cases, the judge holds a hearing at which the attorneys for both sides argue how the judge should decide the motion.

THE COURT OF COMMON PLEAS OF CLARK COUNTY, NEVADA

Bob Lyons and Sue Lyons, Plaintiffs v. Christine Collins, Defendant ANSWER AND COUNTER- CLAIM FOR BREACH OF CONTRACT Case No.

Now comes the defendant, Christine Collins, and answers the complaint of plaintiff herein as follows:

First Defense 1. Admits the allegations in paragraphs 1 and 2.

2. Denies the allegation in paragraph 3.

3. Is without knowledge as to the truth or falsity of the allegations contained in paragraphs 4, 5, 6, 7, 8, and 9.

Second Defense 4. If the court believes the allegations contained in paragraph 3, which the defendant expressly

denies, plaintiffs should still be denied recovery because they were informed prior to the con- struction of the bridge that there should be no more than one person on the bridge at one time and that no individual weighing more than 200 pounds should be allowed to walk on the bridge.

Counterclaim 5. On April 15, the parties agreed that Defendant would build a wooden hanging bridge across a

stream that runs through the defendants’ property at 825 Havercamp Street, in exchange for which plaintiffs would pay defendant $2,000 upon completion of construction.

6. On May 1, 2001, the Defendant built the agreed upon ornament, wooden, hanging bridge across a stream that runs through the defendants’ property at 825 Havercamp Street, but Plaintiffs failed to pay the agreed upon price for the bridge.

7. By their failure to pay, plaintiffs breached their contract and are liable to defendant for the con- tract price of $2,000.

WHEREFORE, defendant prays for a judgment dismissing the plaintiffs’ complaint, and granting the defendant a judgment against plaintiff in the amount of $2,000 plus costs of this action.

Melissa Davenport

Attorney for Defendant

777 Decatur Ave.

Las Vegas, Nevada 89117

Exhibit 3-6 Defendant’s Answer and Counterclaim

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Two primary pretrial motions are a motion for judgment on the pleadings and a motion for summary judgment. Once the parties file the pleadings, either party can file a motion for judgment on the pleadings. The motion is a request for the court to consider that all the facts in the pleadings are true and to apply the law to those facts. The court grants the motion if, after this process, it finds that the only reasonable decision is in favor of the moving party.

Either party can file a motion for summary judgment after the discovery process (described below). The motion asserts that no factual disputes exist and that if the judge applied the law to the undisputed facts, her only reasonable decision would be in favor of the moving party. The difference between this motion and a motion for judgment on the pleadings is that in a motion for summary judgment, the moving party may use affidavits (sworn statements from the parties or witnesses), relevant documents, and depositions or interrogatories (a party’s sworn answers to written questions) to support his motion. The judge grants the motion if, after examining the evidence, she finds no factual disputes. If, however, she finds any factual issues about which the parties disagree, she denies the motion and sends the case to trial.

Discovery. After filing the initial pleadings and motions, the parties gather infor- mation from each other through discovery. The discovery process enables the parties to learn about facts surrounding the case so that they are not surprised in the courtroom. Three common discovery tools are interrogatories, requests to produce documents, and depositions.

Interrogatories are written questions that one party sends to the other to answer under oath. Frequently, a request to admit certain facts accompanies interrogatories. Attorneys work with their clients to answer interrogatories and requested admissions of facts.

A request to produce documents (or other items) forces the opposing party to produce (turn over) certain information unless it is privileged or irrelevant to the case. Parties may request documents such as photographs, contracts, written estimates, medical records, tax forms, and other government documents. In tort cases, the defendant frequently asks the plaintiff to submit a mental- or physical-examination report.

Finally, the parties may obtain testimony from a witness before trial through a deposi- tion. At a deposition, attorneys examine a witness under oath. A court reporter (stenogra- pher) records every word the witnesses and attorneys speak. Both parties receive a copy of the testimony in document form. Depositions provide information and may also set up inconsistencies between a witness’s testimony at the deposition and his testimony at trial. If a party discovers an inconsistency in the testimony of one of the other party’s witnesses, she can bring the inconsistency to the fact finder’s attention to diminish the witness’s cred- ibility. The parties may also use depositions when a witness is elderly, moving, or ill such that he may be unavailable at the time of the trial.

If a party does not comply with requests for discovery, the court may admit the facts the other party sought to discover. Attorneys who feel that certain material is outside the scope of the case often argue that the material is irrelevant to the case. If the court disagrees, however, the party must supply the requested information. Although these discovery tools are important in the United States, not all countries have a discovery process.

In discovery, as in other areas, technology is having an impact. It is estimated that 90 percent of all documents and communications are created and maintained in elec- tronic formats. In December 2006, the Federal Rules of Civil Procedure were amended to reflect changes in technology. Parties are now required to “make provisions for dis- closure or discovery of electronically stored information” 11 at the start of the litigation

11 Rule 16(B), Federal Rules of Civil Procedure.

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Chapter 3 The U.S. Legal System 57

process, and they must develop a discovery plan during their pretrial conferences. Once it appears that litigation is imminent, litigants have an obligation not to delete or destroy electronic files that may be discoverable. However, “absent exceptional circumstances, a court may not impose sanctions . . . on a party for failing to provide electronically stored information lost as a result of the routine, good-faith operation of an electronic informa- tion system.” 12

Parties who might become embroiled in litigation, however, probably should not count on using the good-faith exception because the consequences of destroying elec- tronic data can be significant. For example, in the sex discrimination case of Zubulake v. UBS Warburg LLC, 13 the judge found that the company’s employees had intentionally deleted e-mail messages, lost a number of backup tapes, and failed to produce files as requested. As a sanction, she issued an adverse-inference instruction to the jury, basically telling them that they could assume that any documents not produced would have been harmful to the company’s case. The jury ultimately awarded the woman $29.3 million in damages.

Morgan Stanley had to pay an even bigger price for its failure to meet its obligations for electronic discovery of relevant e-mail messages and documents. In Coleman Hold- ings Inc. v. Morgan Stanley & Co., 14 the firm produced more than 1,300 pages of e-mail messages but failed to reveal in a timely fashion the existence of 1,423 backup tapes. In that case, the court also issued an adverse-inference instruction, stating that Morgan Stanley would have to bear the burden of proving that it lacked knowledge of the fraud. The jury found in favor of the plaintiff and awarded damages in the amount of $1.6 billion. Morgan Stanley also had to pay the U.S. Securities and Exchange Commission $15 million in fines for failure to comply with discovery requirements in a related com- mission investigation.

What organizations can learn from these cases is that as soon as they reasonably antici- pate that litigation will occur, they must suspend their routine policy for retaining and destroying documents and put in place a “litigation hold” to make sure that documents that might be relevant to the lawsuit are preserved. Some plaintiffs’ lawyers are now sending litigation-hold demand letters to potential defendants, making it almost impossible for a firm to claim that relevant documents were innocently deleted.

Pretrial Conference. A pretrial conference precedes the trial. A pretrial conference is an informal meeting of the judge with the attorneys representing the parties. During this conference, the parties try to narrow the legal and factual issues and possibly work out a settlement. If the parties cannot reach a settlement, the attorneys and the judge discuss the administrative details of the trial: its length, witnesses, and any pretrial stipulations of fact or law to which the parties agree.

THE TRIAL If a plaintiff seeks at least $20 in monetary damages, the Seventh Amendment to the U.S. Constitution entitles the parties to a jury trial. The plaintiff must, however, demand a jury trial in his or her complaint. Following the English tradition, most civil trials have 12 jurors; however, in many jurisdictions the number of required jurors has been reduced by the legislature. In some jurisdictions, fewer than 12 jurors may be allowed if both parties consent. If the plaintiff seeks an equitable remedy (an injunction or other court

12 Rule 37(F), Federal Rules of Civil Procedure.

13 231 F.R.D. 159, 2005 U.S. Dist. LEXIS 1525 (S.D.N.Y., Feb. 2, 2005).

14 2005 WL 679071 (Fla. Cir. Ct., Mar. 1, 2005).

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order) or if the parties have waived their right to a jury, a judge serves as the fact finder in the case.

Trials have six stages: jury selection, opening statements, examination of witnesses, closing arguments, conference on jury instructions, and posttrial motions. The following sections describe these stages.

Jury Selection. The jury selection process begins when the clerk of the courts ran- domly selects a number of potential jurors from the citizens within the court’s jurisdiction. Once the potential jurors have reported for jury duty, the voir dire, or jury selection, pro- cess begins. The voir dire process selects the jurors who will decide the case, as well as two or three “alternate jurors” who will watch the trial and be available to replace any juror who, for some legitimate reason, must leave jury duty before the trial ends.

During voir dire, the judge and/or attorneys question potential jurors to determine whether they are able to render an unbiased opinion in the case. If a potential juror’s response to a question indicates that she or he may be biased, either attorney may chal- lenge, or ask the court to remove, that potential juror “for cause.” For example, a lawyer could challenge for cause a potential juror who was a college roommate of the defendant. In most states, each party has a certain number of peremptory challenges. These peremp- tory challenges allow a party to challenge a certain number of potential jurors without giving a reason.

Peremptory challenges, however, may lead to abuse. For example, in the past, attorneys have used peremptory challenges to eliminate a certain class, ethnic group, or gender from the jury. In the 1986 case Batson v. Kentucky, 15 the U.S. Supreme Court ruled that race- based peremptory challenges in criminal cases violate the equal protection clause of the Fourteenth Amendment to the U.S. Constitution. (Chapter 5 discusses the amendments to the Constitution in more detail.) The Supreme Court later extended the ban on race- based challenges to civil cases. In Case 3-2, the U.S. Supreme Court addressed the issue of whether the equal protection clause covers gender-based challenges.

15 476 U.S. 79 (1986).

The State of Alabama filed a complaint for paternity and child support against J.E.B. on behalf of T.B., the unwed mother of a minor child. The court called a panel of twelve males and twenty-four females as potential jurors. Only ten males remained after three individuals were removed for cause. The state used its peremptory challenges to remove nine male jurors, and J.E.B. removed the tenth, resulting in an all female jury. The trial court rejected J.E.B.’s objection to the gender-based challenges, and the jury found J.E.B. to be the father. J.E.B. appealed, and the court of appeals affirmed the trial court’s ruling that the Equal Protection Clause does not prohibit gender-based challenges. The

Alabama Supreme Court declined to hear the appeal, and J.E.B. appealed to the U.S. Supreme Court.

JUSTICE BLACKMUN: Discrimination in jury selec- tion, whether based on race or on gender, causes harm to the litigants, the community, and the individual jurors who are wrongfully excluded from participation in the judicial pro- cess. The litigants are harmed by the risk that the prejudice which motivated the discriminatory selection of the jury will infect the entire proceedings. The community is harmed by the State’s participation in the perpetuation of invidious group stereotypes and the inevitable loss of confidence in

J.E.B. v. ALABAMA, EX. REL. T.B. UNITED STATES SUPREME COURT 114 S. CT. 1419 (1994)

CASE 3-2

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ETHICAL DECISION MAKING

Which values does this decision tend to emphasize?

The voir dire process has become more sophisticated over time. In cases involving sig- nificant amounts of money, rather than relying on their instinct or experience during jury selection, attorneys use professional jury selection services to identify demographic data to help select ideal jurors.

Jury selection firms also provide additional services, including mock trials and shadow juries. Jury selection firms set up mock trials by recruiting individuals who match the demographics of the real jury to listen to attorneys’ arguments and witnesses’ testimony. These mock trials give attorneys a sense of how their approach to the case will appear to the actual jurors. If the mock jury is not receptive to a particular argument or witness’s testimony, the attorneys can modify their approach before trial.

Parties also often hire jury selection firms to provide shadow juries. Like a mock trial, a shadow jury uses individuals whose demographics match the demographics of a trial’s real jurors. A shadow jury, however, sits inside the courtroom to watch the actual trial. At the end of each day of the trial, the shadow jury deliberates, giving the attorneys an idea of how the real jurors are reacting to the case. If the shadow jury finds the opposing side to be winning, the attorneys can modify their strategy.

Many attorneys believe that these services increase their clients’ chances of winning cases. Critics argue, however, that jury selection services give an unfair advantage to one side when only one party can afford these services.

Opening Statements. Once the attorneys have impaneled, or selected, a jury, the case begins with opening statements. Each party’s attorney explains to the judge and jury which facts he or she intends to prove, the legal conclusions to which these facts lead, and how the fact finder should decide the case based on those facts.

The Examination of Witnesses and Presentation of Evidence. Follow- ing opening statements, the plaintiff and defendant, in turn, present their cases-in-chief by examining witnesses and presenting evidence. The plaintiff has the burden of proving the case, meaning that if neither side presents a convincing case, the fact finder must rule in favor of the defendant. Thus, the plaintiff presents her case first.

[continued]

our judicial system that state-sanctioned discrimination in the courtroom engenders.

As with race-based Batson claims, a party alleging gender discrimination must make a prima facie showing of intentional discrimination before the party exercising the challenge is required to explain the basis for the strike. When an explanation is required, it need not rise to the level of a “for cause” challenge; rather, it merely must be based on a juror characteristic other than gender and the proffered explanation may not be pretextual.

Equal opportunity to participate in the fair administra- tion of justice is fundamental to our democratic system. It reaffirms the promise of equality under the law—that all citizens, regardless of race, ethnicity, or gender, have the chance to take part directly in our democracy. When per- sons are excluded from participation in our democratic processes solely because of race or gender, this promise of equality dims, and the integrity of our judicial system is jeopardized.

REVERSED and REMANDED in favor of JEB.

The defendant was contesting the removal of males from the jury. Does this fact weaken the Court’s reasoning? Explain.

CRITICAL THINKING

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The procedure for each witness is the same. First, the plaintiff’s attorney questions the witness in direct examination. The plaintiff’s attorney asks the witness questions to elicit facts that support the plaintiff’s case-in-chief. Questions must relate to matters about which the witness has direct knowledge. Attorneys cannot elicit “hearsay” from the wit- nesses. Hearsay is testimony about what a witness heard another person say. Hearsay is impermissible because the opposing attorney cannot question the person who made the original statement to determine the statement’s veracity.

The federal rules of evidence also prohibit attorneys from asking leading questions. Lead- ing questions are questions that imply a specific answer. For example, an attorney cannot ask a witness, “Did the defendant come to your office and ask you to purchase stock from him?” Instead, attorneys must ask questions such as, “When did you first encounter the defendant?”

After direct examination, opposing counsel may cross-examine the witness. Opposing counsel, however, may ask only questions related to the witness’s direct examination. On cross-examination, attorneys can ask leading questions. Attorneys try to show inconsisten- cies in the witness’s testimony, cast doubt on the claims of the plaintiff’s case, and elicit information to support the defendant’s case.

After cross-examination, the plaintiff’s attorney may conduct a redirect examination, a series of questions to repair damage done by the cross-examination. At the judge’s discre- tion, opposing counsel has an opportunity to re-cross the witness to question his testimony on redirect examination. The parties follow this procedure for each of the plaintiff’s witnesses.

Immediately following the plaintiff’s presentation of her case, the defendant may move for a directed verdict. This motion is a request for the court to direct a verdict for the defendant because even if the jury accepted all the evidence and testimony presented by the plaintiff as true, the jury would still have no legal basis for a decision in favor of the plain- tiff. The federal court system refers to a motion for a directed verdict as a motion for a judg- ment as a matter of law. Courts rarely grant motions for a directed verdict because plaintiffs almost always present at least some evidence to support each element of the cause of action.

If the court denies the defendant’s motion for a directed verdict, the defendant then presents his case. The parties question the defendant’s witnesses in the same manner as they questioned the plaintiff’s witnesses, except that the defendant’s attorney conducts direct and redirect examination and the plaintiff’s attorney conducts cross-examination and re-cross-examination.

Closing Arguments. After the defendant’s case, the attorneys present closing argu- ments. In the closing argument, each attorney summarizes evidence from the trial in a manner consistent with his or her client’s case. The plaintiff’s attorney presents her clos- ing argument first, followed by the defendant’s attorney, and the plaintiff has the option to present a rebuttal of the defendant’s closing argument.

Jury Instructions. In a jury trial, the judge “charges the jury” by instructing the jurors how the law applies to the facts of the case. Both sides’ attorneys submit statements to the judge explaining how they believe he should charge the jury. The judge’s instruc- tions are usually a combination of both sides’ suggestions.

Different types of cases require different standards of proof. In most civil cases, the plaintiff must prove her case by a preponderance of the evidence; in other words, she must show that her claim is more likely to be true than the defendant’s claim. In some civil cases, particularly cases involving fraud or oral contracts, the plaintiff must prove her case by clear and convincing evidence, a higher standard of proof. Criminal cases have an even higher burden of proof: The prosecution must prove its case beyond a reasonable doubt.

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After the judge charges the jury, the jurors retire to the jury room to deliberate. Once they reach a decision, they return to the courtroom, where the judge reads their verdict and discharges them from their duty.

Trial procedures in the United States are quite different from trial procedures in other countries, as the Comparing the Law of Other Countries box illustrates.

Posttrial Motions. Once the trial ends, the party who received the favorable verdict files a motion for a judgment in accordance with the verdict. Until the judge enters the judgment, the court has not issued a legally binding decision for the case.

The party who loses at trial has a number of available options. One option is to file a motion for a judgment notwithstanding the verdict, or judgment non obstante verdicto, asking the judge to issue a judgment contrary to the jury’s verdict. To grant the motion, the judge must find that, when viewing the evidence in the light most favorable to the nonmoving party, a reasonable jury could not have found in favor of that party. In other words, as a matter of law, the judge must determine that the trial did not produce suf- ficient evidence to support the jury’s verdict. This motion is similar to a motion for a directed verdict, except the parties cannot make this motion until after the jury issues a verdict. The federal court system refers to this motion as a motion for judgment as a matter of law.

The losing party can also file a motion for a new trial. Judges grant motions for a new trial only if they believe the jury’s decision was clearly erroneous but they are not sure that the other side should necessarily have won the case. A judge often grants a motion for a new trial when the parties discover new evidence, when the judge made an erroneous ruling, or when misconduct during the trial may have prevented the jury from reaching a fair decision.

APPELLATE PROCEDURE Either party may appeal the judge’s decision on posttrial motions or on her or his final judgment. Sometimes, both parties appeal the same decision. For example, if a jury awarded the plaintiff $10,000 in damages, the plaintiff and the defendant may both appeal the amount of the judgment. Appellate courts, however, reverse only about 1 out of every 10 trial court decisions on appeal.

To be eligible for appeal, the losing party must argue that a prejudicial error of law occurred during the trial. A prejudicial error of law is a mistake so significant that it likely affected the outcome of the case. For example, a prejudicial error could occur if the judge improperly admitted hearsay evidence that allowed the plaintiff to prove an element of her case.

Trials in Japan

Civil procedure in Japan differs significantly from American civil procedure. The Japanese legal system has no juries and no dis- tinct pretrial stage. Instead, a trial is a series of discrete meetings between the parties and the judge. At the first meeting, the parties identify the most critical and contested issues. They choose one and recess to gather evidence and marshal arguments on the issue.

At the next meeting, the judge rules on the chosen issue. If the judge decides against the plaintiff, the case is over. If the

COMPARING THE LAW OF OTHER COUNTRIES

plaintiff wins, the process continues with the next issue. The process continues until the plaintiff loses an issue or until the judge decides all issues in the plaintiff’s favor, resulting in a verdict for the plaintiff.

In addition, the discovery process in the Japanese court system is not as simple as it is in the United States. To obtain evidence, parties must convince the judge to order others to testify or pro- duce documents. The judge can fine or jail parties who refuse to comply with such orders. Additionally, if a party does not comply with the judge’s requests for discovery, the judge may admit the facts the other party sought to discover.

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To appeal a case, the attorney for the appealing party (the appellant) files a notice of appeal with the clerk of the trial court within a prescribed time. The clerk then forwards the record of appeal to the appeals court. The record of appeal typically contains a number of items: the pleadings, a trial transcript, copies of the trial exhibits, copies of the judge’s rul- ings on the parties’ motions, the attorneys’ arguments, jury instructions, the jury’s verdict, posttrial motions, and the judgment order.

The appellant then files a brief, or written argument, with the court. Appellants file briefs to explain why the judgment in the lower court was erroneous and why the appeals court should reverse it. The attorney for the party who won in the lower court (the appellee) files an answering brief. The appellant may then file a reply brief in response to the appel- lee’s brief. Generally, however, appellants do not file reply briefs.

The appeals court then usually allows the attorneys to present oral arguments before the court. The court considers these arguments, reviews the record of the case, and renders a decision.

An appellate court may render four basic decisions. The court can accept the lower court’s judgment by affirming the decision of the lower court. Alternatively, if the appellate court concludes that the lower court’s decision was correct but the remedy was inappropri- ate, it modifies the remedy. If the appellate court decides that the lower court was incorrect in its decision, it reverses the lower court’s decision. Finally, if the appeals court thinks the lower court committed an error but does not know how that error affected the outcome of the case, it remands the case to the lower court for a new trial.

An appellate court usually has a bench with at least three judges. Appellate courts do not have juries; rather, the judges decide the case by majority vote. One of the judges who votes with the majority records the court’s decision and its reasons in the majority opinion. These decisions have precedential value—that is, judges use these prior appellate court decisions to make decisions in future cases. Also, these decisions establish new guidelines in the law that all citizens must follow. If a judge agrees with the majority’s decision, but for different reasons, she may write a concurring opinion, stating the reasons she used to reach the majority’s conclusion. Finally, judges disagreeing with the majority may write a dissenting opinion, giving their reasons for reaching a contrary conclusion. Attorneys arguing that a court should change the law frequently cite dissenting opinions from previ- ous cases in their briefs. Likewise, appellate judges who change the law often cite dissent- ing opinions from past cases.

For most cases, only one appeal is available. In states with both an intermediate and a final court of appeals, a losing party may appeal from the intermediate appellate court to the state supreme court. In a limited number of cases, the losing party can appeal the deci- sion of a state supreme court or a federal circuit court of appeals to the U.S. Supreme Court.

Appeal to the U.S. Supreme Court. Every year thousands of individuals file appeals with the U.S. Supreme Court. The Court, however, hears, on average, only 80 to 90 cases each year. To file an appeal to the U.S. Supreme Court, a party files a petition asking the Court to issue a writ of certiorari, an order to the lower court to send to the Supreme Court the record of the case. The Court issues very few writs.

The justices review petitions and issue a writ only when at least four justices vote to hear the case (the rule of four ). The court is most likely to issue a writ in four instances: (1) The case presents a substantial federal question that the Supreme Court has not yet addressed; (2) multiple circuit courts of appeal have decided the issue of the case in differ- ent ways; (3) a state court of last resort has ruled that a federal law is invalid or has upheld a state law that may violate federal law; or (4) a federal court has ruled that an act of Con- gress is unconstitutional. If the Supreme Court does not issue a writ of certiorari, the lower court’s decision stands.

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Caterpillar The timing of events was crucial to the outcome of the Caterpillar case. At the time Lewis filed the case in the state court system, one of the defendants and the plaintiff were from the same state, so the state court system had jurisdiction. Once the supply company reached an agreement with Lewis, the other defendant, Caterpillar, filed a motion to exercise its right of removal because diversity of citizenship existed in the absence of the Kentucky defen- dant. But the agreement was not final at the time of the motion because the agreement was subject to the insurer’s approval. Thus, the appellate court ruled that because the supply company was still a party to the agreement, the federal court system could not exercise jurisdiction over the case.

The U.S. Supreme Court, however, overruled the appellate court. The Supreme Court ruled that the state court should not have granted Caterpillar’s initial motion to remove the case because at the time of removal, the insurer had not accepted the settlement agreement, the supply company remained a party in the case, and, therefore, the diversity of citizen- ship was not complete. The Supreme Court held further, however, that the district court’s error in hearing the case was not fatal because the settlement agreement was approved and the case satisfied the jurisdictional requirements by the time the federal court issued its decision. The Court ruled that to require the district court to send the case back to the state system would be an undue waste of judicial resources.

Why might Caterpillar have wanted to move the case to the federal court system? First, the case involved product liability claims. Data suggest that average damage awards in product liability cases tend to be higher in state courts than in federal courts. Second, Caterpillar may have feared local prejudice. While all judges must strive for neutrality, out-of-state defendants may fear that state judges are slightly biased in favor of in-state parties.

CASE OPENER WRAP-UP

answer 53

appellate court 41

brief 62

case or controversy 52

complaint 42

counterclaim 54

court of appellate jurisdiction 41

court of original jurisdiction 41

default judgment 53

defendant 42

deposition 56

directed verdict 60

discovery 56

in personam jurisdiction 42

in rem jurisdiction 43

interrogatories 56

jurisdiction 41

long-arm statute 43

mock trial 59

motion 53

motion for judgment on the pleadings 56

motion for summary judgment 56

motion to dismiss 53

peremptory challenge 58

personal service 42

plaintiff 42

prejudicial error of law 61

pretrial conference 57

quasi in rem jurisdiction 43

reply 54

request to produce documents 56

ripeness 52

service of process 42

shadow jury 59

standing 51

subject-matter jurisdiction 44

summons 42

trial court 41

venue 47

voir dire 58

writ of certiorari 62

Key Terms

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In personam jurisdiction is the power of a court to render a decision affecting a person’s legal rights. Subject-matter jurisdiction is the power of a court to render a decision in a particular type of case. The three forms of subject-matter jurisdiction are state, exclusive federal, and concurrent.

Venue is the geographic location of the trial.

The U.S. has two parallel court structures: the state and federal systems. The federal structure has district courts (trial courts), circuit courts of appeal, and the U.S. Supreme Court. The state court structure varies by state, but generally includes courts of common pleas (trial courts), state courts of appeal, and a state supreme court.

Standing: For a person to have the legal right to file a case, the outcome of the case must personally affect that person.

Case or controversy: There must be an issue before the court that a judicial decision is capable of resolving. Parties cannot ask the judge for an “advisory opinion.”

Ripeness: The case cannot be moot; it must be ready for a decision to be made.

The stages of a civil trial include the pretrial, trial, posttrial, and appellate stages.

Pretrial includes consultation with attorneys, pleadings, the discovery process, and the pretrial conference.

The trial begins with jury selection, followed by opening statements, the plaintiff’s case, the defendant’s case, closing arguments, jury instructions, jury deliberations, the jury’s verdict, and the judgment.

After the trial, parties may file posttrial motions.

The parties may then file appeals to the appropriate appellate court and, in some cases, to the U.S. Supreme Court.

Summary of Key Topics

Is the Adversarial System the Most Effective Approach to Justice?

YES NO

Proponents of the adversarial system argue that justice is best served when each individual’s rights and freedoms are protected. The adversarial system requires that the fact finder remain a neutral and objective party, free from bias. The parties are responsible for developing their own individual theories of the case. By allowing individuals to decide what information they wish to present as a part of their case, the system allows them to take a more active role in the legal process.

In addition to promoting individual rights, the adver- sarial system also helps prevent the abuse of power by the finder of fact. Proponents argue that excluding the finder of fact from question asking and evidence collection

Critics of the adversarial system argue that the quest for truth should be central to the administration of justice. By pitting parties against one another in the courtroom, the adversarial system becomes more interested in solving controversies than discovering the truth. Since the parties are allowed to decide what evidence they do and do not wish to present to the fact finder, it is likely that a deci- sion will be rendered on the basis of incomplete and biased information.

In addition to overemphasizing controversy, the adver- sarial system creates a wealth disparity between par- ties. For example, if Suzie the secretary decides to sue her employer, Giant Corporate Entity, the sheer size and

Point / Counterpoint

Jurisdiction

Venue

The Structure of the Court System

Threshold Requirements

Steps in Civil Litigation

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Chapter 3 The U.S. Legal System 65

prevents them from reaching a premature decision or abusing their power.

In response to critics who argue that the adversarial system is more about resolving a dispute than finding the truth, proponents argue that by pitting the two sides against one another, the truth will emerge. The parties involved in the litigation have a stronger motivation to uncover and disclose the facts relevant to the case than does any neu- tral party (such as the judge in the inquisitorial system). Individual rights and zealous advocacy will best lead to the administration of justice.

financial strength of her opponent puts her at an immediate disadvantage. While Suzie may be able to afford an attor- ney, it is likely that her employer will be able to afford a team of attorneys, paralegals, and support staff. The adversarial system quickly goes from a “system designed to protect individual rights” to a system that primarily pro- tects the rights of the wealthy few who can afford better attorneys and fund a lengthy litigation.

Rather than having the adversarial system, the country would be better served by an inquisitorial system. In the inquisitorial system, the finder of fact, not the parties, is responsible for gathering evidence and investigating. The finder of fact has the opportunity to gather as much infor- mation as necessary before rendering an opinion. In the inquisitorial system, the truth, not the controversy, guides the way.

1. Explain the two types of jurisdiction that a court must have to hear a case and render a binding deci- sion over the parties.

2. Explain the differences between trial courts and appellate courts.

3. Identify and define the alternative tools of discovery.

4. Explain the three threshold requirements a plaintiff must meet before he or she can file a lawsuit.

5. Missouri was International Shoe Corporation’s prin- cipal place of business, but the company employed between 11 and 13 salespersons in the state of Washington who exhibited samples and solic- ited orders for shoes from prospective buyers in Washington. The state of Washington assessed the company for contributions to a state unemploy- ment fund. The state served the assessment on one of International Shoe Corporation’s sales repre- sentatives in Washington and sent a copy by regis- tered mail to the company’s Missouri headquarters. International Shoe’s representative challenged the assessment on numerous grounds, arguing that the state had not properly served the corporation. Is the corporation’s defense valid? Why or why not? [ International Shoe Co. v. Washington, 326 U.S. 310 (1945).]

6. The Robinsons, residents of New York, bought a new Audi car from Seaway Volkswagen Corp., a retailer incorporated in New York and with its

principal place of business there. World-Wide Volkswagen, a company incorporated in New York and doing business in New York, New Jersey, and Connecticut, distributed the car to Seaway. Neither Seaway nor World-Wide did business in Oklahoma, and neither company shipped cars there. The Robinsons were driving through Oklahoma when another vehicle struck their Audi in the rear. The gas tank of the Audi exploded, injuring several members of the family. The Robinsons brought a product liability suit against the manufacturer, distributor, and retailer of the car in an Oklahoma state court. Seaway and World-Wide argued that the Oklahoma state court did not have in personam jurisdiction over them. After the state’s trial court and supreme court held that the state did have in personam jurisdiction over Seaway and World- Wide, the companies appealed to the U.S. Supreme Court. How do you think the Court decided in this case? Why? [ World-Wide Volkswagen Corp. v. Woodson, 444 U.S. 286 (1980).]

7. The plaintiff, a Texas resident, and the defendants, Colorado residents, were cat breeders who met at a cat show in Colorado. Subsequently, the plain- tiff sent two cats to the defendants in Colorado for breeding and sent a third cat to them to be sold. A dispute over the return of the two breed- ing cats arose, and the plaintiff filed suit against the defendants in Texas. The defendants alleged that

Questions & Problems

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the Texas court lacked personal jurisdiction over them because they did not have minimum contacts within the state of Texas.

The Texas statute provides that the Texas court could exercise jurisdiction over an out-of-state defen- dant only if (1) the defendant has purposefully estab- lished minimum contacts with the forum state and (2) the exercise of jurisdiction comports with tradi- tional notions of fair play and substantial justice. The defendants were not residents of Texas and had no business in Texas. The only contact the defendants had with Texas was a single trip they made to Texas to pick up two other cats, not related to the litigation, that they were going to take to a cat show. During that same visit, the defendants took a cat unrelated to the lawsuit to see a Texas veterinarian, and the plain- tiff’s husband assisted the defendants with a Web page for their business. The trial court found that sufficient minimum contacts had been established. The defendants appealed. How do you believe the appellate court would rule in this case, and why? [ Hagan v. Field, Court of Appeals of Texas, Fifth District, Dallas, 2006 Tex. App. LEXIS 393.]

8. Le Cabaret 481, Inc., an adult entertainment cor- poration, wanted to open a strip club in the city of Kingston. Kingston, however, passed an ordinance prohibiting adult businesses from operating within 300 feet of any church, school, nursery, public park, or residential property. Le Cabaret 481 filed a suit against the city, arguing that the ordinance left no feasible locations in the city for an adult business and thus violated the company’s First Amendment right to free expression. The city, on the other hand, argued that Le Cabaret 481 did not present a ripe case to the court because the com- pany had not applied for a building permit for its adult business. The company argued that it could not find a location for which it could apply for a

permit. Do you think Le Cabaret 481 satisfied the ripeness requirement for its suit against the city? Why or why not? [ Le Cabaret 481, Inc. v. Munic- ipality of Kingston, 2005 U.S. Dist. LEXIS 706 (2005).]

9. Thirteen record labels filed a copyright violation suit against Hummer Winblad Venture Partners (Hummer), an owner of Napster, a peer-to-peer file- sharing network for online distribution of music. Hummer filed a counterclaim alleging antitrust violations against the record labels because they conspired to exclude independent music distribu- tors like Napster from the online music distribu- tion market. The record labels argued that Hummer lacked standing to make its counterclaims because Hummer, not Napster, made the counterclaims and Hummer never competed directly with the record labels. Hummer, on the other hand, argued that it had standing because it financed Napster, a partici- pant in the online music distribution market. How do you think the court ruled in this case? Why? [ In re Napster Copyright Litig. v. Hummer Winblad Venture Partners, 354 F. Supp. 2d 1113 (2005).]

10. The plaintiffs, parents of underage children, sued the Advanced Brands and Importing Co., an importer of alcoholic beverages, seeking an injunction pro- hibiting advertisers from advertising its beers and damages in the form of compensation for the money spent by their children on illegal purchases of beer. The parents argued that the advertising campaign of the defendant causes underage children, like theirs, to illegally purchase the defendant’s beer. The trial court dismissed the claim, in part, based on lack of standing, and the parents appealed. Do you think the appellate court found that they had standing? Why or why not? [ Alston v. Advanced Brands and Importing Co., 494 F.3d 562 (6th Cir. 2007).]

Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

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C H A P T E R

Alternative Dispute Resolution 4

1 What are the primary forms of alternative dispute resolution?

2 What are other ADR methods?

3 What is court-annexed ADR?

4 How is ADR used in international disputes?

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

CASE OPENER Mandatory Arbitration at Hooters

Hooters Restaurant in Myrtle Beach, South Carolina, used an alternative dispute resolution program, a program to resolve disputes outside the traditional court system. Employees of Hooters had to sign an “agreement to arbitrate employment-related disputes” to be eligible for raises, transfers, and promotions. Under the agreement, both Hooters and the employee agreed to resolve all disputes arising out of employment, including “any claim of discrimi- nation, sexual harassment, retaliation, or wrongful discharge, whether arising under fed- eral or state law,” through arbitration. Arbitration is a type of alternative dispute resolution where a neutral third party makes a decision that resolves the dispute.

In a separate policy document not shared with employees until after they had signed the agreement, Hooters set forth the rules and procedures of its arbitration program:

• The employee had to provide notice of the specifics of the claim, but Hooters did not need to file any type of response to these specifics or notify the employee of what kinds of defenses the company planned to raise.

• Only the employee had to provide a list of all fact witnesses and a brief summary of the facts known to each.

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• While the employee and Hooters could each choose an arbitrator from a list, and the two arbitrators chosen would then select a third to create the arbitration panel that would hear the dispute, Hooters alone selected the arbitrators on the list.

• Only Hooters had the right to widen the scope of arbitration to include any matter, whereas the employee was limited to the matters raised in his or her notice.

• Only Hooters had the right to record the arbitration.

• Only Hooters had the right to sue to vacate or modify an arbitration award if the arbi- tration panel exceeded its authority.

• Only Hooters could cancel the agreement to arbitrate or change the arbitration rules.

Annette Phillips had worked as a bartender at the Hooters restaurant in Myrtle Beach for about five years before Hooters adopted its arbitration policy. Ms. Phillips was given a copy of the agreement to arbitrate to review for five days and then sign. Approximately two years later, a Hooters official grabbed and slapped her buttocks. After appealing to her manager for help and being told to “let it go,” she quit her job. When she threatened to file a lawsuit for sexual harassment, Hooters filed an action in federal district court to compel arbitration of Phillips’s claims. 1

1. Should Phillips be forced to settle her claim through arbitration?

2. Assume your company’s arbitration policy was exactly like Hooters’. Which aspects would you retain, and which might you change?

The Wrap-Up at the end of the chapter will answer these questions using the legal prin- ciples discussed in this chapter.

Many companies, like Hooters Restaurant, are finding that using alternative dispute resolution (ADR) to resolve their legal problems offers many benefits. The term ADR refers to the resolution of legal disputes through methods other than litigation, such as negotiation, mediation, arbitration, summary jury trials, minitrials, neutral case evalua- tions, and private trials. Organizations often use ADR to resolve disputes involving con- tracts, insurance, labor, the environment, securities, technology, and international trade.

Some organizations have created internal mediation systems for resolving disputes within the organization. For example, United Parcel Service (UPS) has a five-step dispute resolution program:

1. Open door: The employees are encouraged to bring their problems to their supervisors.

2. Facilitation: The regional managers ensure that the open-door options are explored.

3. Peer review: The employee and the company representative communicate the dif- fering perspectives of the dispute before a panel of three employees (two selected by the complainant and one by the employer), which recommends a nonbinding solution.

4. Mandatory mediation.

5. Optional binding arbitration. 2

1 Hooters of America, Inc. v. Phillips, 173 F.3d 933 (4th Cir. 1999).

2 F. Peter Phillips, “Mediation Is Alternative to Adjudicating Disputes: Internal Employment Dispute Management Programs Are New Trend,” National Law Journal, June 14, 2004, p. S4.

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Chapter 4 Alternative Dispute Resolution 69

Why might a business prefer to resolve a dispute through ADR rather than litigation? First, ADR methods are generally faster and cheaper than litigation. According to the National Arbitration Forum, the average time from filing a complaint to receiving a judgment through litigation is 25 months. 3 Because ADR is faster, it is usually cheaper. According to the American Intellectual Property Law Association, for litigation of patent cases valued in the $1 million to $25 million range, the average cost to each party from the filing of the complaint through the close of discovery is $1.9 million. 4 Through the end of trial, the average cost to each party is $3.5 million. Thus, if a party can resolve a dispute in the early stages of the case through alternative dispute resolution, this may save significant money. Second, a business may wish to avoid the uncertainty associated with a jury decision; many forms of ADR give the participants more control over the resolu- tion of the dispute. Specifically, the parties can select a neutral third party, frequently a person with expertise in the area of the dispute, to help facilitate resolution of the case. Third, a business may wish to avoid setting a precedent through a court decision. Thus, many businesses prefer ADR because of its confidential nature. Fourth, because many forms of ADR are less adversarial than litigation, the parties are able to preserve a busi- ness relationship.

Not only are businesses increasingly turning to ADR, but courts are generally quite supportive of ADR methods, which alleviate some of the pressure on the overwhelming court dockets. Congress has recognized the benefits of ADR methods through its enact- ment of the Alternative Dispute Resolution Act of 1998. This act requires that federal district courts have an ADR program along with a set of rules regarding the program. Congress also passed the Administrative Dispute Resolution Act, which mandates that federal agencies create internal ADR programs. This chapter explains the various ADR methods, as well as the advantages and disadvantages of each. Because ADR is becoming more favored internationally, the latter portion of this chapter discusses its use in other countries.

Primary Forms of Alternative Dispute Resolution NEGOTIATION Many business managers make frequent use of negotiation, a bargaining process in which disputing parties interact informally, either with or without lawyers, to attempt to resolve their dispute. A neutral third party, such as a judge or jury, is not involved. Thus, negotia- tion differs from other methods of dispute resolution because the parties maintain high levels of autonomy. Some courts require that parties negotiate before they bring their dis- pute to trial.

Before negotiation begins, each side must determine its goals for the negotiation. Moreover, each side must identify the information it is willing to give the other party. A party can enter negotiations with one of two approaches: adversarial or problem solving. In adversarial negotiation, each party seeks to maximize its own gain. In contrast, in problem-solving negotiation, the parties seek joint gain. Typically, however, to reach a successful settlement, each party must give up something in exchange for getting some- thing from the other side. Because negotiation generally occurs in every case before a more

3 National Arbitration Forum, Business-to-Business Mediation/Arbitration vs. Litigation: What Courts, Statistics, & Public Perceptions Show about How Commercial Mediation and Commercial Arbitration Compare to the Litigation System, January 2005, p. 3. 4 AIPLA, Report of the Economic Survey, 2005, pp. 1-109–1-110.

LO1

What are the primary forms of alternative dispute resolution?

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formal dispute resolution method is chosen, negotiation is not necessarily considered an alternative to litigation.

MEDIATION An extension of negotiation is mediation. In mediation, the disputing parties select a neutral party to help facilitate communication and suggest ways for the parties to solve their dispute. Therefore, the distinguishing feature of mediation is that the parties volun- tarily select a neutral third party to help them work together to resolve the dispute. The neutral third party frequently has expertise in the area of the dispute.

Mediation begins when parties select a mediator. Typically, a week before the media- tion, each party provides the mediator with a short brief explaining why it should win. Attorneys, along with client representatives, then meet with the mediator. The mediator first assures the parties that the proceedings are confidential, and the parties take turns explaining the dispute to the mediator.

One of the mediator’s main goals is to help each party listen carefully to the opposing party’s concerns. The mediator asks the parties to identify any additional concerns. This discussion is an attempt to identify underlying circumstances that might have contributed to the dispute. A dispute typically arises after various problematic incidents; mediation permits the parties to address the various incidents, as well as the underlying circumstances leading to those incidents. After concerns have been highlighted, the mediator emphasizes areas of agreement and reframes the disputed points.

The parties then begin generating alternatives or solutions for the disputed points. The mediator helps the parties evaluate the alternatives by comparing the alternatives with the disputed points and interests identified earlier. Finally, the mediator helps the parties create a solution. Because the mediator’s role is to facilitate an agreement, the mediator will often need to be persuasive to help the parties concede certain points so that agreement can be reached.

The mediation concludes when an agreement between the parties is reached. The agree- ment is then usually put into the form of a contract and signed by the parties. The mediator may participate in the drafting of the contract. If one of the parties does not follow the agreement, that party can be sued for breach of contract. However, parties typically abide by the agreement because they helped create it.

If mediation is not successful, the parties can turn to litigation or arbitration to resolve their dispute. However, nothing said during the media- tion can be used in another dispute resolution method; the mediation process is confidential.

There are more than 2,500 state and federal rules regarding mediation. Lawmakers have recognized that with such a large number of different laws governing ADR, conducting business in different states is difficult and unduly complicated. In an attempt to create unifor- mity in mediation procedures, the American Bar Asso- ciation committee helped draft the Uniform Mediation Act (UMA), which provides for a mediation privilege, which protects communications made during media- tion as privileged and requires that mediators identify any conflicts of interest. Thus far, nine states have enacted the UMA. 5

5 “A Few Facts about the Uniform Mediation Act,” www.nccusl.org/Update/uniformact_factsheets/uniformacts-fs-uma2001.asp .

Mediation at work.

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To see how ADR relates to resolving workplace conflicts that arise in the workplace, please see the Connecting to the Core activity on the text Web site at www.mhhe.com/kubasek2e.

Chapter 4 Alternative Dispute Resolution 71

Selecting a Mediator. Mediators are available through nonprofit sources as well as private companies, such as Judicial Arbitration and Mediation Services (JAMS). JAMS has more than 200 full-time neutrals specializing in complex, multiparty business cases. 6

When selecting a mediator, parties should be aware that mediators come from a variety of backgrounds: experts in the area of the dispute, lawyers, judges, psychologists, and sociologists.

Advantages and Disadvantages of Mediation. For disputes in which the par- ties must maintain a working relationship, mediation is popular because it allows parties to preserve their relationship throughout the dispute. Mediation helps parties work together to reach a consensus. Because parties are encouraged to communicate openly, they usually do not experience bitterness toward the opposing party. Furthermore, each party typically leaves mediation with a better understanding of the opposing party; consequently, this understanding may actually facilitate a better working relationship between the parties. Therefore, the first advantage of mediation is that it helps disputing parties preserve their relationships.

The second advantage to mediation is the potential for creative solu- tions. The parties are responsible for offering alternatives to solve problems. A party to mediation is often not necessarily looking for a money award. Instead, that party may be trying to find a solution so that both parties can benefit from the resolution of the dispute.

In addition, parties to mediation have a high level of autonomy. Unlike litigation or arbitration, where a neutral third party makes a decision that resolves the dispute, mediation allows parties to take control of the process and resolve the dispute together. The parties generally have more dedication to the agreement because they helped make the decision. Finally, mediation, like other methods of alternative dispute resolution, is less costly, less time-consuming, and less complicated than litigation.

These benefits can obviously be very worthwhile. However, critics of mediation argue that its informal process improperly creates an image of equality between the parties. Consequently, we improperly assume that the resulting agreement between the parties is also equal. However, if one party has more power than the other, the agreement is not necessarily fair or equal. Thus, the image of equality in mediation can be misleading. Furthermore, a party who knows that he or she has no chance of winning a case could enter the mediation process in bad faith, with no intention of making an agreement. There- fore, some people may abuse the mediation process in an attempt to simply draw out the dispute.

Uses of Mediation. Mediation is used to resolve collective bargaining disputes. Because workers and employers must continue to work together, mediation typically helps preserve the relationship between the workers and the employers. Under the National Labor Relations Act (NLRA), a union must contact the Federal Mediation and Concilia- tion Services to attempt to mediate its demands before beginning a strike to achieve higher wages or better working hours.

Similarly, the Equal Employment Opportunity Commission (EEOC) encourages the mediation of employment discrimination claims. The EEOC has a mediation program that uses mediators employed by the EEOC, as well as external mediators trained in mediation

6 “JAMS: The Resolution Experts: Fact Sheet,” www.jamsadr.com/press/kit.asp .

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and discrimination law. Between 1999 and 2008, the EEOC mediation program held almost 111,000 mediations. 7 Approximately 69 percent of these mediations (over 76,000 charges) were successfully resolved in an average of 85 days. 8

Mediation is also commonly used in environmental disputes. For example, Japan has created a committee, the Environmental Pollution Disputes Committee, devoted solely to the resolution of environmental disputes. This committee may use mediation or arbitra- tion. Why is mediation particularly useful for environmental disputes? First, mediation allows for creative solutions and compromises, which are often needed in environmental disputes. Suppose an endangered species makes its home on land that an entrepreneur recently purchased with the intention of building a bed-and-breakfast facility. Because the Endangered Species Act prohibits landowners from destroying an endangered species’ habitat, the entrepreneur cannot build on the land. Mediation can help the landowner come to some kind of compromise to use the land. For example, there might be a way to preserve a portion of the land so that the species may thrive while the landowner can operate the bed-and-breakfast in perhaps a smaller facility.

Second, multiple parties are often involved in environmental disputes. While most dis- pute resolution methods limit the participation of parties, numerous parties can participate in mediation. Third, those involved in environmental disputes will often become involved in future disputes. Thus, it is important that the parties maintain a good relationship, and mediation helps them do so.

In Germany, mediation has a special use by the parliamentary groups, the Bundestag and the Bundesrat, similar to Congress. These two groups must reach a majority consensus on all pieces of federal legislation in Germany. The Mediation Committee was formed for the purpose of reaching such consensus on bills being debated by the two groups. The Mediation Committee is composed of 16 members from each group. The meetings of the committee are confidential to prevent outside political pressures from barring consensus. Free of unwanted pressures, the committee creates a proposal for the disputed bill. The frequency of the meetings of the Mediation Committee depends on the political atmo- sphere of the time. Between 1972 and 1976, when rival majorities held the Bundestag and the Bundesrat, the Mediation Committee convened 96 times. Yet between 1983 and 1987, the committee met only six times.

Mediation and Litigation. While mediation is one of the more common alterna- tives to litigation, a primary purpose of mediation is to keep disputes out of the court system. However, sometimes litigation results from mediation.

ARBITRATION One of the most frequently used methods of dispute resolution is arbitration, the resolution of a dispute by a neutral third party outside the judicial setting. Arbitration is often a voluntary process in that parties typically have a contractual agreement to arbitrate any disputes. This agreement may stipulate how the arbitrator will be selected and how the hearing will be administered.

If a party wants to begin arbitration, it sends the other party a written demand for arbi- tration. This demand identifies the parties involved, the dispute issue, and the type of relief claimed. The opposing party typically responds to the demand in writing, indicating agree- ment or disagreement with the claim that the dispute is arbitrable.

7 “History of the EEOC Mediation Program,” www.eeoc.gov/mediate/history.html .

8 Ibid.

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Selecting an Arbitrator. If the contract does not specify how the parties will select an arbitrator, they typically use either the Federal Mediation and Conciliation Services (FMCS), a government agency, or the American Arbitration Association (AAA), a private, nonprofit organization. The AAA has more than 7,000 arbitrators and mediators world- wide, over 1,000 of whom are bilingual or multilingual. 9 In 2008, more than 138,477 cases were filed with the AAA. 10

When a party contacts one of the agencies, the party receives a list of potential arbitra- tors. This list includes biographical information about the potential arbitrators, and both parties examine the list and agree on an arbitrator. While most arbitrations are conducted by one arbitrator, panels of three arbitrators are becoming more frequent. Typically, each party chooses one arbitrator, and then those two arbitrators select an additional arbitrator.

Lawyers, professors, or other professionals typically serve as arbitrators. The gen- eral qualifications for being an arbitrator are honesty, impartiality, and subject-matter competence. Additionally, arbitrators are expected to follow the Arbitrator’s Code of Ethics.

The parties must determine whether they will select one arbitrator or a panel of arbitra- tors. Selecting a panel may reduce the risk of error or prejudice in the arbitration decision. However, selecting a panel would also increase the costs associated with the arbitration.

Once the parties agree on an arbitrator, the parties and the arbitrator agree on the loca- tion and time of the arbitration. The parties may or may not have a discovery period. Addi- tionally, they determine which procedural and substantive rules will be followed during the arbitration.

The Arbitration Hearing. The arbitration hearing is quite similar to a trial. Both parties present their case to a neutral third party; they may represent themselves or use legal counsel. During this presentation, the parties may introduce witnesses and docu- mentation, may cross-examine the witnesses, and may offer closing statements. The fact finder offers a legally binding decision. In these ways, a trial and an arbitration hearing are similar.

However, arbitration is also different in several ways. First, the arbitrator often takes a much more active role in an arbitration hearing, in the sense that the arbitrator is more likely than a judge to question a witness. Second, no official written record of the hearing is kept. Third, the rules of evidence applicable in a trial are typically relaxed in arbitration. Fourth, the arbitrator is not as constrained by precedent as are judges.

The Arbitrator’s Award. The arbitrator typically provides a decision within 30 days of the arbitration hearing. The arbitrator’s decision is called an award, even if no monetary compensation is awarded. The arbitrator’s decision differs from a judge’s decision in sev- eral ways. The arbitrator does not have to state any findings of fact, conclusions of law, or reasons to support the award, and he or she is not as bound by precedent as a judge is. Also, because the arbitrator was hired to resolve a dispute between two parties, the arbitra- tor is more likely to make a compromise ruling instead of a win-lose ruling. After all, if the parties are satisfied with the ruling, they will probably be more likely to use that arbitrator again to resolve future disputes.

The arbitrator’s decision is legally binding. In certain cases, a decision may be appealed to the district court. However, few of these cases are appealed. The courts give

9 American Arbitration Association, “Arbitration and Mediation,” www.adr.org/arb_med .

10 American Arbitration Association, “American Arbitration Association Provides Neutral Evaluation for Complex Insurance Disputes” (press release), April 6, 2009.

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extreme deference to arbitrators’ decisions. Unless a party can clearly demonstrate that an arbitrator’s decision was contrary to law or that there was a defect in the arbitration process, the decision will be upheld. The Federal Arbitration Act (FAA), the federal law enacted to encourage the use of arbitration, explicitly lists four grounds on which an arbi- trator’s award may be set aside:

1. The award was the result of corruption, fraud, or other undue means.

2. The arbitrator displayed bias or corruption.

3. The arbitrator refused to postpone the hearing despite sufficient cause, refused to hear relevant evidence, or otherwise misbehaved to prejudice the rights of one of the parties.

4. The arbitrator exceeded his or her authority or failed to use that authority to make a mutual, final, and definite award.

The U.S. Supreme Court has held that these four grounds are the exclusive grounds for vacating, modifying, or correcting an arbitrator’s award, and parties cannot expand on these grounds in contract. 11 Consequently, in the United States, arbitration decisions are generally upheld. Other countries are taking actions to increase the number of arbitra- tions, while reducing the need to appeal the arbitration decisions. For example, Brazilian lawmakers reformed several articles in the Brazilian Civil Code to increase the practice of arbitration. These reforms mandate that parties sign an “arbitration commitment” during arbitration proceedings. This commitment states the disputed issue, the venue of the arbi- tration, and the parties involved. The arbitration commitment renders the outcome of the arbitration comparable to a decision handed down by the judiciary branch. Consequently, parties no longer need to appeal to the judiciary branch after an arbitration hearing.

Legal Principle: An arbitration award can be set aside for only four reasons: (1) the award resulted from fraud or corruption; (2) the arbitrator is biased or cor- rupt; (3) the arbitrator misbehaved such as to prejudice the rights of a party; and (4) the arbitrator misused his authority in the making of the award.

Advantages and Disadvantages of Arbitration. Arbitration may be prefer- able to litigation for several reasons. First, arbitration is more efficient and less expen- sive than litigation. For example, on May 11, 2005, Google filed a complaint with the National Arbitration Forum because another party had registered the following Internet domain names: googkle.com, ghoogle.com, gfoogle.com, and gooigle.com. 12 Less than two months later, an arbitration panel concluded that these domain names were confus- ingly similar to the google.com trademark and that they had been registered in bad faith. Consequently, the panel determined that the googkle.com, ghoogle.com, gfoogle.com, and gooigle.com domain names be transferred to Google.

Second, parties have more control over the process of dispute resolution through arbitration. They choose the arbitrator and determine how formal the process will be. Third, the parties can choose someone to serve as the arbitrator who has expertise in the specific subject matter. Because the arbitrator has expertise, the parties believe that the arbitrator will be able to make a better decision. Fourth, the arbitrator has greater flexibility in decision making than a judge has. Unlike judges, who are bound by precedent, arbitra- tors generally do not have to offer reasons for their decisions.

However, arbitration is not without its critics. First, arbitration panels are being used more frequently, resulting in a loss of some of the prior advantages of arbitration.

11 Hall Street Assoc., L.L.C. v. Mattel, Inc., 128 S. Ct. 1396 (2008).

12 Google Inc. v. Sergey Gridasov, Claim Number: FA0505000474816, National Arbitration Forum (2005), www.arb-forum.com/ domains/decisions/4_7_4816.htm .

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For example, using a panel, as opposed to one arbitrator, causes greater scheduling difficulties because of the number of people involved, consequently negating some of the efficiency associated with arbitration. Along the same lines, paying an arbitration panel is more costly than paying one arbitrator.

Second, because appealing an arbitration award is so difficult, some scholars argue that injustice is more likely to occur. Third, some individuals are concerned that by agreeing to give up one’s right to litigate, one may be losing important civil rights or giving up important potential remedies without really understanding which rights are being given up. Especially in an employment context, people may not really want to give up such rights, but they have no choice if they want the job.

Fourth, some scholars are afraid that if more and more employers and institutions turn to mandatory arbitration, it will become more like litigation. An increasing number of people will be forced to arbitrate their disputes; consequently, the efficiency associated with arbitration will start to erode.

Fifth, some scholars are concerned about the privacy associated with arbitration. Com- panies and employers are able to “hide” their disputes through arbitration. Suppose a credit card company is charging greater amounts of money than its posted finance charge. If an individual arbitrates her claim, other customers might not learn about the problem and therefore won’t know to check their credit card statements to ensure that they are being charged the correct amount. If the claim went to court, the publicity surrounding the case would probably better educate people to pay more attention to their statements. Thus, the confidentiality associated with an arbitration proceeding may be harmful in some cases.

If you applied the ethical principle of universalization to arbitration, would you be able to justify its use in spite of these disadvantages? Why might the application of the univer- salization principle cause one to become hesitant to use arbitration?

Methods of Securing Arbitration. Given the benefits associated with arbitration, parties may voluntarily submit their cases to arbitration. The primary method of securing arbitration is through a binding arbitration clause, a provision in a contract that mandates that all disputes arising under the contract must be settled by arbitration. The clause also typically states how the arbitrator will be selected. Exhibit  4-1 shows an example of a binding arbitration clause that could be included in almost any business contract.

If a contract does not contain a binding arbitration clause, parties may secure arbitration by entering into a submission agreement, a contract providing that a specific dispute will be resolved through arbitration. The submission agreement typically states the following: the nature of the dispute, how the arbitrator will be selected, the place of the arbitration, and any limitations on the arbitrator’s authority to remedy the dispute.

If parties have a binding arbitration agreement or have entered into a submission agree- ment, the parties must resolve the dispute through arbitration. Both federal and state courts

Any controversy, dispute, or claim of whatever nature arising out of, in connection with, or in relation to the interpretation, performance, or breach of this agreement, including any claim based on contract, tort, or statute, shall be resolved, at the request of any party to this agreement, by final and binding arbitration conducted at a location determined by the arbitrator in (City, State) administered by and in accordance with the existing Rules of Practice and Procedure of Judicial Arbitration and Mediation Services (JAMS), Inc., and judgment upon any award rendered by the arbitrator may be entered by any state or federal court having jurisdiction thereof.

Exhibit 4-1 Sample Binding Arbitration Clause

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76 Part 1 The Legal Environment of Business

must uphold agreements to arbitrate. In 2003, the Ninth Circuit joined all other circuits in concluding that Title VII does not bar compulsory arbitration of claims. 13

Like the law in general, however, the law governing arbitration agreements is not a fixed set of rules or precedents. Rather, it changes as new and unforeseen issues arise. In many cases, lawmakers and courts do not fully understand the consequences of the laws they enact and the decisions they issue. Thus, although federal and state courts originally upheld all arbitration agreements, more recently they have not upheld certain types of arbitration clauses. For example, courts do not uphold arbitration agreements when federal statutory rights are at issue if the agreement is not “clear and unmistakable.”

The Supreme Court recently considered whether a broad arbitration clause in individual consumers’ contracts would apply to class actions by the consumers. In Green Tree Finan- cial Corp. v. Bazzle, the Court concluded that the Federal Arbitration Act did not preclude class arbitration; thus, the case would be decided on the basis of the interpretation of the arbitration clause in the context of state law. 14 Similarly, in James v. McDonald’s Corp., the Seventh Circuit agreed that a McDonald’s customer could be compelled to arbitrate a dispute over a prize in McDonald’s “Who Wants To Be a Millionaire?” sweepstakes when the arbitration clause was included in the official rules posted in participating McDonald’s restaurants. 15

Another constraint on binding arbitration clauses is that they must be drafted in such a way as to ensure that the courts do not see them as being unconscionable. An uncon- scionable contract provision has been defined as one in which the terms are “manifestly unfair or oppressive and are dictated by a dominant party.” 16 The doctrine has been used most often to strike down binding arbitration clauses in consumer and employment contracts.

For example, in the Hooters illustration at the beginning of the chapter, the court refused to uphold the contract because of a number of provisions it found to be unconscionable, including requiring that employees provide notice of the specifics of the claim but not making the company file any type of response to these specifics or notify the employee of what kinds of defenses the company planned to raise; making only the employee provide a list of all fact witnesses and a brief summary of the facts known to each; allowing the company to widen the scope of arbitration to include any matter, whereas the employee was limited to the matters raised in his or her notice; giving only the company the right to record the arbitration; allowing only the company to sue to vacate or modify an arbitration award because the arbitration panel exceeded its authority; and allowing only the company to cancel the agreement to arbitrate or change the arbitration rules. Provisions found to be unconscionable in other binding arbitration clauses included provisions that mandated cost sharing for hiring a three-member arbitration panel, 17 limited available damages, 18 adopted unreasonably short time periods for filing claims, and limited the amount of discovery available. 19

Exhibit 4-2 offers tips on creating a binding arbitration clause. 20

13 EEOC v. Luce, Forward, Hamilton, & Scripps, 345 F.3d 742 (9th Cir. 2003).

14 539 U.S. 444 (2003).

15 417 F.3d 672 (7th Cir. 2005).

16 Farris v. County of Camden, 61 F. Supp. 2d 307, 341 (D.N.J. 1999).

17 Maciejewski v. Alpha Systems Lab Inc., 87 Cal. Rptr. 2d 390 (Cal. Ct. App. 1999).

18 Johnson v. Circuit City Stores, Inc., 203 F.3d 821 (4th Cir. 2000).

19 Geiger v. Ryan’s Family Steak House and Employment Dispute Services Inc., 2001 WL 278120 (S.D. Ind. 2001).

20 See, e.g., Shubin v. William Lyon Homes, Inc., 84 Cal. App. 4th 1041 (2000), and Cole v. Burns Internal Security Services, 105 F.3d 1465 (D.C. Cir. 1997).

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However, suppose a binding arbitration clause were included in a contract that was challenged as illegal? Would the arbitration clause govern, thus requiring that an arbitra- tor determine whether the contract itself was illegal? Or would the arbitration clause be considered part of the illegal contract, necessitating that a court hear the dispute? The Supreme Court addressed this question in Buckeye Check Cashing, Inc. v. Cardegna et al. (see Case 4-1).

Exhibit 4-2 Tips for Creating a Binding Arbitration Clause

OVERALL, MAKE SURE THE CLAUSE TREATS BOTH PARTIES FAIRLY

1. Be clear and unmistakable. If you wish to arbitrate employment disputes or discrimination claims, make sure that you explicitly state “employment disputes and discrimination claims” in the binding arbitration clause.

2. The arbitration clause must be bilateral. If the arbitration clause requires one party only to arbi- trate but does not spell out the same requirement for the other party, the clause will probably not be upheld. This agreement would be asking one party to give up its right to have a claim before a jury while the other party retains that right. The courts are concerned about fairness. This bilat- eral consideration must extend to damages. For example, both parties must be able to get the same damages.

3. State explicitly which party will pay the arbitrator’s fees, and make sure that it will not cost the employee more to arbitrate than it would have cost to litigate. Courts have refused to enforce arbitration agreements that require that the plaintiff pay the costs of the arbitration. Some courts have refused to enforce agreements requiring that the employee pay a pro rata share of arbi- tration expenses. Furthermore, a court recently refused to enforce an agreement that did not specify who would pay the arbitrator’s fees along with other costs. For ease and assurance that the agreement will be enforced, companies might consider stating that they will pay the costs of the arbitration.

4. Specify how the arbitrator will be selected. 5. Spell out the costs associated with the arbitration. 6. Avoid limitations on the remedies available to the parties. Limitations on punitive damages or

attorney fees are likely to be causes for refusing to uphold cases.

7. Consider other potential parties when determining where to hold the arbitration. If a credit card company states in its arbitration clause that all disputes will be arbitrated in its state of incorporation, a court might be more likely to not enforce the agreement. Requiring that consumers travel far distances may be perceived as an unfair burden on the consumer.

John Cardegna and Donna Reuter (“Respondents”) entered into several transactions with Buckeye Check Cashing (“Buckeye”) where they received cash in exchange for a personal check in the amount of the cash, plus a finance charge. For each transaction, they signed an agreement that contained a mandatory arbitration provision. Respondents

brought a class action in Florida state court, arguing that the agreement was criminal because it violated Florida lending and consumer- protection laws because the high interest rates were illegal. Pursuant to the mandatory arbitration provi- sion, Buckeye moved to compel arbitration. The trial court denied Buckeye’s motion, holding that a court, rather than

BUCKEYE CHECK CASHING, INC. v. CARDEGNA ET AL. UNITED STATES SUPREME COURT 546 U.S. 440 (2006)

CASE 4-1

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an arbitrator, should resolve a claim that a contract is illegal and void. The District Court of Appeal of Florida for the Fourth District disagreed, holding that because Respondents did not challenge the mandatory arbitration provision itself, the agreement to arbitrate was enforceable and an arbitrator should decide whether the contract was legal. The Florida Supreme Court reversed, holding that enforcing a manda- tory arbitration provision in a contract challenged as unlaw- ful “could breathe life into a contract that not only violates state law but is also criminal in nature” 894 So. 2d 860, 862 (2005). The U.S. Supreme Court granted certiorari to deter- mine whether a court or an arbitrator should consider the claim that a contract containing an arbitration provision is void for illegality. In making its decision, the U.S. Supreme Court relied heavily on two of its previous decisions: Prima Paint Corp. v. Flood & Conklin Mfg. Co., 388 U.S. 395 (1967) and Southland Corp. v. Keating, 465 U.S. 1, 4–5 (1984).

JUSTICE SCALIA: Challenges to the validity of arbitra- tion agreements “upon such grounds as exist at law or in equity for the revocation of any contract” can be divided into two types. One type challenges specifically the validity of the agreement to arbitrate. The other challenges the contract as a whole, either on a ground that directly affects the entire agreement (e.g., the agreement was fraudulently induced), or on the ground that the illegality of one of the contract’s provisions renders the whole contract invalid. Respondents’ claim is of this second type. The crux of the complaint is that the contract as a whole (including its arbitration provi- sion) is rendered invalid by the usurious finance charge.

Prima Paint and Southland answer the question presented here by establishing three propositions. First, as a matter of substantive federal arbitration law, an arbitration provision is severable from the remainder of the contract. Second, unless the challenge is to the arbitration clause itself, the issue of the contract’s validity is considered by the arbitrator in the first instance. Third, this arbitration law applies in state as well as federal courts. The parties have not requested, and we do not undertake, reconsideration of those holdings. Applying them

to this case, we conclude that because respondents challenge the Agreement, but not specifically its arbitration provisions, those provisions are enforceable apart from the remainder of the contract. The challenge should therefore be considered by an arbitrator, not a court.

Respondents point to the language of § 2 [of the FAA], which renders “valid, irrevocable, and enforceable” “a writ- ten provision in” or “an agreement in writing to submit to arbitration an existing controversy arising out of ” a “con- tract.” Since, respondents argue, the only arbitration agree- ments to which § 2 applies are those involving a “contract,” and since an agreement void ab initio under state law is not a “contract,” there is no “written provision” in or “controversy arising out of” a “contract,” to which § 2 can apply. This argument echoes Justice Black’s dissent in Prima Paint: “Sections 2 and 3 of the Act assume the existence of a valid contract. They merely provide for enforcement where such a valid contract exists.” 388 U.S., at 412–413. We do not read “contract” so narrowly. The word appears four times in § 2. Its last appearance is in the final clause, which allows a chal- lenge to an arbitration provision “upon such grounds as exist at law or in equity for the revocation of any contract.” There can be no doubt that “contract” as used this last time must include contracts that later prove to be void. Otherwise, the grounds for revocation would be limited to those that rendered a contract voidable—which would mean (implau- sibly) that an arbitration agreement could be challenged as voidable but not as void. Because the sentence’s final use of “contract” so obviously includes putative contracts, we will not read the same word earlier in the same sentence to have a more narrow meaning. We note that neither Prima Paint nor Southland lends support to respondents’ reading; as we have discussed, neither case turned on whether the challenge at issue would render the contract voidable or void.

We reaffirm today that, regardless of whether the chal- lenge is brought in federal or state court, a challenge to the validity of the contract as a whole, and not specifically to the arbitration clause, must go to the arbitrator.

REVERSED and REMANDED.

Why is the meaning of the word “contract” so crucial to the conclusion reached by Justice Scalia?

What information about the arbitration agreement, if it were true, would weaken Justice Scalia’s interpretation of “contract”?

ETHICAL DECISION MAKING CRITICAL THINKING

The Court had to determine whether Cardegna’s claims should be decided by the courts or by arbitration. Consider the relevant stakeholders who might suffer from these two different options. If the Court held that Cardegna’s problem should be decided by litigation, stakeholders that may have suffered include Buckeye Check Cashing, other companies providing the same services, and all types of businesses that use arbitration clauses. Which relevant stakeholders may suffer from the Court’s deci- sion that Cardegna’s claims should be sent to arbitration?

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Plaintiff Robert Gilmer filed a charge with the Equal Employment Opportunity Commission (EEOC) and sued his employer, defendant Interstate/Johnson Lane Corporation. Gilmer alleged that his employer violated the Age Discrimi- nation in Employment Act (ADEA). When the defendant hired him as a registered securities dealer, Gilmer had signed an agreement to settle by arbitration any disputes arising out of that employment. The employer therefore filed a motion to compel arbitration. The trial court denied the defendant’s motion, and the defendant appealed to the cir- cuit court. The circuit court reversed in favor of the defen- dant, and the plaintiff appealed to the U.S. Supreme Court.

JUSTICE WHITE: The question presented in this case is whether a claim under the Age Discrimination in Employ- ment Act of 1967 (ADEA) can be subjected to compulsory arbitration pursuant to an arbitration agreement in a securi- ties registration application.

.  .  . It is by now clear that statutory claims may be the subject of an arbitration agreement, enforceable pursuant to the FAA. . . . In [recent] cases we recognized that “by agree- ing to arbitrate a statutory claim, a party does not forgo the substantive rights afforded by the statute; it only submits to their resolution in an arbitral, rather than a judicial, forum.”

Although all statutory claims may not be appropriate for arbitration, “[h]aving made the bargain to arbitrate, the party should be held to it unless Congress itself has evinced an inten- tion to preclude a waiver of judicial remedies for the statutory rights at issue.” The burden is on Gilmer to show that Congress intended to preclude a waiver of a judicial forum for ADEA claims. . . . Throughout such an inquiry, it should be kept in mind that “questions of arbitrability must be addressed with a healthy regard for the federal policy favoring arbitration.”

Gilmer concedes that nothing in the text of the ADEA or its legislative history explicitly precludes arbitra- tion. He argues, however, that compulsory arbitration of ADEA claims pursuant to arbitration agreements would be

inconsistent with the statutory framework and purposes of the ADEA. Like the Court of Appeals, we disagree.

We also are unpersuaded by the argument that arbitra- tion will undermine the role of the EEOC in enforcing the ADEA. An individual ADEA claimant subject to an arbi- tration agreement will still be free to file a charge with the EEOC, even though the claimant is not able to institute a private judicial action. Indeed, Gilmer filed a charge with the EEOC in this case.

Gilmer also argues that compulsory arbitration is improper because it deprives claimants of the judicial forum provided for by the ADEA. Congress, however, did not explicitly pre- clude arbitration or other nonjudicial resolution of claims, even in its recent amendments to the ADEA. Moreover, Gilmer’s argument ignores the ADEA’s flexible approach to resolution of claims. The EEOC, for example, is directed to pursue “informal methods of conciliation, conference, and persuasion,” which suggests that out-of-court dispute reso- lution, such as arbitration, is consistent with the statutory scheme established by Congress.

In arguing that arbitration is inconsistent with the ADEA, Gilmer also raises a host of challenges to the adequacy of arbitration procedures. Such generalized attacks on arbi- tration “res[t] on suspicion of arbitration as a method of weakening the protections afforded in the substantive law to would-be complainants,” and as such, they are “far out of step with our current strong endorsement of the federal statutes favoring this method of resolving disputes.”

It is also argued that arbitration procedures cannot ade- quately further the purposes of the ADEA because they do not provide for broad equitable relief and class actions. As the court below noted, however, arbitrators do have the power to fashion equitable relief. Indeed, the NYSE rules applicable here do not restrict the types of relief an arbitrator may award, but merely refer to “damages and/or other relief.”

AFFIRMED in favor of Defendant, Johnson/ Lane Interstate Corp.

ROBERT GILMER v. INTERSTATE/JOHNSON LANE CORPORATION UNITED STATES SUPREME COURT 500 U.S. 20 (1991)

CASE 4-2

Chapter 4 Alternative Dispute Resolution 79

Common Uses of Arbitration. Arbitration is used in a variety of situations. It is commonly used in labor disputes. And just like the management of Hooters, employers are often eager to resolve all employment-related disputes through arbitration. However, before Gilmer, discussed in Case 4-2, employers and employees were extremely uncertain as to whether employees could be required to resolve all employment disputes through arbitration, especially those involving discrimination claims.

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Gilmer upheld the validity of the National Association of Securities Dealers’ policy of requiring all employees who execute, buy, or sell orders at brokerages or investment banks to arbitrate all employment disputes as a condition of their employment. Immediately following this case, the use of mandatory arbitration agreements in employment contracts increased significantly.

However, the EEOC became concerned about whether arbitration agreements that had to be accepted as a condition of employment were actually voluntary. In July 1997, the EEOC issued a statement regarding arbitration agreements; the statement indicated that arbitration of discrimination claims as a condition of employment was in conflict with the fundamental principles of employment laws. What values are involved in the EEOC’s protection of workers against employers forcing employees into arbitration?

While the EEOC strongly supported agreements to arbitrate once a dispute has arisen, they did not support inclusion of arbitration agreements as an unconditional element of employment. In response to the EEOC’s statement, the National Association of Securities Dealers created a policy that allowed employees to choose between entering into a private arbitration agreement with the employer and reserving the right to file suit in a federal or state court for discrimination claims.

Gilmer did not end the questions about whether binding arbitration contracts in the employment area should be enforced. Two subsequent U.S. Supreme Court deci- sions, however, have clarified the impact of the Federal Arbitration Act on binding arbitration clauses in employment contracts. Perhaps the most significant ruling was that in the 2001 case of Circuit City v. Saint Clair Adams. 21 In that case, the plain- tiff, an employee of Circuit City, had signed a binding arbitration agreement that had specifically included claims based on discrimination, but two years later he brought an employment discrimination case against his employer in state court. Circuit City filed suit in federal district court to enjoin the state case and compel arbitration. The district court issued the order.

On appeal of the district court’s order, the circuit court of appeals held that the Federal Arbitration Act did not apply to employment contracts. This ruling was con- trary to all other appellate rulings, and the U.S. Supreme Court heard the case. The high court overruled the circuit court’s ruling, clearly setting forth the rule that the Federal Arbitration Act does apply to employment contracts, thereby making binding

What are the primary facts in Gilmer v. Interstate/Johnson Lane Corporation?

What missing facts should be called for when evaluating the judge’s reasoning?

What ambiguities are present in the reasoning?

ETHICAL DECISION MAKING CRITICAL THINKING

What group of stakeholders would be most happy with the outcome of this case? Which would be the least happy?

21 532 U.S. 105 (2001).

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arbitration agreements in employment contracts enforceable, a decision giving much relief to employers. Many commentators forecast that this decision will lead to an even greater number of employers putting binding arbitration clauses in their employment contracts.

A subsequent decision by the high court, however, was not viewed quite so favorably by many employers. As discussed in Case 4-3, the Court went back to a situation similar to that in Gilmer, but in this case, it was not the employee seeking to bring a discrimination claim—it was the EEOC. While this case involved the ADA, the high court stated that the analysis was applicable to all the civil rights statutes used to eradicate discrimination in the workplace.

Arbitration is also used in medical malpractice cases, environmental disputes, commer- cial contract disputes, and insurance liability claims. However, no area uses arbitration in as great a percentage of cases as does the employment area.

All employees of Waffle House had to sign an agreement requiring employment disputes to be settled by binding arbitration. After Eric Baker suffered a seizure and was fired by Waffle House, he filed a discrimination charge with the Equal Employment Opportunity Commission (EEOC) alleging that his discharge violated the Americans with Disabilities Act of 1990 (ADA) under Title VII. The EEOC subsequently filed an enforcement suit, to which Baker was not a party, alleging that Waffle House’s employment practices, including Baker’s discharge “because of his dis- ability,” violated the ADA. The EEOC sought the following: an injunction to “eradicate the effects of [Waffle House’s] past and present unlawful employment practices”; specific relief designed to make Baker whole, including back pay, reinstatement, and compensatory damages; and punitive damages.

Waffle House sought to dismiss the EEOC’s suit and compel arbitration because of the binding arbitration clause signed by Baker. The District Court denied Waffle House’s motion to dismiss. The Fourth Circuit agreed with the District Court that the arbitration agreement between Baker and Waffle House did not foreclose the enforcement action because the EEOC was not a party to the contract, but had independent statutory authority to bring an action to enforce the statute. However, the appellate court held that the EEOC was limited to injunctive relief and precluded from seeking victim-specific relief because the FAA policy

favoring enforcement of private arbitration agreements outweighs the EEOC’s right to proceed in federal court when it seeks primarily to vindicate private, rather than public, interests. The EEOC appealed to the United States Supreme Court.

JUSTICE STEVENS: In 1972, Congress amended Title VII to authorize the EEOC to bring its own enforcement actions; indeed, we have observed that the 1972 amend- ments created a system in which the EEOC was intended “to bear the primary burden of litigation. . . .” In 1991, Con- gress again amended Title VII to allow the recovery of com- pensatory and punitive damages by a “complaining party.” The term includes both private plaintiffs and the EEOC. . . . Thus, these statutes unambiguously authorize the EEOC to obtain the relief that it seeks in its complaint if it can prove its case against respondent.

The Court of Appeals based its decision on its evaluation of the “competing policies” implemented by the ADA and the FAA .  .  . It recognized that the EEOC never agreed to arbitrate its statutory claim . . . and that the EEOC has “inde- pendent statutory authority” to vindicate the public interest, but opined that permitting the EEOC to prosecute Baker’s claim in court “would significantly trample” the strong fed- eral policy favoring arbitration, because Baker had agreed to submit his claim to arbitration. To effectuate this policy, the court distinguished between injunctive and victim-specific

EQUAL EMPLOYMENT OPPORTUNITY COMMISSION v. WAFFLE HOUSE, INC. UNITED STATES SUPREME COURT 534 U.S. 279 (2002)

CASE 4-3

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VII and the agreement. While this may be a more coherent approach, it is inconsistent with our recent arbitration cases. The FAA directs courts to place arbitration agreements on equal footing with other contracts, but it “does not require parties to arbitrate when they have not agreed to do so.” . . . Here there is no ambiguity. No one asserts that the EEOC is a party to the contract, or that it agreed to arbitrate its claims. It goes without saying that a contract cannot bind a nonparty.

[T]he statutory language is clear; the EEOC has the authority to pursue victim-specific relief regardless of the forum that the employer and employee have chosen to resolve their disputes. Rather than attempt to split the difference, we are persuaded that, pursuant to Title VII and the ADA, whenever the EEOC chooses from among the many charges filed each year to bring an enforcement action in a particular case, the agency may be seeking to vindicate a public inter- est, not simply provide make-whole relief for the employee, even when it pursues entirely victim-specific relief.

The only issue before this Court is whether the fact that Baker has signed a mandatory arbitration agreement limits the remedies available to the EEOC. The text of the relevant statutes provides a clear answer to that question. They do not authorize the courts to balance the competing policies of the ADA and the FAA, or to second-guess the agency’s judgment concerning which of the remedies authorized by law that it shall seek in any given case.

REVERSED in favor of petitioner, EEOC.

relief, and held that the EEOC is barred from obtaining the latter, because any public interest served when the EEOC pursues “make whole” relief is outweighed by the policy goals favoring arbitration.

If it were true that the EEOC could prosecute its claim only with Baker’s consent, or if its prayer for relief could be dictated by Baker, the court’s analysis might be persua- sive. But once a charge is filed, the exact opposite is true under the statute—the EEOC is in command of the process. The EEOC has exclusive jurisdiction over the claim for 180 days. During that time, the employee must obtain a right- to-sue letter from the agency before prosecuting the claim. If, however, the EEOC files suit on its own, the employee has no independent cause of action, although the employee may intervene in the EEOC’s suit. In fact, the EEOC takes the position that it may pursue a claim on the employee’s behalf even after the employee has disavowed any desire to seek relief. The statute makes the EEOC the master of its own case and confers on the agency the authority to evaluate the strength of the public interest at stake. Absent textual support for a contrary view, it is the public agency’s province—not that of the court—to determine whether pub- lic resources should be committed to the recovery of victim- specific relief. And if the agency makes that determination, the statutory text unambiguously authorizes it to proceed in a judicial forum.

The Court of Appeals . .  . simply sought to balance the policy goals of the FAA against the clear language of Title

How are previous rules of law and precedents used in Jus- tice Stevens’s reasoning? Is sufficient evidence provided to support the extension of these precedents to this case?

The EEOC filed the claim because of the damages suffered by Baker as a result of Waffle House’s actions. Are there potential alternative causes for the damages suffered by Baker?

ETHICAL DECISION MAKING CRITICAL THINKING

What is the purpose of the decision that Waffle House made in the facts leading to this case?

Other ADR Methods Several other methods of ADR are used less frequently than those discussed above. Some of these methods are similar to negotiation, involving the assistance of a neutral third party. It will be clear after finishing this section that today’s manager really does have a variety of options to choose from when a dispute arises. Exhibit 4-3 provides some key

LO2

What are other ADR methods?

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Exhibit 4-3 Questions to Ask When Selecting a Dispute Resolution Method

questions for a manager to consider when choosing from among this array of dispute resolution options.

MED-ARB Med-arb is a dispute resolution process in which the parties agree to start out in media- tion and, if the mediation is unsuccessful on one or more points, also agree to move on to arbitration. In some cases, the same neutral third party may participate in both the mediation and the arbitration. However, some critics argue that if parties know that the mediator may become the ultimate decision maker, they will be less likely to disclose information during the mediation stage. In contrast, others argue that having the same neutral mediator-arbitrator offers faster resolution because the third party is familiar with the facts of the case. 22

SUMMARY JURY TRIAL The summary jury trial began in 1983 when a court in Cleveland attempted to relieve pressure on an overloaded docket. A summary jury trial is an abbreviated trial that leads to a nonbinding jury verdict. Two advantages are inherent in this method of dispute reso- lution. First, it is quick; a summary jury trial lasts only a day. Second, because the jury offers a verdict, both parties get a chance to see how their case would fare before a jury of their peers.

The process of the summary jury trial is similar to that of a regular trial, but there are some important differences. Each judge can set his or her own rules. At the start of the summary trial, the judge advises the jury on the law. Then, each party’s lawyer presents an opening statement along with a limited amount of evidence before the jury. Two key differences here are that the lawyers have a limited amount of time for this presentation and there are generally no witnesses. All the evidence is presented by the lawyers. The jury then reaches a verdict. Although this verdict is only advisory, the jury is not aware that the verdict is not binding. After the jury provides the verdict, the parties participate in a settle- ment conference, where they decide either to accept the jury verdict, to reject the verdict, or to settle on some compromise. Approximately 95 percent of cases are settled at this time. However, if the case is not settled, it will go to a regular trial. At that trial, nothing from the summary jury trial is admissible as evidence.

If you are a party in a dispute, ask yourself the following questions to determine which dispute resolution method would be best.

1. How concerned am I about keeping costs low?

2. How quickly do I want to resolve the dispute?

3. Do I want to keep the dispute private?

4. Do I want to protect the relationship between the disputing parties?

5. Am I concerned about vindication?

6. Do I want to set a precedent with the resolution of my dispute?

22 See Gerald F. Phillips, “Same Neutral Med-Arb: What Does the Future Hold?” Dispute Resolution Journal 60 (May–July 2005), p. 24.

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MINITRIAL A minitrial is similar to arbitration and mediation because it involves a neutral third party. Disputing businesses generally use minitrials. Business representatives of the disputing businesses participate and have settlement authority. Lawyers for each side present their arguments before these representatives and the neutral adviser, who then offers an opinion as to what the verdict would be if the case went to trial. The neutral adviser’s opinion, like the jury’s verdict in the summary jury trial, is not binding. Next, the business representa- tives discuss settlement options. If they reach an agreement, they enter into a contract that reflects the terms of the settlement.

A minitrial may be preferred to arbitration for three reasons. First, a minitrial is less costly than arbitration. Second, in the typical minitrial, the business representatives, who presumably understand the complex matters of the dispute better than an outside arbitrator, have settlement authority. Third, the procedures of the minitrial can be modified to meet more precisely the needs of the parties. For example, parties may give the neutral adviser the authority to settle the case if the representatives cannot come to a settlement agreement after a certain period of time.

EARLY NEUTRAL CASE EVALUATION With early neutral case evaluation, the parties select a neutral third party and explain their respective positions to this neutral, who then evaluates the strengths and weaknesses of the case. The parties use this evaluation to reach a settlement. Eighteen federal district courts currently use early neutral case evaluation. 23

PRIVATE TRIALS Several states now allow private trials, an ADR method in which a referee is selected and paid by the disputing parties to offer a legally binding judgment in a dispute. The referees

E-COMMERCE AND THE LAW

ADR in Cyberspace

Increasingly, litigants are using arbitration and mediation to resolve disputes in e-commerce cases. The National Arbitration Forum (NAF) is one of the world’s most active organizations in the ADR field, and it is helping more and more litigants resolve e-commerce disputes. This chapter has already discussed one example of NAF’s work: the conflict involving Google over which domain names right- fully belong to that company. Another example involves a dispute between Sigma Two Group LLC and Avenstar.

Sigma Two Group manufactures simulated firefly lights for residential and consumer use. It sells its goods using the domain name fireflymagic.com. Avenstar, a competitor, registered the domain name magicalfireflies.com and used this site to sell com- peting goods. Sigma Two Group asked NAF to step in to resolve the domain-name conflict. NAF considered the “magical fireflies” case on the basis of its authority under the Uniform Domain Name Dispute Resolution Policy (UDRP) of the Internet Corporation for

Assigned Names and Numbers, known as ICANN. NAF determined that the domain names magicalfireflies.com and fireflymagic.com were confusingly similar. It also ruled that Avenstar had no rights or legitimate interest in the domain name magicalfireflies.com and that, in fact, the company had registered and used the domain name in bad faith. The result was that Avenstar was required to transfer the domain name magicalfireflies.com to Sigma Two.

An important advantage of using the ADR policy outlined in ICANN is that it is faster and cheaper than pursuing litigation based on trade- mark law. NAF relies on its panel of legal experts, who apply their knowledge of trademark, copyright, and e-commerce law. In ruling on the magical fireflies case, an attorney for Sigma Two pointed out that “[i]t’s important for businesses with similar problems to know there is a speedy and relatively inexpensive dispute resolution process that may resolve their problem short of litigating in federal court.”

Source: “Christie, Parker & Hale, LLP Wins Favorable Ruling for Client Sigma Two Group LLC in Domain Name Dispute,” Business Wire, July 9, 2008.

23 Michael H. Diamant et al., “Strategies for Mediation, Arbitration, and Other Forms of Alternative Dispute Resolution,” SK074 ALI-ABA 205 (2005), citing the CPR Institute for Dispute Resolution, www.cprador.org .

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do not have to have any specific training; however, because retired judges often serve as referees, this method is often referred to as “rent-a-judge.”

Generally, a private trial occurs after a case has been filed in district or state court. After the parties have engaged in discovery and developed their positions, the parties may choose to participate in a private trial. The parties would typically notify the trial judge overseeing their case that they are participating in a private trial. The disputing parties determine the time and place of the trial and conduct the trial in private to ensure confi- dentiality. The referee writes a report stating the findings of fact and the conclusions of the law. This report is filed with the trial judge; however, if any party is dissatisfied with the resolution of the case, the party can request a trial before a trial court judge. If this request is denied, the party can appeal the decision of the referee.

Recently, private firms have started to offer private jury trials. The jurors are hired by the private firms and are often better educated than typical jurors and have served in mul- tiple private jury trials. Many scholars criticize the typical jury because they believe that such a jury is unable to accurately fulfill its role as fact finder. Thus, offering a better- educated, experienced jury helps assuage criticisms of the jury yet offers the advantage of judgment by a jury of peers.

The private trial has been criticized for several reasons. First, scholars argue that use of the private trial could lead to a two-tiered system of justice. Those who have financial resources can afford a private trial that is much faster than litigation, while those who are lacking resources are forced to use the slower public system. Second, private trials, like arbitration, have been criticized because they allow disputing parties to “hide” the dispute from the public.

Court-Annexed ADR The 1998 Alternative Dispute Resolution Act required that in all district courts, civil liti- gants must “consider the use of an alternative dispute resolution process at an appropriate stage in the litigation.” However, each district court can decide whether to require ADR. Some courts mandate certain forms of ADR, while other courts make ADR completely

ADR in Japan

Some judges, lawyers, and politicians in the United States advo- cate the adoption of Japan’s ADR techniques into the U.S. judiciary system. The techniques come in three forms: compromise, concili- ation, and arbitration.

Compromise (wakai) is defined as a contractual agreement between parties that becomes the basis for a voluntary settlement. Due to the voluntary nature, no compromise is possible if one party does not wish to settle. Compromise may be proposed at three dis- tinct times. First, a simple compromise may be reached before the initiation of a suit. Second, after initiation, but before litigation, the parties may appear in court and present a compromise. Such a compromise is legally binding on both parties. Third, parties may compromise during litigation, which is when most compromises occur. It has been estimated that nearly one-third of all disputes are settled using compromise.

COMPARING THE LAW OF OTHER COUNTRIES

The second ADR technique used in Japan is conciliation (chotei). Conciliation, reaching compromise through a third party’s interven- tion, has been a part of Japanese culture for hundreds of years. In modern times, conciliation committees consist of one judge and two appointed members of the community. Acceptance of the com- mittee’s recommendation is not necessary, but if the parties wish to concede, the recommendation has the force of a judgment.

The final type of ADR is arbitration (chusai). The arbitration pro- cedure in Japan is markedly similar to that in the United States. A two- or three-judge panel reaches a recommendation that is a binding decision.

The success and popularity of all three types of ADR in Japan are attributed to the attitudes of the citizens. People in Japan are reluctant to bring a lawsuit against a fellow citizen. To them, using ADR is a less brash way to resolve a dispute than suing someone outright. Obviously, this attitude is quite distinct from that of the American legal culture.

LO3

What is court-annexed ADR?

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voluntary. Some simply mandate that all potential litigants be informed about alternatives to litigation. Some courts refer almost all civil cases to ADR, while others refer cases according to subject matter.

Mediation is the primary ADR process used in federal district courts. In the federal sys- tem, most of the district courts and almost all the circuit courts have mediation programs using judges or lawyers as mediators. Mediation programs are also under way in more than one-third of the state courts and in many bankruptcy courts. The Fourth Circuit Court of Appeals held at least one mediation conference in 675 cases in fiscal year 2002, 600 cases in fiscal year 2003, and 623 cases in fiscal year 2004. 24

The district courts vary greatly in terms of which ADR methods are approved. For example, in the Northern District Court of Alabama, each judge conducts an ADR evalu- ation conference to determine whether a case is appropriate for ADR. The case could be either arbitrated or mediated. In contrast, in the Northern District of California, arbitration, mediation, early neutral evaluation, and settlement conferences have been approved for use, and approximately 43 percent of parties choose mediation. 25 The ADR staff of the Northern District of California also works with parties to structure a nonbinding summary bench or jury trial. The judicial officer may order a nonbinding arbitration to all simple contract and tort cases under $100,000.

Moreover, some courts use ADR to resolve particular disputes within a case. For example, some judges appoint special masters or discovery masters to assist in resolving complex disputes. The special master may mediate discovery disputes within the case and make discovery rulings if the parties cannot resolve the disputes. A judge may also be creative in employing ADR methods to resolve discovery disputes. When the parties could not agree to a location for a deposition, a Florida district court judge created a new form of ADR technique by ordering the parties to “convene at a neutral site agreeable to both parties. If counsel cannot agree on a neutral site, they shall meet on the front steps of the [courthouse]. Each lawyer shall be entitled to be accompanied by one paralegal who shall act as an attendant and witness. At that time and location, counsel shall engage in one (1) game of ‘rock, paper, scissors.’ The winner of this engagement shall be entitled to select the location for the 30(b)(6) deposition. . . .” 26

Appellate courts also use ADR techniques. All 13 appellate courts have created pro- grams to help parties resolve issues on appeal. These programs typically encourage mediation. For example, the Tenth Circuit’s mediation office may schedule a mandatory settlement conference for any civil case on its docket. Once the conference is scheduled, the parties are required to participate. The purpose of the conference is to explore the pos- sibility of settlement.

Use of ADR in International Disputes Think, for a moment, how difficult litigation would be for an international dispute. Where would the case be heard? Who would decide the case? What kinds of awards would be offered? Because these questions are difficult to answer in the global context, ADR is favored over litigation. For example, the European Union has been considering a directive

24 Robert J. Niemic, Mediation & Conference Programs in the Federal Courts of Appeals: A Sourcebook for Judges and Lawyers, 2nd ed. University of Michigan Library: Ann Arbor:: 2006, p. 40.

25 Justin Scheck, “The Option to Be Heard,” The Recorder, January 2, 2007, p. 7.

26 Avista Management, Inc. v. Wausau Underwriters Ins. Co., Case No. 6:05-cv-1430-Orl-31JGG, District Court for the Middle District of Florida (Order of June 6, 2006).

LO4

How is ADR used in international disputes?

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that would offer mediation as a dispute resolution option for companies doing business in Europe. 27

Currently, 144 countries belong to the United Nations Convention on the Recogni- tion and Enforcement of Foreign Arbitral Awards, otherwise known as the New York Convention. This treaty ensures that an arbitration award will be enforced by countries that are parties to the treaty. There are three defenses to lack of enforcement of the arbitration award. First, the arbitrator acted outside the scope of her or his authority when making the decision. Second, one of the parties to the agreement did not have the authority to enter into a legal contract. Third, the losing party did not receive notice of the arbitration.

Various organizations offer dispute resolution methods for international companies. These organizations include the American Arbitration Association, the International Chamber of Commerce, the United Nations Commission of International Trade Law, and the London Court of International Arbitration. The number of arbitration cases they hear each year is not insubstantial; the International Chamber of Commerce Commission on Arbitration alone heard 541 arbitration cases in 2000. 28

The United States favors arbitration for resolution of international disputes. The Mitsubishi case illustrates this U.S. policy (see the Case Nugget). Similarly, given that arbitration in Japan and China has become increasingly popular, the Japan Commercial Arbitration Association (JCAA) and the China International Economic and Trade Arbitra- tion Commission (CIETAC) have revised their rules to encourage the filing of international arbitration cases in Japan. 29

27 C. Mark Baker and Aníbal M. Sabater, “Continental Drift: The European Union Tries to Warm Up to ADR, but Its Embrace Is Tentative, at Best,” National Law Journal, November 27, 2006, p. 14. 28 Emmanuel Gaillard, “The New ADR Rules of the International Chamber of Commerce,” New York University Law Journal, October 10, 2001, p. 3. 29 Melanie Ries and Bryant Woo, “International Arbitration in Japan & China: A Review of the Revised Arbitration Rules of the JCAA and CIETAC,” Dispute Resolution Journal 61 (November 2006–January 2007), p. 63.

Preference for Arbitration

Mitsubishi Motors Corp. v. Soler Chrysler-Plymouth 473 U.S. 614 (1985)

Plaintiff Mitsubishi Motors was a joint-venture company formed by a Swiss and a Japanese firm to engage in the worldwide distribution of motor vehicles manufactured in the United States and bearing Mitsubishi and Chrysler trademarks. Defendant Soler Chrysler- Plymouth, a dealership incorporated in Puerto Rico, entered into a distributorship agreement with Mitsubishi that included a binding arbitration clause. Defendant Soler began to have difficulty selling the requisite number of cars, so it asked Mitsubishi to delay ship- ment of several orders. The defendant refused to accept liability for its failure to sell vehicles under the contract. In accordance with a binding arbitration clause in the distribution agreement, plain- tiff Mitsubishi filed an action to compel arbitration. The district court ordered arbitration of all claims, including the defendant’s

CASE NUGGET

allegations of antitrust violations. The court of appeals reversed in favor of Soler Chrysler-Plymouth. Plaintiff Mitsubishi appealed to the U.S. Supreme Court.

The Supreme Court considered whether an American court could enforce an agreement to resolve antitrust claims by arbi- tration when that agreement arises from an international trans- action. The Supreme Court found that the liberal policy favoring arbitration agreements in the Arbitration Act “creates a body of federal substantive law establishing and regulating the duty to honor an agreement to arbitrate.” The Supreme Court concluded that “concerns of international comity, respect for the capacities of foreign and transnational tribunals, and sensitivity to the need of the international commercial system for predictability in the resolution of dispute” required that the Court enforce the parties’ agreement.

The Supreme Court decided in favor of Mitsubishi, requiring “this representative of the American business community to honor its bargain” by holding the agreement to arbitrate enforceable.

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Hooters The District Court of Virginia denied Hooters’ petition to compel arbitration. Hooters appealed to the Fourth Circuit Court of Appeals, which likewise refused to enforce the arbitration agreement. The court held that although an agreement to arbitrate sexual harass- ment claims is generally enforceable, the employer in this particular case promulgated “egregiously unfair” arbitration rules that called into question its contractual obligation to draft the arbitration rules in good faith. 30 The court found the arbitration rules so one- sided that it concluded, “Their only possible purpose is to undermine the neutrality of the proceeding.” Thus, when employers create mandatory arbitration agreements, they should consider the principles of fairness when drafting these agreements.

Although the procedures that turned the arbitration proceeding into a one-sided affair clearly need to be redrafted, Hooters did do some things well. For example, it clearly stipu- lated in the agreement exactly which claims were going to be arbitrated, thereby giving employees full notice of the rights they were giving up. It also gave employees five days to think about signing the agreement. Had Hooters’ provided full details of the arbitration procedures, employees would have had time to review and consider the contents of the agreement.

CASE OPENER WRAP-UP

30 Hooters of America, Inc. v. Phillips, 173 F.3d 933 (4th Cir.1999).

adversarial negotiation 69

alternative dispute resolution (ADR) 68

arbitration 72

binding arbitration clause 75

med-arb 83

mediation 70

minitrial 84

negotiation 69

private trial 84

problem-solving negotiation 69

submission agreement 75

summary jury trial 83

Key Terms

Negotiation: An informal bargaining process, with or without lawyers, to try to solve a dispute.

Arbitration: An ADR method in which a neutral third party (known as the arbitrator) hears both parties’ cases and renders a binding decision.

Summary jury trial: An abbreviated trial that leads to a nonbinding jury verdict.

Minitrial: An ADR method in which a neutral adviser oversees presentation of the dispute, with the settlement authority residing with the senior executives of the disputing corporations.

Summary of Key Topics Primary Forms of Alternative Dispute Resolution

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Should Companies Be Permitted to Include Binding Arbitration Clauses in Consumer Contracts?

YES NO

Arbitration is a much faster way to resolve a likely small dispute. Through the discovery process, a defendant could draw out a case for two to three years before the case would actually go to trial. Thus, the consumer benefits from the binding arbitration clause because it forces the defendant to resolve the dispute quickly.

According to a recent study by Ernst & Young, 55 per- cent of consumer arbitrations were resolved in the con- sumer’s favor.* Another study suggested that 93 percent of people who participated in arbitration thought that they were treated fairly.† Consumers receive fair and fast treat- ment through mandatory arbitration.

Consumers have a choice as to whether to purchase a good or service, and in some cases the purchase may include a requirement on how disputes will be resolved. If a consumer is opposed to a mandatory arbitration clause, the consumer can purchase the good or service from another provider. In conclusion, companies should be per- mitted to include binding arbitration clauses in their con- sumer contracts.

Arbitration may require that the consumer pay more up-front costs to begin the dispute resolution process. For example, the consumer may have to pay for the costs of the arbitrator. To file a complaint, a consumer has to pay filing fees only, which cost around $150. To file a claim through the American Arbitration Associa- tion, a consumer has to pay between $500 and $1,000, and the consumer is required to advance the arbitrator’s fees.

Many consumers are not likely to read all the fine print when applying for a credit card or purchasing a service. A consumer has no bargaining power to remove a manda- tory arbitration clause from the contract; consequently, the consumer has no choice. It is unfair to force a consumer to submit a dispute to arbitration when she or he has no power to bargain regarding that aspect of the sales or ser- vice contract.

Finally, because arbitration is secret, a company can “hide” its disputes from the general public. The public exposure associated with lawsuits encourages companies to better respond to and resolve disputes. In conclusion, consumers are harmed more than helped by binding arbi- tration clauses in consumer contracts.

Early neutral case evaluation: An ADR method in which parties independently explain their positions to a neutral third party who evaluates the strengths and weaknesses of the case. This evaluation guides them in their settlement.

Private trial: A trial in which the disputing parties select and pay a referee to provide a legally binding judgment in a dispute.

Programs whereby courts encourage or mandate that parties use some form of ADR before they bring a dispute to trial.

ADR is favored in international disputes.

* Ernst & Young, “Outcomes of Arbitration: An Empirical Study of Consumer Lending Cases,” www.adrforum.com/rcontrol/documents/ResearchStudiesAndStati stics/2005ErnstAndYoung.pdf .

† “Report to the Securities and Exchange Commission Regarding Arbitrator Conflict Disclosure Requirements in NASD and NYSE Securities Arbitrations,” www. nyse.com/pdfs/arbconflict.pdf .

Court-Annexed ADR

Use of ADR in Interna- tional Disputes

Other ADR Methods

Binding arbitration clauses are often included in con- sumer contracts and even in consumer bills. For exam- ple, if you open a credit card account, the terms and

conditions of the credit application will likely require that you submit any dispute you have to binding arbitration.

Point / Counterpoint

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1. What are the advantages and disadvantages of ADR?

2. When will a court overturn an arbitrator’s decision?

3. What type of ADR is preferred for resolving inter- national disputes?

4. Unity Communications Corp. resold phone services provided by Cingular pursuant to a reseller agree- ment that included an arbitration clause. Unity sued Cingular in federal district court, alleging breach of contract. The parties engaged in pretrial activity, and Cingular filed a motion for summary judgment regarding a letter agreement between Unity and Cingular. The district court denied the motion for summary judgment, and on appeal the Fifth Circuit affirmed the district court’s decision. On remand before the district court, Cingular moved the court to compel arbitration. The district court ruled that Cingular had waived its right to arbitration by par- ticipating in the litigation and waiting three years to raise the arbitration argument. Do you think the appellate court agreed? Why? [ Unity Communica- tions Corp. v. Cingular Wireless, 256 Fed. App. 679 (5th Cir. 2007).]

5. General Dynamics sent out a companywide e-mail to its employees announcing a policy requiring arbitration of employment disputes. Some time after the e-mail was sent, an employee filed a law- suit arguing that he was fired because of a disabil- ity. General Dynamics argued that the employee should be required to arbitrate his claim under the new company policy. Do you think the court required that the employee arbitrate his claim? Why? [ Campbell v. General Dynamics (D. Mass. 2004).]

6. The plaintiffs, members of the International Broth- erhood of Teamsters, Local 30, sued the Turnpike Commission, arguing that the commission was violating the Fair Labor Standards Act (FLSA) by imposing a fluctuating-hours method of compensa- tion on the plaintiffs. The grievance first went to mediation; when this process was unsuccessful, the lawsuit was filed. The plaintiffs sought to introduce evidence of statements made by one of the com- mission’s attorneys during depositions taken for and introduced in the mediation. They sought to introduce the evidence on the grounds that it was

necessary for them to establish their retaliation claim under the FLSA. The defendants argued that the statements, which were made for the purpose of furthering the mediation process, should not be admissible in court. How do you believe the court ruled in this case? Why? [ Patsy B. Sheldone et al. v. Pennsylvania Turnpike Commission, 48 Fed. R. Serv. 3d 943 (2001).]

7. Miller injured her arm while at work at Public Storage Management. She took a medical leave for eight months. At the end of the leave, she was unable to return to work and was fired. Miller filed suit against Public Storage Management for viola- tion of the Americans with Disabilities Act. Miller’s employment contract included an arbitration clause mandating that any controversy over employment discrimination be resolved through arbitration. How did the court of appeals rule? Why? [ Miller v. Public Storage Management, Inc., 121 F.3d 215 (5th Cir. 1997).]

8. When Matthew Shankle was hired by B-G Main- tenance Management, he signed an employment agreement that included a binding arbitration clause. This clause stated that any disputes between Shankle and B-G were to be resolved through arbi- tration and that Shankle would “be responsible for one-half of the arbitrator’s fees, and the company is responsible for the remaining half.” Shankle was fired, and he brought suit against B-G for employment discrimination. B-G moved to man- date arbitration. The arbitrator required a $6,000 deposit. The district court ruled in Shankle’s favor, refusing to compel arbitration because the fee- splitting requirement was held to be unenforceable. B-G appealed. Did the appellate court agree with Shankle? Why or why not? [ Shankle v. B-G Main- tenance Management of Colorado, 163 F.3d 1230 (10th Cir. 1999).]

9. The Fair Labor Standards Act (FLSA) requires payment of overtime to employees who work more than 40 hours a week unless the employee is in an “administrative” or “executive” position. Delfina Montes worked more than 40 hours a week for Shearson Lehman, and the firm did not pay her overtime on the grounds that she held an

Questions & Problems

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administrative position that was exempt from the FLSA overtime requirement. An arbitrator hear- ing this case decided in favor of Shearson Lehman. Montes petitioned the district court to vacate the arbitration board’s decision because Shearson’s attorney made the following statements before the arbitration board: “[Y]ou as an arbitrator are not guided strictly to follow case precedent”; “You have to decide whether you’re going to follow the statutes that have been presented to you, or whether you will do .  .  . what is right and just and equi- table in this case.” Montes argued that the arbitrator could not simply ignore the law when arbitrating a case, which was what she felt Shearson’s attorneys had asked the arbitrator to do.

Montes’s petition was denied by the district court. How do you believe the court of appeals ruled in this case? Why? [ Delfina Montes v. Shearson Lehman Brothers, Inc., 128 F.3d 1456 (11th Cir. 1997).]

10. After Joel Varela died due to a work-related acci- dent, his spouse and children filed a wrongful death action against his employee, Igloo Products Corp. Igloo filed a motion to compel arbitration under the terms of the arbitration agreement that Varela had signed in connection with his participation in an employee injury benefit plan. The trial court denied the motion to compel arbitration. What do you think happened on appeal? Why? [ In re Igloo Products Corp., 238 S.W.3d 574 (Tex. App. 2007).

Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

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LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

C H A P T E R

Constitutional Principles

1 What is federalism?

2 How does the U.S. government’s system of checks and balances operate?

3 What effects does the commerce clause have on the government’s regulation of business?

4 How does the Bill of Rights protect the citizens of the United States?

CASE OPENER Restricting Retail and the Commerce Clause

In January 2002, Islamorada, a Florida municipality, enacted an ordinance that prohibited “formula retail stores” from exceeding a specified street-level frontage and total square footage. According to the ordinance, formula retail stores included those businesses required to “maintain any of the following: standardized array of services or merchandise, trademark, logo, service mark, symbol, décor, architecture, layout, uniform, or similar standardized feature.” As justification for the ordinance, Islamorada cited an interest in preserving its “small-town community.”

Later that year, Island Silver, the owner and operator of an existing retail store in Islamorada, entered into a contract to sell its property to a developer who wished to build a Walgreens drugstore. The property in question was zoned for highway commercial use under the local code and could be used for a retail department store (including a pharmacy) such as Walgreens. The developer planned to maintain the existing building but modify the layout and appearance to meet the standards set forth by Walgreens. Ultimately, the developer withdrew because the challenges associated with the formula-retail- store ordinance would prevent Walgreens from opening the location. Island Silver sued Islamorada for damages and injunctive relief on the grounds that the ordinance violated, among other things, the commerce clause.

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On February 28, 2007, the district court ruled in favor of Island Silver. The court found that the ordinance violated the dormant commerce clause by having a discriminatory impact on interstate commerce. Additionally, the court ruled that the putative local benefits were outweighed by the burden imposed on interstate commerce. Islamorada appealed the judgment to the Eleventh Circuit Court of Appeals. 1

1. Does Islamorada’s ordinance violate the commerce clause? Why or why not?

2. Did Islamorada indicate a legitimate purpose to justify the use of the ordinance? Why or why not?

The Wrap-Up at the end of the chapter will answer these questions.

The U.S. Constitution sets forth the framework of our nation’s government; it estab- lishes a system of government that divides power between the federal government and the states. This system of government provides the focus for this chapter.

In this chapter we examine the constitutional provisions that affect business. Then we turn our focus to the primary source of the federal government’s authority to regulate business: the commerce clause. We next examine the federal government’s authority to tax and spend. Finally, in the last part of the chapter, we focus on how several amendments to the Constitution affect business.

The U.S. Constitution The U.S. Constitution establishes a system of government based on the principle of federalism, according to which the authority to govern is divided between federal and state governments. According to the Tenth Amendment to the Constitution, all powers that the Constitution neither gives exclusively to the federal government nor takes from the states are reserved for the states. Because the federal government has only those powers granted to it by the Constitution, federal legislation that affects business must be based on an expressed constitutional grant of authority.

In addition to allocating authority between state and federal governments, the Constitu- tion allocates the power of the federal government among the three branches of govern- ment. The first three articles of the Constitution establish three independent branches of the federal government: the legislative, executive, and judicial branches. The Constitution ensures that each branch maintains a separate sphere of power to prevent any one branch from obtaining undue power and monopolizing control of government.

The Constitution also establishes a system of checks and balances. Each branch’s pow- ers keep the other branches from dominating the government. For example, Congress, the legislative or lawmaking branch, has the power to enact legisla- tion, but the president can veto a law that Congress passes. The legislature, however, can overturn a presidential veto with a two-thirds vote of the members of Congress. And if Congress passes a bill and the president signs it, the judi- ciary can strike it down as unconstitutional. Exhibit 5-1 illustrates the system of checks and balances in more detail.

Legal Principle: Under the current system of checks and balances, each branch of government has its own distinct responsibilities, and each

1 Island Silver & Spice et al. v. Islamorada, 542 F.3d 844 (11th Cir. 2008).

LO1

What is federalism?

To see how the system of checks and balances relates to the checks and balances taught in internal con- trols in accounting, please see the Connecting to the Core activity on the text Web site at www.mhhe.com/ kubasek2e.

LO2

How does the U.S. government’s system

of checks and balances operate?

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one has its powers checked by the other two branches to ensure that no branch has enough unchecked power to take control of the government.

JUDICIAL REVIEW Although the Constitution does not explicitly allow courts to review legislative and executive actions to determine whether they are constitutional, early common law established this process, which is known as judicial review. In the landmark 1803 U.S. Supreme Court case Marbury v. Madison, 2 Chief Justice John Marshall wrote for the majority:

[I]f a law be in opposition to the constitution; if both the law and the constitution apply to a particular case, so that the court must either decide that case [conforms] to the law, disre- garding the constitution; or [conforms] to the constitution, disregarding the law; the court must determine which of these conflicting rules governs the case. This is of the very essence of judicial duty.

Judicial review also allows courts to review the constitutionality of lower courts’ decisions.

Exhibit 5-1 The System of Checks and Balances

– Can pass amendments to overrule judicial rulings – Can impeach judges – Establishes lower courts and sets number of judges

– Can declare laws passed by Congress unconstitutional

– Can veto laws passed by legislative branch – Can call special sessions of Congress

– Can refuse to approve president's budget – Can overrule presidential vetoes – Can refuse to approve presidential appointments – Can refuse to ratify treaties – Can impeach and remove president

– Can declare acts of the executive branch unconstitutional

– Appoints federal judges – Can pardon federal offenders

Executive BranchJudicial Branch

Legislative Branch

2 5 U.S. 137 (1803).

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The Supremacy Clause and Federal Preemption The supremacy clause, located in Article VI of the Constitution, provides that the Constitution, laws, and treaties of the United States constitute the supreme law of the land, “any Thing in the Constitution or Laws of any State to the Contrary notwithstanding.” Any state or local law that directly conflicts with the Constitution, federal laws, or treaties is void. Federal laws include rules passed by federal administrative agencies. For example, the Federal Aviation Administration has banned the use of cell phones on airplanes. If a Missouri law permitted cell phone usage on airplanes, it would be unconstitutional according to the supremacy clause.

In some areas, the state and federal governments have concurrent authority; that is, both governments have the power to regulate the same subject matter. In such cases, the states may regulate in the area as long as a person’s compliance with the state regulation would not cause him or her to be in violation of a federal regulation. For example, Con- gress has established a number of environmental standards, but some states have passed even more protective standards.

Sometimes, however, in areas where the state and federal governments have concurrent authority, the federal government can decide to regulate that area exclusively. In such a sit- uation, according to the doctrine of federal preemption, the state law is unconstitutional. To determine whether Congress intended to provide exclusive regulation, courts look to the language of the statute and transcripts of congressional hearings.

The Commerce Clause The primary source of authority for federal regulation of business is the commerce clause, located in Article I, Section 8, of the Constitution. This clause states that the U.S. Congress has the power to “regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.” This allocation of authority simultaneously empowers the federal government and restricts the power of state governments . For example, in the open- ing vignette, the plaintiff believed the commerce clause restricted the power of the local government that was effectively burdening out-of-state competitors through its formula- retail-stores ordinance.

THE COMMERCE CLAUSE AS A SOURCE OF AUTHORITY FOR THE FEDERAL GOVERNMENT Today, most federal regulations are exercises of congressional authority under the com- merce clause. As long as a law affects commerce among the states, or interstate commerce, in some way, the regulation is generally constitutional. The phrase “among the several states” has been subject to changing interpretations throughout U.S. history. Prior to the 1930s, courts interpreted the clause very strictly, requiring that the regulated activity actu- ally involve trade between states. This interpretation limited federal regulation of business.

In the 1930s, however, the Supreme Court began to interpret the commerce clause more broadly. The 1937 case NLRB v. Jones & Laughlin Steel Corp. was a turning point in the Supreme Court’s interpretation of the commerce clause. In that case, the Court ruled that Congress could regulate labor relations at a manufacturing plant because a work stop- page at the plant would seriously affect interstate commerce. The Court stated, “Although activities may be intrastate in character when separately considered, if they have such a close and substantial relationship to interstate commerce that their control is essential or appropriate to protect that commerce from burdens or obstructions, Congress cannot be

LO3

What effects does the commerce clause have

on the government’s regulation of business?

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denied the power to exercise that control.” 3 Since that case, Congress has regulated a broad range of business activities according to the commerce clause, through legislation such as the Federal Mine Safety and Health Act, which sets standards for safety in coal mines; the Americans with Disabilities Act, which prohibits firms from discriminating against employees and potential employees who have disabilities; and the Consumer Protection Act, which criminalizes certain loan-sharking activities. Although businesses have chal- lenged statutes like these as being beyond the scope of congressional power, courts have upheld the statutes as valid exercises of congressional authority according to the commerce clause. 4

The 1995 case United States v. Lopez, 5 however, marked another significant change in the Supreme Court’s interpretation of the commerce clause. In Lopez, the Court ruled that Congress had exceeded its commerce clause authority when it passed the Gun-Free School Zone Act, a law banning the possession of guns within 1,000 feet of any school. In its rul- ing, the Court said that Congress could not regulate in an area that had “nothing to do with commerce, or any sort of economic enterprise.”

Case 5-1 illustrates how the Supreme Court applies the commerce clause to determine the constitutionality of congressional regulations.

3 NLRB v. Jones & Laughlin Steel Corp., 301 U.S. 1 (1937).

4 See U.S. v. Lake, 985 F.2d 265 (1995); International House of Pancakes v. Theodore Pinnock, 844 F. Supp. 574 (1993); and Perez v. United States, 402 U.S. 146 (1971).

5 514 U.S. 549 (1995).

Petitioner Christy Brzonkala met respondents Antonio Morrison and James Crawford at a campus party at Virginia Polytechnic Institute (Virginia Tech), where they were all students. At the party, the respondents allegedly assaulted and raped her. According to Brzonkala, during the months following the rape, Morrison made boasting, debasing, and vulgar remarks in the dormitory’s dining room about what he would do to women. Brzonkala alleged she become severely emotionally disturbed and depressed as a result of this attack and Morrison’s subsequent behavior. Conse- quently, she had to seek assistance from a university psy- chiatrist, who prescribed antidepressant medication. Shortly thereafter, she stopped attending classes and withdrew from the university.

Brzonkala filed a complaint against the respondents under the university’s Sexual Assault Policy. Morrison was initially found guilty and suspended for two semesters, but his punishment was ultimately set aside.

She then sued Morrison, Crawford, and Virginia Tech in federal court, alleging, among other claims, that Morrison’s

and Crawford’s attack violated the Violence Against Women Act. The respondents moved to dismiss the complaint on the grounds that it failed to state a claim and that the Act’s ( § 13981’s) civil remedy was unconstitutional.

The District Court found that Brzonkala’s complaint stated a claim against the respondents under § 13981, but dismissed the complaint because it concluded that Con- gress lacked constitutional authority to enact § 13981’s civil remedy. The United States Court of Appeals, by a divided vote, affirmed the District Court’s conclusion. Brzonkala appealed.

CHIEF JUSTICE REHNQUIST: . . . Section 13981 was part of the Violence Against Women Act of 1994.  .  . . It states that “[a]ll persons within the United States shall have the right to be free from crimes of violence motivated by gender.” To enforce that right, subsection (c) declares:

“A person .  .  . who commits a crime of violence moti- vated by gender and thus deprives another of the right declared in subsection (b) of this section shall be liable to

CHRISTY BRZONKALA v. ANTONIO J. MORRISON ET AL. UNITED STATES SUPREME COURT 120 S. CT. 1740 (2000)

CASE 5-1

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the party injured, in an action for the recovery of compensa- tory and punitive damages, injunctive and declaratory relief, and such other relief as a court may deem appropriate.” . . .

Every law enacted by Congress must be based on one or more of its powers enumerated in the Constitution. . . . [W]e turn to the question whether § 13981 falls within Congress’ power under Article I, § 8, of the Constitution. Brzonkala and the United States rely upon the third clause of the Arti- cle, which gives Congress power “[t]o regulate Commerce with foreign Nations, and among the several States, and with the Indian Tribes.”

As we discussed at length in Lopez, our interpretation of the Commerce Clause has changed as our Nation has developed. . . . Lopez emphasized, however, that even under our modern, expansive interpretation of the Commerce Clause, Congress’ regulatory authority is not without effec- tive bounds.

. . . [M]odern Commerce Clause jurisprudence has “iden- tified three broad categories of activity that Congress may regulate under its commerce power.” . . . “First, Congress may regulate the use of the channels of interstate commerce.” . . . “Second, Congress is empowered to regulate and protect the instrumentalities of interstate commerce, or persons or things in interstate commerce, even though the threat may come only from intrastate activities.” . . . “Finally, Congress’ commerce authority includes the power to regulate those activities having a substantial relation to interstate com- merce, . . . i.e., those activities that substantially affect inter- state commerce.”

Petitioners . . . seek to sustain § 13981 as a regulation of activity that substantially affects interstate commerce. Given § 13981’s focus on gender-motivated violence wherever it occurs . . . we agree that this is the proper inquiry.

Since Lopez most recently canvassed and clarified our case law governing this third category of Commerce Clause regulation, it provides the proper framework for conduct- ing the required analysis of § 13981. In Lopez, we held that the Gun-Free School Zones Act of 1990, which made it a federal crime to knowingly possess a firearm in a school zone, exceeded Congress’ authority under the Commerce Clause. Several significant considerations contributed to our decision.

First, we observed that § 922(q) was “a criminal stat- ute that by its terms has nothing to do with ‘commerce’ or any sort of economic enterprise, however broadly one might define those terms.” .  .  . [T]he pattern of analysis is clear. “Where economic activity substantially affects inter- state commerce, legislation regulating that activity will be sustained.”

Both petitioners and Justice Souter’s dissent downplay the role that the economic nature of the regulated activity plays in our Commerce Clause analysis. But a fair reading of Lopez shows that the noneconomic, criminal nature of the conduct at issue was central to our decision in that case. . . .

Lopez’s review of Commerce Clause case law demonstrates that in those cases where we have sustained federal regula- tion of intrastate activity based upon the activity’s substan- tial effects on interstate commerce, the activity in question has been some sort of economic endeavor.

The second consideration that we found important in analyzing § 922(q) was that

the statute contained “no express jurisdictional ele- ment which might limit its reach to a discrete set of firearm possessions that additionally have an explicit connection with or effect on interstate com- merce.” Such a jurisdictional element may establish that the enactment is in pursuance of Congress’ regulation of interstate commerce.

Third, we noted that neither § 922(q) “nor its legislative history contain[s] express congressional findings regarding the effects upon interstate commerce of gun possession in a school zone.” . . . While “Congress normally is not required to make formal findings as to the substantial burdens that an activity has on interstate commerce,” the existence of such findings may “enable us to evaluate the legislative judgment that the activity in question substantially affect[s] interstate commerce, even though no such substantial effect [is] vis- ible to the naked eye.”

Finally, our decision in Lopez rested in part on the fact that the link between gun possession and a substantial effect on interstate commerce was attenuated. The United States argued that the possession of guns may lead to vio- lent crime, and that violent crime “can be expected to affect the functioning of the national economy in two ways. First, the costs of violent crime are substantial, and, through the mechanism of insurance, those costs are spread throughout the population. Second, violent crime reduces the willing- ness of individuals to travel to areas within the country that are perceived to be unsafe.” The Government also argued that the presence of guns at schools poses a threat to the edu- cational process, which in turn threatens to produce a less efficient and productive workforce, which will negatively affect national productivity and thus interstate commerce.

We rejected these “costs of crime” and “national pro- ductivity” arguments because they would permit Congress to “regulate not only all violent crime, but all activities that might lead to violent crime, regardless of how tenuously they relate to interstate commerce.” We noted that, under this but- for reasoning: “Congress could regulate any activity that it found was related to the economic productivity of individual citizens: family law (including marriage, divorce, and child custody), for example. Under the[se] theories . . . , it is difficult to perceive any limitation on federal power, even in areas such as criminal law enforcement or education where States histori- cally have been sovereign. Thus, if we were to accept the Gov- ernment’s arguments, we are hard pressed to posit any activity by an individual that Congress is without power to regulate.”

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With these principles underlying our Commerce Clause jurisprudence as reference points, the proper resolution of the present cases is clear. Gender-motivated crimes of vio- lence are not, in any sense of the phrase, economic activity. While we need not adopt a categorical rule against aggre- gating the effects of any noneconomic activity in order to decide these cases, thus far in our Nation’s history our cases have upheld Commerce Clause regulation of intrastate activ- ity only where that activity is economic in nature.

Like the Gun-Free School Zones Act at issue in Lopez, § 13981 contains no jurisdictional element establishing that the federal cause of action is in pursuance of Congress’ power to regulate interstate commerce.

In contrast with the lack of congressional findings that we faced in Lopez, § 13981 is supported by numerous findings regarding the serious impact that gender-motivated violence has on victims and their families.  .  . . But the existence of congressional findings is not sufficient, by itself, to sustain the constitutionality of Commerce Clause legislation. As we stated in Lopez, “[S]imply because Congress may conclude that a particular activity substantially affects interstate com- merce does not necessarily make it so.” . . . Rather, “[w]hether particular operations affect interstate commerce sufficiently to come under the constitutional power of Congress to reg- ulate them is ultimately a judicial rather than a legislative question, and can be settled finally only by this Court.”

In these cases, Congress’ findings are substantially weak- ened by the fact that they rely so heavily on a method of rea- soning that we have already rejected as unworkable if we are to maintain the Constitution’s enumeration of powers. Con- gress found that gender-motivated violence affects interstate commerce “by deterring potential victims from traveling inter- state, from engaging in employment in interstate business, and from transacting with business, and in places involved in interstate commerce; . . . by diminishing national productivity, increasing medical and other costs, and decreasing the sup- ply of and the demand for interstate products.” Given these findings and petitioners’ arguments, the concern that we expressed in Lopez that Congress might use the Commerce Clause to completely obliterate the Constitution’s distinction between national and local authority seems well founded.

The reasoning that petitioners advance seeks to follow the but-for causal chain from the initial occurrence of vio- lent crime (the suppression of which has always been the prime object of the States’ police power) to every attenu- ated effect upon interstate commerce. If accepted, petition- ers’ reasoning would allow Congress to regulate any crime as long as the nationwide, aggregated impact of that crime has substantial effects on employment, production, transit, or consumption. Indeed, if Congress may regulate gender- motivated violence, it would be able to regulate murder or any other type of violence since gender-motivated violence, as a subset of all violent crime, is certain to have lesser eco- nomic impacts than the larger class of which it is a part.

We accordingly reject the argument that Congress may regulate noneconomic, violent criminal conduct based solely on that conduct’s aggregate effect on interstate com- merce. The Constitution requires a distinction between what is truly national and what is truly local.  .  . . In rec- ognizing this fact we preserve one of the few principles that has been consistent since the Clause was adopted. The regulation and punishment of intrastate violence that is not directed at the instrumentalities, channels, or goods involved in interstate commerce has always been the prov- ince of the States.

AFFIRMED in favor of respondents.

Dissent JUSTICE SOUTER, with whom Justice Stevens, Justice Ginsberg, and Justice Breyer join:

.  .  . Congress has the power to legislate with regard to activity that, in the aggregate, has a substantial effect on interstate commerce. The fact of such a substantial effect is not an issue for the courts in the first instance, but for the Congress, whose institutional capacity for gathering evidence and taking testimony far exceeds ours. By pass- ing legislation, Congress indicates its conclusion, whether explicitly or not, that facts support its exercise of the com- merce power. The business of the courts is to review the con- gressional assessment, not for soundness but simply for the rationality of concluding that a jurisdictional basis exists in fact. Any explicit findings that Congress chooses to make, though not dispositive of the question of rationality, may advance judicial review by identifying factual authority on which Congress relied.

One obvious difference from United States v. Lopez is the mountain of data assembled by Congress, here showing the effects of violence against women on interstate commerce. Passage of the Act in 1994 was preceded by four years of hearings, which included testimony from physicians and law professors; from survivors of rape and domestic vio- lence; and from representatives of state law enforcement and private business. The record includes reports on gender bias from task forces in twenty-one states, and we have the ben- efit of specific factual findings of the eight separate Reports issued by Congress and its committees over the long course leading to enactment.

Having identified the problem of violence against women, Congress may address what it sees as the most threatening manifestation. . . . Congress found that “crimes of violence motivated by gender have a substantial adverse effect on interstate commerce, by deterring potential victims from traveling interstate, from engaging in employment in interstate business, and from transacting with business, and in places involved, in interstate commerce .  .  . [,] by diminishing national productivity, increasing medical and other costs, and decreasing the supply of and the demand for interstate products. . . .”

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Explain why you find the reasoning in either the majority or minority opinion more persuasive.

ETHICAL DECISION MAKING CRITICAL THINKING

Explain how different stakeholders would be the primary beneficiaries of the majority and minority decisions.

[continued]

Congress thereby explicitly stated the predicate for the exercise of its Commerce Clause power. Is its conclusion irrational in view of the data amassed? True, the methodol- ogy of particular studies may be challenged, and some of the figures arrived at may be disputed. But the sufficiency of the evidence before Congress to provide a rational basis for the finding cannot seriously be questioned. . . . Indeed, the legislative record here is far more voluminous than the record compiled by Congress and found sufficient in two prior cases upholding Title II of the Civil Rights Act of 1964 against Commerce Clause challenges.

The fact that the Act does not pass muster before the Court today is therefore proof, to a degree that Lopez was not, that the Court’s nominal adherence to the substantial effects test is merely that. Although a new jurisprudence has not emerged with any distinctness, it is clear that some congres- sional conclusions about obviously substantial, cumulative

effects on commerce are being assigned lesser values than the once-stable doctrine would assign them. These devalua- tions are accomplished not by any express repudiation of the substantial effects test or its application through the aggrega- tion of individual conduct, but by supplanting rational basis scrutiny with a new criterion of review.

Thus, the elusive heart of the majority’s analysis in these cases is its statement that Congress’s findings of fact are “weakened” by the presence of a disfavored “method of rea- soning.” This seems to suggest that the “substantial effects” analysis is not a factual enquiry, for Congress in the first instance with subsequent judicial review looking only to the rationality of the congressional conclusion, but one of a rather different sort, dependent upon a uniquely judicial competence.

This new characterization of substantial effects has no support in our cases (the self-fulfilling prophecies of Lopez aside), least of all those the majority cites.

THE COMMERCE CLAUSE AS A RESTRICTION ON STATE AUTHORITY The federal government’s authority to regulate interstate commerce sometimes conflicts with the states’ authority to regulate intrastate commerce. Courts have attempted to resolve this conflict by distinguishing between regulations of commerce and regulations under states’ police power. Police power consists of the residual powers retained by each state to safeguard the health and welfare of its citizenry. Typical exercises of a state’s police power include state criminal laws, building codes, zoning laws, sanitation standards for restau- rants, and regulations for the practice of medicine.

Sometimes a state’s use of its police power affects interstate commerce. If the purpose of a state law is to regulate interstate commerce or to discriminate against interstate commerce, the law is usually unconstitutional. Likewise, if a law substantially interferes with interstate commerce, it is generally unconstitutional. This restriction on states’ authority to pass laws that substantially affect interstate commerce is called the dormant commerce clause.

Most cases are not so simple, however, and courts must balance the states’ interest in protecting their citizens against the impact on interstate commerce. In balancing these com- peting interests, a court generally asks whether the state regulation is rationally related to a legitimate state end. If it is, the court then asks whether the regulatory burden imposed on interstate commerce is outweighed by the state’s interest in enforcing the legislation. The court may also inquire whether there is a less drastic alternative available to attain the legiti- mate state purpose. In the opening vignette, the court is asked to determine whether Islamo- rada’s interest in preserving a small-town community is a legitimate purpose when weighed against the impact the ordinance has on interstate commerce by formula retail stores.

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Although the supremacy clause establishes the sovereignty of federal law, courts gener- ally presume that laws passed in accordance with states’ police power are valid. For exam- ple, the city of Chicago passed an ordinance banning spray paint in the city as a means to reduce graffiti. Paint manufacturers challenged the legislation as a violation of the dormant commerce clause, but the U.S. court of appeals upheld the legislation. 6 The legislation did not treat paint from out-of-state manufacturers any differently than paint from in-state manufacturers; it had been demonstrated that limiting the availability of spray paint would decrease the amount of graffiti; and it is within the states’ police power to determine that graffiti is not good for the public welfare. In the opening vignette, Islamorada could have had its ordinance upheld had the store-frontage and square-footage requirements been required of all retailers. The preservation-of-a-small-town-community argument would have carried a lot more weight if all retailers were to be held to the same standards.

Case 5-2 illustrates how the United States Supreme Court responded to an attempt to challenge a state regulation on grounds that it places an undue burden on interstate commerce.

6 Nat’l Paint & Coatings Ass’n v. Chi., 803 F. Supp. 135 (1992).

Michigan and New York passed state statutes allowing in-state, but not out-of-state, wineries to sell wine directly to state residents. The statutes permitted out-of-state wine wholesalers, on the other hand, to sell to state residents. Thus, out-of-state wineries wishing to sell wine to Michigan and New York residents had to sell through a wholesaler. Because many small wineries produce insufficient quantities of wine to sell via wholesaler, however, the statutes effectively prohibited them from selling to Michigan and New York residents.

Michigan residents and an out-of-state winery challenged the statutes as violating the commerce clause of the U.S. Con- stitution, while a similar case was filed on behalf of residents of New York and another winery. In both district courts, the states were successful in arguing that the statutes advanced legitimate public purposes: curbing wine sales to minors via the Internet, stemming tax evasion on wine sales, protecting public health and safety, and ensuring regulatory account- ability. On appeal, the Court of Appeals for the Sixth Circuit invalidated the Michigan law, while the Court of Appeals for the Second Circuit upheld the New York law. Both cases were appealed to the United States Supreme Court, which joined the cases and issued the following opinion.

JUSTICE KENNEDY: . . . These consolidated cases pres- ent challenges to state laws regulating the sale of wine from out-of-state wineries to consumers in Michigan and

New York. The details and mechanics of the two regulatory schemes differ, but the object and effect of the laws are the same: to allow in-state wineries to sell wine directly to con- sumers in that State but to prohibit out-of-state wineries from doing so, or, at the least, to make direct sales impractical from an economic standpoint. It is evident that the object and design of the Michigan and New York statutes is to grant in- state wineries a competitive advantage over wineries located beyond the States’ borders. In Pike, the Supreme Court adopted a balancing test to determine whether state statutes that incidentally burden interstate commerce violate the Commerce Clause. The Court held that [w]here the statute regulates evenhandedly to effectuate a legitimate local pub- lic interest, and its effects on interstate commerce are only incidental, it will be upheld unless the burden imposed on such commerce is clearly excessive in relation to the putative local benefits. If a legitimate local purpose is found, then the question becomes one of degree. And the extent of the bur- den that will be tolerated will of course depend on the nature of the local interest involved, and on whether it could be pro- moted as well with a lesser impact on interstate activities.

. . . The States offer two primary justifications for restricting direct shipments from out-of-state wineries: keeping alcohol out of the hands of minors and facilitating tax collection. . . . The States, aided by several amici, claim that allowing direct shipment from out-of-state wineries undermines their ability

GRANHOLM v. HEALD UNITED STATES SUPREME COURT 544 U.S. 460 (2005)

CASE 5-2

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to police underage drinking. Minors, the States argue, have easy access to credit cards and the Internet and are likely to take advantage of direct wine shipments as a means of obtain- ing alcohol illegally. The States provide little evidence that the purchase of wine over the Internet by minors is a problem. Indeed, there is some evidence to the contrary. . . .

Under our precedents, which require the “clearest show- ing” to justify discriminatory state regulation, this is not enough.

Even were we to credit the States’ largely unsupported claim that direct shipping of wine increases the risk of underage drinking, this would not justify regulations limit- ing only out-of-state direct shipments. . . .

The States’ tax-collection justification is also insuffi- cient. Increased direct shipping, whether originating in state or out of state, brings with it the potential for tax evasion. . . . Michigan and New York benefit, furthermore, from pro- visions of federal law that supply incentives for wineries to comply with state regulations.  .  .  . The States have not shown that tax evasion from out-of-state wineries poses such a unique threat that it justifies their discriminatory regimes.

Michigan and New York offer a handful of other rationales, such as facilitating orderly market conditions,

protecting public health and safety, and ensuring regulatory accountability. These objectives can also be achieved through the alternative of an evenhanded licensing requirement. Finally, it should be noted that improvements in technology have eased the burden of monitoring out-of-state wineries. Background checks can be done electronically. Financial records and sales data can be mailed, faxed, or submitted via e-mail.

In summary, the States provide little concrete evidence for the sweeping assertion that they cannot police direct shipments by out-of-state wineries. Our Commerce Clause cases demand more than mere speculation to support discrimination against out-of-state goods. The “burden is on the State to show that ‘the discrimination is demonstrably justified,’ ”  .  .  . The Court has upheld state regulations that discriminate against interstate commerce only after finding, based on concrete record evidence, that a State’s nondiscriminatory alternatives will prove unworkable.  .  .  . Michigan and New York have not satisfied this exacting standard.

The judgment holding that the state laws were invalid was affirmed, and the conflicting judgment was

reversed, in favor of the wineries.

Although the dormant commerce clause does impose many restrictions on state author- ity, the power to offer tax credits to businesses within the state, which might be seen by some as “affecting” interstate commerce, is not prohibited. Therefore, individual states have the ability to provide tax credits for companies that locate in or do business within their boundaries. Tax credits for businesses are important because individual states may use them to lure or keep businesses within their state’s limits. For businesses, the tax credits offered by the states may be extremely important. The value of tax credits can reach well into the millions, and this is often a source of cost savings for businesses. Thus, tax credits can be the deciding factor for a business when selecting where to invest and set up operations.

In recent years, the states’ ability to provide tax credits to businesses has been challenged, most notably in Daimler Chrysler v. Cuno. In the Cuno case, a group of plaintiffs alleged that $280 million in tax credits, offered to Daimler Chrysler by the state of Ohio, was in vio- lation of the commerce clause. However, in 2006 the U.S Supreme Court heard the case and ruled that the challenges brought by the plaintiffs had no standing in federal court. The case was then dismissed, and the states were free to continue offering tax credits to businesses. 7

7 www.supremecourtus.gov/opinions/05pdf/04-1704.pdf ; and www.law.duke.edu/publiclaw/supremecourtonline/certGrants/2005/ daivcun .

Explain why you agree or disagree with the reasoning of the court in this case.

ETHICAL DECISION MAKING CRITICAL THINKING

Identify the primary stakeholders and explain how each is helped and hurt by the outcome of this case.

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Taxing and Spending Powers of the Federal Government No government can function without a source of revenue. Article I, Section 8, of the Con- stitution gives the federal government the “Power to lay and collect Taxes, Duties, Imports and Excises.” The taxes laid by Congress, however, must be uniform across the states. In other words, the government cannot impose higher taxes on residents of one state than another.

Although tax collection allows the government to provide essential services, the gov- ernment can also use taxes for other purposes. For example, to encourage the development of certain industries and discourage the development of others, the government can pro- vide tax credits for firms entering favored industries. As long as the “motive of Congress and the effect of its legislative action are to secure revenue for the benefit of the general government,” 8 the tax is constitutional. The fact that it also has a regulatory impact does not affect the constitutionality of the tax.

Article I, Section 8, also grants Congress spending power by authorizing it to “pay the Debts and provide for the common Defence and general Welfare of the United States.” As with its power to tax, Congress can use its spending power to achieve social welfare objec- tives. For example, in the 1987 case South Dakota v. Dole, 9 the Supreme Court upheld a federal statute that grants federal funds for state highways to only those states in which 21 is the legal drinking age.

Other Constitutional Restrictions on Government THE PRIVILEGES AND IMMUNITIES CLAUSE Article IV, Section 2, of the Constitution states that “Citizens of each State shall be entitled to all Privileges and Immunities of Citizens in the several States.” This provision, called the privileges and immunities clause, prohibits states from discriminating against citi- zens of other states when those nonresidents engage in ordinary and essential activities. These activities include buying and selling property, seeking employment, and using the court system. States may treat residents and nonresidents differently only when they have substantial reason for doing so.

For example, according to the privileges and immunities clause, a state cannot prohibit nonresidents from opening restaurants in the state. States can, however, allow state univer- sities to charge higher tuition to out-of-state students because residents pay taxes that fund state universities, while out-of-state students do not.

THE FULL FAITH AND CREDIT CLAUSE Article IV, Section 1, of the Constitution contains the full faith and credit clause. This clause states, “Full Faith and Credit shall be given in each State to the public Acts, Records, and judicial Proceedings of every other State.” This provision requires that courts in all states uphold contracts and public acts established in other states. For example, this clause protects wills, marriage and divorce decrees, and judgments in civil courts. Courts have held, however, that states do not have to give full faith and credit to laws that violate their “public policy.” Thus, for example, although Massachusetts per- mits same-sex marriage, the full faith and credit clause does not require that other states recognize such marriages.

9 483 U.S. 203 (1987).

8 J. W. Hampton Co. v. United States, 276 U.S. 394 (1928).

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THE CONTRACT CLAUSE Article I, Section 9, contains the contract clause, which states that government may not pass any “Law impairing the Obligation of Contract.” In application, courts interpret this clause to mean that no law can be passed that will unreasonably interfere with existing contracts. For example, in the 1934 U.S. Supreme Court case Home Building & Loan Association v. Blaisdell, 10 the Home Building & Loan Association challenged Minnesota’s Mortgage Moratorium Act as a violation of the contract clause. The act, implemented tem- porarily during the Great Depression, authorized courts to extend the redemption periods of mortgages to delay foreclosures of mortgages on real estate. The Court ruled that the act’s provisions were within the state’s police power to protect its citizens and did not vio- late the contract clause. Although the act impaired contractual obligations between lenders and borrowers, the Court held that courts must balance even substantial contractual impair- ments against states’ interest in protecting the welfare of their citizens.

The Amendments to the Constitution The first 10 amendments to the U.S. Constitution, known as the Bill of Rights, substan- tially affect government regulation of business. These amendments prohibit the federal government from infringing on individual freedoms. Moreover, the Fourteenth Amend- ment extends most of the provisions in the Bill of Rights to the states, prohibiting state interference in citizens’ exercise of their rights. Thus, the federal and state governments cannot deprive individuals of the freedoms protected by the Bill of Rights.

Many other countries do not have constitutional provisions to protect citizens from the government. The Australian constitution, for example, creates the framework for govern- ment in Australia. In many of the countries that do have individual protections in their constitutions, these protections have emerged recently, as the Comparing the Law of Other Countries box on Canada’s constitution illustrates. Some other countries’ constitutions provide rights that American citizens do not have. The constitution of Belarus, for exam- ple, featured later in this chapter, guarantees citizens’ right to health care.

Courts apply many amendments to corporations because corporations are treated, in most cases, as “artificial persons.” The remainder of this chapter describes the amendments that

10 290 U.S. 398.

E-COMMERCE AND THE LAW

Sales Taxes on Internet Transactions?

Due to the rapid rise in Internet commerce in recent years, many states have become concerned about their ability to collect sales tax on Internet transactions. Sales taxes are a large source of rev- enue for state governments, but states can require that a business submit sales tax payments only if the business has a store or dis- tribution center in the state. Otherwise, states cannot collect sales taxes, although residents are supposed to keep track of their out- of-state purchases (including those made over the Internet) and self-report the taxes on these purchases. The tax is known as a use tax, but the reality is that very few residents actually pay such taxes.

Bills have been unsuccessfully proposed in the past to allow for sales tax of purchases made over the Internet. Congress has been unenthusiastic about enacting enabling legislation that would allow states to ask Internet companies to collect sales taxes. Also, state laws vary regarding what gets taxed. For example, New Jer- sey has a separate sales tax for fur coats. California offers a partial exemption for sales tax on farm equipment. The variety in state laws means it would be complicated for Internet retailers to collect state sales taxes. If states adopted uniform rules, it would be easier to collect sales taxes. In the meantime, as e-commerce sales grow, states are missing out on tax revenue.

Source: Joshua Zumbrun, “A Flat Sales Tax?” Forbes, December 28, 2009; and 2009 WLNR 25303357.

LO4

How does the Bill of Rights protect the

citizens of the United States?

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104 Part 1 The Legal Environment of Business

Exhibit 5-2 Summary of the Bill of Rights

AMENDMENT PROVISIONS

First • Protects freedom of religion, press, speech, and peaceable assembly.

• Ensures that citizens have the right to ask the government to redress grievances.

Second • Finds that in light of the need for a well-regulated militia for security, government cannot infringe on citizens’ right to bear arms.

Third • Provides that government cannot house soldiers in private residences during peacetime, or during war except for provisions in the law.

Fourth • Protects citizens from unreasonable search and seizure.

• Ensures that government issues warrants only with probable cause.

Fifth • Ensures that government does not put citizens on trial except by the indictment of a grand jury.

• Gives citizens the right to not testify against themselves.

• Prevents government from trying citizens twice for the same crime.

• Creates the right to due process.

• Provides that government cannot take private property for public use without just compensation.

Sixth • Provides the right to a speedy public trial with an impartial jury, the right to know what criminal accusations a citizen faces, the right to have witnesses both against and for the accused, and the right to have an attorney.

Seventh • States that in common law suits where the monetary value exceeds $20, citizens have the right to a trial by jury.

Eighth • Provides that government will not set bail at excessive levels.

• Prohibits government imposition of excessive fines.

• Prohibits cruel and unusual punishment.

Ninth • Provides that although the Bill of Rights names certain rights, such naming does not remove other rights retained by citizens.

Tenth • Provides that powers that the Constitution does not give to the federal government are reserved to the states.

most significantly affect the regulatory environment of business. Exhibit 5-2 summarizes the first 10 amendments.

THE FIRST AMENDMENT Freedom of Speech and Assembly. The First Amendment guarantees freedom of speech, including gestures and other forms of expression, and of the press. It prohibits abridgment of the right to assemble peacefully and to petition the government for redress of grievances. Finally, it prohibits the government from aiding the establishment of reli- gion and from interfering with the free exercise of religion.

Like other rights, First Amendment rights are not absolute. For example, a person does not have the right to yell “Fire!” in a crowded theater. Nor does the First Amendment pro- tect false statements about another that are injurious to that person’s reputation. Due to the difficulty of determining the boundaries of individual rights, courts hear a large number of First Amendment cases.

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Political Speech. The First Amendment protections also apply to corporations. Courts do not, however, treat all corporate speech the same. Sometimes corporations engage in political speech; that is, they support political candidates or referenda. At one time, states restricted firms’ political advertising because they feared that corporations, with their large assets, would drown out other voices. However, in 2010, the United States Supreme Court struck down as unconstitutional federal campaign financing legislation that had prohibited corporations and unions from spending money to elect or defeat candidates for Congress or the White House. In Citizens United v. Federal Election Commission, 11 the court described corporations not as the “creatures of the law:” that some previous courts had considered them, but rather as “associations of citizens” deserving the same free speech rights as individuals. Justice Scalia wrote that, “To exclude or impede corporate speech is to muzzle the principal agents of the modern economy.  .  .  We should celebrate rather than condemn the addition of this speech to the public debate.” 12 The effect of this case on corporate behavior remains to be seen.

Commercial Speech. Not all corporate speech is politi- cal speech. Commercial speech is speech that conveys information related to the sale of goods and services. Courts analyze government restrictions on commercial speech according to a four-part test established in Cen- tral Hudson Gas & Electric Corp. v. Public Service Commission of New York. 13 The Central Hudson test is illustrated in Exhibit 5-3 .

In Case 5-3 , the Supreme Court applied this test to several New York regulations.

Constitution Act of Canada

The United States is not the only country to hold that a national constitution is the supreme law of the land. Section 52(1) of the Constitution Act of Canada, passed in 1982, states, “[T]he Constitu- tion of Canada is the supreme law of Canada, and any law that is inconsistent with the provisions of the Constitution is, to the extent of the inconsistency, of no force or effect.”

The Constitution Act established the Canadian Charter of Rights and Freedoms, which superseded the 1960 Canadian Bill of Rights. The Bill of Rights had applied only to the Canadian national gov- ernment, not to the provincial governments. Like the Fourteenth Amendment of the U.S. Constitution, Section 32(1) of the Canadian

COMPARING THE LAW OF OTHER COUNTRIES

Charter states that the charter applies to Canada’s Parliament and national government and to the legislature and government of each province of Canada. Like the U.S. Bill of Rights, the Canadian Char- ter protects rights and fundamental freedoms, including freedom of conscience and religion, freedom of peaceful assembly and association, freedom from unreasonable searches and seizures, and the right to equal protection of the law. These rights and free- doms, however, are qualified. The charter states, in Section 1, “The Canadian Charter of Rights and Freedoms guarantees the rights and freedoms set out in the subject only to such reasonable limits prescribed by law as can be demonstrably justified in a free and democratic society.”

11 130 S. Ct. 876 (2010).

12 Id.

13 447 U.S. 557 (1980).

This photo may look like an exercise of free speech, but the Court ulti- mately ruled that the suspension of the maker of the banner was not a violation of his free speech rights in Morse v. Frederick, better known as the “Bong Hits for Jesus” case.

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106 Part 1 The Legal Environment of Business

Exhibit 5-3 The Central Hudson Test for Commercial Speech

Speech is NOT PROTECTED

by the First Amendment

Speech is PROTECTED

by the First Amendment

YES

NO

YES

YES

YES

NO

NO

NO

Does the speech concern an illegal activity? Is it misleading?

Is the government interest served by the restriction on commercial speech substantial?

Does the regulation directly advance the government interest asserted?

Is the regulation more extensive than necessary to serve the government interest?

Bad Frog, a Michigan corporation, manufactures and markets alcoholic beverages under its “Bad Frog” trademark. Each label prominently features an artist’s rendering of a frog hold- ing up its middle “finger.” Versions of the label feature slogans such as “He just don’t care,” “An amphibian with an attitude,” “Turning bad into good,” and “The beer so good . . . it’s bad.”

In May 1996, Bad Frog’s New York distributor applied to the New York State Liquor Authority for brand label approval and registration pursuant to section 107-a(4)(a) of New York’s Alcoholic Beverage Control Law. NYSLA denied

the application in July. Explaining its rationale for the rejec- tion, the Authority found that the label “encourages combat- ive behavior” and that the gesture and the slogan, “He just don’t care,” placed close to and in larger type than a warn- ing concerning potential health problems, foster a defiance to the health warning on the label, entice underage drinkers, and invite the public not to heed conventional wisdom and to disobey standards of decorum.

In addition, the Authority said that it considered that approval of this label means that the label could appear in

BAD FROG BREWERY v. NEW YORK STATE LIQUOR AUTH. U.S. COURT OF APPEALS FOR THE SECOND CIRCUIT 134 F.3D 87 (1998)

CASE 5-3

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[continued]

grocery and convenience stores, with obvious exposure on the shelf to children of tender age, and that it is sensitive to the label’s adverse effects on a youthful audience.

Bad Frog filed suit against the NYSLA in October 1996 and sought a preliminary injunction barring NYSLA from taking any steps to prohibit the sale of beer by Bad Frog under the controversial labels.

JON O. NEWMAN, CIRCUIT JUDGE: Bad Frog’s label attempts to function, like a trademark, to identify the source of the product. The picture on a beer bottle of a frog behav- ing badly is reasonably to be understood as attempting to identify to consumers a product of the Bad Frog Brewery. In addition, the label serves to propose a commercial transac- tion. Though the label communicates no information beyond the source of the product, we think that minimal informa- tion, conveyed in the context of a proposal of a commercial transaction, suffices to invoke the protections for commer- cial speech, articulated in Central Hudson. We thus assess the prohibition of Bad Frog’s labels under the commercial speech standards outlined in Central Hudson.

Central Hudson sets forth the analytical framework for assessing governmental restrictions on commercial speech:

At the outset, we must determine whether the expression is protected by the First Amendment. For commercial speech to come within that provi- sion, it at least must concern lawful activity and not be misleading. Next, we ask whether the asserted government interest is substantial. If both inquiries yield positive answers, we must determine whether the regulation directly advances the government interest asserted, and whether it is not more exten- sive than is necessary to serve that interest.

The last two steps in the analysis have been considered, somewhat in tandem, to determine if there is a sufficient “‘fit’ between the [regulator’s] ends and the means chosen to accom- plish those ends.” The burden to establish that “reasonable fit” is on the governmental agency defending its regulation, though the fit need not satisfy a least-restrictive-means standard.

A. Lawful Activity and Not Deceptive We agree with the District Court that Bad Frog’s labels pass Central Hudson’s threshold requirement that the speech “must concern lawful activity and not be misleading.” The consumption of beer (at least by adults) is legal in New York, and the labels cannot be said to be deceptive, even if they are offensive.

B. Substantial State Interests NYSLA advances two interests to support its asserted power to ban Bad Frog’s labels: (i) the State’s interest in “pro- tecting children from vulgar and profane advertising,” and (ii) the State’s interest “in acting consistently to promote

temperance, i.e., the moderate and responsible use of alco- hol among those above the legal drinking age and abstention among those below the legal drinking age.”

Both of the asserted interests are “substantial” within the meaning of Central Hudson. States have “a compelling interest in protecting the physical and psychological well- being of minors,” and “this interest extends to shielding minors from the influence of literature that is not obscene by adult standards.”

The Supreme Court also has recognized that states have a substantial interest in regulating alcohol consumption. We agree with the District Court that New York’s asserted con- cern for “temperance” is also a substantial state interest.

C. Direct Advancement of the State Interest To meet the “direct advancement” requirement, a state must demonstrate that “the harms it recites are real and that its restriction will in fact alleviate them to a material degree.” A restriction will fail this third part of the Central Hudson test if it “provides only ineffective or remote support for the government’s purpose.”

(1) Advancing the Interest in Protecting Children from Vulgarity. A prohibition that makes only a minute contribu- tion to the advancement of a state interest can hardly be con- sidered to have advanced the interest “to a material degree.”

NYSLA endeavors to advance the state interest in pre- venting 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 vul- gar displays throughout contemporary society, including comic books targeted directly at children, barring such dis- plays from labels for alcoholic beverages cannot realistically be expected to reduce children’s exposure to such displays to any significant degree.

We appreciate that NYSLA has no authority to prohibit vulgar displays appearing beyond the marketing of alcoholic beverages, but a state may not avoid the criterion of materially advancing its interest by authorizing only one component of its regulatory machinery to attack a narrow manifestation of a perceived problem. If New York decides to make a substantial effort to insulate children from vulgar displays in some signif- icant 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 mate- rial 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. We do not mean that a state must attack a problem with a total effort or fail the third criterion of a valid commercial speech limitation. Our point is that a state must demonstrate 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.

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[continued]

The valid state interest here is not insulating children from these labels, or even insulating them from vulgar dis- plays on labels for alcoholic beverages; it is insulating chil- dren from displays of vulgarity.

(2) Advancing the state interest in temperance. We agree with the District Court that NYSLA has not established that its rejection of Bad Frog’s application directly advances the state’s interest in “temperance.”

NYSLA maintains that the raised finger gesture and the slogan “He just don’t care” urge consumers generally to defy authority and particularly to disregard the Surgeon General’s warning, which appears on the label next to the gesturing frog. NYSLA also contends that the frog appeals to youngsters and promotes underage drinking.

The truth of these propositions is not so self-evident as to relieve the state of the burden of marshalling some empiri- cal evidence to support its assumptions. All that is clear is that the gesture of “giving the finger” is offensive. Whether viewing that gesture on a beer label will encourage disregard of health warnings or encourage underage drinking remain matters of speculation.

NYSLA has not shown that its denial of Bad Frog’s application directly and materially advances either of its asserted state interests.

D. Narrow Tailoring Central Hudson’s fourth criterion, sometimes referred to as “narrow tailoring,” requires consideration of whether the pro- hibition is more extensive than necessary to serve the asserted state interest. Since NYSLA’s prohibition of Bad Frog’s labels has not been shown to make even an arguable advancement of

the state interest in temperance, we consider here only whether the prohibition is more extensive than necessary to serve the asserted interest in insulating children from vulgarity.

In this case, Bad Frog has suggested numerous less intrusive alternatives to advance the asserted State inter- est in protecting children from vulgarity, short of a com- plete statewide ban on its labels. Appellant suggests “the restriction of advertising to point-of-sale locations; limita- tions on billboard advertising; restrictions on over-the-air- advertising; and segregation of the product in the store.” 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 con- cerned 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 appel- lant’s products may be displayed within such stores. Or, with the labels permitted, restrictions might be imposed on placement of the frog illustration on the outside of six-packs or cases, sold in such stores.

NYSLA’s complete statewide ban on the use of Bad Frog’s labels lacks a “reasonable fit” with the state’s asserted interest in shielding minors from vulgarity, and NYSLA gave inadequate consideration to alternatives to this blanket suppression of commercial speech.

REVERSED and REMANDED.

Suppose an editorial writer read the Bad Frog case and con- cluded that the Supreme Court is apparently uninterested in temperance. Explain how the editorial writer has misunder- stood the Court’s reasoning.

ETHICAL DECISION MAKING CRITICAL THINKING

What values are competing with freedom of speech in this case?

How do the standards in the Central Hudson decision give us a strong sense about how important freedom of speech is to the Court as a value?

Unprotected speech. The First Amendment right to free speech is not absolute. In the 1942 case Chaplinsky v. New Hampshire, 14 the U.S. Supreme Court held:

There are certain well-defined and narrowly limited classes of speech, the prevention and punishment of which have never been thought to raise any Constitutional problem.

14 315 U.S. 568 (1942).

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Chapter 5 Constitutional Principles 109

These include the lewd and obscene, the profane, the libelous, and the insulting or fighting words—those which by their very utterance inflict injury or tend to incite an immediate breach of the peace.

Thus, for example, the First Amendment does not protect defamation, or speech that harms the reputation of another. As you will learn in Chapter 6, moreover, courts may require that an individual who uses such speech compensate the person whose reputation was harmed by the speech.

The First Amendment does not protect obscenity either, although in many cases courts find it difficult to determine whether particular speech constitutes obscenity. In the 1973 case Miller v. California, 15 the U.S. Supreme Court established a three-part standard to determine whether speech is obscene:

1. Would the average person, applying contemporary community standards, find that the speech, taken as a whole, appeals to the prurient (marked by or arousing an immoder- ate or unwholesome interest or desire) interest?

2. Does the speech depict or describe, in a patently offensive way, sexual conduct specifi- cally defined by law?

3. Does the speech, taken as a whole, lack serious literary, artistic, political, or scientific value?

If the answer to all three questions is yes, then the First Amendment does not protect the speech in question. You may note that there are significant ambiguities in the Miller standard.

Fighting words are a third class of unprotected speech. In Chaplinsky v. New Hamp- shire, a man protesting the government called the city marshal a “damned racketeer” and a “damned Fascist.” The city arrested him for violating a statute prohibiting the use of offensive, derisive, or annoying words toward another in a public place. The U.S. Supreme Court held: “The English language has a number of words and expressions which by gen- eral consent are ‘fighting words’ when said without a disarming smile. . . . Such words, as ordinary men know, are likely to cause a fight.” The Court further held that “‘damned racketeer’ and ‘damned Fascist’ are epithets likely to provoke the average person to retali- ation, and thereby cause a breach of the peace.” 16 Thus, the Court determined that the First Amendment did not protect the man’s speech.

Many universities believe that “hate speech,” or derogatory speech directed at members of another group, such as another race, satisfies the definition of fighting words. Thus, 60 percent of universities have banned verbal abuse and verbal harassment, and 28 per- cent of universities have banned advocacy of an offensive viewpoint. 17 State and federal appellate courts have struck down almost every one of these hate-speech codes and codes of conduct that has been challenged, usually on grounds of being overbroad or vagueness. For example, in 2008, the Third Circuit Court of Appeals struck down Temple University’s sexual harassment policy that provided, in part, that “all forms of sexual harassment are prohibited, including .  .  . expressive, visual, or physical conduct of a sexual or gender- motivated nature, when . . . such conduct has the purpose or effect of unreasonably inter- fering with an individual’s work, educational performance, or status; or (d) such conduct has the purpose or effect of creating an intimidating, hostile, or offensive environment.” 18

16 See note 12.

15 413 U.S. 15 (1973).

17 Timothy C. Shiell, Campus Hate Speech on Trial (Lawrence: University Press of Kansas, 1998), pp. 2, 49.

18 Christian M. Dejohn v. Temple University, 537 F.3d 301(2008).

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The policy was challenged by a student who felt that by expressing his opinions in class about the role of women in combat, he would be risking violating the policy, causing the policy to have a chilling effect on speech in the classroom. The appellate court agreed, find- ing the policy facially overbroad. 19 A student group was granted a preliminary injunction on overbreadth grounds against enforcement of San Francisco State University’s speech code that gave the school permission to punish students for behavior that was not “civil” or was inconsistent with the university’s goals.” 20 No cases have reached the Supreme Court yet. The international community, however, is less protective of hate speech. For example, a United Nations declaration and a number of foreign laws state that hate speech is not a protected form of expression. 21

Freedom of Religion. The First Amendment contains two provisions that protect citizens’ freedom of religion. The establishment clause maintains that government “shall make no law respecting an establishment of religion.” In the 1971 case Lemon v. Kurtzman, 22 the U.S. Supreme Court codified the following three tests to determine whether a particular government statute violates the establishment clause:

1. Does the statute have a secular legislative purpose?

2. Does the statute’s principal or primary effect either advance or inhibit religion?

3. Does the statute foster an excessive government entanglement with religion?

To determine whether the statute fosters an excessive government entanglement with religion, courts examine the character and purposes of the institutions benefited, the nature of the aid that the government provides, and the resulting relationship between the govern- ment and the religious authority.

19 Id.

20 College Republicans of San Francisco State Univ.v. Reed, 523 F. Supp. 2d. 2007).

21 Ibid., p. 32.

22 403 U.S. 602 (1971).

How Do Courts Balance the Govern- ment’s Interest in Protecting Children from Exposure to Sexually Oriented Pro- gramming with Upholding Basic Free Speech Principles?

U.S. v. Playboy 529 U.S. 803 (2000)

Congress passed the Communications Decency Act (CDA) to regulate speech or expression that is harmful to minors. An adult- oriented cable television operator, Playboy Entertainment Group, Inc. (Playboy), challenged the filtering provision of the CDA, which aimed to scramble or block channels during hours when children are likely to be viewing.

Playboy won the case. The Supreme Court stated:

CASE NUGGET

The history of the law of free expression is one of vindication in cases involving speech that many citizens may find shabby, offensive, or even ugly. It follows that all content-based restrictions on speech must give us more than a moment’s pause. If television broadcasts can expose children to the real risk of harmful exposure to indecent materials, even in their own home and with- out parental consent, there is a problem the Government can address. It must do so, however, in a way consistent with First Amendment principles. Here the Government has not met the burden the First Amendment imposes. The Government has failed to show that [the section of the CDA Playboy has challenged] is the least restrictive means for addressing a real problem; and the District Court did not err in holding the statute violative of the First Amendment.

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Legal Principle: A state statute will not violate the establishment clause if it has a secular legal purpose, has a primary effect of neither advancing nor inhibiting religion, and does not foster an excessive government entanglement with religion.

The free-exercise clause states that government cannot make a law “prohibiting the free exercise” of religion. Although government must remain neutral in matters of religion, determining whether a government action advances religion or merely allows free exercise of religion is often difficult. Likewise, determining whether a government action establishes religion or simply avoids interference with free exercise of religion is also difficult.

Issues concerning the establishment clause and the free-exercise clause often arise in workplace settings. In government workplaces, this conflict sometimes raises difficult issues. For example, in 1966, Tucker, an employee of the California Department of Edu- cation, insisted on signing office memos with his name and the letters “SOTLJC,” an abbreviation for “Servant of the Lord Jesus Christ.” In an attempt to avoid workplace disruptions and the appearance of government support for religion, Tucker’s supervisor prohibited all displays of religious symbols in the workplace. The supervisor suspended Tucker for refusing to comply with the restrictions. When Tucker challenged the suspen- sion on grounds that the rules interfered with his free exercise of religion, the appellate court agreed. 23

In private workplaces, issues related to free exercise of religion most often arise under Title VII, the federal law prohibiting employment discrimination. We discuss this impor- tant legislation in greater detail in Chapter 42.

THE FOURTH AMENDMENT Freedom from Unreasonable Searches and Seizures. The Fourth Amend- ment guarantees citizens the right to be “secure in their persons, their homes, and their personal property.” Thus, it prohibits government from conducting unreasonable searches of individuals and seizing their property to use as evidence against them.

A search is unreasonable if the government official conducting the search does not first obtain a search warrant from a court. A search warrant is a court order that authorizes law enforcement agents to search for or seize items specifically described in the warrant. Government officials can obtain search warrants only if they can show probable cause to believe that the search will uncover specific evidence of criminal activity. In other words, the government officials must have a sufficient reason based on known facts to obtain a warrant.

Free Speech in China

The Chinese constitution does not guarantee freedom of speech or assembly, nor does it recognize any form of natural rights or human rights. Instead, it recognizes citizens’ rights, which are specifically enumerated in the Chinese constitution or laws. Not only does the Chinese constitution not provide protections for expressive activity,

COMPARING THE LAW OF OTHER COUNTRIES

but numerous Chinese laws prohibit citizens from engaging in political acts directed against the regime—acts that are protected in the United States. For example, Article 25 of China’s Publishing Control Act prohibits the publication of any material that opposes the basic rules of the constitution. Articles 7 and 12 of the Law on Assemblies, Processions, and Demonstrations prohibit assemblies, processions, and demonstrations that oppose those basic rules.

23 Tucker v. State of Cal. Dep’t of Ed., 97 F.3d 1204 (9th Cir. 1996).

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The Supreme Court has ruled, however, that in certain circumstances, government offi- cials do not need a search warrant. For example, when law enforcement officials believe it is likely that the items sought will be removed before they can obtain a warrant, they may conduct a search without a warrant. Law enforcement officials frequently conduct automo- bile searches without a warrant according to this rule.

In most other cases, though, law enforcement officials must obtain a warrant before conducting a search. For example, an Ohio law required that buyers of five or more beer kegs provide the beer distributor with the address of the party where the kegs would be consumed. Additionally, the law required that the buyers sign a form allowing police and liquor agents to enter their property without a warrant to search the premises to enforce state liquor laws. In 2001, a college professor challenged the law on grounds that it infringed on citizens’ Fourth Amendment rights. 24 Before the court decided the case, Ohio repealed the law. 25

In addition to protecting individuals and their homes, the Fourth Amendment also pro- tects corporations and places of business. This protection generally applies in criminal cases, but Fourth Amendment issues also arise when government regulations authorize administrative agencies to conduct warrantless searches.

Although administrative searches usually require search warrants, courts have estab- lished an exception to this rule: If an industry has a long history of pervasive regulation, a

* 273 F.3d 429 (2d Cir. 2001).

24 Robert Ruth, “Lawsuit Challenges Restrictions on Beer Buyers,” Columbus Dispatch, May 26, 2001, p. 1B. 25 Hooper v. Morkle, 219 F.R.D. 120 (2003).

E-COMMERCE AND THE LAW

Is Computer Code Speech?

In fall 1999, Eric Corley, publisher of the online journal 2600: The Hacker Quarterly, posted DeCSS (De-Content Scramble System) to the journal. This program allows individuals with technological expertise to decipher CSS (Content Scrambling System), the code the film industry has developed to prevent people from making copies of DVD movies. In addition to posting DeCSS, Corley included links that led site visitors to other sites that posted DeCSS (hyperlinks).

Soon after Corley posted DeCSS and the hyperlinks, he found himself in trouble with the Hollywood studios that are members of the Motion Picture Association of America (MPAA). They sued Cor- ley, asking a judge to issue an injunction prohibiting both the initial posting and the hyperlinks.

The Hollywood studios were trying to protect their property rights. Congress had passed a statute, the Digital Millennium Copy- right Act (DMCA), to help artists and other copyright holders curb piracy. The DMCA prohibits the use of, or trafficking in, computer code that circumvents the encryption scheme that protects cer- tain digital content. The DMCA makes it clear that the entertain- ment industry has the right to put copyright protection codes on a range of digital media, including DVD movies. The Hollywood stu- dios are trying to stop pirates from making it possible for people to have access to films that are being shown in theaters. If piracy is allowed, who will purchase movie tickets or DVDs?

Corley asserted that he is not a pirate. Instead, he and his com- pany are protectors of free speech. Corley argued that the DMCA violates the rights of programmers and scientists to share software programs and computer code. He believes the First Amendment guarantees him the right to post DeCSS and the hyperlinks. Corley maintains that journalists, programmers, and scientists should be free to share information on the Web and should not be respon- sible if people use the information to engage in piracy. In August 2000, New York district judge Lewis Kaplan issued a permanent injunction prohibiting Corley from posting DeCSS on his Web site or knowingly linking via a hyperlink to any other Web site contain- ing DeCSS. This injunction enforced the DMCA’s anticircumvention provisions. Judge Kaplan ruled that the DMCA was a valid exercise of the government’s power and that the law did not violate Corley’s First Amendment rights.

On November 28, 2001, a three-judge panel of the U.S. Court of Appeals for the Second Circuit, in Manhattan, affirmed Kaplan’s decision and reasoning. * The appellate court panel agreed with Judge Kaplan’s decision that computer code is content-neutral speech and that a narrowly tailored injunction did not burden substantially more speech than necessary to further the govern- ment’s interest in preventing unauthorized access to copyrighted materials.

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warrantless search is not unreasonable. In such industries, administrative agencies can use warrantless searches to ensure that firms uphold regulations.

This pervasive-regulation exception, however, is not always easy to interpret. Courts have ruled that warrantless searches authorized by the Federal Mine Safety and Health Act are legal because the federal regulatory presence is comprehensive and well defined. Thus, reasonable commercial-property owners ought to know that their property is subject to periodic inspections. 26 A warrantless search based on the Occu- pational Safety and Health Act, however, may violate the Fourth Amendment because no significant legislation of working conditions existed before Congress passed that act in 1970. Hence, businesspeople covered by the law cannot reasonably anticipate warrantless searches.

For example, in the 1988 U.S. Supreme Court case Braswell v. United States, 27 the Court distinguished between the rights of corporate-record custodians and sole proprietors. Braswell was both the operator and the sole shareholder of his busi- ness. When a grand jury issued a subpoena requiring that he produce corporate books and records, Braswell argued that the subpoena violated his Fifth Amendment privilege against self-incrimination. The Court denied Braswell’s claim, writing that “subpoenaed business records are not privileged, and as a custodian for the records, the act of producing the records is in a representative capacity, not a personal one, so the records must be produced.” 28 The Court held that the subpoena would have

26 Raymond J. Donovan, Secretary of Labor, United States Department of Labor v. Douglas Dewey et al., 452 U.S. 594, 101 S. Ct. 2534 (1981). 27 487 U.S. 99 (1988). 28 Ibid.

E-COMMERCE AND THE LAW

Technology and the Fourth Amendment

Technological improvements have raised new issues in the appli- cation of the Fourth Amendment. New technologies have made eavesdropping and other covert activities easier. For example, in a 2001 U.S. Supreme Court case, police had information suggesting that Danny Kyllo grew marijuana in his home. Growing marijuana indoors requires heat lamps that use large amounts of electricity, and Kyllo had unusually high electric bills. The police used a ther- mal imager, an instrument that detects heat emissions, to provide them with the evidence necessary to obtain a warrant to physically search his house.

The Court addressed the issue of whether the use of thermal- imaging instruments on private property constituted a “search.” Judges analyze cases by comparing them to past cases to see how other judges determined similar cases. Thus, in this case, the Court asked whether using thermal-imaging instruments is more like going through someone’s garbage or more like using a high- powered telescope to look through someone’s window. Previous Supreme Court cases held that the former behavior does not con- stitute a search but the latter scenario does constitute a search

and therefore requires a warrant. The appellate court, examining the use of this technology for the first time, ruled that using ther- mal imaging was not a search prohibited by the Fourth Amendment without a warrant.

On appeal, however, the U.S. Supreme Court ruled that police use of thermal-imaging devices to detect heat patterns emanat- ing from private homes constitutes a search that requires a war- rant. The Court held, further, that the warrant requirement applies not only to the relatively crude thermal-imaging device but also to any “more sophisticated systems” that give the police knowl- edge that in the past would have required physical entry into the home. In explaining the Court’s decision, Justice Scalia wrote that in the home, “all details are intimate details, because the entire area is held safe from prying government eyes.” He added that the Court’s precedents “draw a firm line at the entrance to one’s house.”

This case, however, is not necessarily the final word on the use of technology. The Court relied heavily on the fact that police used thermal imaging to see inside Kyllo’s home. Thus, courts may in the future uphold thermal imaging of other locations.

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violated Braswell’s privilege against self-incrimination if his business had been a sole proprietorship.

THE FIFTH AMENDMENT The Fifth Amendment protects individuals in several important ways. First, it protects against self-incrimination, meaning that in a criminal case, the defendant does not have to testify in court as a witness against herself or himself. The Fifth Amendment also protects against double jeopardy. Thus, government cannot try a person more than once for the same crime.

Due Process. For businesspeople and corporations, the Fifth Amendment’s due process clause provides extensive protection. This clause states that government cannot deprive a person of life, liberty, or property without due process of law.

The due process clause guarantees two types of due process: procedural and substan- tive. Procedural due process requires that the government use fair procedures when taking the life, liberty, or property of an individual or corporation. At a minimum, pro- cedural due process entitles a person to notice of any legal action against her and to a hearing before an impartial tribunal. Originally, courts interpreted the due process clause as protecting an individual’s right of procedural due process only in federal crim- inal proceedings. The subsequent passage of the Fourteenth Amendment extended the requirement of due process to criminal proceedings by state governments. Today, courts apply the due process clause to diverse situations, including the termination of welfare benefits, food stamps, or Social Security benefits; the suspension of a driver’s license; the discharge of a public employee from his job; and the suspension of a student from school.

The procedures that government must follow when taking an individual’s life, liberty, or property vary according to the nature of the taking. Generally, more procedures are neces- sary as the magnitude of potential deprivation increases.

Substantive due process refers to the basic fairness of laws that may deprive an individual of her life, liberty, or property. To satisfy the substantive due process require- ment, government must have a proper purpose for enacting laws that restrict individuals’ liberty or the use of their property. The standard for determining whether a law violates substantive due process depends on the nature of the potential deprivation. Laws affect- ing fundamental rights must bear a substantial relationship to a compelling government purpose. These fundamental rights generally include the rights protected in the Constitu- tion: the right to vote, the right to travel freely from state to state, the right to privacy, and so on. Compelling state interests include, for example, public safety and national security.

Not all laws, however, affect fundamental rights. To show that laws that do not affect fundamental rights satisfy the substantive due process requirement, government must prove only that the law bears a rational relationship to a legitimate state interest. Courts uphold most government regulations according to this rational-basis test. For example, courts have upheld minimum-wage laws, rent control laws, banking regulations, environ- mental laws, and regulations prohibiting unfair trade practices according to the rational- basis test.

The Prohibition Against Uncompensated Takings. The Fifth Amendment also provides that when government takes private property for public use, it must pay the

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owner just compensation, or fair market value, for his property. This provision is called the takings clause, and it applies to corporations. Several significant issues have arisen with respect to the takings clause. For example, what constitutes a “public use” for which government can take private property?

Kelo v. City of New London is a U.S Supreme Court case that specifically addressed the issue of what constitutes “public use.” In 1998, the Pfizer pharmaceutical company decided to build a new research facility in the city of New London, Connecticut. The city of New London was excited about the corporate addition and believed that the new Pfizer facility would bring business, revenue, and job creation to the area. In an effort to further economic development, the city of New London wished to supplement the new Pfizer facility with additional construction. The city, with the help of private developers, created a plan for a new conference center, hotel, and housing and retail units in the area surround- ing the Pfizer facility.

Complications in the city’s plan occurred because the land surrounding the Pfizer facility was privately held. Consequently, before the city could move forward with development, it had to first use its power of eminent domain to obtain the privately held land. When the city of New London attempted to seize the homes and land around the Pfizer facility, several citizens filed suit. In court, the citizens alleged that the city’s plan did not constitute “public use” and was thus unconstitutional and in violation of their Fifth Amendment rights. However, the U.S Supreme Court, in a 5-4 decision, found that the use of eminent domain for the purpose of economic development was constitutional. The citizens of New London were therefore required to surrender their land. 29

The takings clause has prompted other issues as well. What happens, for instance, when a government regulation interferes so substantially with an individual’s use of her property that it effectively “takes” her property? For example, environmental regulations often affect the way landowners can use their property. In many cases, property owners have challenged the constitutionality of these regulations. While the courts have not drawn a clear line as to when a regulation is so extensive that it con- stitutes a taking, it is clear that if the regulation prohibits the owner from deriving any economic benefit from the land, a taking has occurred and the owner must be compensated.

The classic case in which such a regulatory taking occurred was Lucas v. South Caro- lina Coastal Commission, 30 which arose out of a dispute between a beachfront-property owner and the state of South Carolina over a law prohibiting permanent construction on any eroding beach. Lucas had bought two beachfront lots for $975,000 in 1986, before the passage of the law in question. Lucas, who had not yet begun construction on his property when the law was passed, lost the right to use his property for condominiums, so he chal- lenged the law as constituting a taking without just compensation. The state court agreed with Lucas that the regulation denied him full value of his property and thus constituted a taking, so it awarded him $1.2 million in damages. The South Carolina Supreme Court disagreed and overturned the lower court’s decision.

Lucas appealed the decision to the U.S. Supreme Court, which reversed the state supreme court, holding that a state regulation that deprives a private property owner of all economically beneficial uses of property constitutes a taking of private property for

29 545 U.S. 469; 125 S. Ct. 2655; and www.law.cornell.edu/supct/html/04-108.ZO.html .

30 112 U.S. 2886 (1992).

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which the Fifth Amendment’s takings clause requires payment. This total deprivation of the value of the property is referred to as a regulatory taking. While we know that total deprivation constitutes a taking, we do not know the minimum that might be arguably a taking.

Legal Principle: A regulatory taking, entitling a property owner to just compen- sation, occurs when a regulation deprives the property owner of all economically ben- eficial uses of the land.

The Privilege Against Self-Incrimination. Although most provisions of the Fifth Amendment apply to corporations, corporations do not enjoy the Fifth Amendment’s protection against self-incrimination. Sole proprietors, however, are entitled to this protec- tion. Thus, different businesses have different constitutional rights depending on their form of business organization.

THE NINTH AMENDMENT Privacy Rights. The Ninth Amendment states, “The enumeration in the Constitution, of certain rights, shall not be construed to deny or disparage others retained by the people.” Although this amendment does not expressly guarantee the right to privacy, courts have interpreted the Ninth Amendment, together with the First, Third, Fourth, and Fifth amend- ments, as providing individuals with a right to privacy.

In the 1965 case Griswold v. Connecticut, 31 the Supreme Court ruled that a Connecti- cut law prohibiting the use of contraceptives was unconstitutional because it violated individuals’ right to privacy. Justice Douglas wrote:

[S]pecific guarantees in the Bill of Rights have penumbras [fringes].  .  .  . Various guar- antees create zones of privacy. The right of association contained in the penumbra of the First Amendment is one.  .  . . The Third Amendment in its prohibition against the quartering of soldiers “in any house” in time of peace without the consent of the owner is another facet of that privacy. The Fourth Amendment explicitly affirms the “right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures.” The Fifth Amendment in its Self-Incrimination Clause enables the citizen to create a zone of privacy which government may not force him to surrender to his detriment.

The right to privacy has since been used in a broad variety of contexts.

THE FOURTEENTH AMENDMENT Equal Protection. The Fourteenth Amendment contains the equal protection clause, which prevents states from denying “the equal protection of the laws” to any citi- zen. This clause combats discrimination because it applies whenever government treats certain individuals differently than other similarly situated individuals, usually through a classification scheme.

As with the due process clause, to determine whether a law violates the equal protection clause, courts use different standards based on the nature of the rights the classification affects. Three different standards of scrutiny apply: strict scrutiny, intermediate scrutiny, and the rational-basis test.

31 381 U.S. 479 (1965).

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If a law prevents individuals from exercising a fundamental right, or if the law’s classifi- cation scheme involves suspect classifications, the action will be subject to strict scrutiny. Suspect classifications include classifications based on race, national origin, and citizen- ship. Courts uphold suspect classifications only if they are necessary to promote a com- pelling state interest. In cases involving suspect classifications, courts do not begin their analysis with a presumption that the classification is constitutional, so few laws pass the strict-scrutiny standard. For example, in the 1954 case Brown v. Board of Education, 32 the U.S. Supreme Court ruled that the classification scheme used to racially segregate public schools violated the equal protection clause.

Several courts have held, however, that in some cases, remedying past discrimination against a group is a compelling state interest. Chapter 42 discusses this issue in greater detail.

If the law’s classification scheme is based on gender or on the legitimacy of children, courts use intermediate scrutiny. According to this standard, the law is constitutional only if it is substantially related to an important government objective.

When a classification scheme involves other matters, courts apply a rational-basis test. According to this test, courts ask whether there is any justifiable reason to believe that the classification scheme advances a legitimate government interest. Because courts begin their analysis with a strong presumption that the government action is constitutional, almost all laws pass this test.

The Constitution of the Republic of Belarus

The constitution of Belarus, adopted in 1994, provides Belarusian citizens with an exhaustive set of rights that surpasses most other nations’ constitutions. The Belarusian constitution guarantees the following rights to citizens:

• Citizens accused of crimes are presumed innocent until proven guilty (Article 26).

• The defendant in a criminal case enjoys protection from provid- ing evidence against herself or close family relations (Article 27).

• Citizens can move freely and choose their place of residence within the Republic of Belarus. They can leave Belarus and return without hindrance (Article 30).

• Citizens have the right to profess any religion individually or jointly with others or to profess none at all. They also have the right to express and spread beliefs connected with their attitudes toward religion and to participate in religious rituals (Article 31).

• Citizens have freedom of thought and belief and may freely express their thoughts and beliefs (Article 33).

COMPARING THE LAW OF OTHER COUNTRIES

• Citizens may organize assemblies, rallies, street marches, demonstrations, and pickets that do not disturb law and order or violate other citizens’ rights (Article 35).

• Citizens have the right to choose a profession, type of occu- pation, and work in accordance with their capabilities, educa- tion, and vocational training. Moreover, they have the right to healthy and safe working conditions.

• The constitution binds the Belarusian government to create the conditions necessary for full employment of the population. For citizens who are unemployed for reasons beyond their control, the constitution guarantees training in new specializations, an upgrade of their qualifications, and unemployment benefits (Article 41).

• The constitution limits the workweek to 40 hours. It guaran- tees annual paid leave, weekly rest days, and shorter working hours for citizens who work at night (Article 43).

• Citizens have the right to health care, including free treat- ment at all government health care establishments (Article 45).

32 347 U.S. 483 (1954).

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Federalism: The authority to govern is divided between two sovereigns, or supreme lawmakers: the federal government and the states.

Checks and balances: The Constitution divides power among the legislative, executive, and judicial branches of government. The system of checks and balances allocates specific powers to each branch to keep the other branches from dominating government.

Federal supremacy: Any state or local law that directly conflicts with the U.S. Constitution or fed- eral laws or treaties is void.

Concurrent authority: Both state and federal governments have the power to regulate certain matters; generally, the federal government defers to the state.

Summary of Key Topics The U.S. Constitution

The Supremacy Clause and Federal Preemption

commerce clause 95

commercial speech 105

concurrent authority 95

contract clause 103

dormant commerce clause 99

due process clause 114

equal protection clause 116

establishment clause 110

federal preemption 95

federalism 93

free-exercise clause 111

full faith and credit clause 102

intermediate scrutiny 117

judicial review 94

police power 99

political speech 105

privileges and immunities clause 102

procedural due process 114

rational-basis test 117

search warrant 111

strict scrutiny 117

substantive due process 114

supremacy clause 95

takings clause 115

Key Terms

Formula Retail Ordinance The appellate court found that “the stipulated facts indicate that the formula retail pro- vision’s disproportionate burden on interstate commerce, such as the effective exclu- sion of interstate formula retailers, clearly outweighs any legitimate local benefits.” The Islamorada ordinance had an indirect effect on interstate commerce. The court also ruled, however, that the ordinance did not “facially discriminate against interstate commerce.” As such, had Islamorada been able to show that it had a “legitimate local purpose” that could not have been served by nondiscriminatory alternatives, it may have won the case. Although Islamorada stated an interest in preservation of a “small-town community” as its legitimate purpose, it was unable to demonstrate that it had such a community to preserve.

CASE OPENER WRAP-UP

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Federal preemption: The federal government uses this doctrine to strike down laws that do not directly conflict with a federal law but attempt to regulate an area within federal legislative jurisdiction.

This clause grants the federal government the authority to pass regulations that significantly affect interstate commerce. Today, it provides the basis for most federal government regulations.

Police powers are the residual powers retained by states to pass laws to safeguard the health and welfare of their citizens.

The dormant commerce clause prohibits states from passing laws that significantly interfere with interstate commerce.

Congressional taxes must be uniform across all states. Congress can use taxes and spending for purposes other than generating revenue; e.g., it can use them to indirectly promote social goals.

The privileges and immunities clause prohibits states from discriminating against citizens of other states.

The full faith and credit clause states that in civil matters, courts in all states must uphold rights established by legal documents.

The contract clause states that Congress cannot pass laws that unreasonably interfere with existing contracts.

First Amendment:

• Protects corporate speech in certain circumstances. It protects corporate political speech to the same extent that it protects individuals’ political speech. The Central Hudson test determines whether the First Amendment protects particular corporate commercial speech.

• Contains the establishment clause, which states that Congress may not make laws respecting an establishment of religion, and the free-exercise clause, which states that Congress may not make laws prohibiting the free exercise of religion.

Fourth Amendment:

• Protects both corporations and individuals from unreasonable government searches and sei- zures. Although administrative searches generally require a warrant, administrative agen- cies may inspect some industries without a warrant to ensure compliance with industry regulations.

Fifth Amendment:

• States that government cannot take an individual’s life, liberty, or property without due process of law. There are two types of due process: procedural due process, which focuses on rules for enforcing laws and entitles individuals to notice of legal action against them, and substantive due process, which requires that government have a proper purpose for enacting laws that restrict individuals’ liberty or the use of their property.

• States that if government takes private property for public use, it must compensate the owner. The extent to which some government regulations constitute takings, however, generates much litigation.

• Includes a privilege against self-incrimination, although the provision does not apply to corpora- tions. Only individual citizens and sole proprietorships may exercise this right.

• Guarantees individuals equal protection under the law. Courts use three different standards of scrutiny in equal protection cases: (1) strict scrutiny, to analyze government actions that abridge fundamental rights or that include suspect classifications; (2) intermediate scrutiny, to analyze

The Commerce Clause

Taxing and Spending Powers of the Federal Government

Other Constitutional Restrictions on Government

The Amendments to the Constitution

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Should Warrantless Wiretapping Be Allowed under the Fourth Amendment ?

YES NO

Warrantless wiretapping differs from standard wiretapping procedures only in the lack of a court-ordered warrant. In matters of national security and cases in which secrecy is of paramount importance, the acquisition of intelligence information must come before the procedural formalities of the legal system. Valuable surveillance necessary for the protection of U.S. citizens is conducted by warrantless wiretapping and should not be prevented because of a lack of a warrant.

The Internet has spawned an expanded realm of com- munications that creates new risks to national security. Technologies such as e-mail, instant messaging, and Web sites allow individuals or nations to communicate in ways that are difficult to monitor in real time while still trying to obtain a warrant. Internet technology has accelerated the pace of communication, and the methods for surveillance must accelerate as well to match. Some terrorist attacks have been planned not through traditional channels, for which it is reasonable to obtain warrants in advance, but through the Internet. New situations require new methods of surveillance.

The events of recent years demand a reexamination of the traditional intent of the Fourth Amendment. The rise in terrorist attacks and the new dynamics of conflict have shifted the nature of the conflict from that of conflict between nations to that of conflict among factions within one nation or several. Traditional conceptions of how wire- tapping was applied in a different time must be replaced to preserve the overall intent of the Fourth Amendment: to keep people “secure in their persons.”

The Fourth Amendment was designed to protect the right to privacy of all U.S. citizens. Breaching that privacy with- out a court-ordered warrant sets a dangerous precedent for the powers given to the federal government. The act of wiretapping without a warrant from the court violates the separation of powers doctrine by placing full authority for search and seizure in the hands of the executive branch of the federal government.

Moreover, the Internet has brought forth a wide array of additional methods of communication that can poten- tially be “wiretapped.” E-mail, instant messaging, Web sites, and other forms of electronic communication com- pound the problem by rendering private citizens even more vulnerable to surveillance by the federal government. Because electronic wiretaps are easier to obtain, monitor, and record than traditional wiretaps, the volume of infor- mation that the federal government can gather and use is significantly larger than it was before the advent of the Internet.

Questions have been raised as to the efficacy of the warrantless wiretapping program. Since the program remains shrouded in secrecy, it is hard to demonstrate a reasonable benefit from the wiretapping. The program was initially designed for monitoring communications into and out of other countries, not within the borders of the United States. Nevertheless, the program has recently been applied to U.S. citizens communicating within U.S. borders. This marks a vast expansion of the power of the federal government regarding surveillance of the civilian population.

Point / Counterpoint

classifications based on gender or on legitimacy of children; (3) the rational-basis test, to ana- lyze classifications involving other matters.

Fourteenth Amendment:

• Applies the due process clause, except parts of the Fifth Amendment, to the states and contains the equal protection clause.

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1. Explain how each branch of the government checks the power of the other branches.

2. How can both Sue and Sam be correct when Sue claims the commerce clause increases govern- ment’s power and Sam claims the commerce clause reduces government’s power?

3. What is the purpose of the contract clause? 4. How does the First Amendment protection of cor-

porate political speech differ from the protection of corporate commercial speech?

5. In 1998, the Vermont legislature enacted a stat- ute requiring manufacturers of certain mercury- containing products (including thermostats, batteries, and lamps) to label their products and packaging to inform consumers that the products (1) contain mercury and (2), on disposal, should be recycled or disposed of as hazardous waste. The trade asso- ciation of manufacturers of mercury-containing lightbulbs (NEMA) brought action against state officials, seeking to have the law declared uncon- stitutional and asking for a preliminary injunction to prohibit enforcement of the law. The U.S. district court granted the preliminary injunction, and the officials appealed. On what grounds do you believe the statute was challenged? Why do you believe the challenge was or was not successful? [ National Electrical Manufacturers Association v. William H. Sorrell, Attorney General of the State of Vermont, John Kassel, et al., Second Circuit Court of Appeals 53 ERC 1385 (2001).]

6. During a legal search of Alvin Smith’s house, police discovered a large amount of child pornog- raphy. A subsequent police investigation revealed that Smith had taken 1,768 sexually explicit pic- tures of girls below the age of 18. The investiga- tion also revealed that the children depicted in the pictures were Florida residents and that Smith, a Florida resident, took the pictures in his house. The paper on which the photographs were printed, however, came from Rochester, New York, and the photographs were processed by equipment made in California. The government prosecuted Smith for violating a federal statute prohibiting child pornog- raphy. Smith challenged his conviction on grounds that Congress overstepped its commerce clause

authority because his production of child pornogra- phy did not involve or substantially affect interstate commerce. Do you think the court agreed with Smith’s argument? Why or why not? [ United States v. Smith, 402 F.3d 1303 (2005).]

7. An interstate trucking company filed suit against the state of Michigan, alleging that Michigan’s $100 annual fee on trucks involved in intrastate commerce violates the dormant commerce clause. The trucking company argued that the fee discrimi- nates against trucks involved in both intrastate and interstate commerce because they spend less time carrying cargo in Michigan than do trucks involved with solely intrastate commerce. The state argued that the fee is a valid exercise of its police power, intended to defray the costs of regulating the size and weight of trucks in Michigan. With whom do you think the U.S. Supreme Court sided in this case? Why? [ Am. Trucking Ass’ns v. Mich. PSC, 125 S. Ct. 2419 (2005).]

8. The Glendale Traffic Code prohibited any cars parked on public streets from having for sale signs on them. Cars containing for sale signs could only be parked on private driveways or private property. When Pagen was ordered by police to remove the for sale sign in his car that was parked on the public street in front of his house, he challenged the ordi- nance as violating his First Amendment rights. Do you think the court agreed or disagreed with him? Why? [Pagan v. Fruchey, 492 F 3d. 766 (6th Cir. 2007).]

9. In 2004, the Oklahoma state legislature amended laws that previously forbade employees from bringing firearms onto company property. Under the amended laws, employers could be held criminally liable if they prohibited employees from storing firearms inside their locked vehicles while located on company property. Multiple Oklahoma business owners filed a suit to chal- lenge the constitutionality of the amendments. The owners argued, among other things, that the Occupational Safety and Health Act was passed to establish standards for worker safety and, there- fore, that the states were preempted from pass- ing a law that might interfere with the creation

Questions & Problems

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of a safe workplace. The district court found that the amended state laws created an obstacle to the creation of a safe workplace in accordance with the Occupational Safety and Health Act and therefore ruled in favor of the employers. The case was appealed to the 10th U.S. Circuit Court of Appeals. Do you believe the court of appeals agreed that OSHA preempted the state law? Why or why not? [Ramsey Winch Inc. et al. v. C. Brad Henry et al., No. 07-5166, 2009 WL 388050 (10th Cir., Feb. 18, 2009).]

10. Harris County arrested Carl Pruett for violating a law prohibiting bail-bond businesses from solicit- ing individuals with outstanding arrest warrants. The purpose of the law, according to the county, was to prevent individuals from fleeing the county when notified of their outstanding arrest warrants by bail-bonding companies. Pruett argued that the law was an unconstitutional restriction of his right to free speech. How do you think the court ruled in this case? Why? [ Harris County Bail Bond Bd. v. Pruett, 2005 Tex. App. LEXIS 1912 (2005).]

Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them

in the Student Center portion of the OLC, along with quizzes and other helpful materials.

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PA R

T 1

  The Legal Environm

ent of B usiness

International and Comparative Law 6

1 What is international law?

2 How is business transacted in the international marketplace?

3 What ethical considerations impact business in the international marketplace?

4 What is the General Agreement on Tariffs and Trade, and what are its important provisions?

5 What are regional trade agreements?

6 What is comparative law?

7 How does contract law differ among states?

8 How does employment law differ among states?

9 How are disputes settled in the international marketplace?

C H A P T E R

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

CASE OPENER Resolving a Breach of Contract Under the CISG

Chicago Prime Packers, Inc., is a Colorado corporation with its principal place of busi- ness in Avon, Colorado. Northam Food Trading Company is a Canadian corporation with its principal place of business in Montreal, Quebec, Canada. Chicago Prime and Northam are wholesalers of meat products. On March 30, 2001, Chicago Prime contracted with Northam to sell 1,350 boxes (40,500 pounds) of government-inspected fresh, blast-frozen pork back ribs, which Chicago Prime purchased from Brookfield Farms, a meat processor. The agreed-on price for the ribs was $178,200, and payment was required within seven days of the date of shipment. The ribs were stored at three different locations en route to

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Northam’s customer Beacon Premium Meats, but at all times they were stored at or below acceptable temperatures. However, the ribs ultimately proved to be spoiled and were con- demned by the U.S. Department of Agriculture. Nevertheless, Chicago Prime continued to demand payment from Northam. Chicago Prime brought a breach of contract action against Northam in U.S. federal court after Northam refused to pay for the ribs.

1. What law will the court apply to this transaction?

2. Could the parties have selected the law for the court to apply before the occurrence of their dispute?

The Wrap-Up at the end of this chapter will answer these questions.

The terms international law and comparative law are often used interchangeably, but they are quite different. International law governs the conduct of states and international orga- nizations and their relationships with one another and with natural and juridical persons. 1

A state, for purposes of international law, is an entity possessing territory, a permanent population, a government, and the legal capacity to engage in diplomatic relations. 2 We generally think of international organizations as consisting of states. The United Nations, the International Monetary Fund, the International Bank for Reconstruction and Develop- ment (World Bank), and the World Trade Organization are international organizations. The term natural and juridical persons refers to individuals as well as business organizations.

In contrast, comparative law is the study of the legal systems of different states. For example, a comparative legal theorist might study contracts in the American, Chinese, and French legal systems by identifying and contrasting applicable national laws. Compara- tive legal studies start with the examination of national sources of law embodied in con- stitutions, legislative enactments, administrative rules and regulations, and the decisions of judicial bodies. But where do we find principles of international law? Article 38 of the Statute of the International Court of Justice, a part of the United Nations system, identifies four sources of international law: customs, international agreements, general principles of law recognized by legal systems throughout the world (such as equity and elementary considerations of humanity), and secondary sources (such as decisions of the International Court of Justice, resolutions of the U.N. General Assembly, and scholarly writings). 3

Legal Principle: International law governs the conduct of states and international organizations and their relationships with one another and natural and juridical per- sons, while comparative law is the study of legal systems of different nation states.

Most important for our purposes are customs and international agreements. Customary international law has two characteristics. First, in order to be deemed a custom, a practice must be general and consistent among states. Second, states must accept this general and consistent practice as binding law. The U.S. Supreme Court has held that in the absence of a governing international agreement or controlling executive or legislative act or judicial decision, U.S. courts must rely on customary international law. 4

1 Restatement (Third) of the Foreign Relations Law of the United States, § 101 (1987).

2 Montevideo Convention on the Rights and Duties of States, December 26, 1933, art. 1, 165 L.N.T.S. 19, reprinted in American Journal of International Law 28 (Supp. 1934), p. 75.

3 Statute of the International Court of Justice, June 26, 1945, art. 38, 59 Stat. 1055, 1060. 4 Paquete Habana, 175 U.S. 677, 700 (1900).

LO1

What is international law?

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Chapter 6 International and Comparative Law 125

By contrast, an international agreement is a written agreement made between states governed by international law that relates to an international matter. 5 International agree- ments can be bilateral (between two states) or multilateral (between three or more states). Regardless of their form, they do not take effect until ratified. Ratification occurs in many different ways. In the United States, it requires the advice and consent of two-thirds of the Senate after the president submits the agreement for consideration. 6

Doing Business Internationally The simplest method of entering a foreign market is through the export of the company’s product to the foreign marketplace. A foreign sales representative is an agent who distrib- utes, represents, or sells goods on behalf of a foreign seller and forwards orders directly to the company. The representative is usually compensated through commissions on completed transactions. Companies may also engage distributors for their products, who purchase goods from a seller for resale in a foreign market. Distributors are responsible for supporting and servicing the products they sell. Unlike the foreign sales representative, the distributor takes title to the goods and assumes the risk of being unable to resell them at a profit.

Companies seeking to enter foreign markets may also do so through franchise and licensing agreements. A franchise agreement is a contract whereby a com- pany (known as the franchisor ) grants permission (a license) to a foreign entity (known as a franchisee ) to utilize the franchisor’s name, trademark, or copyright in the operation of a business and associated sale of goods in a foreign state. In return for this license, the franchisee pays the franchisor, usually a percent- age of the franchisee’s gross or net sales. In a licensing agreement, the foreign company (known as the licensor ) grants permission to a company in the targeted market (known as the licensee ) to utilize the licensor’s intellectual property, con- sisting of patents, trademarks, copyrights, or trade secrets. In return, the licensor receives royalty payments from the licensee, usually based on the licensee’s gross or net sales.

Companies seeking a more permanent presence in a foreign jurisdiction have several options. A company may establish a representative office for limited purposes, such as market analysis or product promotion. An even more significant presence arises from a joint venture with a company in the host state, wherein the parties share profits and man- agement responsibilities for a specific project. Companies may also establish a foreign subsidiary, or affiliate. An affiliate is a business enterprise located in one state that is directly or indirectly owned and controlled by a company located in another state. The affiliate is usually established in conformity with the laws of the foreign state and is sub- ject to that state’s regulation.

Ethical Considerations International businesspersons must take ethical considerations into account in the decision- making process. A company considering exporting its product for ultimate consumption by overseas consumers must resolve usage and safety issues. Foreign consumers may not fully understand risks associated with use of the product, or national safety standards may offer less protection than those applicable in the United States. Although tobacco prod- ucts, for example, are subject to stringent regulation in the United States with respect to advertising, health warnings, and availability to minors, that is the exception rather than the global norm. 5 Vienna Convention on the Law of Treaties, May 23, 1969, art. 2, 1155 U.N.T.S. 331. 6 U.S. Const., art. II, § 2, cl. 2.

LO2

How is business trans- acted in the international

marketplace?

LO3

What ethical consider- ations impact business

in the international marketplace?

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Ethical considerations are not limited to products. Companies must also carefully consider the location of their operations. Ethical considerations also arise from how a com- pany does business overseas. For example, the Foreign Corrupt Practices Act (FCPA) prohibits U.S. companies from offering or paying bribes to foreign government officials, political parties, and candidates for office for the purpose of obtaining or retaining busi- ness. 7 The direct trigger for the FCPA was an investigation launched by the U.S. Secu- rities and Exchange Commission in the 1970s that discovered that 450 U.S. companies had engaged in bribery overseas totaling more than $400 million. For example, aircraft manufacturer Lockheed paid $12.6 million to Japanese officials and $10 million to Dutch, Italian, and German officials in its efforts to convince these officials to purchase Lock- heed aircraft on behalf of their respective governments. The FCPA also requires that firms maintain records to fairly and accurately reflect transactions and the disposition of assets. Exhibit 6-1 summarizes recently settled cases involving alleged violations of the FCPA.

The General Agreement on Tariffs and Trade There are two primary types of barriers to international trade. Tariffs are taxes levied on imported goods. They can be calculated as a percentage of the value of the imported good (ad valorem tariff), on the basis of the number or weight of the imported units or a flat per-unit charge (specific tariff), or as a combination of the two (compound tariff). A non- tariff barrier is any impediment to trade other than tariffs, including quotas, embargoes, and indirect barriers. Quotas are limits on imported goods, usually imposed for national economic reasons or for the protection of domestic industry. An embargo is a ban on trade with a particular state or on the sale of specific products, usually on the basis of foreign policy or national security. Indirect barriers are laws, practices, customs, and traditions that limit or discourage the sale and purchase of imported goods.

The General Agreement on Tariffs and Trade (GATT) is a comprehensive multilateral trading system designed to achieve distortion-free international trade by minimizing tariffs and removing artificial barriers. GATT is a legacy of the Great Depression and World War II. Originally conceived as a temporary measure, it became effective on January 1, 1948, and included the United States as one of 23 signing countries. Since then it has undergone numerous changes as a result of eight different negotiating rounds. The most recently completed round is the Uruguay Round, which was completed in 1994 and took effect on January 1, 1995. Thus, the most recent version of GATT is known as GATT 1994. The most recent round of GATT, the Doha Development Agenda, has been under negotiation for several years, and negotiations for its completion are presently stalled.

The Uruguay Round established the World Trade Organization (WTO). The WTO facilitates international cooperation in opening markets and provides a forum for future

7 15 U.S.C. §§ 78dd-1–78ff (2000).

COMPANY STATE CONTRACT FINE (MILLIONS)

Baker Hughes Kazakhstan Oil and gas $ 44.0

Kellogg, Brown & Root Nigeria Natural gas 579.0

Siemens China, Russia, and 7 other states

Equipment, service, and construction

1,600.0

Titan Corporation Benin Telecommunications 28.5

Willbros Group Nigeria Oil services 32.0

Exhibit 6-1 Summary of Recent Settlements of FCPA Cases

LO4

What is the General Agreement on Tariffs and Trade, and what are its important provisions?

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trade negotiations and the settlement of international trade disputes. WTO membership presently consists of 153 states, thereby making GATT the most comprehensive trading system in world history.

GATT established several general principles of trade law. Article I addresses the prin- ciple of most-favored-nation relations , a principle now known as normal trade relations. This principle requires that WTO member states treat like goods coming from other WTO member states on an equal basis. WTO member states are specifically prohibited from discriminating against like products on the basis of their country of origin. National treat- ment is set forth in Article III. It prohibits WTO member states from regulating, taxing, or otherwise treating imported products any differently from domestically produced prod- ucts. Article XI prohibits quantitative restrictions that limit the importation of certain products on the basis of number of units, weight, or value, for national economic reasons, or for the protection of domestic industry.

Legal Principle: As a general rule, GATT prohibits discrimination against imported goods on the basis of their country of origin and also prevents quantitative restrictions on such imports.

Article VI relates to dumping and subsidies. Dumping is the practice wherein an exporter sells products in a foreign state for less than the price charged for the same or comparable goods in the exporter’s home market. Article VI condemns dumping if it causes or threatens to cause material injury to an established industry. Government author- ities usually make this determination by examining the volume of imports, their effect on prices, and their impact on the industry. After investigation, the remedy for dumping is the assessment of antidumping duties, tariffs equal to the difference between the export and domestic prices.

A subsidy is a government payment to a specific industry or enterprise. Subsidies can be direct transfers of funds, such as loans and grants; loan guarantees; tax credits; government procurement; and price supports. There are three basic types. Actionable subsidies are illegal under Article VI. They include subsidies payable to domestic manufacturers either on the basis of export performance or for the use of domestic, rather than imported, input in the manufacturing process. Actionable subsidies are remedied through the imposition of coun- tervailing duties, special tariffs imposed on subsidized goods to offset the benefit of the ille- gal subsidy. Nonactionable subsidies are expenditures on research and development, aid to underdeveloped regions within a state, and aid to foster compliance with environmental stan- dards. Domestic subsidies are generally not actionable unless they are not part of the govern- ment’s legitimate responsibility of directing industrial growth and funding social programs and they cause material injury to benefits conferred by GATT on other WTO member states.

Legal Principle: As a general rule, GATT prohibits dumping and subsidies that are based on export performance or the use of domestic rather than imported input in the manufacturing process.

The Dispute Settlement Understanding allows recognized governments of WTO mem- ber states to bring an action alleging a violation of GATT. After an aggrieved state files a complaint, the states that are parties to the dispute consult with one another in an attempt to resolve the dispute. The states may also ask a trade expert to mediate. If these efforts are unsuccessful, the WTO Secretariat establishes a panel of three to five trade experts to hear oral arguments and review the written submissions of the parties. The panel then drafts and ultimately adopts a report determining the merits of the claims. Aggrieved states have the right to contest the panel’s decision before the WTO’s appellate body. The panel and the appellate body may only recommend that a state found in violation of its obligations cease and desist from such practices within a reasonable time. Failure to comply may lead to the

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imposition of sanctions, usually consisting of the suspension of concessions by the injured state. Such sanctions may impose only an equivalent burden on the noncomplying state and can be imposed only for as long as the trade barrier remains in place.

Regional Trade Agreements There are three basic types of regional trade agreements: multilateral free trade agree- ments, customs union, and bilateral free trade agreements. In a multilateral free trade agreement, three or more states agree to reduce and gradually eliminate tariffs and other trade barriers. The North American Free Trade Agreement (NAFTA) between the United States, Canada, and Mexico is a multilateral free trade agreement. In effect since January 1, 1994, NAFTA mirrors many of the provisions set forth in GATT but accords favorable treatment only to goods of “North American origin.” NAFTA also reduces bar- riers to direct foreign investment and ensures the free flow of capital. Disputes between NAFTA members are resolved through a dispute resolution process coordinated by the Free Trade Commission. This process includes attempts to reach a negotiated settlement, the convocation of dispute resolution panels to hear evidence and determine the existence of a violation, and enforcement of orders through the authorization of retaliation in the event of noncompliance. Unlike GATT, NAFTA addresses environmental and workers’ rights issues. Its three members pledge to cooperate in protecting the environment and developing common environmental standards. They also recognize basic labor rights, including freedom of association, the right to engage in collective bargaining and strikes, prohibitions on forced labor and child labor, freedom from employment discrimination, the right to receive equal pay for work of equal value, and the right to minimum acceptable working conditions and occupational safety and health. The United States is also a party to the Central American Free Trade Agreement (CAFTA) with El Salvador, Guatemala, Nicaragua, Honduras, Costa Rica, and the Dominican Republic.

A customs union is a free trade area with the additional feature of a common external tariff on products originating outside the union. The European Union (EU) is a customs union. It is a loose association of states with a basis in international law formed for the pur- pose of forging closer ties among the peoples of Europe. The modern EU had its inception in three treaties between Belgium, France, Italy, Luxembourg, the Netherlands, and West Germany (now Germany) in the 1950s. These treaties integrated industrial sectors within the states, eradicated internal tariffs, created a common external tariff for goods originating in nonmember states, and strove to create a common market through the free movement of people, services, goods, and capital. Subsequent rounds of expansion added Austria, Denmark, Finland, Greece, Ireland, Portugal, Spain, Sweden, and the United Kingdom. Expansion in 2004 added 10 more states: Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia. This expansion created the larg- est regional trading bloc in the world, containing more than 440 million people. The most recent expansion in January 2007 added Bulgaria and Romania.

States may also enter into bilateral free trade agreements, which relate to trade between two states. The United States has several bilateral free trade agreements, includ- ing those with Australia, Bahrain, Chile, Israel, Jordan, Morocco, Peru, and Singapore.

Comparative Law What are the benefits of comparing the laws and legal systems of different states? First, we gain a better understanding of the general purpose of law by studying other legal systems and their goals. Second, we can better develop a critical viewpoint on our own legal system

LO5

What are regional trade agreements?

LO6

What is comparative law?

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as just one of many alternatives. Third, the specific laws you will encounter will likely be different from U.S. laws. After thinking critically about alternative laws, you might decide your own state should adopt the other state’s law or method of resolving a dispute.

What do comparative legal scholars actually study? What kinds of questions do they ask? Generally they ask two types: questions about the system and its procedures and ques- tions about substantive law. Below we look at different legal systems and procedures. Then we consider substantive law by comparing contract law and employment law in a variety of states. The chapter concludes with a look at dispute resolution between private parties.

Legal Systems and Procedures CIVIL LAW SYSTEMS Many civil law systems are derived from Roman law. Other civil law systems were strongly influenced by the French Civil Code of 1804 and the German Civil Code of 1896. Other legal systems fashioned their own laws around a mixture of these. The codes generally covered areas of private law such as property, contracts, torts, and family law and tended to reflect preferences for the protection of private property, individual freedom, and freedom of contract.

Today, codes in civil law systems serve as the sole official source of law. Secondary sources include custom and general principles of law; precedent is not an important source of civil law. The civil law system is the most common legal system in the world. We find examples in most European nations, the People’s Republic of China, and Japan. Louisiana, because of its French roots, has a “mixed” legal system.

Civil law systems assume a separation of powers, but it is unlike the U.S. system of checks and balances. In civil law systems, the legislative branch has ultimate authority. Remember, the ultimate source of law in a civil law system is the code. The judicial branch interprets the code and applies it to resolve disputes. However, the judicial branch cannot create its own law. Thus, the separation of powers refers to the limitations on the judicial branch and the superiority of the codes.

Judges in the civil law system typically assume the role early in their careers, following a training period and examination. At the highest judicial levels they are typically profes- sors or experienced practitioners.

After the pleadings have entered the legal system, the evidence period—a series of meetings and hearings—begins. The judge is primarily responsible for developing evi- dence by asking witnesses questions and introducing legal theories. Neither the parties nor the judge is required to formally admit evidence to the court, and hearsay and opinion are acceptable.

Judges in the civil law system have primary responsibility for determining and applying the correct legal principles. However, the judge responsible for deciding the case may not be the same one who helped gather evidence. In fact, several judges might serve on a panel to decide the case.

COMMON LAW SYSTEMS Common law systems originated in the English legal system. English common law began in 1066, when William the Conqueror assumed the English throne. The centralization of government that followed paved the way for a centralized court system.

In the common law system, the courts develop rules governing areas of law. In addition to relying on constitutions, legislation, and regulations, they are guided by precedent, or stare decisis; thus, if a higher court has created a precedent, a lower court is bound by that

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precedent. However, if a court cannot find a precedent to guide its reasoning, it may offer its own rule. Both the emphasis on precedent and the judge’s ability to create rules are important characteristics of common law systems. Common law systems exist in Australia, India, the United Kingdom, and the United States.

Unlike civil law judges who are trained and tested, judges in the common law system are typically appointed. In the United States, some judges are elected.

Because common law judges have opportunities to make law through their decisions, they are relatively well known and the public perceives them as powerful. Some in the United States have been criticized for being “activists” and going beyond the bounds of their roles.

The common law system is an adversarial system, in which two opposing sides present their arguments before a neutral fact finder who determines which side has presented the most credible evidence or met its burden of proof. The adversarial method leads to proce- dures that differ from those in civil law systems. First, after the advocates enter pleadings in the common law system, there is a period in which discovery is conducted. Second, the judge typically does not become significantly involved in the case until trial. Third, in the common law system, the judge is not responsible for gathering any evidence; the parties themselves bear this responsibility. Fourth, common law systems often rely on juries as fact finders; civil law systems do not use juries. Fifth, as a consequence of the use of juries, common law systems have extensive rules governing admissibility of evidence.

OTHER LEGAL SYSTEMS Although the civil and common law systems are predominant, other legal systems deserve mention. Socialist legal systems, such as exist in Cuba and North Korea, are based on the premise that the rights of society as a whole outweigh the rights of the individual. In such systems, law does not act as a limit on the exercise of government power. Traditionally, the state owns the means of production and property in a socialist legal system.

An Islamic legal system is based on the fundamental tenet that law is derived from and interpreted in harmony with Shari’a (“God’s law”) and the Koran. The preeminent concern is moral conduct, such as honoring agreements and acting in good faith. However, there are many interpretations of Islamic law, as evidenced by the differences between the legal sys- tems in Iran, Pakistan, and Saudi Arabia and that practiced by the former Taliban regime in Afghanistan.

Substantive Law COMPARATIVE CONTRACT LAW The U.S. businessperson in the global marketplace should give careful thought to the ques- tion of what law may be applicable to the interpretation and enforcement of his or her contracts. Anyone who assumes all applicable laws are identical, or similar enough that differences do not matter, is likely to be unpleasantly surprised. This section reviews the sources of contract law in the international marketplace and notes some of the similarities and differences between these sources.

The Lex Mercatoria and National Contract Codes. One potential source of contract law is the lex mercatoria, literally the “law of merchants.” This is the body of customs or trade usages merchants developed to facilitate business transactions. Its sources are public international law, uniform laws, general principles of contract law, rules of inter- national organizations, custom and usage, standard form contracts, and arbitral decisions.

LO7

How does contract law differ among states?

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Another source of law applicable to international contracts is national laws. In the United States, these laws are embodied in the common law of contracts and, for contracts relating to the sale of goods, in the Uniform Commercial Code. Given the predominance of the civil law system, most nations’ contract laws are set forth in codes. These codes have many simi- larities to U.S. law. For example, Section 2-615 of the Uniform Commercial Code excuses delays in the delivery of goods or nondelivery in the event performance has been rendered “impracticable by the occurrence of a contingency the nonoccurrence of which was a basic assumption on which the contract was made.” In a similar fashion, the Civil Code of the Russian Federation excuses nonperformance if it is the result of an unanticipated “essential change of circumstances” that could not be avoided through the exercise of reasonable care. A similar excuse for nonperformance exists in the Unified Contract Law of the People’s Republic of China and in the Principles of European Contract Law. Under China’s national contract code, a nonperforming party is excused from liability if its inability to perform was the result of force majeure (“superior force”). Force majeure is a “situation which, on an objective view, is unforeseeable, unavoidable and is not able to be overcome.” The Prin- ciples of European Contract Law excuse nonperformance if it is due to an impediment that is not “reasonably expected” and is beyond the control of the nonperforming party.

Despite their similarities, the differences between U.S. law and national contract codes may be very pronounced. The Principles of European Contract Law provide that a contract is concluded only when the acceptance reaches the offeror. The principles further require that the parties give reasons for terminating contract negotiations. In the United States, parties do not owe one another a duty to negotiate in good faith and may terminate nego- tiations in bad faith without liability unless the other party relied on the likelihood of a final agreement. Furthermore, the European principles do not require that the contract be in writing. Rather, a contract can be proved by any means. Contracts are subject to inter- pretation utilizing the totality of the circumstances surrounding the transaction, including statements made by the parties before entering into the contract.

Even in the areas where U.S. law and national contract codes converge, international businesspeople must be aware of differences. Despite having writing requirements like those in the United States, China’s Unified Contract Law provides, in addition, that all written contracts must state the name and residence of each party, subject matter of the contract, quantity and quality of the subject matter, price, time, place and methods of con- tractual performance, liability for breach, and methods of dispute resolution.

Legal Principle: Despite numerous similarities among contract laws, interna- tional businesspersons must be aware of significant differences between U.S. and other national contract laws.

The Convention on the International Sale of Goods. The Convention on the International Sale of Goods (CISG) applies to the commercial sale of goods. A com- mercial sale of goods is the exchange of tangible personal property between merchants in return for consideration. A merchant is a person engaged in the transfer of goods in the ordinary course of business.

The CISG was adopted in 1980 and has been ratified by the majority of states in the devel- oped world, including Australia, Canada, China, Korea, Mexico, Russia, most nations of West- ern Europe, and the United States, where it became effective in 1988. Notable states that have not adopted the CISG include Brazil, India, Pakistan, Saudi Arabia, and the United Kingdom.

Two sets of laws govern the sale of goods in the United States, the CISG and the Uniform Commercial Code (UCC). The UCC applies when both parties to the sales transaction are residents of the United States. The CISG is applicable when one party is a U.S. resident and the other is a resident of a jurisdiction that has ratified the CISG. Nevertheless, the parties are

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always free to opt out of the CISG and select another law to apply to their transaction. In the absence of such a selection, the CISG applies to the sale of goods between merchants residing in different states that have ratified the CISG. The CISG also applies if national conflict-of- law rules direct the court or arbitral body to apply the law of a state that has ratified the CISG. Finally, the CISG may serve as evidence of trade usage and customs. National contract law applies in areas not covered by the CISG, such as services, real estate, and intellectual property.

How do U.S. businesspeople determine which set of rules they want to apply to their international contracts? There are numerous similarities between the UCC and CISG. For example, both recognize express warranties and implied warranties of merchantability and fitness for a particular purpose arising from the sale of goods. 8 Both the UCC and the CISG limit damages to those that were foreseeable at the time of the formation of the contract. Fur- thermore, only damages that can be proved with some degree of certainty may be awarded. The nonbreaching party has a duty to mitigate damages, and damage awards can be reduced to the extent that the loss could have been prevented or minimized through mitigation.

However, the differences between the UCC and CISG are substantial in many areas. Exhibit 6-2 summarizes some of these differences.

8 Compare UCC §§ 2-313–316 with CISG art. 35.

RULE OR DOCTRINE UCC PROVISION CISG PROVISION

Mailbox rule Acceptance is generally effective upon mailing.

Acceptance is generally effective only upon receipt.

Statute of frauds Requires that contracts for the sale of goods in excess of $500 be in writing.

No required writing.

Parol evidence rule Prevents introduction of preliminary negotiations to alter an unambiguous written contract.

No parol evidence rule.

Notice of noncon- forming goods

Specific description of nonconformity is generally not required.

Specific description of nonconformity is required.

Additional time to perform contract

None unless specified in contract. Nachfrist—allows additional time for performance of a contract upon notice to the other party.

Exhib it 6-2 Some Differences between the UCC and the CISG

LO8

How does employment law differ among states?

COMPARATIVE EMPLOYMENT LAW The employment relationship in the United States is governed by the employment-at-will standard. This standard means either the employer or the employee may terminate the employment relationship at any time. Furthermore, both parties are free to determine the conditions of employment. If an express employment agreement exists, however, and either party breaks it, the other can sue for breach of contract.

Although the employment-at-will doctrine remains predominant in the United States, the nature of the employment relationship has changed. Federal, state, and local govern- ment restrictions protect workers in the areas of minimum wages, unemployment and workers’ compensation, occupational health and safety, employment discrimination, and termination. These restrictions vary significantly when a U.S. firm seeks to hire employees outside the United States where the employment-at-will standard does not apply.

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This section discusses two such differences, minimum-wage laws and termination. We conclude with a look at the effect of international labor standards on the employment relationship.

National Regulation of the Employment Relationship

Minimum-Wage Laws. Under the Fair Labor Standards Act (FLSA), all U.S. employers are required to pay a minimum wage to employees. 9 The current federal minimum wage under the act is $7.25 per hour, as of summer 2009. States are free to adopt minimum-wage laws in excess of (but not below) the federal rate, and the majority have done so. 10

The U.S. businessperson seeking to hire employees overseas will find a wide variety of frequently changing laws relating to the payment of minimum wages. Some states, such as the People’s Republic of China have no national minimum-wage laws. Minimum wages are established by provincial and municipal government officials. A similar method of reg- ulation exists in Canada, which also lacks a national minimum-wage law. Minimum wages are established individually by the provinces. Thus, the hourly minimum wage is C$10 (Canadian dollars) in Nunavut, C$9.50 in Ontario, but only C$7.75 in New Brunswick. In other states that lack national minimum-wage laws, such as Denmark, Finland, Germany, Italy, and Sweden, industrial collective agreements establish minimum wages.

Some states with minimum wages vary them depending on the age of the worker. In Ire- land, employers are required to pay no less than €8.65 (euros) per hour. However, employ- ers are permitted to reduce this amount by 30 percent for employees under the age of 18. A 20 percent reduction is permitted for employees over the age of 18 but in their first year of employment since turning 18. The permitted reduction is 10 percent for workers in their second year of employment since turning 18.

Other states calculate minimum wages on the basis of weekly earnings. Australia requires that employers pay at least A$543.78 (Australian dollars) per week. States may also require the payment of minimum wages calculated on the basis of monthly earnings. In the Russian Federation, national law establishes the minimum wage as R2,300 (rubles) per month. Some states have a combination of minimum-wage requirements. For example, in 2007, Taiwan adopted a law raising the minimum monthly wage to NT$17,280 (new Taiwan dollars) and the minimum hourly wage to NT$95. Other states use different combi- nations. For example, Greece has a monthly minimum wage of €701, but this amount may vary depending on whether the worker is employed in a white- or blue-collar position, the length of the worker’s service, and his or her marital status.

Employment Termination Laws. The employment-at-will doctrine has been modified over the years by federal and state laws prohibiting the termination of employment on the basis of certain statuses such as race, gender, age, and disability. 11 Termination for whistle- blowing is also prohibited. 12 Finally, the ability to terminate employment may be impacted by statements contained within employment manuals. 13

9 29 U.S.C. § 206(a)(1) (2000).

10 The states are Alaska, Arizona, California, Colorado, Connecticut, Delaware, Florida, Hawaii, Illinois, Iowa, Maine, Mas- sachusetts, Michigan, Missouri, Montana, Nevada, New Jersey, New Mexico, New York, Ohio, Oregon, Pennsylvania, Rhode Island, Vermont, Washington, and West Virginia. Washington currently has the highest minimum wage in the United States, $8.55 per hour.

11 29 U.S.C. § 623(a)(1) (2000) (age discrimination); 42 U.S.C. § 2000e-2(a)(1) (2000) (race, national origin, gender, and reli- gion); Americans with Disabilities Act of 1990, Pub. L. No. 101-336, 104 Stat. 327.

12 Whistleblower Protection Act of 1989, Pub. L. No. 101-12, 103 Stat. 16.

13 See, e.g., Litton v. Maverick Paper Co., 354 F. Supp. 2d 1209 (D. Kan. 2005); Continental Airlines, Inc. v. Keenan, 731 P.2d 708 (Colo. 1987); Gaudio v. Griffin Health Servs. Corp., 733 A.2d 197 (Conn. 1999); O’Brien v. New England Tel. & Tel. Co., 664 N.E.2d 843 (Mass. 1996); Bobbitt v. The Orchard, Ltd., 603 So. 2d 356 (Miss. 1992); Wuchte v. McNeil, 505 S.E.2d 142 (N.C. App. 1998); Thompson v. St. Regis Paper Co., 685 P.2d 1081 (Wash. 1984).

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The employment-at-will doctrine has been rejected in many states throughout the world. In some states, employment is viewed as a property right or a lifetime entitlement. These jurisdictions sharply restrict the ability of the employer to terminate the relationship. The German Termination Protection Act of 2004 provides that, in the absence of detri- mental behavior, employees of “works” with more than 10 employees can be terminated for operational reasons only if the termination is “socially justified.” Social justification depends on the worker’s age, years of service, disability, and number of dependents. The employer must provide notice of four weeks to seven months, depending on the employ- ee’s years of service. Termination also must be coordinated with the appropriate works councils. Employers must pay severance equal to one-half month’s gross salary for every year of service.

Termination laws are similar in other jurisdictions. France’s Labor Code states that ter- mination of employment by companies with more than 20 employees on economic grounds other than faute grave (serious fault or gross negligence on the part of the employee) or elimination or transformation of the job requires written notice in French, a pretermi- nation meeting with the employee, consultation with the appropriate works committee, and a required waiting period. Redundancies (layoffs for economic reasons) require the existence of severe economic constraints and notice to the government. China’s Labor Contract Law recognizes three separate grounds for termination. First, the occurrence of certain events such as expiration of the term, death of the employee, or bankruptcy of the employer may cause termination of the employment agreement. Second, the employee may terminate the agreement upon 30 days’ written notice unless the termination occurs under “extreme circumstances.” Third, the employer may terminate the agreement for the employee’s failure to satisfy the conditions of employment during any probation- ary period, material breach of contract, serious dereliction of duty, corruption, conflict of interest, criminal activity, or inability to perform the work due to a nonwork-related injury or illness or for a major change in the employer’s circumstances (upon 30 days’ notice or payment of one month’s wages). Mass layoffs are defined as termination of 20 or more employees or 10 percent of the total number of employees. Such layoffs are only permitted in the event of bankruptcy, “serious difficulties” in production or opera- tions, changes that require layoffs (such as technological innovation), or “major change in objective economic circumstances.” The employer must explain the circumstances to affected labor unions and workers no less than 30 days in advance. Such employers may also be required to retain “priority persons” such as employees with long fixed-term or open-ended contracts and those who are the only employed members of a family contain- ing elderly persons or minors.

International Labor Standards. Employers must ensure that their employ- ment practices conform to international labor standards. This concern is particularly acute in the developing world, where national labor protections are lax or nonexistent, enforcement attitudes vary widely, and the temptation to exploit local populations is significant.

International labor standards arise from general human rights instruments that apply across a broad spectrum of areas and from specialized documents that focus exclusively on labor. The Universal Declaration of Human Rights of 1948, often referred to as the basis for modern human rights law, prohibits slavery and grants everyone the right to free choice of employment, just and favorable conditions of work, reasonable limitation of working hours, and compensation adequate to provide for the worker’s health and

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that of his or her family. 14 The International Covenant on Economic, Social and Cultural Rights also recognizes these rights, as well as fair wages and safe and healthy working conditions. 15

Many of the specialized instruments that focus exclusively on labor rights are based on norms developed by the International Labor Organization (ILO). Established in 1919 by the Treaty of Versailles, the ILO operates under the principle that “labor should not be regarded merely as a commodity or article of commerce.” In 1998, the ILO issued its Declaration on Fundamental Principles and Rights at Work. This statement enumerated a number of “core labor standards,” including freedom of association, the right to engage in collective bargaining, and the elimination of all forms of forced or compulsory labor, child labor, and employment discrimination. 16 Many of the ILO’s instruments relate to specific labor practices. For example, the Convention Concerning Forced or Compulsory Labor and the Abolition of Forced Labor Convention obligate states to prohibit the utiliza- tion of forced or compulsory labor, including labor for the benefit of private individuals, companies, or associations. 17 Violation of standards established by general human rights instruments served as the basis for allegations brought against Del Monte Fresh Produce that arose from its investment in Guatemala, as noted in Case 6-1 .

14 Universal Declaration of Human Rights, G.A. Res. 217A (III), U.N. GAOR, 3d Sess., at 71, arts. 4, 23–25, U.N. Doc. A/810 (1948).

15 International Covenant on Economic, Social and Cultural Rights, G.A. Res. 2200A (XXI), 21 U.N. GAOR, 21st Sess., Supp. No. 16, arts. 6–7, 11, U.N. Doc. A/6316 (1966).

16 ILO, Declaration on Fundamental Principles and Rights at Work, art. 2(a–d) (1998).

17 Abolition of Forced Labor Convention (ILO No. 105), art. 1, 320 U.N.T.S. 291 (1957); Convention Concerning Forced or Compulsory Labor (ILO No. 29), arts. 1–2, 4–5, 39 U.N.T.S. 55 (1930).

Plaintiffs, seven Guatemalan citizens residing in the United States and former officers in SITRABI, a national trade union of plantation workers, brought this action against defendants Del Monte Fresh Produce, Inc., and its wholly owned Guatemalan subsidiary Bandegua. SITRABI and Bandegua were negotiating a new collective bargaining agreement for workers at the plantation. Plaintiffs alleged that Bandegua retained a private armed security force to plan violent action against the Plaintiffs and other SITRABI leaders. This force was alleged to have held SITRABI lead- ers, including the Plaintiffs, hostage at SITRABI’s head- quarters, during which time they were threatened with death. The Plaintiffs were then forcibly escorted to a local radio station where they were compelled to broadcast an announcement that the labor dispute was over and that they were resigning. The Plaintiffs were then returned to

SITRABI headquarters where they signed resignation let- ters at gunpoint and were threatened with death if they failed to leave Guatemala.

Per Curiam The Alien Tort Act provides that “[t]he district courts shall have original jurisdiction of any civil action by an alien for a tort only, committed in violation of the law of nations or a treaty of the United States.” 28 U.S.C. § 1350 (2005). To obtain relief under the ATA, plaintiffs must be (1) an alien, (2) suing for a tort, which was (3) committed in violation of international law. The first two elements are not dis- puted. Del Monte does challenge Plaintiffs’ contention that the underlying acts show a violation of the laws of nations: prohibitions against (1) cruel, inhuman, degrading treat- ment or punishment; (2) arbitrary detention; and (3) crimes

ALDANA V. DEL MONTE FRESH PRODUCE, INC. U.S. COURT OF APPEALS FOR THE ELEVENTH CIRCUIT (2005) 416 F.3D 1242 (11TH CIR. 2005)

CASE 6-1

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labor in Guatemala is too tenuous to establish a prima facie case, especially in the light of Sosa ’s demand for vigilant doorkeeping.

The district court also decided that Plaintiffs’ claims did not constitute torture. We conclude that Plaintiffs alleged sufficient facts to establish torture causing severe mental suffering. Plaintiffs allege they were (a) in the custody or physical control of the security force; (b) suffered severe, prolonged mental and physical pain or suffering; by being (c) threatened with imminent death; for the purposes of (d) punishing Plaintiffs for their labor activities. The com- plaint alleges that [four] Plaintiffs were told they would be killed that night. [Two] Plaintiffs were filmed with a video camera and told they “would be giving their last messages.” Another paragraph discusses a collective threat: taking pic- tures of the seven Plaintiffs, “stating that [a member of the security force] wanted a clear photo of the faces before he killed them all.” These allegations describe imminent death threats: (1) the security force was heavily armed; (2) Plain- tiffs were unarmed and restrained; and (3) for many hours the security force made specific threats that Plaintiffs (for their past acts) would be killed not sometime in the future, but that very night. All things considered, the acts alleged in the complaint could constitute torture—based on intentionally inflicted emotional pain and suffering.

Plaintiffs’ allegations of intentionally inflicted physical pain and suffering do not meet the statutory elements of torture. The only specified acts of physical violence we can discern from the complaint involved pushing, shoving and having one’s hair pulled. These acts do not constitute severe pain or suffering.

We affirm the district court’s order dismissing Plain- tiffs’ complaint entirely, except we vacate the dismissal of Plaintiffs’ claims for alleged torture based on intentionally inflicted mental pain and suffering.

against humanity. The Supreme Court recently interpreted the Alien Tort Act in Sosa v. Alvarez-Machain, 542 U.S. 692 (2004). There, the Court explained that the ATA is jurisdictional in nature but that it also provides a cause of action “for the modest number of international law viola- tions with a potential for personal liability at the time [of its enactment].” According to the Court, causes of action under the ATA are not static; new ones may be recognized, if the claim is “based on the present-day law of nations to rest on a norm of international character accepted by the civilized world and defined with a specificity compa- rable to the features of the 18th century paradigms we have recognized.” But the Court said that federal courts should exercise “great caution” when considering new causes of action, and maintain “vigilant doorkeeping . . . thus [open- ing the door] to a narrow class of international norms [rec- ognized] today.”

Based largely on our reading of Sosa, we agree with the district court’s dismissal of Plaintiffs’ nontorture claims under the Alien Tort Act. We see no basis in law to recog- nize Plaintiffs’ claim for cruel, inhuman, degrading treat- ment or punishment. Accordingly, we affirm the district court’s decision on the cruel, inhuman, degrading treatment or punishment claims. We do the same for Plaintiffs’ claim for arbitrary detention. In Sosa, the Court determined that “a single illegal detention of less than a day .  .  . violates no norm of customary international law so well defined as to support the creation of a federal remedy.” We also agree with the district court’s dismissal of the crimes against humanity claim. First, such crimes were not expressly pled in the complaint. Second, to the extent that crimes against humanity are recognized as violations of international law, they occur as a result of “widespread or systematic attack” against civilian populations. And Plaintiffs’ reliance on alleged systematic and widespread efforts against organized

Was the court correct in holding Del Monte responsible for the actions of the security forces with respect to their alleged infliction of emotional distress as torture? Should multinational corporations be responsible for the actions of security forces acting on their behalf or on behalf of their subsidiaries?

ETHICAL DECISION MAKING CRITICAL THINKING

This case potentially affects stakeholders other than labor. What other stakeholders may be affected by the actions described in this case? What interests of these stakeholders may be impacted by the outcome?

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Dispute Settlement in an International Context Disputing parties to international transactions can resolve their differences in two ways. Assuming settlement negotiations, mediation, conciliation, or some other form of non- adversarial dispute resolution fails, they can resort to litigation or arbitration. However, each of these methods has disadvantages of which an international businessperson must be aware.

LITIGATION The first step in litigation is determining whether the selected court has jurisdiction, specifically, the power to hear the case and resolve the dispute. Judgments entered by a court without jurisdiction are null and void. There are two primary types of jurisdiction. A court must possess subject-matter jurisdiction, which is power over the type of case presented to it. In the United States, subject-matter jurisdiction is based on the type of case (such as civil, criminal, probate, or domestic relations) or the amount of money at issue.

In contrast, personal jurisdiction is the power of the court over the persons appear- ing before it. General personal jurisdiction permits adjudication of any claims against a defendant regardless of whether the claim has anything to do with the forum, or loca- tion, where the claim is filed. To obtain general personal jurisdiction, the defendant must maintain some presence in the forum. For a court to exercise specific personal jurisdic- tion, the defendant must have purposefully availed itself of the protections of the forum, and the selected forum must be reasonable. 18 Merely placing a product into the stream of commerce is not sufficient unless the product was designed specifically for the forum or the defendant provided regular advice to customers or maintained a distributor in the forum. The reasonableness of the selected forum is determined by balancing the burden on

LO9

How are disputes settled in the international

marketplace?

Personal Jurisdiction and the Internet

Hy Cite Corporation v. badbusinessbureau.com

297 F. Supp. 2d 1154 (W.D. Wis. 2004)

Hy Cite, a Wisconsin corporation, marketed and sold china, glassware, cookware, and related products under the trademark “Royal Prestige.” Badbusinessbureau.com was a limited liability company organized and existing under the laws of St. Kitts/Nevis, West Indies. Badbusinessbureau owned and operated a Web site, “The Rip-Off Report,” which served as a forum for the posting of consumer complaints. Hy Cite’s products were subject to 30 to 40 of these complaints. Hy Cite filed a lawsuit against badbusiness- bureau claiming the postings were false and damaged Hy Cite’s reputation.

CASE NUGGET

The U.S. district court dismissed Hy Cite’s complaint for lack of personal jurisdiction. The court held that badbusinessbureau did not have “continuous and systematic general business contracts” with Wisconsin due to the absence of an office, agents and employees, and a substantial amount of business in the forum. The court found the lack of targeting of Wisconsin Internet users to be indicative of a lack of general personal jurisdiction. The court also rejected the exercise of specific personal jurisdiction. It held that badbusinessbu- reau did not purposefully avail itself of the benefits and protections of Wisconsin’s laws because it received no donations or advertise- ments from Wisconsin residents and did not advertise in Wiscon- sin or target its residents. Furthermore, badbusinessbureau did not engage in intentionally harmful behavior expressly directed at Wis- consin residents. Rather, the harmful conduct, if any, was the com- plaints written by consumers and posted by them on the Web site.

18 Asahi Metal Indus. v. Superior Court, 480 U.S. 102, 109, 113 (1987).

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the defendant, the interest of the forum in resolving the dispute, the plaintiff’s interest in obtaining relief in the forum, and foreign policy concerns. For example, the forum may be unreasonable if the majority of the evidence and witnesses are located outside the forum or the case involves an occurrence that is of little relevance to the jurors that might decide the case. The Case Nugget addresses the issue of asserting personal jurisdiction over a foreign defendant on the basis of the defendant’s presence in the jurisdiction through the Internet.

Legal Principle: For a U.S. court judgment to be fully enforceable, the court must possess power over the type of case (subject-matter jurisdiction) and the people appearing before it (personal jurisdiction), which may be obtained by the defendant’s presence in the forum (general personal jurisdiction) or purposeful availment of the protection of the forum (specific personal jurisdiction).

There are numerous defenses available to the exercise of jurisdiction. The Foreign Sovereign Immunities Act is a federal statute that denies subject-matter jurisdiction and grants immunity from civil actions to foreign states and their political subdivisions, agen- cies, and instrumentalities. 19 One important exception to foreign sovereign immunity is a situation in which the immune entity engages in a commercial activity. A commercial activity is defined as a regular course of commercial conduct or a particular commercial transaction with a U.S. nexus.

There are also several instances when a court may refuse to exercise existing jurisdic- tion. State doctrine has been defined as “a nonjurisdictional, prudential doctrine based on the notion that the courts of one country will not sit in judgment on the acts of the govern- ment of another state done within its own territory.” 20 The political question doctrine may be invoked when there has been a demonstrable constitutional commitment of an issue to a coordinate political department; there is a lack of judicially discoverable and manageable standards; it is impossible to decide the case without resolving an issue appropriate for nonjudicial discretion or without demonstrating lack of respect for coordinate branches of government; there is an unusual need for unquestioning adherence to a political decision already made; and there is the potential of embarrassment from multiple pronouncements by various departments on one question. 21 Comity has been defined as the “recognition which one nation allows within its territory to the legislative, executive or judicial acts of another nation.” 22

Forum non conveniens is a doctrine that permits courts to decline to exercise jurisdic- tion where there is a more convenient forum to hear the case. 23 This determination is based on judicial analysis of the adequacy of the alternative forum and the balance of private- and public-interest factors. Public-interest factors include court congestion, the unfairness of imposing jury duty on a community with no relation to the litigation, the interest of the community in having localized controversies decided at home, and the avoidance of prob- lems associated with conflict of laws and the application of foreign law. Private-interest factors include ease of access to evidence, the cost for witnesses to attend trial, and the availability of compulsory process.

Case 6-2 demonstrates the application of the doctrine of forum non conveniens in the context of product liability litigation.

19 28 U.S.C. §§ 1602–1611 (2000). 20 Underhill v. Hernandez, 168 U.S. 250, 252 (1897). 21 Baker v. Carr, 369 U.S. 186, 217 (1962). 22 Hilton v. Guyot, 159 U.S. 113, 164 (1895).

23 Piper Aircraft Co. v. Reyno, 454 U.S. 235, 254 n.22 (1981); and Gulf Oil Corp. v. Gilbert, 330 U.S. 501, 507 (1947).

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CASE 6-2

In 1995, while in Houston, the plaintiff, Jorge Luis Machuca Gonzalez (“Gonzalez”) saw several magazine and televi- sion advertisements for the Chrysler LHS. The advertise- ments sparked his interest, and Gonzalez visited Houston car dealerships. Convinced by these visits that the Chrysler LHS was a high quality and safe car, Gonzalez purchased a Chrysler LHS upon returning to Mexico.

On May 21, 1996, Gonzalez’s wife was involved in a colli- sion with another moving vehicle while driving the Chrysler LHS in Atizapan de Zaragoza, Mexico. The accident triggered the passenger-side air bag. The force of the air bag’s deployment instantaneously killed Gonzalez’s three-year-old son, Pablo.

E. GRADY JOLLY, CIRCUIT JUDGE: Gonzalez brought suit in Texas district court against (1) Chrysler, as the manu- facturer of the automobile; (2) TRW, Inc. and TRW Vehicle Safety Systems, Inc., as the designers of the front sensor for the air bag; and (3) Morton International Inc., as designer of the air bag module. Gonzalez asserted claims based on products liability, negligence, gross negligence, and breach of warranty. Texas, however, has a tenuous connection to the underlying dispute. Neither the car nor the air bag module was designed or manufactured in Texas. The accident took place in Mexico, involved Mexican citizens, and only Mexican citi- zens witnessed the accident. Moreover, Gonzalez purchased the Chrysler LHS in Mexico (although he shopped for the car in Houston, Texas). Because of these factors, the district court granted the defendants’ motions for dismissal on the ground of forum non conveniens. Gonzalez now appeals.

The primary question we address today involves the threshold inquiry in the forum non conveniens analysis: Whether the limitation imposed by Mexican law on the award of damages renders Mexico an inadequate alternative forum for resolving a tort suit brought by a Mexican citizen against a United States manufacturer.

The forum non conveniens inquiry consists of four consid- erations. First, the district court must assess whether an alter- native forum is available. An alternative forum is available if the entire case and all parties can come within the jurisdic- tion of that forum. Second, the district court must decide if the alternative forum is adequate. An alternative forum is adequate if the parties will not be deprived of all remedies or treated unfairly, even though they may not enjoy the same ben- efits as they might receive in an American court. If the district court decides that an alternative forum is both available and adequate, it next must weigh various private interest factors. If consideration of these private interest factors counsels against dismissal, the district court moves to the fourth consideration in the analysis. At this stage, the district court must weigh

numerous public interest factors. If these factors weigh in the moving party’s favor, the district court may dismiss the case.

The heart of this appeal is whether the alternative forum, Mexico, is adequate.

The jurisprudential root of the adequacy requirement is the Supreme Court’s decision in Piper Aircraft Co. v. Reyno, 454 U.S. 235 (1981). The dispute in Piper Aircraft arose after sev- eral Scottish citizens were killed in a plane crash in Scotland. A representative for the decedents filed a wrongful death suit against two American aircraft manufacturers. The Court noted that the plaintiff filed suit in the United States because U.S. laws regarding liability, capacity to sue, and damages are more favorable to her position than are those of Scotland. The Court further noted that Scottish law does not recognize strict liabil- ity in tort. The Court held that although the relatives of the decedent may not be able to rely on a strict liability theory, and although their potential damage award may be smaller, there is no danger that they will be deprived of any remedy or treated unfairly in Scotland. Thus, the Court held that Scotland pro- vided an adequate alternative forum for resolving the dispute, even though its forum provided a significantly lesser remedy.

Gonzalez contends that a Mexican forum would provide a clearly unsatisfactory remedy because (1) Mexican tort law does not provide for a strict liability theory of recovery for the manufacture or design of an unreasonably dangerous product and (2) Mexican law caps the maximum award for the loss of a child’s life at approximately $2,500 (730 days’ worth of wages at the Mexican minimum wage rate). Thus, according to Gonzalez, Mexico provides an inadequate alternative forum for this dispute.

Gonzalez’s first contention may be quickly dismissed based on the explicit principle stated in Piper Aircraft. There is no basis to distinguish the absence of a strict products lia- bility cause of action under Mexican law from that of Scot- land. Accordingly, we hold that the failure of Mexican law to allow for strict liability on the facts of this case does not render Mexico an inadequate forum.

Gonzalez’s second contention—that the damage cap renders the remedy available in a Mexican forum “clearly unsatisfactory”—is slightly more problematic. We start from basic principles of comity. Mexico, as a sovereign nation, has made a deliberate choice in providing a specific remedy for this tort cause of action. In making this policy choice, the Mexican government has resolved a trade-off among the competing objectives and costs of tort law, involving interests of victims, of consumers, of manufacturers, and of various other economic and cultural values. In resolving this trade-off, the Mexican people, through their duly-elected lawmakers, have decided to limit tort damages with respect to a child’s

GONZALES v. CHRYSLER CORP. U.S. COURT OF APPEALS FOR THE FIFTH CIRCUIT (2002)

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toward Mexico as the appropriate forum. It is clear to us that this finding does not represent an abuse of discretion. After all, the tort victim was a Mexican citizen, the driver of the Chrys- ler LHS (Gonzalez’s wife) is a Mexican citizen, and the plain- tiff is a Mexican citizen. The accident took place in Mexico. Gonzalez purchased the car in Mexico. Neither the car nor the air bag was designed or manufactured in Texas. In short, there are no public or private interest factors that would suggest that Texas is the appropriate forum for the trial of this case.

For the foregoing reasons, the district court’s dismissal of this case on the ground of forum non conveniens is affirmed.

death. It would be inappropriate—even patronizing—for us to denounce this legitimate policy choice by holding that Mexico provides an inadequate forum for Mexican tort vic- tims. In short, we see no warrant for us, a United States court, to replace the policy preference of the Mexican government with our own view of what is a good policy for the citizens of Mexico.

Having concluded that Mexico provides an adequate forum, we now consider whether the private and public inter- est factors nonetheless weigh in favor of maintaining this suit in Texas. The district court found that almost all of the pri- vate and public interest factors pointed away from Texas and

Given the cap on damages in Mexican law for the loss of a child and the cost of litigation, is it likely that Gonzales will file a lawsuit in Mexico? Does Mexico offer an inadequate forum because it does not make economic sense for Gonza- lez to file his lawsuit in Mexico? Why or why not?

ETHICAL DECISION MAKING CRITICAL THINKING

Would the universalization principle or the Golden Rule pro- vide any strong argument against the ruling made by Judge Jolly?

Businesses can minimize some of the uncertainties associated with personal jurisdic- tion by carefully selecting the forum and inserting choice-of-law clauses in international agreements. A forum selection agreement allows the parties to choose where disputes between them will be resolved. In the United States, such clauses are presumptively valid and will be disregarded only if they are unreasonable. 24 Grounds for ignoring a forum selection clause include fraud or coercion in its procurement, unconscionability, lack of notice, or serious inconvenience posed by the selected forum. A choice-of-law clause lets the parties to a contract choose the law of a certain state to apply to the interpretation of the contract or in the event of a dispute. Choice-of-law clauses are generally enforceable as long as there is a reasonable relation between the transaction and the law of the selected jurisdiction.

Legal Principle: The parties to an international contract may select the forum in which disputes are to be resolved and the applicable law within the terms of their agreement.

The plaintiff must also select the proper venue for the litigation. Proper venue is the court with subject-matter and personal jurisdiction that is the most appropriate geographic location for the resolution of the dispute. With respect to federal litigation in the United States, the Alien Venue Statute provides that aliens may be sued in any federal judicial district but makes an exception for suits against foreign sovereigns, which may be initiated only in the U.S. District Court for the District of Columbia. 25

24 M/S Bremen v. Zapata Off-Shore Co., 407 U.S. 1, 15 (1972).

25 28 U.S.C. § 1391(d) (2000).

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There are other problems with litigation as a method of international dispute resolution. Methods of discovery used in civil litigation in the United States may be ineffective if used to obtain evidence located abroad. Although the Hague Evidence Convention, a mul- tilateral convention establishing procedures for transnational discovery between private persons in different states, attempts to resolve such problems, it has been ratified by only 31 states. Furthermore, judgments obtained in foreign courts may not be enforceable in other states. For example, in the United States, foreign judgments are not entitled to full faith and credit but are only evidence of the justice of the plaintiff’s claims. 26 U.S. courts may ignore the results of foreign proceedings under numerous circumstances, including lack of fairness, jurisdiction, or timely notice; fraud; and inconsistency with U.S. public policy. Foreign states take similar views with respect to U.S. judgments. Courts in such states may refuse to enforce U.S. civil judgments deemed to be criminal or penal in nature (such as taxes and fines) and awards of punitive damages.

ARBITRATION Arbitration is a type of alternative dispute resolution by private, nonofficial persons selected in a manner provided by law or the agreement of the parties. The New York Convention, 27 an international agreement governing the arbitration of private international disputes, has been ratified by 144 states to date, including the United States. The conven- tion applies when an award is made and one party seeks enforcement in the territories of the contracting states. It requires that each state recognize written arbitration agreements and recognize arbitral awards as enforceable in its national courts.

Arbitration as a means of dispute resolution has many advantages over litigation. It is cheaper and faster, and it is a nonpublic procedure. Arbitration also permits the parties to select the forum and the presiding party. Concerns regarding the enforceability of a judicial decision entered in one state but sought to be enforced in another state are also minimized. However, the ability of parties in arbitration to conduct discovery of the opposing party’s case may be limited, as well as the ability to appeal an adverse decision. Furthermore, arbitrators’ decisions may not serve as precedent in future cases. Any company contem- plating the use of arbitration as a means of dispute resolution must carefully balance these disadvantages with the benefits of the arbitral process.

26 Restatement (Third) of the Foreign Relations Law of the United States, § 481 (1987). 27 Convention on the Recognition and Enforcement of Foreign Arbitral Awards, June 10, 1958, 21 U.S.T. 2517, 330 U.N.T.S. 38.

Resolving a Breach of Contract Under the CISG In the case of Chicago Prime Packers, Inc. v. Northam Food Trading Co., 28 the district court held that the transaction was governed by the CISG. The CISG was applicable as Chicago Prime was a U.S. resident and Northam Food Trading was a resident of a jurisdic- tion that had ratified the CISG. The court held that because the contract did not contain an

CASE OPENER WRAP-UP

28 320 F. Supp. 2d 702 (N.D. Ill. 2004).

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inspection provision, the requirement under Article 38 of the CISG that the buyer examine the goods, or cause them to be examined, “within as short a period as is practicable in the circumstances” was controlling. Decisions under the CISG indicated that the buyer bears the burden of proving that the goods were inspected within a reasonable time. Northam did not present any evidence as to why the ribs, or a portion of the ribs, were not and could not have been examined by Northam, Beacon, or someone acting on their behalf when the shipment was delivered to Beacon or within a few days thereafter.

Northam also failed to prove that it gave notice to Chicago Prime of the alleged lack of conformity within a reasonable time after it ought to have discovered the alleged lack of conformity. Article 39 of the CISG states that “[a] buyer loses the right to rely on a lack of conformity of the goods if he does not give notice to the seller specifying the nature of the lack of conformity within a reasonable time after he has discovered it or ought to have discovered it.” A buyer bears the burden of showing that notice of nonconformity has been given within a reasonable time. The court further noted that when defects are easy to discover by a prompt examination of the goods, the time of notice must be reduced. The putrid condition of the meat was apparent even in its frozen state. Because the court found that Northam failed to examine the shipment of ribs in as short a period of time as was practicable, it followed that Northam also failed to give notice within a reasonable time after it should have discovered the alleged nonconformity.

As a result, the court entered a judgment in favor of Chicago Prime Packers, Inc., and against Northam Food Trading Company in the amount of $178,200 plus $27,242.63, rep- resenting prejudgment interest calculated at a rate of 5 percent from May 1, 2001, for a total payment of $205,442.63.

Before their dispute arose, the parties could have selected the law for the court to apply through a choice-of-law clause, which permits the parties to a contract to choose the law of a certain state to apply to the interpretation of the contract in the event of a dispute. Choice- of-law clauses are generally enforceable as long as there is a reasonable relation between the transaction and the law of the selected jurisdiction. The same rules apply with respect to the CISG. The parties are always free to opt out of the CISG and select another law to apply to their transaction. Thus, the parties could have selected U.S. or Canadian sales law to apply to the resolution of disputes arising from their transaction. In the absence of such a selection, the CISG applied to this transaction.

affiliate 125

arbitration 141

bilateral trade agreement 128

choice-of-law clause 140

comparative law 124

Convention on the Inter- national Sale of Goods (CISG) 131

Dispute Settlement Understanding 127

distributor 125

dumping 127

Foreign Corrupt Practices Act (FCPA) 126

foreign sales representative 125

foreign subsidiary 125

forum selection agreement 140

franchise agreement 125

free trade agreement 128

General Agreement on Tariffs and Trade (GATT) 126

general personal jurisdiction 137

Hague Evidence Convention 141

international law 124

joint venture 125

jurisdiction 137

lex mercatoria 130

licensing agreement 125

national treatment 127

New York Convention 141

nontariff barrier 126

normal trade relations 127

North American Free Trade Agreement (NAFTA) 128

Key Terms

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personal jurisdiction 137

quantitative restriction 127

specific personal jurisdiction 137

subject-matter jurisdiction 137

subsidy 127

tariff 126

venue 140

World Trade Organization (WTO) 126

International law refers to the laws governing the conduct of states and international organizations and their relations with one another and natural and juridical persons.

Firms participating in international markets have special ethical considerations, including whether to do business with repressive governments, whether to provide products for the poor at reduced prices, and whether to treat workers according to local custom or to international standards of humane treatment.

GATT is a comprehensive multilateral trading system designed to achieve distortion-free interna- tional trade through the minimization of tariffs and removal of artificial barriers. It established sev- eral general principles of trade law:

• Article I: Addresses the principle of most-favored-nation relations, now known as normal trade relations; requires that WTO member states treat like goods coming from other WTO member states on an equal basis, specifically prohibiting member states from discriminating against like products on the basis of their country of origin.

• Article III: Sets forth the principle of national treatment, which prohibits WTO member states from regulating, taxing, or otherwise treating imported products any differently than domesti- cally produced products.

• Article VI: Prohibits certain types of dumping and subsidies.

• Article XI: Prohibits quantitative restrictions on imports (e.g., limits on importation of certain products on the basis of number of units, weight, or value for national economic reasons or the protection of domestic industry).

Free trade agreement: Two or more states agree to reduce and gradually eliminate tariffs and other trade barriers [e.g., North American Free Trade Agreement (NAFTA)].

Customs union: States in a free trade area agree on a common external tariff on products originating outside the union (e.g., European Union).

Bilateral trade agreement: Two states agree on issues relating to trade between them (e.g., United States–Australia agreement).

Comparative law is the study of the legal systems of different states. This study provides a better understanding of the general purpose of law, assists in the development of a critical viewpoint of one’s own legal system, and demonstrates that one’s own legal system is only one of many alterna- tives. After thinking critically about alternative laws, one might decide that one’s own state should adopt the other state’s law or method of resolving a dispute.

Civil law systems constitute the majority of the world’s legal systems and are based on detailed national legal codes, which serve as the sole official source of law. Common law systems derive from the British and American models and are based on constitutions, legislation, regulations, and their interpretation by courts of law. Socialist law systems are based on the premises that the rights of society as a whole outweigh individual rights and that the state owns the means of production and property. Islamic law systems are based on the tenet that law is derived from and interpreted in conformance with Shari’a (“God’s Law”) and the Koran.

If the parties to international transactions are unable to resolve their dispute through nonadversarial methods, the parties may use litigation or arbitration to resolve their differences.

Summary of Key Topics Doing Business Internationally

Ethical Considerations

The General Agreement on Tariffs and Trade

Regional Trade Agreements

Comparative Law

Legal Systems and Procedures

Dispute Settlement in an International Context

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Should U.S. Courts Refer to Foreign Law in Their Decisions? NO YES

Reference to foreign law fails to recognize the excep- tional nature of the U.S. legal system and experience. Such reference is an unnecessary surrender of sovereignty and abdication of the judiciary’s responsibility to inter- pret and apply the national laws of the land. The U.S. Constitution and statutes enacted in accordance with it should be interpreted according to the framers’ original intent and congressional intent. Reference to foreign law in U.S. courts fails to recognize that only domestic law should serve the American people. Additionally, foreign legislative bodies that adopt laws and the courts that inter- pret them are not accountable to the American people. Utilization of such laws and decisions expands judicial discretion in the United States beyond that which is desir- able. Finally, there is little need for uniformity in many areas of the law.

Reference to foreign law in U.S. court decisions recog- nizes that the United States is a member of the family of nations and demonstrates respect for the legal systems of other states. Foreign law may serve as a source of inspi- ration for U.S. courts, enriches legal thinking, enhances judicial creativity, and strengthens democratic ties and the foundations of different legal systems. U.S. judges could learn from their brethren in other states. Reference to for- eign law promotes uniformity and predictability, which is extremely important in international business transactions. State courts already reference foreign law when they cite the decisions of courts in other states, the results of which are persuasive authority at best. In any event, foreign law is not binding on U.S. courts, and there is no danger that such law could serve as precedent or mandate an outcome in a particular case.

Point / Counterpoint

1. Spain divided unroasted nondecaffeinated coffee into five separate classifications. A 7 percent tariff was imposed on three of these classifications. The other two classifications were duty-free. Brazil, the principal supplier of the coffee subject to the tar- iff, alleged that the Spanish classification regime failed to extend most-favored-nation treatment to like products originating from Brazil, thus violat- ing GATT. Spain defended the classifications on the basis that the products were not like products due to differences resulting from geographic fac- tors, cultivation methods, processing, and genetics. The GATT panel rejected these arguments. The panel noted that most coffees are blends, coffee is universally regarded as a well-defined and single product intended for drinking, and no other state maintained a similar classification scheme. The panel thus concluded that the classification system discriminated against like products in violation of GATT’s most-favored-nation requirement. Do you agree with this decision? Is coffee a single univer- sal product regardless of where it is grown, how it is processed, or what the cost is to consumers?

[ Spain—Tariff Treatment of Unroasted Coffee, 1981 GATTPD LEXIS 5 (1981).]

2. Italy adopted a law that permitted the govern- ment to extend credit to Italian farmers in order to finance the purchase of agricultural machin- ery. Farmers purchasing machinery manufac- tured in Italy were entitled to a loan of up to 75 percent of the value of the machinery for a term of five years at a 3 percent interest rate. Farmers purchasing machinery not manufactured in Italy were also entitled to loans but at an interest rate of 10 percent. The United Kingdom claimed that the Italian loan program violated GATT’s national treatment obligation by modifying the conditions of sale between imported and domestically pro- duced machinery. Italy defended the loan program on the basis that national treatment applied only to sales in the context of international trade and not to internal conditions of sale. Italy also claimed that national treatment was not applicable to eco- nomic development initiatives such as the loan pro- gram. The GATT panel disagreed and held that the national treatment requirement applied to internal

Questions & Problems

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conditions impacting domestic sales. The panel also concluded that economic development initia- tives were required to be consistent with the prin- ciple of national treatment. Based on this decision, are there any limits to the concept of national treat- ment? How might a state undertake an economic development initiative without violating national treatment? [ Italy—Imported Agricultural Machin- ery, GATT Report L/833-7S/60 (1958).]

3. A Canadian winery entered into a contract to pur- chase corks from the U.S. subsidiary of a French company. The parties reached an agreement on quantity, price, payment, and shipping terms during a telephone conversation. The corks were sent to the winery in 11 separate shipments accompanied by invoices providing that “[a]ny dispute arising under the present contract is under the sole jurisdic- tion of the Court of Commerce of the City of Per- pignan.” The winery never objected to the language contained in the invoices. The winery subsequently filed a lawsuit in the U.S. district court in Cali- fornia against the U.S. subsidiary and its French parent as a result of the tainting of its wine by the corks. The sellers moved to dismiss the litigation on the basis of the forum selection agreement. The district court enforced the clause and dismissed the litigation, but the U.S. Court of Appeals for the Ninth Circuit reversed this decision. Applying the CISG, the Ninth Circuit held that the forum selec- tion clause was a material alteration of the parties’ oral agreement. As such, the winery’s failure to object to the inclusion of the clause was irrelevant. Do you agree? How would you define the term material alteration? Should parties in international commercial transactions be penalized for their fail- ure to adequately review documents? Why or why not? [ Chateau des Charmes Wines Ltd. v. Sabate USA, Inc., 328 F.3d 528 (9th Cir. 2003).]

4. In Asahi Metal Industries v. Superior Court, the U.S. Supreme Court held that the mere placement of a product in the stream of commerce is not sufficient to subject the manufacturer to the per- sonal jurisdiction of a California state court in the absence of “purposeful availment,” such as design- ing a product specifically for the forum, maintain- ing a distributor in the forum, or providing regular advice to customers in the forum. Is this reasoning still valid in the modern global marketplace, where goods routinely cross international boundaries?

Why or why not? [ Asahi Metal Industries v. Supe- rior Court, 480 U.S. 102 (1987).]

5. The owners of several well-known trademarks brought an action in China against the owner of real property located on Silk Street in Beijing. Silk Street has more than 1,200 stalls for merchandise and attracts more than 15 million shoppers annu- ally. The basis of the lawsuit was that the property owner tolerated the sale of pirated merchandise by tenants to whom it leased retail space. The Beijing Second Intermediate People’s Court held the land- lord liable for its failure to stop its tenants from selling known pirated goods. The court ordered the landlord to stop vendors from selling infring- ing products and awarded damages of $13,000 against the landlord and tenants. The case was sub- sequently settled through a court-mediated agree- ment that provided for the landlord to shut down six to eight offending vendors at a time for up to a week. However, the settlement agreement has encountered fierce opposition by affected mer- chants and consumers who claim that only the government possesses the right to shut a business. Is the court-mediated agreement likely to be effec- tive? Are the retailers likely to suffer injury to their corporate reputations with Chinese consumers by insisting on stringent protection of their intel- lectual property rights? Is enduring piracy a price of access to the lucrative Chinese marketplace? Should it be? [ Burberry, Chanel, Prada, Moët Hen- nessy Louis Vuitton and Gucci v. Beijing Xiushui Haosen Clothing Market, Beijing Second Interme- diate People’s Court (2005).]

6. A U.S.-based Internet service provider that oper- ated an auction site was sued in a French court by two nonprofit organizations dedicated to the elimi- nation of anti-Semitism. The basis of the lawsuit was the availability of Nazi-related propaganda and Third Reich memorabilia on the auction site. The French Criminal Code prohibits the exhibition of Nazi propaganda and the offering of artifacts for sale. The French court ordered the Internet service provider to eliminate the access of French citizens to its auction site and other sites containing Nazi propaganda and post warnings to French citizens with respect to the French Criminal Code. A daily penalty of €100,000 was to be assessed for every day that the service provider failed to comply with the order. Although the service provider did

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implement part of the court’s order, it claimed that it did not have the technology to block French citi- zens from accessing prohibited Web sites unless it removed all Nazi-related material. Such removal would conflict with the service provider’s First Amendment rights under the U.S. Constitution. As a result, the service provider filed a lawsuit in the United States seeking a declaration that the French court’s order was not enforceable. How should the U.S. court decide this case? Should the U.S. court enforce the order of the French court? Why or why not? Should an Internet service provider be respon- sible for all material accessible through use of its service? If the answer to this question is no, should there be an exception for extremely offensive materials such as those relating to Nazism? Were the Internet service provider’s business practices respectful of the social policies and cultural sen- sitivities of the locations where it transacted busi- ness? [ Yahoo!, Inc. v. La Ligue Contre Le Racisme et L’Antisemitisme, 169 F. Supp. 2d 1181 (N.D. Cal. 2001).]

7. In an interview published in the New York Times in February 1976, former Lockheed president A. Carl Kotchian defended the payment of bribes by the company as follows:

Some call it gratuities. Some call them question- able payments. Some call it extortion. Some call it grease. Some call it bribery. I look at these pay- ments as necessary to sell a product. I never felt I was doing anything wrong.

More than 30 years later, Reinhard Siekaczek, an accountant employed by Siemens who oversaw an annual budget for questionable payments in excess of $50 million, stated:

I never thought I would go to jail for my compa- ny. . . . We thought we had to do it. Otherwise, we’d ruin the company.  .  .  . People will only say about Siemens that they were unlucky and that they broke the Eleventh Commandment. The Eleventh Com- mandment is “Don’t get caught.”

Given these attitudes, is the Foreign Corrupt Prac- tices Act likely to result in a change in corporate culture at multinational businesses? Is the FCPA a success or a failure to the extent that its prohibi- tions are not taken seriously, as demonstrated by the above statements?

8. A construction company submitted a bid to build a municipal swimming pool in the Netherlands. The mayor and his municipal councilors found this bid to be the best and to be within the municipality’s budget for the project. However, the town council rejected the bid and awarded the contract to another firm. The construction company sued the town for expenses incurred in preparing the bid and damages suffered as a result of loss of the contract. The court held that, under Dutch law, there are three stages of contract negotiation. In the initial stage, either party may break off negotiations without incur- ring liability. In the second or continuing stage, either party may break off the negotiations but is liable to the other party for expenses. In the final stage, the parties are prohibited from terminating negotiations without incurring liability for dam- ages resulting from loss of the contract. Parties enter the third stage of negotiations when they have a mutual and reasonable expectation that a contract will result from the negotiations. In this case, the court concluded the parties were in the continuing-negotiation stage and awarded the construction company the expenses incurred in preparing its bid proposal. Is such an approach to contract negotiations realistic? How would you define the different stages of negotiation created by the court? [ Plas v. Valburg, 18-6 Netherlandse Jurisprudentie 723 (1983).]

9. A U.S. citizen was injured on a cruise ship operat- ed by an Italian company. The passenger filed suit in a U.S. federal court one year and two months later. The Italian company claimed that the provi- sions of the cruise ticket barred civil actions al- leging personal injury filed more than one year after the injury. The passenger claimed that this provision was invalid under Italian law, which was designated in another portion of the ticket as the “ruling law of the contract.” The court applied this choice-of-law clause despite the fact that this was a consumer transaction rather than a commercial transaction between merchants. The court found there was no fraud, injustice, or public policy that prevented the enforcement of the choice-of-law clause against its own drafter. As the one-year stat- ute of limitations was unenforceable under Italian law, the passenger’s claims were not time-barred. Should choice-of-law provisions be limited to

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Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

commercial transactions rather than extending to consumer transactions such as cruises? If you have ever taken a cruise, did you read the ticket before your departure? If your ticket contained a choice of

law, do you believe that you had any ability to suc- cessfully negotiate its provisions with the cruise line? [ Milanovich v. Costa Crociere, S.p.A., 954 F.2d 763 (D.C. Cir. 1992).]

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C H A P T E R

Crime and the Business Community 7

1 What are the basic elements of a crime?

2 What are some of the common crimes affecting businesses, and how do we prove them?

3 When a crime is committed to benefit a corporation, who can be held liable?

4 What are the basic constitutional safeguards for a person accused of a crime?

5 What are the basic steps of a criminal proceeding?

6 How can we prevent white-collar crimes?

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

CASE OPENER Untenable Trading

James Gansman was a partner in the Transaction Advisory Services division at Ernst & Young in New York. While working in his capacity as an Ernst & Young attorney, Gansman had access to confidential information regarding the mergers and acquisitions of sev- eral Ernst & Young clients. For example, Gansman learned that Ernst & Young had been retained to advise the Blackstone Group about the possible purchase of Freescale Semi- conductor (a major supplier of automotive, networking, and wireless communication semiconductors) for $17.6 billion. When Blackstone retained Ernst & Young, the firm was warned to not tell anyone the name of the company it intended to purchase.

Gansman conveyed the information about the Blackstone purchase to Donna Murdoch, a close friend and investment banker. He stated in court documents that he conveyed the information to her because of their close and personal relationship and that he knew she would buy and sell securities on the basis of this tip. Acting on Gansman’s information, Murdoch began to buy stock in Freescale Semiconductor. After Blackstone finalized the multibillion-dollar purchase of Freescale, Murdoch made a profit of more than $158,000.

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As a result of Gansman’s information about the Blackstone deal (and six others like it), Murdoch made at least $392,035. Murdoch also made trading recommendations to her father and several others. On the basis of Gansman’s information, Murdoch’s father made a profit of at least $63,400, and the others made profits of over $140,760. In total, Gansman’s leaks resulted in profits of at least $596,195.

The Securities and Exchange Commission filed suit against Gansman and Murdoch for the misappropriation of information. Although Murdoch pleaded guilty to 15 counts of securities fraud, Gansman went before a jury in the Southern District of New York. 1

1. Do you believe Gansman did anything illegal?

2. If a person has inside information and does not trade on it himself but passes it on to another who uses it to trade, is the person who passed on the information guilty of insider trading?

The Wrap-Up at the end of the chapter will answer these questions.

Crime comes in many forms, and sometimes the number of people affected can quickly grow. Although some crimes might at first seem victimless, there is always a victim. While Murdoch, and everyone else to whom she passed on Gansman’s information, made large sums of money, they did so at the expense of other investors. It is important to remember that crime always has a victim, even if the victim is not readily identifiable.

In this chapter, we explain the elements of criminal law, common business crimes, and how liability can be assessed to corporations and corporate executives. We introduce com- mon criminal defenses and constitutional safeguards, describe the criminal justice process, and identify some primary laws for combating business crime.

Elements of a Crime The purpose of criminal law is to punish an offender for causing harm to public health, safety, or morals. Thus, in a criminal trial, society is seen as the victim, and the government files charges against the defendant. In contrast, in a civil trial there is an individual victim or victims, and an individual person or corporation can file a suit.

Criminal laws usually define criminal behavior and set guidelines for punishment. To punish an individual for criminal behavior, the government must demonstrate the two ele- ments of a crime:

1. Wrongful behavior, that is, actus reus or a guilty act. 2. Wrongful state of mind, also known as mens rea or a guilty mind.

The government thus must show that a defendant committed a prohibited act with a wrong- ful intent.

To prove the first element, actus reus, the government must establish the nonmental ele- ments of the crime and demonstrate that a prohibited act or consequence resulted because of the defendant’s actions.

To prove the second element, mens rea, the government must prove that the defendant acted with purpose, knowledge, recklessness, or negligence, depending on which of these states of mind is required by the law defining the relevant offense. The defendant’s type

1 SEC v. James E. Gansman et al., Civil Action No. 08-CV-4918 (PKC)(S.D.N.Y).

LO1

What are the basic elements of a crime?

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of wrongful state of mind helps determine the seriousness of the punishment. First, a defendant can purposefully commit a crime by engaging in a specific wrongful behavior to bring about a specific wrongful result. Second, a defendant can knowingly commit a wrongful act if the person knows the act is wrongful or believes so yet does nothing to confirm or disconfirm this belief. Third, a defendant is reckless if a criminal act occurs when the individual consciously ignores substantial risk. Finally, a defendant is negligent if he or she does not meet the standard of care a reasonable person would use under the circumstances.

Only certain crimes, typically violations of regulatory statutes, allow punishment with- out proof of guilty mind. This liability without fault, or strict liability, applies to actions that, regardless of the care taken, are specifically prohibited, such as selling cigarettes or alcohol to a minor. Although a business might not have intended to sell to a minor (thus lacking a guilty mind), the statutory violation still allows liability to be assessed.

Classification of Crimes Crimes are divided into categories based on the seriousness of the offense. Today, the categories used are felonies, misdemeanors, and petty crimes. Felonies include serious crimes, such as murder, that are punishable by imprisonment for more than one year or death. Misdemeanors are less serious crimes punishable by fines or imprisonment for less than one year. Petty offenses, such as violating a building code, are minor misdemeanors usually punishable by a jail sentence of less than six months or a small fine. The statute defining the crime usually establishes whether the crime is a felony, misdemeanor, or petty offense.

Crimes may also be federal or state, depending on whether they are enacted by the state or federal legislature.

Common Crimes Affecting Business When people hear the word crime, they often think of homicide. In this section, however, we examine not violent offenses but crimes that occur in a business context. As a future business manager, you should become familiar with the following crimes, which could affect your company.

PROPERTY CRIMES AGAINST BUSINESS We now examine four criminal acts: robbery, burglary, larceny, and arson. Certainly, these crimes do not occur solely in the business context; however, they are crimes that could be committed against your future business. We distinguish these crimes from white- collar crimes for three reasons. First, nonemployees often commit these four crimes, while employees usually commit white-collar crimes. Second, these crimes are commit- ted against the business, while white-collar crimes are usually committed against society. Third, these crimes may provoke violence, while white-collar crimes usually do not.

Robbery. Most states define robbery as the forceful and unlawful taking of personal property. If force or fear is absent, the crime is theft. Someone who steals your wallet undetected while you are walking down the street has committed theft. Someone who tack- les you, pins you down, and wrests your wallet from you has committed robbery. Some- one who threatens you with a deadly weapon while taking your property would likely be charged with aggravated robbery, which carries a more severe penalty.

LO2

What are some of the common crimes affecting businesses, and how do we prove them?

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Burglary. A burglary occurs when someone unlawfully enters a building with the intent to commit a felony. Although burglary is commonly referred to as breaking and entering, the requirement for burglary is met whenever a person enters a building without the owner’s consent and with intent to commit a wrongful act.

Larceny. Although the definition may vary slightly state by state, larceny is the secretive and wrongful taking and carrying away of the personal property of another with the intent to permanently deprive the rightful owner of its use or possession. Unlike robbery, larceny does not require force or fear. In the business context larceny occurs, for example, when an employee takes office supplies, such as paper or blank CDs, for personal use.

States generally make a distinction between grand larceny and petty larceny. Grand larceny involves items of greater value; thus, it is a felony and carries more severe penal- ties than does petty larceny. As the Comparing the Law of Other Countries box reveals, other nations distinguish degrees of larceny in different ways that sometimes reflect their culture.

Arson. Arson is the intentional burning of another’s dwelling. The definition is typically expanded to include other real property beyond dwellings, as well as destruc- tion by means other than burning, such as the use of explosive devices.

WHITE-COLLAR CRIME Originally, white-collar crimes were distinguished from other crimes by the social status of the offender. The more modern approach is to define white-collar crime as a variety of nonviolent illegal acts against society that most often occur in the business context. Clearly, the crimes in the opening scenario fall under this broad definition.

Mail fraud, bribery, embezzlement, and computer crimes are typically classified as white-collar crimes. These occur more frequently than you might think. According to some estimates, one in three U.S. house- holds is the victim of white-collar crime every year.

The consequences of white-collar crimes are far- reaching. First, the cost can be tremendous. Fraud in the

Larceny in Spain

The common legal definition of larceny in the United States is the fraudulent intent to deprive an owner permanently of property with- out threat or force. Someone who intends to return the property cannot be convicted of larceny. In Spain, however, larceny occurs if the property is merely taken without the owner’s consent, without respect to a time period.

COMPARING THE LAW OF OTHER COUNTRIES

Punishment for larceny in Spain is relatively minor with one exception. If the stolen property is something (1) used in religious services, (2) stolen during a religious service, or (3) stolen from a religious building, the fine and potential jail time immediately increase. In U.S. law, location is immaterial except as it may dictate whether the crime is tried in federal or state court. A crucifix stolen from a church and a rake stolen from a garage are treated equally under U.S. law.

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health care industry alone costs society an estimated $100 billion each year. And Bernie Madoff, perpetrator of what has been called the largest investor fraud scheme ever com- mitted by a single person, cost his clients alone an estimated $65 billion in losses. Second, when company employees commit the crime, many companies fail to report it to avoid publicity and the offense goes unpunished. Third, white-collar crimes can be costly to the environment. For example, improper disposal of chemicals in a stream has long-term repercussions for marine life, the surrounding ecosystem, and any humans who come in contact with the contaminated water source.

Money collected in fines from corporate executives engaged in criminal activity has not been insignificant. In 2008, the government won over $1.12 in fines, judgments, and settlements from health care fraud cases alone. And in 2009, repeat offender Pfizer Dug Company was assessed a record-breaking $2.3 billion in criminal fines. 2 However, fines are only one way those found guilty of white-collar crimes might be punished; there are at least four others.

First is incarceration. As the prevalence of white-collar crime has increased, so has the number of white-collar offenders in jail. Bernie Madoff, an atypical criminal because of the magnitude of his crime, received the maximum sentence possible, 150 years. A second punishment is mandated community service. Junk-bond king Michael Milliken was required to give speeches on corporate crime after being convicted of insider trading. Third, the judge may prohibit the offender from engaging in an occupation where the same or a similar criminal act could occur again. Fourth, the offender can be placed under house arrest and wear a monitoring device.

Bribery. One of the better-known white-collar crimes is bribery. Bribery is the offer- ing, giving, soliciting, or receiving of money or any object of value for the purpose of influencing the judgment or conduct of a person in a position of trust. Bribery of a public official is a statutory offense under federal law, which also covers bribes offered to wit- nesses in exchange for testimony. The Salt Lake City Olympics Bid Committee allegedly gave International Olympic Committee (IOC) members between $4 million and $7 million in cash and other benefits like college tuition payments, shopping trips for bathroom fix- tures and doorknobs, and trips to the Super Bowl.

To demonstrate bribery under the federal statute, the government must show three ele- ments: (1) Something of value was offered, given, or promised to (2) a federal public official with (3) intent to influence that person’s judgment or conduct. The “thing of value” has been construed very liberally; actual commercial value is not necessary. Had the Salt Lake City Olympics Bid Committee given a member of the IOC stock shares in a start-up company that was never established, this act may constitute bribery even though the stock is commercially worthless. In the actual case, ultimately, the Department of Justice was unable to prove any of the 15 charges of bribery filed against two members of the Salt Lake City committee. Several members of the committee resigned, however; and 10 members of the IOC were fired, and another 10 were sanctioned.

The statute defines public officials broadly, as members of Congress, government officers and employees, and anyone “acting for or on behalf of” the federal government “in any official function, under or by authority of” a federal government department or agency. Private employees responsible for carrying out federal programs or policies are considered public officials.

2 Devlin Barrett, AP, Pfizer To Pay Record $2.3B Penalty Over Promotions Repeat Offender Pfizer Paying Record $2.3B Settlement For Illegal Drug Promotions, September 2, 2009, Available at http://www.texaslawyers.com/coomer/ pharmaceutical marketingfraudlawsuits.htm .

LO3

When a crime is committed to benefit a corporation, who can be held liable?

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Another offense is commercial bribery, a bribe in exchange for information or payoffs. Suppose Comdac Computers is looking for a company that manufactures a certain part. Jane Devlon owns such a company and realizes that if Comdac gets its parts from her, she will make a lot of money. She offers Comdac’s contractor $500,000 in exchange for his promise that Comdac will buy all such parts from only her factory for the next year. Devlon might also bribe the contractor to disclose the dollar amounts of any competing bids so that she can offer a better bid to win the contract.

The Foreign Corrupt Practices Act (FCPA) serves to combat bribery of foreign officials. You might think of it as an extension of the law to prevent bribery of a public official. Multinational organizations often pressure the United States to conform its law to certain international standards. To conform to the antibribery convention adopted by the Organiza- tion for Economic Cooperation and Development (OECD), Congress amended the FCPA by broadening the scope of actions covered and the definition of a public official. Unfor- tunately, however, many of the world’s leading exporting countries are failing to enforce the OECD antibribery convention. According to the Transparency International (TI) “2009 Progress Report,” only 4 of the 36 countries TI evaluated are actively enforcing the con- vention. Enforcement was moderate in 11 countries, and there was little or no enforcement in 21 countries. 3

Extortion. Extortion, otherwise known as blackmail, is the making of threats for the purpose of obtaining money or property. Whereas bribery is offering someone something to obtain a desired result, extortion is the threat of doing something if the victim does not relinquish money or a specific piece of property.

Many celebrities have been victims of extortion and attempted extortion. Most recently, David Letterman went public with allegations that a CBS producer was attempting to force him to pay $2 million to keep the producer from revealing Letterman’s affair with a young staff member. In 1997, the famous family man Bill Cosby was the victim of an extor- tion attempt by 23-year-old Autumn Jackson, who requested $40 million from Cosby in exchange for not telling the press that she was the star’s illegitimate daughter. In that case, Cosby had given the girl and her mother over $100,000 in the past, and he admitted that he had had an affair with her mother but denied being the girl’s father. Jackson, who was convicted along with two accomplices, received a 26-month prison sentence.

In 1993, comedian Louie Anderson paid $100,000 to Richard John Gordon to keep him from selling the tabloids a story stating that Anderson had propositioned a man in Las Vegas. Seven years later, Gordon sought an additional payment of $250,000 to keep the story under wraps, but this time Anderson went to the police, and his blackmailer ended up going to prison.

Fraud. Criminal fraud encompasses a variety of means by which an individual inten- tionally uses misrepresentation to gain an advantage over another. Fraud generally requires the following three elements: (1) a material false representation made with intent to deceive (scienter), (2) a victim’s reasonable reliance on the false representation, and (3) damages. Under both federal and state statutes, schemes to defraud include credit card fraud, insur- ance fraud, and securities fraud. Exhibit 7-1 summarizes fraudulent acts in the corporate setting, many of which we discuss below.

When these fraudulent schemes are uncovered and successfully prosecuted, there are generally several individuals involved; if the government can secure cooperation of at least

3 “2009 Progress Report on the OCED Anti-bribery Convention,” June 23, 2009, www.financialtaskforce.org/2009/06/23/ 2009-progress-report-on-the-oecd-anti-bribery-convention/ .

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one of the defendants, a number of significant sentences are handed down. For example, in 2009, when a $2.8 billion fraudulent scheme led to the bankruptcy of National Century Financial Enterprises, its CEO and owner was sentenced to 30 years in prison, and its co-owner to 25 years, for conspiracy, fraud, and money laundering. A former vice chair- man was sentenced to 25 years for conspiracy, securities fraud, wire fraud, and money laundering, but she fled after the conviction. The defendants were also ordered to pay $2.3 billion in restitution. 4 The executive vice president for compliance was sentenced to 48 months in prison for securities fraud but was released for testifying against the others. Also convicted were the former director of compliance and the former chief financial officer. 5

In June 2000, the FBI achieved the largest securities fraud crackdown in its history when it arrested a group of Mafia leaders for a series of scams that cost investors an esti- mated $25 million. Government officials claimed the Mob bought large stakes in small companies and then bribed and coerced brokers to promote the stocks to other investors at inflated prices.

The Enron scandal also included securities fraud, with Enron’s top executives alleg- edly overstating its earnings to maintain high stock prices and using complex accounting

4 Dept. of Justice, “Former National Century Financial Enterprises CEO Sentenced to 30 Years in Prison,” www.usdoj.gov/usao/ohs .

5 Ibid.

Exhibit 7-1 Selected Types of Fraudulent Crimes

1. Forgery: The fraudulent making or altering of any writing in a way that changes the legal rights and liabilities of another.

2. Defalcation: The misappropriation of trust funds or money held in a fiduciary capacity. 3. False entry: An entry in the books of a bank or corporation designed to represent funds that do

not exist.

4. False token: A false document or sign of existence used to perpetrate a fraud, such as counterfeit money.

5. False pretenses: A designed misrepresentation of existing facts or conditions by which a person obtains another’s money or goods, such as the writing of a worthless check.

6. Fraudulent concealment: The suppression of a material fact that a person is legally bound to disclose.

7. Mail fraud: The use of mail to defraud the public. 8. Health care fraud: Any fraudulent act committed in the provision of health care products or

services.

9. Telemarketing fraud: Any scheme, including cramming and slamming, that uses the telephone to commit a fraudulent act.

10. Ponzi scheme: An investment swindle in which high profits are promised from fictitious sources and early investors are paid off with funds raised from later ones.

11. Check kiting: Drawing checks on an account in one bank and depositing them in an account in a second bank when neither account has sufficient funds to cover the amounts drawn. Just before the checks are returned for payment to the first bank, the kiter covers them by depositing checks drawn on the account in the second bank. The brief delay in transferring funds from one bank to the other, known as the “float” time, creates an artificial balance in the account.

12. Pretexting: Using fraudulent means to obtain information about someone’s phone use. 13. Mortgage and real estate fraud: Any fraudulent act committed by anyone involved in a real estate

transaction, including sellers, buyers, mortgage brokers, title closers, land developers, and real estate lawyers.

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methods to hide debt. These executives and other big investors sold their overvalued stock while encouraging employees to continue buying it. When the company’s value plum- meted, many Enron employees lost all their retirement investments.

Another specific type of securities fraud in the Enron case, as well as in the chapter’s opening scenario, is insider trading. Insider trading is generally the buying or selling of a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider-trading violations may also include “tipping” such information and trading on it by the person “tipped.” 6 Enron’s big investors and top executives knew the stock prices were inflated due to over- stated earnings. They used this information, which was not public knowledge, to sell off their stock before the price fell. In the opening scenario, Gansman passed information to Murdoch, who then traded on the basis of that information. Murdoch’s profits were a direct result of Gansman’s tip. How might insider trading violate each of the ethical norms we have discussed?

Stock-option backdating occurs when an employee falsifies documents to make it appear as if the company had granted options on certain dates. The employee selects dates after the fact by looking for past dates on which the stock price was low, thereby falsely inflat- ing the company’s net profits. In 2007, Myron F. Olesnyckyj, the former general counsel of Monster Worldwide, Inc., pleaded guilty to securities fraud for participating in a multiyear scheme with other Monster executives to backdate stock options granted to thousands of Monster officers, directors, and employees, including himself. Monster thus granted undis- closed compensation to its employees, failed to recognize compensation expenses, and overstated its net income by $340 million from 1997 through 2005. Olesnyckyj personally made $381,000 from the scheme, which he forfeited.

False pretenses, another type of fraud, is the illegal obtaining of property belonging to another through materially false representations of an existing fact, with knowledge of their falsity and intent to defraud. Suppose Jim goes door-to-door selling vacuum cleaners at an amazing discount. To obtain the discount, the customers must pay immediately for delivery in three to five business days. However, Jim has no vacuum cleaners and does not plan on delivering any. He has committed the crime of false pretenses.

In July 2009, New York City lawyer Marc S. Dreier, whom prosecutors called a “Houdini of impersonation and false documents,” 7 was sentenced to 20 years in prison for selling over $700 million worth of bogus promissory notes to investors. Five months later, ex-SEC lawyer Robert Miller pleaded guilty to helping Dreier defraud hedge funds by impersonating a representative of both a Canadian pension plan and an Icelandic hedge fund in a scheme to sell a fictitious $44.7 million note. 8

Forgery is the fraudulent making or altering of any writing in a way that changes the legal rights and liabilities of another. If you sign your colleague’s name to the back of a check made out to her, you have committed forgery.

One of the most frequently prosecuted frauds is mail fraud, the use of mail to defraud the public, which is a federal crime under the Mail Fraud Act of 1990. To prove mail fraud, the government must demonstrate (1) an intent to defraud and (2) the use of or causing the use of mail to further the fraudulent scheme. Case 7-1 demonstrates the consideration of these two elements.

6 U.S. Securities and Exchange Commission, www.sec.gov/answers/insider.htm .

7 “Marc S. Dreier,” New York Times, November 18, 2009, http://topics.nytimes.com/top/reference/timestopics/people/d/marc_s_ dreier/index.html?inline = nyt-per .

8 “Dreier Fraud Case Leads to Guilty Plea by Ex-SEC Lawyer Miller,” Bloomberg.com, November 18, 2009, www.bloomberg .com/apps/news?pid = 20601103&sid = awYs1J0cYkL4 .

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CASE 7-1

Gerson Cohen, a meat salesperson for Butler Foods, made illegal cash payments to supermarkets’ meat managers in an attempt to persuade them to buy their meat from Butler Foods. If the customer bought at least 10,000 pounds of meat per week, the cash payments usually amounted to one penny per pound. Larry Lipoff, part owner of Butler Foods, gave the cash payments to the salespeople, who gave the cash to the customer. Over three years, Cohen made payments totaling $111,548.21 to managers for Thriftway Food Stores. The District Court convicted Cohen on twenty-five counts of mail fraud, in viola- tion of 18 U.S.C. § 1341. Cohen appealed his conviction.

JUDGE NYGAARD: Cohen argues that the Government’s evidence was insufficient to prove that he used the U.S. mail. We disagree. An essential element of mail fraud is “the use of the United States mails in furtherance of the fraudu- lent scheme”— United States v. Hannigan, 27 F.3d 890, 892 (3d Cir. 1994). This element requires some competent evi- dence that, as a routine business practice or office custom, the type of document at issue in the case was sent through the U.S. mail. As we indicated in Hannigan, “[T]he pros- ecution need not affirmatively disprove every conceivable alternative theory as to how the specific correspondence was delivered,” but “some reference to the correspondence in question is required.”

UNITED STATES OF AMERICA v. GERSON COHEN U.S. COURT OF APPEALS FOR THE THIRD CIRCUIT 171 F.3D 796 (1999)

The statute also bans the use of wire, radio, and television transmissions to defraud the public, and in 1994 Congress amended it to include commercial carriers and cou- rier services such as FedEx and UPS. Internet mail has not been explicitly legislated into the mail fraud law. However, in response to the growing threat of fraud from this source, the Postal Inspection Service formed the Internet Mail Fraud Initiative, which trains postal inspectors across the country in specialized techniques and strategies that

Cohen himself need not have placed the particular documents into the U.S. mail. A mailing is knowingly caused within the terms of the statute where one does an act with knowledge that the use of the mails will follow in the ordinary course of business.  .  .  . Here, the bookkeeper for Butler Foods, who supervised the clerical workers who were responsible for generating and mailing invoices, testified extensively about the company’s standard business practice for billing its customers. She testified that after the meat invoices were prepared, they were placed in envelopes, run through the postal meter, and put in a U.S. mail bin which Lipoff took to the post office in his car. She testified that Butler Foods never used any delivery method other than the U.S. mail for any of its invoices, and that the Thriftway invoices at issue in this case were handled in the normal manner.

A manager at the company testified that it was standard practice to pick up the invoices in the U.S. mail bin and drop them off at the post office, and that he himself did this on occasion. Finally, an accountant for the Thriftway stores tes- tified that it was normal business practice for his company to receive Butler Foods’ invoices through the U.S. mail. This testimony provides sufficient evidence that Butler routinely delivered its invoices through the U.S. mails.

AFFIRMED.

Are you persuaded Thriftway was using the mail to perpetu- ate a fraudulent scheme? Why or why not? What part of the opinion supports your conclusion?

ETHICAL DECISION MAKING CRITICAL THINKING

Return to the WPH process of ethical decision making. In other words, who are the stakeholders in this decision?

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target cyber scammers. Postal inspectors also work with analysts at the Internet Fraud Complaint Center, the Federal Trade Commission’s Consumer Sentinel, and the Postal Inspection Service’s Fraud Complaint System (FCS), soliciting and receiving fraud referrals for investigative attention. A major outcome of the Internet Mail Fraud Initia- tive was that the FCS was enhanced to receive online complaints directly from Internet users. 9

The Department of Justice recently named health care fraud its top priority after violent crime. Submitting false claims to insurance plans such as Medicare or Medicaid is health care fraud, as is prescribing unneeded equipment to patients for kickbacks from the equip- ment manufacturers.

The National Fraud Information Center reported that telephone cramming was the top telemarketing fraud of 1998. Cramming is a scheme in which companies bill consumers for optional services they did not order. Another scheme is slamming, in which consumers are tricked into changing their phone service to another carrier.

The elderly, more susceptible to telemarketing fraud, are often the specific targets of such schemes. Thus, the Department of Justice and the FBI have been collaborating on various undercover operations, such as Operation Senior Sentinel, to investigate and pros- ecute fraudulent telemarketers.

In 2008, over 1 million debtors filed for bankruptcy to be relieved of oppressive debt. Yet claims need to be carefully reviewed to prevent bankruptcy fraud by either party. A debtor might hide assets so that they will not be considered during the proceedings, or a creditor might file a false claim against a debtor. One debtor in Illinois filed a bankruptcy claim and failed to list the fact that he had just filed his state and federal tax returns prior to filing bankruptcy and was expecting to receive significant tax refunds. The Department of Justice estimates that 10 percent of all bankruptcy petitions con- tain elements of fraud. However, in 2007 the U.S. Trustee Program made only 1,163 bankruptcy-related criminal referrals, despite the fact that in 2006 the Justice Depart- ment created an Internet hotline for reporting suspected bankruptcy fraud to the Trustee Program.

Some cases encompass multiple types of fraud. A Beverly Hills lawyer was recently convicted of three counts of mail fraud, seven counts of wire fraud, and five counts of lying to a court hearing. In an elaborate fraud, the lawyer had purchased a yacht for $1.9 million, sold it to two partners to drive up its insurance value, and had a company he owned repur- chase it and insure it for $3.5 million. Finally, he and his partners sank the yacht and tried to collect the insurance.

Pretexting is using or causing others to use false pretenses, fraudulent statements, fraudulent or stolen documents, or other misrepresentations, including posing as an account holder or employee of a telecommunications carrier, to obtain telephone records of another. Pretexting entered the national lexicon in 2006 when news broke that the investigators hired by Hewlett-Packard’s board of directors to locate the source of sev- eral leaks to the media were engaging in this practice. Under the federal Telephone Records and Privacy Protection Act of 2006, anyone convicted of employing fraudulent tactics to persuade phone companies to hand over confidential data about a customer’s calling habits can be jailed for up to 10 years. Some states also have statutes outlawing pretexting.

To minimize the chances that your firm will be a victim of fraud, review Exhibit 7-2 , “Fraud Prevention Tips.”

9 For more about Internet crime, see https://postalinspectors.uspis.gov/radDocs/pubs/ar01_03.pdf .

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Embezzlement. Suppose Kathleen gives Devin, her attorney, $5,000 to put in escrow, an account where Devin will have access to the money although it is not his to use as he pleases. Devin takes some of that money out and uses it to gamble, fixing the records to cover himself. Devin has committed the crime of embezzlement, the wrongful conversion of another’s property by one lawfully in possession of it. Embezzlement is distinguished from larceny because the embezzler does not take property from another; he is already in possession of it.

It is often employees in banks who commit embezzlement. As the recent embezzlement of $6.9 million from the American Cancer Society demonstrates, even nonprofit organi- zations are vulnerable. The Chinese government, which has been focusing on economic

Exhibit 7-2 Fraud Prevention Tips Red Flags Suggesting Possible Fraud

When an investment opportunity seems too good to be true, it may indeed be less good than it seems, especially if it contains these red flags of fraud:

• No independent proof, such as names and addresses of specific companies in which the fund invests.

• Control by a single person.

• No audited financial statements and no evidence of internal controls.

• Rates of return that are significantly higher than those for other funds with a similar investment strategy.

• New investors’ reliance primarily on existing investors in deciding to invest.

Investors should also be wary of these false “assurances” that an investment opportunity is not fraudulent:

• Long-time existence of investment opportunity: A Ponzi scheme can operate for a long time. As long as the company keeps getting new investors, it can continue to use them to pay off the few who insist on collecting their returns. Many investors may be content to accumulate paper profits, especially if there is a financial incentive to reinvest them. The Financial Advisory Fund had been in business for almost 20 years before its fraudulent foundation was uncovered.

• A list of names and addresses of satisfied investors you can contact: All such schemes will have some satisfied investors who have received payments from the new investors’ money.

• Membership in the Better Business Bureau: Any company can pay to join. • A report of profitability from Dun & Bradstreet: Dun & Bradstreet does not do an independent

financial audit of a company’s profits. As stated on its Web site, it simply provides information companies send it about profits.

• Acceptance of money rolled over from IRAs: There is no government check on the soundness of firms that roll over IRAs.

• Bank references: If a firm has a large sum in a checking account and has never sought a loan from the bank, the bank will have no reason to do any due diligence on it, particularly if the owner of the firm is personable and the account has never been overdrawn.

• Glossy brochures and television ads: All you need for both is some money and the knowledge that many people are impressed by a fancy brochure or ad campaign.

These tips come from Barry Minkow, who started a carpet-cleaning business at age 16, took his multimillion-dollar company public at age 20, and faced a 23-year prison sentence and a $26 million victim restitution payment at age 21 for massive fraud and theft. His fascinating story of building a company through Ponzi schemes, check kiting, and theft is told in his book, Cleaning Up. Minkow is now a pastor and the cofounder of the Fraud Discovery Institute.

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crimes, caught employees in two major Chinese banks altering deposit slips and bank orders to direct money to personal accounts throughout China. Those employees received death sentences, as discussed in the Comparing the Law of Other Countries box.

Even though Ponzi schemes have been around for a long time, and there has been sig- nificant publicity surrounding a number of them, people still continue to fall for them. For example, in mid-2009, the Securities and Exchange Commission and the Commodity Futures Trading Commission charged two California men, Peter Son and Jin Chung, of luring about 500 investors, primarily Korean-Americans, into a scam in which the money from the new investors was used to pay the old ones. 10 Many of those who fell for Bernie Madoff’s massive Ponzi scheme were highly intelligent and sophisticated individuals who one would normally not think would be victims of such fraud.

Computer Crimes. The term computer crime refers broadly to any wrongful act that (1) is directed against computers, (2) uses computers to commit a crime, or (3) involves computers. Computer crime is not necessarily a new kind of crime but is, instead, a new way of committing traditional crimes. Consider fraud, a crime that has existed for centu- ries. Today, online auctions such as eBay are a common location of fraud in the United States. Indeed, some statistics suggest that using computers is simply a more profitable method of committing crimes. According to the FBI, the cost of online scams and fraud for Americans more than doubled from 2008 to 2009, reaching nearly $560 million. 11

Computer crimes are often difficult to prosecute, largely because they are difficult to detect. They can be committed by an insider, such as an employee, or by an outsider, such as a hacker —a person who illegally accesses a computer system to obtain information or steal money. Computer systems are also quite open to attack. The American Society for Industrial Security has reported that U.S. companies experienced losses from computer crimes of more than $250 billion in a single year. Attacks are also frequent. The IRS alone detects 800 to 1,200 cases of computer system misuse annually.

A cyber terrorist is a hacker who intends to exploit a target computer or network to create a serious impact, such as crippling a communications network or sabotaging a

10 “Two California Men Charged in Ponzi Scheme,” USA Today, June 10, 2009, p. B1. 11 Victor Godinez, “Experts At Dallas Cyber Summit Say Speed Essential In Fight Against High-Tech Crime,” Dallas News, June 1, 2010, Available at http://www.dallasnews.com/sharedcontent/dws/bus/stories/050610dnbuscybersec.3f79f2c.html .

Embezzlement and Bribery in China

Between 1981 and 1982, the People’s Republic of China witnessed a dramatic rise in white-collar crimes, including embezzlement, extortion, and bribery. Chinese officials were alarmed by the increase and sought to severely punish all offenders regard- less of political or social rank. On March 8, 1982, a resolution entitled “Severely Punishing Criminals Who Do Great Damage to the Economy” was added to the Chinese Criminal Code. It targeted top-ranking officials by stating that any state functionaries who extort, accept bribes, or exploit their office would no longer receive the standard fixed-term punishment (usually 10 years). Instead, they would be sentenced to life imprisonment or put to death.

Bank fraud is another white-collar crime that may be pun- ishable by death. In 2004, China executed four people, including

COMPARING THE LAW OF OTHER COUNTRIES

employees of two of its Big Four state banks, for fraud totaling $15 million. Three cases involved China Construction Bank, where a former accounting officer worked with others to steal 20 mil- lion yuan ($2.4 million) using fake papers. The officer and an accomplice were executed, along with another Construction Bank employee found to have taken 20 million yuan from the bank in an unrelated case.

The precise number of people executed in China is a secret, but estimates range from 5,000 to 10,000 a year for crimes including murder, corruption, and on occasion even bottom-pinching. Such punishment may seem extreme, but the reaction of the Chinese to the increase in white-collar crime reflects their culture’s unusually great concern for social harmony.

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business or organization. A successful cyber-terrorist attack can affect millions of people if it strikes a major stock exchange, any bank, or any federal agency or government.

To aid prosecutions of computer crimes, Congress passed the Counterfeit Access Device and Computer Fraud and Abuse Act of 1984 (also know as the Computer Fraud and Abuse Act, or CFAA). The act prohibits six broad categories of computer crimes:

1. Unauthorized use of or access to a computer to obtain classified military or foreign policy information with the intent to harm the United States or to benefit a foreign country.

2. Unauthorized use of a computer to collect financial or credit information protected under federal privacy law.

3. Unauthorized access to a federal computer and the use, modification, destruction, or disclosure of data it contains or the prevention of authorized persons’ use of such data.

4. Alteration or modification of data in financial computers causing a loss of $1,000 or more.

5. Modification of data that impedes medical treatment to individuals.

6. Fraudulent transfer of computer passwords or other similar data that could aid unau- thorized access that either (a) affects interstate commerce or (b) permits access to a government computer.

Computer crimes in the first category are felonies, whereas the others are misdemeanors. The National Information Infrastructure Protection Act of 1996 amended the Computer

Fraud and Abuse Act to extend protection to any computer attached to the Internet. The Justice Department also formed the Computer Crime and Intellectual Property Section (CCIPS) in its Criminal Division. Attorneys in this division prosecute only federal com- puter crimes. They also coordinate their activities with numerous government entities, the private sector, scholars, and foreign representatives to develop a global response to com- puter crime.

Destruction of Computer Data. Destruction of data is one of the most serious problems facing companies today. A virus is a computer program that rearranges, damages, destroys, or replaces computer data. The most economically destructive computer crime to date was the creation of the “love bug” virus, which spread rapidly throughout the world by e-mail in May 2000. Once the e-mail was opened, the virus destroyed files on the user’s computer and then sent itself to every address in that computer’s e-mail address book. In the end, the love bug caused over $10 billion in damages and halted computers in major companies and government agencies worldwide.

Companies can try to prevent the destruction of data by installing virus detection pro- grams on their computers, installing firewalls, and adopting procedures such as the use of confidential passwords and encryption keys. However, virus detection programs recognize only previously existing harmful files. If someone creates a new virus, the detection pro- gram is useless. To counter this drawback, all antivirus providers offer a subscription ser- vice by which users can get automatic updates that provide as much protection as possible against newly created viruses for which cures have been developed.

Unlawful Appropriation of Data or Services. An employee who uses his or her computer in a manner not authorized by the employer, such as to run a personal business on the side, has committed a crime, most often theft of company assets (the computer). Employers must clearly communicate with employees about authorized versus unauthorized behavior. As a business manager, you will want to explicitly list acceptable computer uses and penal- ties for unauthorized use.

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Liability for Crimes An individual or a corporation can be charged with and convicted of a crime. How- ever, there has been much debate over whether corporations should be held criminally responsible.

CORPORATE CRIMINAL LIABILITY Under the common law, a corporation could not be considered a criminal because it was not an actual person and thus did not have a “mind.” Consequently, it could not meet the mens rea (guilty-mind) requirement for a crime. Slowly, however, courts began to impose liability on corporations for strict-liability offenses, those offenses that do not require state of mind. Next, courts imposed liability on corporations by imputing the state of mind of the employee to the corporation. Currently, corporations can be held criminally account- able for almost any crime except those punishable only by a prison sentence.

The first case in which criminal liability was assigned to a corporation for a crime other than a strict-liability offense was decided by the Supreme Court in 1909. 12 Courts have since refined the standards required for finding a corporation criminally liable for the acts of one of its employees or agents. Today, it must be shown that (1) the individual was acting within the scope of her or his employment; (2) the individual was acting with the purpose of benefiting the corporation; and (3) the act was imputed to the corporation.

LIABILITY OF CORPORATE EXECUTIVES Corporate executives may also be personally liable for a business crime, regardless of whether it was committed for their personal benefit or that of the corporation. Under the “responsible corporate officer” doctrine, a court may assess criminal liability even on a corporate executive or officer who did not engage in, direct, or know about a specific criminal violation. As Case 7-2 demonstrates, corporate executives sometimes have the responsibility and power to ensure the company’s compliance with the law. One who fails to do so can be held criminally liable.

12 New York Central & Hudson River Railroad Company v. United States, 212 U.S. 481 (1909).

Defendant Park, the president of a national food-chain corporation, was charged, along with the corporation, with violating the Federal Food, Drug, and Cosmetic Act by allowing food in the warehouse to be exposed to rodent contamination. Park conceded that his responsibility for the “entire operation” included warehouse sanitation but claimed he had delegated the responsibility for sanita- tion to dependable subordinates. He admitted at trial that he had received a warning letter from the Food and Drug

Administration about unsanitary conditions at one of the company’s warehouses. The trial court found him guilty, the court of appeals reversed, and the case was appealed to the U.S. Supreme Court.

CHIEF JUSTICE BURGER: The question presented was whether “the manager of a corporation, as well as the corpora- tion itself, may be prosecuted under the Federal Food, Drug, and Cosmetic Act of 1938 for the introduction of misbranded

UNITED STATES v. PARK UNITED STATES SUPREME COURT 421 U.S. 658 (1975)

CASE 7-2

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and adulterated articles into interstate commerce.” In Dotterweich, a jury had disagreed as to the corporation, a jobber purchasing drugs from manufacturers and shipping them in interstate commerce under its own label, but had convicted Dotterweich, the corporation’s president and gen- eral manager.

Central to the Court’s conclusion that individuals other than proprietors are subject to the criminal provisions of the Act was the reality that “the only way in which a corporation can act is through the individuals who act on its behalf.”

The rationale of the interpretation given the Act in Dotterweich, as holding criminally accountable the per- sons whose failure to exercise the authority and supervisory responsibility reposed in them by the business organization, resulted in the violation complained of, has been confirmed in our subsequent cases. . . . In order to make “distributors of food the strictest censors of their merchandise,” the Act punishes “neglect where the law requires care, and inac- tion where it imposes a duty.” “ The accused, if he does not will the violation, usually is in a position to prevent it with no more care than society might reasonably expect and no more exertion than it might reasonably extract from one who assumed his responsibilities.”

Thus, Dotterweich and the cases which have followed reveal that in providing sanctions which reach and touch the individuals who execute the corporate mission—and this by no means necessarily confined to a single corporate agent or employee—the Act imposes not only a positive duty to seek out and remedy violations when they occur, but also, and primarily, a duty to implement measures that will insure

that violations will not occur. The requirements of foresight and vigilance imposed on responsible corporate agents are beyond question, demanding, and perhaps onerous, but they are not more stringent than the public has a right to expect of those who voluntarily assume positions of authority in business enterprises whose services and products affect the health and well-being of the public that supports them.

The Act does not, as we observed in Dotterweich, make criminal liability turn on “awareness of some wrongdo- ing” or “conscious fraud.” The duty imposed by Congress on responsible corporate agents is, we emphasize, one that requires the highest standard of foresight and vigilance, but the Act, in its criminal aspect, does not require that which is objectively impossible. The theory upon which responsible corporate agents are held criminally accountable for “caus- ing” violations of the Act permits a claim that a defendant was “powerless” to prevent or correct the violation to “be raised defensively at a trial on the merits.”

. . . [I]t is equally clear that the Government established a prima facie case when it introduced evidence sufficient to warrant a finding by the trier of the facts that the defendant had, by reason of his position in the corporation, responsi- bility and authority either to prevent in the first instance, or promptly to correct, the violation complained of, and that he failed to do so. The failure thus to fulfill the duty imposed by the interaction of the corporate agent’s authority and that statute furnishes a sufficient causal link. The considerations, which prompted the imposition of this duty, and the scope of the duty, provide the measure of culpability.

REVERSED in favor of the Government.

The Court relied heavily on the Dotterweich decision in coming to its present conclusion. Why? Do you think the Court should have relied so much on this case?

ETHICAL DECISION MAKING CRITICAL THINKING

Suppose you were in Park’s position and allowed food in your warehouse to be exposed to rodent contamination. If you were guided by the public disclosure test, what would you decide to do?

Since United States v. Park (Case 7-2), the general rule that corporate executives may be held accountable for crimes arising from their failure to meet their responsibility has remained intact. In fact, it has broadened; now executives can be held criminally liable for offenses we generally do not think of as crimes. In United States v. Iverson, 13 a cor- porate officer of a waste treatment facility was convicted and sentenced for violating the Clean Water Act after he ordered employees to illegally dispose of wastewater. This case demonstrates that corporate executives can be sentenced not only for committing common

13 162 F.3d 1015 (1998).

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law crimes we have traditionally understood to be criminal offenses but also for violating provisions of regulatory statutes that permit criminal sanctions. Using the idea of vicari- ous liability, courts have held employers liable for the wrongful acts of their employees if the employer directed, partook in, or authorized the wrongful act.

Legal Principle: As a general rule, when a lower-level employee commits a crime, she or he will be individually liable for the crime, and under the responsible corpo- rate officer doctrine, the employee’s manager, and any other corporate official who could have prevented the crime, can also be held vicariously liable for the crime.

Defenses to Crimes In addition to claiming the defendant is innocent or the prosecution did not follow proper procedures, the defense may use several affirmative defenses, which are excuses for unlawful behavior. Some of the most common are infancy, mistake of fact, intoxication, insanity, duress, and entrapment.

INFANCY By law, persons under the age of majority (the age at which someone becomes a legal adult) are considered infants. They are typically judged as lacking the mental capabilities of an adult, and thus infancy can be a partial defense to defuse the guilty-mind requirement of a crime. However, for some offenses a defendant under the age of majority can be deter- mined by a judge to be a legal adult and be tried as such.

MISTAKE OF FACT A mistake-of-fact defense tries to prove the defendant made an honest and reasonable mistake that negates the guilty-mind element of a crime. For example, in the opening sce- nario, if Murdoch thought the information provided by Gansman was public knowledge, she would not be guilty of insider trading.

In contrast, mistake of law is generally not a legitimate defense. For example, nei- ther Murdoch nor Gansman could escape conviction by claiming Gansman did not know insider trading is against the law. While initially these two rules may seem contradictory (because in both cases the defendant seems to lack a guilty mind), the mistake-of-law rule serves a policy goal. Courts have refused to recognize mistake of law as a defense because they fear creating a disincentive for people to learn basic tenets of law.

INTOXICATION A person who was forced to ingest or involuntarily ingested an intoxicating agent can claim involuntary intoxication. This defense applies only if intoxication left the person unable to understand that the act committed was wrong. In most states, a defendant who knowingly chose to become intoxicated cannot claim intoxication as a defense.

INSANITY Although insanity is a well-known criminal defense, it is not used as often as the public believes. A person cannot simply claim he or she is or was crazy; psychiatrists usually testify to the defendant’s mental state at the time of the crime. Standards vary from state to state, but in general defendants can claim insanity if their mental condition when the crime was committed was so impaired that they could not (1) understand the wrongful nature of the act or (2) distinguish between right and wrong in a general sense.

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The insanity defense often creates a “battle of the experts.” The psychiatrist for the defense claims the accused was insane, and the psychiatrist for the prosecution refutes that diagnosis. The complexity of the insanity standards almost guarantees that experts will disagree. Further, legal scholars debate whether psychiatrists can determine whether an individual is or was insane at the time of the criminal act.

Adding to the difficulty, the test used to establish the defendant’s mental state varies by jurisdiction. Approximately one-third of the states still apply the M’Naghten test, also known as the “right-wrong test.” This allows a defendant to be found not guilty if she did not understand the nature of the act.

The irresistible-impulse test allows a verdict of not guilty by reason of insanity even if the accused knew a criminal act was wrong, as long as some “irresistible impulse” result- ing from a mental deficiency drove the person to commit the crime.

A third test for establishing criminal insanity is recognized in the Model Penal Code, Section 4.01, which states, “A person is not responsible for criminal conduct if at the time of such conduct as a result of mental disease or defect he lacks substantial capacity either to appreciate the wrongfulness of his conduct or to conform his conduct to the requirements of the law.” While this standard is easier to meet than the first two, it is still extremely dif- ficult to prove criminal insanity.

In raising the insanity defense for Andrea Yates, accused of the murder of her five children, Yates’s lawyer argued that his client believed killing them was the right thing to do. In support, he offered evidence that she had said her children were “going to be tormented the rest of their lives, and they were going to perish in the fires of hell,” so she killed them to save them. This defense was not successful in her first trial. However, that verdict was overturned on appeal due to erroneous testimony, and in retrial the defense was successful.

DURESS If Greg threatened Bill with immediate bodily harm or loss of life unless Bill performed a wrongful act, Bill can use the duress defense. However, to claim duress, Bill must estab- lish the following three elements:

1. Greg threatened Bill with serious bodily harm or loss of life. Threatening to take Bill’s money would not be considered duress.

2. Greg’s threat of harm must be more serious than the harm caused by Bill’s crime. If Greg threatened to seriously injure Bill’s daughter unless Bill handed over the $5,000 in the company cash register, duress would apply.

3. Greg’s threat of harm must be immediate and inescapable. If Greg threatened to kill Bill in a year if Bill did not comply with Greg’s order, Bill could not use the duress defense.

ENTRAPMENT The entrapment defense applies if the idea for a crime originated with a police officer or some other government official who suggested it to the defendant, who would not oth- erwise have committed the crime. The purpose of this defense, common in white-collar cases, is to prevent law enforcement officials from instigating crime. To refute the defense, the prosecution must demonstrate that the defendant either was not induced by government agents to commit the crime or was predisposed to commit it. A long-time drug dealer could not use the entrapment defense to claim that an undercover agent who offered to buy the dealer’s drugs was the one who gave her the idea to sell drugs.

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Chapter 7 Crime and the Business Community 165

NECESSITY One possible defense is to say a crime was necessary to prevent a more severe crime from occurring. Section 3.01 of the Model Penal Code allows for the necessity defense when “the harm or evil sought to be avoided by such conduct is greater than that sought to be prevented by the law defining the offense charged.” A person could use the necessity defense if he or she broke into a store to prevent arson from occurring at night.

JUSTIFIABLE USE OF FORCE Although not typical in white-collar crime cases, one defense in cases of physical violence is justifiable use of force. The best-known example is self-defense in protection of your life. However, in many jurisdictions, justifiable use of force can apply to defense of your dwelling or other property and to the prevention of a crime. The force used must be rea- sonable, which is understood in the law to be enough to make an adequate defense but not more than necessary for protection. Deadly force (sufficient to kill or cause serious bodily harm) is unjustifiable where the threat of deadly force does not exist, and it can never be used to protect property, as the law values life over property.

Constitutional Safeguards The state obviously has vast resources that it can use to try to obtain a guilty verdict. To reduce this imbalance of power, constitutional safeguards are built into the system that protect defendants during criminal proceedings. Most, but not all, are contained within the Bill of Rights, the first 10 amendments to the Constitution.

FOURTH AMENDMENT PROTECTIONS 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 probable cause, supported by oath or affirmation, and particu- larly describing the place to be searched, and the persons or things to be seized.

The Fourth Amendment contains two important safeguards: protection from unreason- able search and seizure, and restrictions on warrants. The prohibition against unreason- able search and seizure is fairly straightforward. Government officials are not allowed to perform any searches without a proper warrant or without probable cause for a search. The Fourth Amendment therefore protects an individual’s privacy.

The restriction on warrants requires that warrants be specific about who is to be arrested and on what cause or what objects are to be sought and in which locations. The Fourth Amendment thus prevents law enforcement officials from searching anywhere they wish for anything illegal they might find.

Fourth Amendment protections extend to businesses as well. Government inspectors may not legally enter a business to conduct an inspection without a warrant, except to search highly regulated industries such as food, liquor, or firearms. General manufactur- ing is not a highly regulated industry; thus a warrant is required for an agent to inspect a manufacturing plant.

FIFTH AMENDMENT PROTECTIONS . . . nor shall any person be subject for the same offense to be twice put in jeopardy

of life or limb; nor shall be compelled in any criminal case to be a witness against himself, nor be deprived of life, liberty, or property, without due process of law.

LO4

What are the basic constitutional safeguards

for a person accused of a crime?

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The three main provisions of the Fifth Amendment are the prohibition on double jeopardy, the right not to incriminate yourself, and the right to due process.

Double jeopardy occurs when a person is retried for the same criminal offense after being declared not guilty. The Constitution expressly forbids this, but only for criminal offenses. A person found not guilty of a criminal offense may still face a civil charge, decided independently of the verdict in the criminal case and entailing a lower burden of proof. Such was the case with O. J. Simpson, who was acquitted of murder charges in the deaths of Nicole Brown Simpson and Ron Goldman but found civilly liable for their deaths. To “take the fifth” is to invoke your constitutional right not to testify against your- self. A criminal defendant does not have to, and cannot be forced to, testify against himself or herself. This right applies not to corporations but only to natural persons (remember, corporations are legal entities, not natural persons, in the eyes of the law). Nonetheless, sole proprietorships that have not been incorporated may be considered natural persons embodied in the person of the owner, who may therefore use the Fifth Amendment protec- tion against self-incrimination.

The guarantee of due process of law ensures that a defendant may not be stricken of life, liberty, or property without first going through the appropriate legal actions (typically a trial or plea bargaining). Unlike the right not to incriminate oneself, the guarantee of due process of law does extend to corporations.

SIXTH AMENDMENT PROTECTIONS In all criminal prosecutions, the accused shall enjoy the right to a speedy and

public trial, by an impartial jury . . . 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 assistance of counsel for his defense.

Sixth Amendment protections are crucial to ensuring fair proceedings in a criminal trial. These rights are:

1. The right to a speedy and public trial.

2. The right to a trial by an impartial jury.

3. The right to be informed of the accusations against you.

4. The right to confront witnesses.

5. The right to have witnesses on your side.

6. The right to counsel at various stages of the proceedings.

EIGHTH AMENDMENT PROTECTIONS Excessive bail shall not be required, nor excessive fines imposed, nor cruel and

unusual punishments inflicted.

While the explicit meanings of “excessive bail,” “excessive fines,” and “cruel and unusual punishment” are open to judicial interpretation, the protections embodied in the Eighth Amendment are easy to grasp.

FOURTEENTH AMENDMENT PROTECTIONS 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 jurisdiction the equal protection of the laws.

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While not part of the Bill of Rights, the Fourteenth Amendment does contain important constitutional safeguards that extend the federal guarantee of due process—and most con- stitutional protections—to all states.

THE EXCLUSIONARY RULE The exclusionary rule, not stated in any specific amendment, holds that all evidence obtained in violation of the constitutional rights spelled out in the Fourth, Fifth, and Sixth amendments is normally not admissible at trial. Such evidence is considered “fruit of the poisonous tree” because it is the result of an illegal procedure.

Under the good-faith exception, however, evidence found when an official acts in good faith is admissible. Evidence gathered by a law enforcement official who uses an incorrect search warrant to obtain evidence but acts in good faith, believing the search warrant to be correct and valid, is admissible. The inevitability exception holds that illegally obtained evidence may be used at trial if it would have been obtained “inevitably” by law enforce- ment officials using lawful means.

Criminal Procedure Criminal procedure differs from civil procedure in several key ways. First, the govern- ment, as prosecutor, always brings the criminal case, whereas in a civil case the plaintiff filing the case can be an individual, business, or government entity. Second, in a criminal case the objective is punishment, so the defendant may be fined or imprisoned. In a civil case the objective is to remedy a wrong done to the plaintiff, so the defendant will have to compensate the plaintiff or be subject to an equitable remedy, such as an injunc- tion or order for specific performance. Other differences will become clear as you read the following sections describing the pretrial, trial, and posttrial procedures in a criminal case. Exhibit 7-3 illustrates the complete criminal procedure.

Exhibit 7-3 Steps in a Criminal Procedure

Arrest

Booking

First Appearance

Information (for misdemeanor)

Indictment by a Grand Jury (for felony)

Arraignment

Trial

Appeal

LO5

What are the basic steps of a criminal

proceeding?

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PRETRIAL PROCEDURE Before an arrest, grand juries may conduct criminal investigatory proceedings or issue a grand jury subpoena for company records. Criminal proceedings generally begin when an individ- ual is arrested by a law enforcement officer for a crime. The arresting agent is often a police officer but may also be part of another government agency, such as the Bureau of Alcohol, Tobacco, Firearms and Explosives; the Federal Bureau of Investigation; or the Immigration and Naturalization Service. Ordinarily, to obtain the necessary arrest warrant, the agent must demonstrate that there is probable cause, or likelihood, that a suspect committed or is plan- ning to commit a crime. A magistrate, the lowest-ranking judicial official, issues the arrest warrant. In certain circumstances, however, law enforcement agents can arrest a suspect with- out a warrant if they believe there is probable cause but not enough time to obtain the warrant.

To comply with the Supreme Court’s requirements for protecting a citizen’s rights, law enforcement officers must inform any individual they arrest of his or her Miranda rights. If the officers fail to do so, any information a defendant offers at the time of the arrest is not admissible at trial. The Miranda rights and warnings are these:

1. “You have the right to remain silent and refuse to answer any questions.”

2. “Anything you say may be used against you in a court of law.”

3. “You have the right to consult an attorney before speaking to the police and have an attorney present during any questioning now or in the future.”

4. “If you cannot afford an attorney, one will be appointed for you before the questioning begins.”

5. “If you do not have an attorney available, you have the right to remain silent until you have had an opportunity to consult with one.”

6. “Now that I have advised you of your rights, are you willing to answer any questions without an attorney present?”

The Supreme Court, however, in 2010, showed that it is not rigid in terms of exactly how the defendant must be told of his rights. 14 In a case in February, the defendant was taken down to police headquarters and told, “You have the right to remain silent. If you give up the right to remain silent, anything you say can be used against you in court. You have the right to talk to a lawyer before answering any of our questions. If you cannot afford to hire a lawyer, one will be appointed for you without cost and before any ques- tioning. You have the right to use any of these rights at any time you want during this interview.” 15 The defendant then signed a form acknowledging that he had been read his rights, understood them, and was willing to talk to the officers. He then admitted to being in possession of a prohibited firearm.

Once the defendant obtained a lawyer, he moved to suppress the statement on grounds that Miranda warnings were deficient because they did not adequately convey the sus- pect’s right to the presence of an attorney during questioning, The court denied the motion and the defendant was convicted. On appeal, the state appellate court found that the state- ments should have been suppressed. The case was appealed to the state supreme court on the specific question of, ““Does the failure to provide express advice of the right to the presence of counsel during questioning vitiate Miranda warnings which advise of both (A) the right to talk to a lawyer ‘before questioning’ and (B) the ‘right to use’ the right” to consult a lawyer ‘at any time’ during questioning?” 16

14 Florida v. Powell, 130 S. Ct. 1195.

15 Id.

16 Id.

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The Florida Supreme Court found that the advice Powell received was misleading because it suggested that Powell could “only consult with an attorney before ques- tioning” and did not convey Powell’s entitlement to counsel’s presence throughout the interrogation.

However, the U.S. Supreme Court disagreed, saying that Miranda does not require any specific words to be used to communicate the defendant’s rights. Looking at what the police said, the majority found no rights were omitted, “The first statement commu- nicated that Powell could consult with a lawyer before answering any particular ques- tion, and the second statement confirmed that he could exercise that right while the interrogation was underway. In combination, the two warnings reasonably conveyed [the suspect’s] right to have an attorney present, not only at the outset of interrogation, but at all times.” 17

While Justice Stevens, in dissent, argued that the separate and distinct right “to have counsel present during any questioning” was not provided by the police, it is clear from the outcome of the case that in the future the court is not going to be looking for precise language in determining whether Miranda has been satisfied.

Case 7-3 presents the seminal case of Miranda v. Arizona in which these rights were spelled out . Notice the points of law from which the Miranda rights are derived.

17 Id.

On March 13, 1963, Ernesto Miranda was arrested for kid- napping and rape and taken to a Phoenix police station. After being identified by the complaining witness, he was questioned by two police officers, who emerged from the interrogation room two hours later with a written and signed confession. At the top of the statement was a typed paragraph stating the confession was made voluntarily, without threats or prom- ises of immunity, and “with full knowledge of my legal rights, understanding any statement I make may be used against me.”

At trial, the officers admitted Miranda had not been advised he had a right to have an attorney present, and the written confession was admitted into evidence over the objection of defense counsel. The officers testified to a prior oral confession made by Miranda during the interro- gation. Miranda was found guilty and sentenced to 20 to 30 years’ imprisonment. On appeal, the Supreme Court of Arizona held that Miranda’s constitutional rights were not violated and affirmed the conviction. Miranda appealed to the Supreme Court, which joined his case with the cases of three other defendants making similar constitutional argu- ments regarding a violation of rights.

JUSTICE WARREN: The cases before us raise questions which go to the roots of our concepts of American criminal jurisprudence: the restraints society must observe consistent with the Federal Constitution in prosecuting individuals for crime. More specifically, we deal with the admissibility of statements obtained from an individual who is subjected to custodial police interrogation and the necessity for proce- dures which assure that the individual is accorded his privi- lege under the Fifth Amendment to the Constitution not to be compelled to incriminate himself.

This case is but an explication of basic rights enshrined in our Constitution—that “No person .  .  . shall be com- pelled in any criminal case to be a witness against him- self,” and that “the accused shall . . . have the Assistance of Counsel”—rights which were put in jeopardy in this case through official overbearing. These precious rights were fixed in our Constitution only after centuries of persecution and struggle. And in the words of Chief Justice Marshall, they were secured “for ages to come, and .  .  . designed to approach immortality as nearly as human institutions can approach it.”

MIRANDA v. ARIZONA UNITED STATES SUPREME COURT 384 U.S. 436 (1966)

CASE 7-3

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Our holding .  .  . briefly stated is this: the prosecution may not use statements, whether exculpatory or inculpa- tory, stemming from custodial interrogation of the defen- dant unless it demonstrates the use of procedural safeguards effective to secure the privilege against self-incrimination. By custodial interrogation, we mean questioning initiated by law enforcement officers after a person has been taken into custody or otherwise deprived of his freedom of action in any significant way. As for the procedural safeguards to be employed, unless other fully effective means are devised to inform accused persons of their right of silence and to assure a continuous opportunity to exercise it, the following mea- sures are required.

Prior to any questioning, the person must be warned that he has a right to remain silent, that any statement he does make may be used as evidence against him, and that he has a right to the presence of an attorney, either retained or appointed. The defendant may waive effectuation of these rights, provided the waiver is made voluntarily, know- ingly and intelligently. If, however, he indicates in any manner and at any stage of the process that he wishes to consult with an attorney before speaking there can be no

questioning. Likewise, if the individual is alone and indi- cates in any manner that he does not wish to be interro- gated, the police may not question him. The mere fact that he may have answered some questions or volunteered some statements on his own does not deprive him of the right to refrain from answering any further inquiries until he has consulted with an attorney and thereafter consents to be questioned.

From the testimony of the officers and by the admission of respondent, it is clear that Miranda was not in any way apprised of his right to consult with an attorney and to have one present during the interrogation, nor was his right not to be compelled to incriminate himself effectively protected in any other manner. Without these warnings the statements were inadmissible. The mere fact that he signed a state- ment which contained a typed-in clause stating that he had “full knowledge” of his “legal rights” does not approach the knowing and intelligent waiver required to relinquish con- stitutional rights.

Therefore, in accordance with the foregoing, the judg- ment of the Supreme Court of Arizona is reversed.

REVERSED.

What is the reasoning structure in the Miranda case?

Does Justice Warren offer a logically powerful argument for giving defendants’ rights greater protection than was cus- tomary at the time?

ETHICAL DECISION MAKING CRITICAL THINKING

In arguing for greater protection of the rights of the accused, what values is Justice Warren upholding?

With what values might Justice Warren’s values be in contention?

The Miranda rights are not absolute. In fact, the Supreme Court has several times allowed for exceptions. In New York v. Quarles, 18 the Court created a “public safety” exception that allows statements to be used at trial, even if a person was not informed of his or her Miranda rights, if the need to protect the public is served by the admissibility of the statements in question. In Arizona v. Fulminante, 19 the Court held that a coerced confes- sion can be ignored and treated as nonprejudicial at trial if the other evidence is sufficient to obtain a conviction.

In a third exception to the Miranda rights, Davis v. United States 20 held that defendants must “unequivocally and assertively” state their right to counsel in order to activate it. The phrase “Maybe I should talk to a lawyer” or a similar utterance made during an inter- rogation does not affirmatively signal that an accused desires to activate his or her right to counsel.

18 467 U.S. 649 (1984).

19 499 U.S. 279 (1991).

20 512 U.S. 452 (1994).

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Despite being recognized for over 40 years, Miranda rights are still applied with limitations; a ruling by the U.S. Supreme Court is often necessary. For example, in the second term of 2004 alone, the high court made three rulings clarifying applications of the warnings. In Missouri v. Seibert, 21 the court held that a confession made after receipt of the Miranda warnings was inadmissible if the police had asked for it before giving the warnings. In United States v. Patane, 22 the Court ruled that physical evidence discovered as a result of statements made without the Miranda warnings was admissible in court as long as the statements were not forced by police, even though the statements themselves were not admissible. In the third case, Yarborough v. Alvarado, 23 the court clarified that a person was “in custody” and therefore entitled to receive Miranda warnings when a reasonable person of the defendant’s age and educational background would not feel free to leave or terminate the questioning.

The current Supreme Court, a more conservative court, has been narrowing Miranda the last few years. The following Case Nugget highlights the most recent, and controver- sial, 5-4 decision interpreting Miranda.

After being arrested and read their Miranda rights, defendants are taken to the police station for booking, a procedure during which the name of the defendant and the alleged crime are recorded in the investigating agency’s or police department’s records. After the prosecutor files the complaint, the defendant makes the first appearance before a magis- trate, who determines whether there was probable cause for the arrest. If not, the individual is freed.

If the defendant committed a minor offense and pleads guilty, the magistrate sentences the individual. However, if the defendant claims innocence, the magistrate ensures that the defendant has a lawyer or appoints one, if necessary for an indigent defendant, and sets bail. Bail is the amount of money defendants pay the court on release from custody as security that they will return for trial.

Next, the prosecutor has a choice: Should the case be prosecuted? The Principles of Federal Prosecution, established by the U.S. Department of Justice, suggest that at the federal level the decision to prosecute depends on two primary factors: (1) whether the evidence is sufficient to obtain a conviction, and (2) whether prosecuting the case serves a federal interest. If the prosecutor decides not to go forward with the case, the defendant may still be liable for his or her actions in civil court.

A prosecutor who chooses to proceed with a criminal action must demonstrate the likelihood that the defendant’s actions and intent meet the elements of a crime by charg- ing the defendant with a crime through an information or an indictment. For a misde- meanor, the prosecutor must present the magistrate with evidence sufficient to justify prosecution through an information, a formal written accusation stating the facts and specifying the violation of criminal law. However, for a felony, the prosecutor must pres- ent a grand jury with evidence adequate to justify bringing the defendant to trial. If the grand jury agrees that the evidence is adequate, it issues an indictment, a written accusation against the defendant. Note that the grand jury does not determine guilt. It is simply a group of citizens who consider evidence of criminal conduct presented by the prosecutor and then determine whether there is enough evidence to try the defendant for the crime.

In early December 2001, Enron Corp., once a multibillion-dollar energy trader, filed for bankruptcy. The U.S. Securities and Exchange Commission (SEC) then stated it would

21 542 U.S. 600 (2004).

22 542 U.S. 630 (2004).

23 541 U.S. 652 (2004).

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widen its investigation into Enron by considering whether Arthur Andersen, the account- ing firm that was Enron’s chief auditor, destroyed documents while the investigation was under way—in fact, until November 8, 2001, when the SEC issued Andersen a subpoena. On March 14, 2002, the U.S. Justice Department issued an indictment against the account- ing firm, and a grand jury indicted Andersen for ordering its employees to intentionally destroy documents that included information about official proceedings and criminal investigations.

In federal cases, a defendant accused of a felony has a constitutional right to a grand jury indictment. However, a felony prosecution may proceed by information if the defen- dant waives that right. For instance, in a high-profile case in which the defense attorney is trying to work out a deal with the prosecution, the defendant may ask that the case proceed by information. Federal misdemeanor cases may proceed by indictment or information.

If the criminal trial takes place in state court, the defendant may or may not have access to a grand jury. The U.S. Supreme Court has held that a grand jury trial is not a fundamen- tal right, and thus states are not required to offer grand juries. About half the states still require that felony prosecutions be initiated by grand jury indictments; most of the rest use information to commence prosecution.

The defendant appears in court to answer the indictment in an appearance called the arraignment. At this time, the defendant enters a plea of guilty or not guilty. A defen- dant may also plead nolo contendere, not admitting guilt but agreeing not to contest the charges. The advantage of a nolo contendere plea over a plea of guilty is that the former cannot be used against the defendant in a civil suit. If the defendant pleads not guilty, his case will be heard before a petit jury, a fact-finding jury.

At any time, the prosecutor and defendant can make a plea bargain, an agreement in which the prosecutor agrees to reduce charges, drop charges, or recommend a certain sen- tence if the defendant pleads guilty. Plea bargaining benefits both parties: The defendant gets a lesser sentence, and the prosecution saves time and resources by not trying the case. Businesspeople who commit crimes that affect business often engage in plea bargaining to avoid the publicity associated with a trial and the risk of a severe sentence.

Berghuis v.Thompkins

United States Supreme Court 130 S. Ct. 2250 (2010)

The facts of the case are simple. Thompkins, a murder suspect, was read his rights, but refused to sign a statement saying he understood his rights. He remained silent for almost three hours as police continued to question. After two hours and 45 minutes of questioning, Mr. Thompkins said yes in response to each of three questions: “Do you believe in God?” “Do you pray to God?” and, “Do you pray to God to forgive you for shooting that boy down?” His yes to the third question was used to convict him of murder.

The appellate court ruled that the statement should have been excluded because prosecutors could not prove that Mr. Thompkins had knowingly and voluntarily waived his right to remain silent. But the high court disagreed, even though Justice Kennedy wrote

CASE NUGGET

that “some language in Miranda could be read to indicate that waivers are difficult to establish absent an explicit written waiver or a formal, express oral statement.” The majority still held that absent an explicit invocation of the right to remain silent, police may continue to interrogate a suspect, and what he says may be used against him in court.

As the dissent pointed out, the original Miranda decision said that you cannot presume a defendant has waived his rights just because he remains silent; a lengthy interrogation that results in a confession usually means the confession is coerced. But Kennedy said that decisions since Miranda had undercut that decision’s lan- guage and that a more sensible decision put the burden on the suspect to exercise his rights. “A suspect who has received and understood the Miranda warnings, and has not invoked his Miranda rights, waives the right to remain silent by making an uncoerced statement to the police.”

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TRIAL PROCEDURE If the case goes to trial and the crime is a felony or a misdemeanor punishable by six months or more in prison, the defendant has a constitutional right to a jury trial. In most states, if the defendant waives the right to a jury trial, a judge will hear the case and act as fact finder in a bench trial.

In a criminal trial, the prosecutor has the burden of proof, and the defendant does not have to prove anything. The burden of proof has two elements. To meet the burden of production of evidence, the prosecution must produce any tangible evidence and testi- mony that prove the elements of the crime the defendant allegedly committed. To meet the burden of persuasion, the prosecutor must persuade the jury beyond reasonable doubt that the defendant committed the crime. The burden of proof, then, is higher in a criminal case than in a civil case, because in a civil case the burden of persuasion requires only that the claim be supported by a preponderance of the evidence.

As noted above, the defendant in a criminal trial need not testify, and her refusal to testify cannot be held against her. However, if she does choose to testify, then like all other witnesses, she must swear to tell the truth. In Italy, all witnesses except the defendant tes- tify under oath.

After the jury hears the case, it deliberates and tries to reach a verdict. If the jury finds the defendant not guilty, he or she is acquitted and released. If the jury returns a guilty ver- dict, the judge will set a date for sentencing the criminal. A jury unable to reach a verdict is a “hung jury.”

POSTTRIAL PROCEDURE If the petit jury returns a verdict of not guilty, the government cannot appeal the acquittal. However, if the verdict is guilty, the defendant may appeal by claiming that a prejudicial error of law occurred at the original trial.

If there is no appeal, the defendant will be sentenced after the judge has received additional relevant information. Before 1991, sentencing was indeterminate, with judges allowed but not required to engage in free-form fact finding before selecting the appropriate punishment within broad statutory ranges. In 1991, however, there was a shift to determinate sentencing, under which federal sentences are determined largely by sentencing guidelines prescribing a specific range of possible penalties for each crime.

Judges are given certain factors to consider in sentencing, such as the defendant’s criminal record. Guidelines have also been established for white-collar crimes, once again allowing judges to consider individual factors such as the company’s history of past viola- tions and cooperation with federal investigators. Many states have adopted similar state sentencing guidelines.

The role of the federal sentencing guidelines has been sharply curtailed by two sig- nificant Supreme Court cases. The first, Blakely v. Washington, 24 used a Sixth Amendment challenge to the procedure for imposing an aggravated penalty above the standard range set by the guidelines. In Blakely, the Court held that in cases relying on state laws for deter- minate sentencing, judges are bound by facts consistent with the verdict or admitted by the defendant. Blakely pleaded guilty to a lower offense than the one with which he was origi- nally charged. The prosecutor recommended that Blakely be sentenced to the statutorily

24 124 S. Ct. 2531 (2004).

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mandated maximum of 53 months, but the judge expanded his sentence to three years beyond that recommendation. The Court found that the extension violated Blakely’s Sixth Amendment rights because he did not admit to the facts the judge took into consideration nor did a jury find them relevant to a verdict. Note that Blakely does not hold determinate sentencing to be unconstitutional but, rather, requires that it comply with Sixth Amend- ment protections.

The second case, U.S. v. Booker, 25 had far more radical effects, extending the Blakely holding to the federal sentencing guidelines. Moreover, Booker found that the two sections of federal law mandating determinate sentences were unconstitutional and struck them from the statute, effectively making the act advisory. With sentencing no longer manda- tory, judicial fact finding is not “legally essential to punishment” and does not pose any Sixth Amendment problem.

Tools for Fighting Business Crime Three federal crime-fighting laws are RICO, the False Claims Act, and the Sarbanes-Oxley Act of 2002. RICO and the False Claims Act were originally created with different pur- poses in mind. Sarbanes-Oxley, however, was created specifically to combat white-collar crime.

25 125 S. Ct. 738 (2005).

THE RACKETEER INFLUENCED AND CORRUPT ORGANIZATIONS ACT One of the most important tools for fighting white-collar crime is in Title IX of the Orga- nized Crime Control Act of 1970: the Racketeer Influenced and Corrupt Organizations (RICO) Act, originally enacted to combat organized crime. In effect it prevents legitimate

LO6

How can we prevent white-collar crimes?

Some people argue that there might be a lot less white-collar crime if we saw more white-collar criminals in handcuffs.

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businesses from serving as covers for racketeering. Anyone whose business or property has been damaged by racketeering activity can sue to recover treble damages and attorney fees in a civil action.

Demonstrating a claim under RICO requires proof of a pattern of racketeering—that is, more than one action. Some courts have also found that a pattern requires continued crimi- nal activity over a “substantial” period of time. Racketeering includes almost all criminal actions, such as acts of violence, fraud, bribery, securities fraud, and the provision of ille- gal goods and services, making RICO an extremely effective tool in combating white- collar crimes.

In addition to being held civilly liable under RICO, a violator may be subject to crimi- nal penalties—a fine of up to $25,000 per violation, imprisonment for up to 20 years, or both.

THE FALSE CLAIMS ACT Since 1986 private citizens have been using the False Claims Act to sue employers for fraud against the government. An employee in a health care facility who realizes his employer is submitting fraudulent claims to Medicare can bring a suit for fraud against the employer on behalf of the government. The employee must first notify the government of intent to file the case. If the government chooses to intervene and prosecute the case itself with the employee’s help, the employee can receive 25 percent of the amount recovered. If the government opts not to act, an employee who pursues the case on behalf of the government receives 30 percent.

Certainly, an employee who brings a suit against an employer might be worried about retaliation, such as being fired or demoted. Thus, the act provides protection for employees who use it. An employer found guilty of retaliation may be forced to pay the employee twice the amount of lost back pay plus special damages.

The biggest settlement under the act as of 2010 was $1 billion with Pfizer in September of 2009. 26 Previously, the record was the more than $900 million that Tenet Health Corporation settled for in 2006 regarding improper billing to Medicare and other federal health programs. The whistle-blowers stood to recover $135 million to $225 million for their efforts under the False Claims Act. The reward in this case was far above the norm. The estimated mean award in all qui tam cases that included government involvement and were settled between the act’s inception and the close of fiscal year 2008 was around $3,460,000. Between the law’s amendment in 1986 to encourage private whistle- blowers and the end of 2009, the government has recovered $2.399.854.364 under this act. As of September 30, 2009, the U.S. government had a total of 996 qui tam cases (cases filed by private individuals on behalf of the government) under investigation. 27

Some critics of the False Claims Act argue that whistle-blowers are receiving money that should belong to taxpayers, while others say that the act prompts people not to report fraud right away but to wait until the value of the case grows. Still others complain that the act results in frivolous lawsuits as employees try to find an “easy” way to make money.

Defenders of the act say that it has uncovered significant cases of fraud that might have cost the government millions of dollars. They also point out how difficult it is for an employee reporting fraud to get a job in that field in the future, and thus a significant incen- tive must be offered for employees to act.

26 The False Claims Act Legal Center, Top False Claims Act Cases, http://www.taf.org/top100fca.htm, accessed June 2, 2010.

27 The False Claims Act Legal Center, www.taf.org/statistics.htm , accessed May 1, 2010

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To see how the disallowance provi- sions of the IRS relate to the fight against white-collar crime, please see the Connecting to the Core

activity on the text Web site at www.mhhe.com/kubasek2e.

176 Part 1 The Legal Environment of Business  

A number of False Claims Act cases have been filed against universities, including an interesting 2006 case against Chapman University. Three faculty members alleged that the institution had for years encouraged early dismissals, resulting in many students’ not getting the minimum classroom training required in several subjects. If the college had admitted it engaged in this practice, it would never have been accredited or have received millions of dollars in federal grants and student aid, which the lawsuit claimed it took under false pretenses. 28 The U.S. District Court for the Central Division of California granted summary judgment for Chapman University in 2007. The court argued that the credit-hour requirements were guidelines for independent evaluators that, when applied to Chapman University, revealed no fraudulent misrepresentation by the university. Also, the court stated that the plaintiffs failed to offer evidence that the early dismissal policy was as widespread as they claimed it was. 29 The plaintiffs appealed to the Ninth Circuit. However, with the American Council on Education, the Council for Higher Education Accreditation, and five other higher-education associations all filing briefs in 2009 supporting Chapman University, it seems unlikely that the circuit court will rule for the plaintiffs.

THE SARBANES-OXLEY ACT Congress passed the Sarbanes-Oxley Act in 2002 largely in response to the business scan- dals of the early 2000s that implicated firms such as Enron, WorldCom, Global Crossing, and Arthur Andersen. While much of the act consists of new rules and regulations for accounting firms, part of it specifically addresses white-collar crime.

Sarbanes-Oxley Section 201 makes it illegal for registered public accounting firms to provide these nonaudit services to an audit client:

1. Bookkeeping or other services related to the accounting records or financial statements of the audit client.

2. Financial information systems design and implementation.

3. Appraisal or valuation services, fairness opinions, or contribution-in-kind reports.

4. Actuarial services.

5. Internal audit outsourcing services.

6. Management functions or human resources.

7. Broker or dealer, investment adviser, or investment banking services.

8. Legal services and expert services unrelated to the audit.

9. Any other service the Board determines, by regulation, is impermissible.

Also under Sarbanes-Oxley, it is now a felony to willfully fail to maintain proper records of audits and work papers for at least five years, and the pun- ishment is up to 10 years’ imprisonment. The destruction of documents in a federal bankruptcy investigation is now a felony with possible sentences of up to 20 years’ imprisonment. The punishment for securities fraud has been increased to 25 years’ imprisonment.

In addition, Sarbanes-Oxley extended the statute of limitations regarding the discovery of fraud to two years from the date of discovery of the fraud and five years from the criminal act. It has also taken affirmative steps toward further protecting whistle-blowers.

28 Martin Van Der Werf, “Lawsuit U.: The Growing Reach of the False Claims Act Has Lawyers Fearing Trouble Everywhere,” Chronicle of Higher Education, August 4, 2006, http://chronicle.com/weekly/v52/i48/48a02301.htm .

29 U.S. v. Chapman University, 2007 U.S. Dist. LEXIS 98166.

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Chapter 7 Crime and the Business Community 177

Untenable Trading Gansman was found guilty of six counts of securities fraud (insider trading) on the basis of a jury’s finding that he had misappropriated information. The jury found that the profits made by Murdoch, Murdoch’s father, and the others with whom Murdoch shared informa- tion were the direct result of Gansman’s tips. Although Gansman has not yet been sen- tenced, each count of securities fraud carries a maximum prison term of 20 years and a maximum fine of twice the gross gain from the offense.

If you were asked by a friend for privileged information regarding stocks, how would you respond? If you do pass on the information and your friend uses it to trade in stocks, you may both be liable for insider trading.

CASE OPENER WRAP-UP

actus reus 149

affirmative defense 163

arraignment 172

arrest 168

arson 151

bail 171

bench trial 173

booking 171

bribery 152

burden of proof 173

burglary 151

computer crime 159

cyber terrorist 159

duress 164

embezzlement 158

entrapment 164

extortion 153

false pretenses 155

felony 150

first appearance 171

forgery 155

fraud 153

hacker 159

indictment 171

infant 163

information 171

insanity 163

insider trading 155

involuntary intoxication 163

justifiable use of force 165

larceny 151

liability without fault 150

mens rea 149

Miranda rights 168

misdemeanor 150

mistake of fact 163

necessity 165

nolo contendere 172

petit jury 172

petty offense 150

plea bargain 172

probable cause 168

robbery 150

strict liability 150

strict-liability offense 161

vicarious liability 163

virus 160

white-collar crime 151

Key Terms

Actus reus is wrongful behavior (guilty act). Mens rea is a wrongful state of mind or intent (guilty mind).

Felonies are serious crimes punishable by imprisonment for more than one year or death.

Misdemeanors are less serious crimes punishable by fines or imprisonment for less than one year.

Petty offenses are minor misdemeanors punishable by small fines or short jail sentences.

Summary of Key Topics Elements of a Crime

Classification of Crimes

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Property crimes against business:

1. Robbery: The forceful and unlawful taking of personal property.

2. Burglary: The unlawful entry into a building with the intent to commit a felony.

3. Larceny: The secretive and wrongful taking and carrying away of the personal property of another with the intent to permanently deprive the rightful owner of its use or possession.

4. Arson: The intentional burning of another’s dwelling.

White-collar crimes:

1. Bribery: The offering, giving, soliciting, or receiving of money or any object of value for the purpose of influencing the judgment or conduct of a person in a position of trust.

2. Extortion: The making of threats for the purpose of obtaining money or property.

3. Fraud: An individual’s intentional use of misrepresentation to gain an advantage over another. Fraud generally requires the following three elements: (1) a material false representation made with intent to deceive (scienter), (2) a victim’s reasonable reliance on the false representation, and (3) damages.

4. Embezzlement: The wrongful conversion of another’s property by one lawfully in possession of it.

5. Computer crime: Any wrongful act that (1) is directed against computers, (2) uses computers to commit a crime, or (3) involves computers. Examples are the destruction of computer data and the unlawful appropriation of data or services.

Both corporations, as legal entities, and the corporate officers and managers can be held liable for crimes committed on behalf of the corporation.

Infancy: The person is not of legal age and lacks the mental capabilities of an adult. It is a partial defense used to defuse the guilty-mind requirement.

Mistake: The defendant made an honest and reasonable mistake that negates the guilty-mind element of a crime.

Involuntary intoxication: The defendant was forced to ingest or involuntarily ingested an intoxicating agent that left him unable to understand that the act committed was wrong.

Insanity: The defendant’s mental condition when the crime was committed was so impaired that she could not (1) understand the wrongful nature of the act or (2) distinguish between right and wrong in a general sense.

Duress: The crime was committed in response to a threat of immediate bodily harm.

Entrapment: The idea for the crime was put into the defendant’s head by a law enforcement official.

Necessity: Committing the crime was necessary to prevent a more severe crime from occurring.

Justifiable use of force: The defendant used reasonable force in self-defense to protect his life. In many jurisdictions, this defense also applies to the defense of the defendant’s dwelling or other property and to the prevention of a crime.

Fourth Amendment:

1. Protection from unreasonable search and seizure.

2. Restrictions on warrants.

Fifth Amendment:

1. Prohibition of double jeopardy.

2. Right not to incriminate oneself.

3. Right to due process.

Common Crimes Affecting Business

Liability for Crimes

Defenses to Crimes

Constitutional Safeguards

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Sixth Amendment:

1. Right to a speedy and public trial.

2. Right to a trial by an impartial jury of one’s peers.

3. Right to be informed of the accusations against oneself.

4. Right to confront witnesses.

5. Right to have witnesses on one’s side.

6. Right to counsel at various stages of the proceedings.

Eighth Amendment:

1. Freedom from excessive bail.

2. Freedom from excessive fines.

3. Freedom from cruel and unusual punishment.

Fourteenth Amendment:

1. Extension of the right to due process to all state matters.

2. Extension of most constitutional rights to defendants at the state level.

Exclusionary rule:

1. Illegally obtained evidence is inadmissible in court.

Pretrial procedure: The arrest, booking, first appearance, indictment, and arraignment.

Trial procedure: Jury selection, trial with burden of proof on prosecution, jury deliberations, jury verdict, and (if guilty) sentencing hearing.

Posttrial procedure: Appeal.

RICO: Prohibits persons employed by or associated with an enterprise from engaging in a pattern of racketeering activity. Anyone whose business or property has been damaged by this pattern of activity can sue under RICO to recover treble damages and attorney fees in a civil action.

False Claims Act: Allows employees to sue employers on behalf of the federal government for fraud against the government. The employee retains a share of the recovery as a reward for his or her efforts.

Sarbanes-Oxley Act: Criminalizes specific nonaudit services when provided by a registered account- ing firm to an audit client; also increases the punishment for a number of white-collar offenses.

Criminal Procedure

Tools for Fighting Business Crime

As you are considering this issue, you might want to think about statistics that would help you resolve it.

LESS SEVERELY THAN VIOLENT CRIMINALS MORE SEVERELY THAN VIOLENT CRIMINALS

Street crimes are different in kind than white-collar crimes. Whereas white-collar crime affects only individuals’ prop- erty, street crime threatens individuals’ lives and health. The law ought to recognize that protecting lives is more important than protecting property.

It is far from clear that white-collar crime has less serious consequences than street crime. For example, individu- als who defraud the government in effect steal taxes paid by all members of society, whereas individuals in posses- sion of small amounts of marijuana may never adversely affect other members of society.

Point / Counterpoint

How Severely Should the Law Punish Individuals Convicted of White-Collar Crime?

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1. How does criminal law differ from civil law, both in terms of their purposes and in terms of the proce- dures used in each type of case.

2. Explain how crimes are classified.

3. List and define the primary affirmative defenses used in criminal cases.

4. Explain the federal laws that are currently being used to fight white-collar crime.

5. Robert Morris, a PhD student in computer sci- ence at Cornell University, designed a computer program known as a “worm” and released it onto the Internet. The worm spread and multiplied and eventually caused computers at various educational and military institutions to crash. Morris argued that he released the worm to demonstrate to fellow graduate students the lack of security protecting computer networks. With what crime was he most likely charged? Was this prosecution successful?

[ United States v. Robert Tappen Morris, 928 F.2d 504 (1991).]

6. The Pasquantinos, while in New York, ordered liquor over the telephone from discount pack- age stores in Maryland. They employed Hilts and others to drive the liquor over the Canadian bor- der, without paying the required excise taxes. The drivers avoided paying taxes by hiding the liquor in their vehicles and failing to declare the goods to Canadian customs officials. During the time of the Pasquantinos’ smuggling operation, between 1996 and 2000, Canada heavily taxed the importation of alcoholic beverages. The Pasquantinos and Hilts were indicted for charges of federal wire fraud. They contest no wire fraud existed because the fed- eral government cannot enforce the revenue laws of Canada and this therefore prevents the existence in the United States of a fraud charge. How did the Supreme Court rule? Should the Pasquantinos and

Questions & Problems

Moreover, white-collar crime tends to affect higher- income individuals, whereas street crime tends to affect lower-income individuals who lack the resources to protect themselves. Street crime disproportionately affects lower- income individuals who cannot afford the private security measures that higher-income individuals use to protect their persons and their property. The law ought to protect those who lack the power to protect themselves.

A third reason to punish white-collar crime less heavily than street crime is that white-collar criminals are more likely to engage in careful cost-benefit analy- sis when determining whether to commit white-collar crime. If the severity of the punishment, discounted by the chance they will get caught, is not less than the expected payoff from the white-collar crime, rational individuals will not see the crime as a profitable enterprise. It seems less likely that street criminals engage in the same kind of careful cost-benefit analysis before deciding, for exam- ple, whether to use illegal drugs. Thus, the most effective punishment for undeterrable street crime is likely to be severe punishment that incapacitates the criminals so that they are unable to commit more street crime. White-collar crime, on the other hand, can effectively be curbed by set- ting the punishment just high enough to make the crime unprofitable.

Indeed, white-collar crime affects all groups in society in both direct and indirect ways. Companies victimized by white-collar crime often must raise the prices of their goods to recoup the costs of the crime. Everyone in society feels the effects of the higher prices. Street crime, while by no means negligible, tends to affect smaller circles of people. Thus, to get the biggest bang for our buck, we should punish white-collar crime more heavily than street crime.

Another reason to punish white-collar crime more heavily than street crime focuses on the underlying causes of crime. Much street crime has its roots in other social problems. Often, individuals commit street crime because of the poor environments in which they were raised. Much white-collar crime, however, is committed by well-off individuals out of avarice. The law ought to dole out more severe punishments for crimes caused by individual responsibility, and society ought to use other mechanisms to address crime caused by aleatory factors.

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Hilts be able to succeed in their legal argument? [ Pasquantino v. United States, 125 S. Ct. 1766 (2005).]

7. Each year the Cook County, Illinois, Treasurer’s Office holds a public auction at which it sells tax liens it has acquired on the property of delinquent taxpayers. Prospective buyers bid on the liens. The winning bidder obtains the right to purchase the lien in exchange for paying the outstanding taxes on the property. Cook County awards the liens on a rotating basis when there are tie bids, spreading the property among the bidders. To prevent people from using multiple bidders to increase their odds, the county adopted the “Single, Simultaneous Bid- der Rule,” which requires each “tax buying entity” to submit bids in its own name and prohibits it from using “apparent agents, employees, or related entities” to submit simultaneous bids for the same parcel. Upon registering for an auction, each bid- der must submit a sworn affidavit affirming that it complies with the Single, Simultaneous Bidder Rule.

A group of regular participants in Cook County’s tax sales filed a complaint contending that Sabre Group, LLC, had fraudulently obtained a dispro- portionate share of liens by violating the Single, Simultaneous Bidder Rule at the auctions held from 2002 to 2005. As a result, when the county allocated liens on a rotating basis, it treated the firms related to Sabre Group as independent enti- ties, allowing them collectively to acquire a greater number of liens than would have been granted to a single bidder acting alone. The related firms then purchased the liens and transferred the certificates of purchase to Sabre Group. The group of regular bidders sued, alleging that Sabre Group violated and conspired to violate RICO by conducting its affairs through a pattern of racketeering activity involving numerous acts of mail fraud. The bidders assert that Sabre Group sent mail to the property owners, which thus furthered its scheme. The dis- trict court dismissed the RICO claim, arguing that while the bidders were financially harmed, they did not rely on the alleged fraudulent mail and thus could not sue under RICO. The court of appeals reversed because the fraudulent mail harmed the bidders, even if they did not directly rely on this mail. Sabre Group appealed to the Supreme Court. Did Sabre Group’s actions violate RICO, and could

the bidders sue? What would the bidders need to prove to succeed with their claims? [ Bridge v. Phoenix Bond & Indemnity Co., 128 S. Ct. 2131 (2008).]

8. Two campus security officers questioned Michael Jensen when they saw him walking across campus with a dormitory lounge chair propped on his head at 3:13 a.m. Jensen refused to identify himself to the officers but claimed he was simply playing a prank by carrying the chair from one residence hall to another residence hall across campus. The officers repeatedly asked him for identification, which he repeatedly refused to provide. When the officers told him that they would remove his identi- fication from his jeans pocket, he began to comply. When the officers told Jensen that he was under arrest, Jensen ran away. Later, he was caught and indicted by a grand jury for petit larceny. Jensen claimed that there was no evidence that he did not intend to return the chair and thus the indictment was flawed. Why did the court of appeals affirm the indictment? [ People of New York v. Jensen, 86 N.Y. 2d 248 (1995); 1995 N.Y. LEXIS 2230.]

9. Throughout the 1990s, Morteza Eghbal and Marilyn Trujillo purchased Housing and Urban Development (HUD) foreclosed homes and resold them for profit to buyers with mortgage-secured loans insured by HUD. Eghbal and Trujillo sold to buyers who lacked sufficient assets to cover the down payment on the properties, and they provided the down payment for the buyers. HUD would not insure a loan for a home for which the down payment was paid by the seller. To that end, HUD required that a seller of a home sign a docu- ment called “Addendum to the HUD-1 Settlement Statement.” By signing the addendum, the seller certified that he had not, and would not, pay the buyer for any part of the down payment and that he did not have knowledge of any loans made to the buyer for purposes of financing the transaction other than those described in the sales contract. HUD would not insure a loan without a validly signed addendum. For each instance in which they provided the down payment, Eghbal and Trujillo fraudulently signed the addendum, falsely stating that they provided no funds toward the down pay- ment. HUD ultimately paid out about $2.8 million for the balances owing on 27 defaulted mortgages for properties Eghbal and Trujillo sold.

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The government sued Eghbal and Trujillo under the False Claims Act (FCA). The government argued that without the false statements on the addendum, HUD would not have insured the mortgage loans. Eghbal and Trujillo contend that the government failed to show that their false statements set in motion a false claim. Eghbal and Trujillo sought only to fraudulently induce HUD to insure the mort- gage, not to have the buyers default or cause the mortgage holders to make claims on HUD. Eghbal and Trujillo were not parties to the actual claims pre- sented to HUD, made after the buyers defaulted, that resulted in monetary payments by the government. The district court granted summary judgment in favor of the government, and Eghbal and Trujillo appealed. Did the addendums constitute a false claim helping to defraud the government? Why? [ U.S. v. Eghbal, 548 F.3d 1281 (9th Cir. 2008).]

10. Bernadette Sablan was fired from her job at the Bank of Hawaii for circumventing security procedures

when retrieving files. One night after drinking at a bar with a friend, she entered an unlocked door at the bank. She went to her old workstation and logged on to the mainframe by using an old pass- word. She contends that she simply accessed sev- eral files and logged out. The government argued that she changed and deleted several files. Regard- less, her actions damaged several bank files.

Sablan was charged with computer fraud. She argued that the government had to establish the mens rea element of the crime—that is, the govern- ment had to prove she intentionally tried to damage the files. The district court ruled that the intention element applied only to accessing the files. Sablan argued that the legislation in question was intended to apply only to those who intentionally damage computer data, and she appealed. How did the court of appeals rule? Why? [ United States v. Sablan, 92 F.3d 865, 866 (9th Cir. 1996).]

Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

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Tort Law 8

1 How do we classify torts?

2 What are some of the most common intentional torts, and what are the elements needed to prove these torts?

3 What types of damages are available in tort cases?

C H A P T E R

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

CASE OPENER Plastic Surgeon Defamation

Dr. Walter Sullivan was one of several plastic surgeons in Las Vegas visited by Julie Jones. Jones, an exotic dancer, sought plastic surgery to improve her ability to make money in her profession. After visiting Dr.Sullivan for a consultation, she then visited Dr. Joseph Bongiovi, Jr. During her consultation with Dr.Bongiovi, Jones mentioned her earlier visit with Dr. Sullivan. Dr. Bongiovi then told her that Dr. Sullivan had a patient die the previ- ous week during the same procedure Jones sought. Dr. Bongiovi told her the death was the direct result of Sullivan’s negligence.

Despite Dr. Bongiovi’s allegations, Jones saw Sullivan again and scheduled the surgery with him. Jones did, however, attend a prescheduled appointment with Dr. Bongiovi. Dur- ing the appointment, Dr. Bongiovi confirmed what he said before, at Jones’s prompting, that Dr. Sullivan had recently been responsible for a patient’s death during the same pro- cedure Jones sought.

On the basis of the confirmation from Bongiovi, Jones called to cancel her surgical appointment with Sullivan. When Sullivan’s office manager asked why she was canceling the appointment, Jones said she had been told that Sullivan was under investigation for a patient’s death. When Sullivan learned of the cancellation, he called Jones to find out who had made the statements; he was unsuccessful in obtaining a name. After speaking

PA R

T 1

  The Legal Environm

ent of B usiness

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with Sullivan, Jones again called Dr. Bongiovi’s office to receive confirmation about the allegation. Bongiovi’s assistant confirmed that the statements were true.

When Dr. Sullivan eventually learned the identity of Dr. Bongiovi, he filed suit for defamation. According to Dr. Sullivan, Dr. Bongiovi’s statements were slanderous per se. At the conclusion of a trial, a jury found in favor of Sullivan and awarded him $250,000 in compensatory damages and $250,000 in punitive damages. Dr. Bongiovi appealed, argu- ing that the jury should have been instructed that actual malice was the standard because Sullivan was a public figure. Furthermore, Dr. Bongiovi argued that the compensatory and punitive damages awarded were exorbitant.

1. What defenses, if any, could Bongiovi have presented to prevent the damage awards?

2. Under which ethical system, if any, should Bongiovi be required to pay damages to Sullivan? Why?

The Wrap-Up at the end of the chapter will answer these questions using the legal prin- ciples discussed in this chapter.

As a business manager, you may encounter one party who believes he or she has been injured by the actions of another, as Dr. Sullivan believed he had been injured by Dr. Bonjiovi. A tort (from a French word meaning “wrong”) is a wrong or injury to another, other than a breach of contract. This chapter first examines the goals of tort law and the three primary classifications of torts. It next explains a variety of intentional torts and concludes by discussing damages available in tort cases.

Introduction to Tort Law The preceding chapter showed that the state always brings suit in a criminal case, but crime victims may be able to bring a tort action against the criminal because the same actions that constitute a criminal offense often constitute a tort.

While the primary objectives of criminal law are to punish wrongdoers and preserve order in society, tort law’s primary objective is to provide compensation for injured parties. Tort law also contributes to maintaining order because it discourages private retaliation by injured persons and their friends. After all, we do not want a community where vigilantes roam about righting some harm they believe they have suffered.

A third objective of tort law is to satisfy our collective sense of right and wrong by providing that someone who creates harm should make things right by compensating those harmed. The recognition that offenders will have to pay for personal injuries they cause may also deter the commission of torts. Exhibit 8-1 summarizes the purposes of tort law and the types of torts.

Although this chapter discusses torts as if they were the same everywhere, tort law is primarily state law, so states may have slightly different definitions of each tort. This chap- ter uses definitions common in most states, noting significant differences where they exist.

Despite the public impression of a litigation explosion, tort litigation has been declin- ing gradually since 1990. 1 The National Center for State Courts’ statistics on tort filings in 15 states showed a general downward trend each year from 1995 to 2004. In 2003, the last

1   National Center for State Courts, www.ncsconline.org/D_Research/csp/2002_Files/2002_Tables_10-16.pdf (accessed September 9, 2005). Unfortunately, this oft-cited data is the most current data available.

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year for which detailed data are available, there were 198,377 cases. 2 However, potential tort liability should still concern a competent business manager.

Classification of Torts In the United States torts are classified as intentional, negligent, or strict liability. The categories differ in terms of the elements needed to prove the tort, available damages, available defenses, and degree of willfulness of the actor. Intentional torts occur when the defendant takes an action intending certain consequences or knowing they are likely to result. Negligent torts occur when the defendant acts in a way that subjects other people to an unreasonable risk of harm. In other words, the defendant is careless to someone else’s detriment. Finally, strict-liability torts occur when the defendant takes an action that is inherently dangerous and cannot ever be undertaken safely, no matter what pre- cautions the defendant takes. Not all countries share the same definitions, however. The Chinese legal system, for example, more narrowly defines the activities actionable under tort law.

This chapter focuses on intentional torts. Negligence and strict liability are discussed in Chapter 9.

Intentional Torts Intentional torts, the most “willful” of torts, share the common element of intent. This intent is not to harm but, rather, to engage in a specific act, which ultimately results in an injury, physical or economic, to another. In fact, motive is not required to prove liability in an intentional tort case. Moreover, tort law assumes people intend the normal conse- quences of their actions. For example, if Rob threw a rock toward a group of people, we assume under the law that he intended to hit someone with the rock and that the person hit would be hurt, regardless of Rob’s intention merely to scare the group.

Exhibit 8-1 Tort Law Definition: The body of law that concerns torts. A tort is a civil wrong that gives the injured party the

right to bring a lawsuit against the wrongdoer to recover compensation for injuries.

Purposes of Tort Law: 1. To compensate innocent persons who are injured

2. To prevent private retaliation by injured parties

3. To reinforce a vision of a just society

4. To deter future wrongs

Types of Torts: 1. Intentional tort: Occurs when the defendant acts with the intention of engaging in a specific act

that ultimately results in an injury.

2. Negligent tort: Occurs when the defendant fails to act in a responsible way and thereby subjects other people to an unreasonable risk of harm.

3. Strict-liability tort: Occurs when the defendant takes an action that is inherently dangerous and cannot be undertaken safely.

2 Examining the Work of State Courts, 2005: A National Perspective from the Court Statistics Project, 2006, p. 27. (The Court Statistics Project is a joint project of the National Center for State Courts, the State Justice Institute, and the Bureau of Justice Statistics of the Department of Justice.)

LO1

How do we classify torts?

LO2

What are some of the most common inten-

tional torts, and what are the elements needed to

prove these torts?

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Not all harms intentionally committed will fall neatly into an existing category of torts. Therefore, a general theory of intentional tort liability has been created to aid judges in their decision making. Section 870 of the Restatement (Second) of Torts explains the gen- eral theory:

One who intentionally causes injury to another is subject to liability to the other for that injury, if his conduct is generally culpable and not justifiable under the circumstances. This liability may be imposed although the actor’s conduct does not come within a traditional category of tort liability.

Intentional torts are divided into (1) torts against persons, (2) torts against property, and (3) torts against economic interests.

INTENTIONAL TORTS AGAINST PERSONS Torts against persons are intentional acts that harm an individual’s physical or mental integrity. As you might imagine, there are a significant number. Those a businessperson is most likely to either commit or be a victim of are assault and battery, defamation, privacy torts, false imprisonment, intentional infliction of emotional distress, and misuse of legal procedure.

Assault and Battery. Imagine that, after searching for a parking space for 20 min- utes, you finally pull into a spot. However, as soon as you turn off your engine, a large man pounds on your car window, yelling angrily, “You just took my spot! If you don’t move your car now, I’m going to hit you so hard you won’t remember what your car looks like!” The man has just assaulted you.

An assault occurs when one person places another in fear or apprehension of an imme- diate, offensive bodily contact. If you think the man pounding your window is just joking and you start laughing, no assault has taken place because the element of apprehension is missing. However, apprehension and fear are not the same thing when it comes to assault. A person may be in apprehension of physical harm but be too courageous to be afraid. An assault occurs if apprehension exists, regardless of fear.

Someone who is overly fearful is not assaulted every time he or she experiences appre- hension. The test for assault is reasonable apprehension. If a reasonable person would experience apprehension in a given situation, and the person in that situation does experi- ence apprehension (not necessarily fear), an assault occurs.

Likewise, if someone called you on the telephone and threatened to come over and break your nose, this is not an assault because there is no question of immediate bodily harm. Immediacy is also the reason that words, however violent, are not typically considered enough to establish an assault. Words without a sign of action do not usually imply immedi- acy. Moreover, words, in most situations, are not enough to create reasonable apprehension of harm. Without immediacy or reasonable apprehension, they do not constitute an assault.

Regardless, if words are enough to establish a reasonable apprehension of immediate harm, they constitute an assault, typically when combined with what might otherwise be an innocent movement. Pat has had a few too many beers and starts an argument with Sam. Sam tries to calm Pat down, at which point Pat screams “I’m going to cut you” and starts to reach toward his pocket, causing Sam to become apprehensive. Together, Pat’s words and actions constitute an assault, as reasonable apprehension of immediate physical bodily harm has been established by a threat and what can be construed as a motion toward grab- bing a knife.

An assault is often, but not always, followed by a battery, an intentional, unwanted, offensive bodily contact. Almost any unwanted intentional contact constitutes a battery,

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even if harmless, and intent is irrelevant for establishing liability. If the touch was intended as a joke but a reasonable person would be offended, the contact is deemed “offensive.” 3 If the man in the parking lot actually hit you, his action constitutes a bat- tery. But if you both happened to be getting out of your cars at the same time and bumped into each other, no battery has occurred because there was no intentional bodily contact.

Legal Principle: An assault occurs when a person is placed in fear or apprehension of an offensive bodily contact; if the contact actually occurs, it constitutes a battery.

A limited number of defenses are available to an action for a battery (see Exhibit 8-2 ). Consent mitigates the element of unwanted. A person cannot commit a battery if the other party consented to the contact.

The most common defense is self-defense, responding to the force of another with com- parable force to defend yourself. If the man in the parking lot took a swing at you and, to try to keep him from hitting you, you shoved him, causing him to fall backward and hit his head on the street, you could escape liability for battery by arguing you were acting in self- defense. You cannot respond with greater force than is being used against you. You may use deadly force only against another’s deadly force.

A third defense, defense of others, is just what it sounds like. If the parking lot man is pummeling you, your brother could use his fists and try to hit the man in an attempt to make him stop hitting you. The degree of force your brother can use in defending you is limited to the degree of force you could use yourself.

A final defense to a claim of battery is defense of property. You can use reasonable force to defend your property from an intruder. The use of deadly force in defense of property is rarely, if ever, considered justified.

Defamation. The tort alleged in this chapter’s opening case was defamation, the intentional publication (or communication to a third party) of a false statement harmful to an individual’s reputation. 4 In addition to the person who publishes a false statement, anyone who republishes, or in any manner repeats, a defamatory statement is also liable for defamation, even if he or she cites the original source of the defamation.

If the defamation is published in a permanent form, such as in a magazine or newspaper, it is known as libel. 5 Television and radio broadcasts are also considered libel, since they are permanently recorded. In the case of libel, “general damages” are presumed. Thus, the victim is entitled to compensation for damages that are presumed to flow from defamation but are hard to prove, such as humiliation.

Exhibit 8-2 Defenses to Battery Consent Battery did not occur because the other party agreed to the contact.

Self-defense You responded to the unwanted contact with comparable force to defend yourself.

Defense of others You tried to defend another from the unwanted contact with a force comparable to what you could use to defend yourself.

Defense of property You used reasonable force to defend your property from an intruder.

3 Restatement (Second) of Torts, sec. 19.

4 Restatement (Second) of Torts, sec. 558.

5 Restatement (Second) of Torts, sec. 568.

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If the defamation is made orally, it is slander. 6 Because slander lacks permanence, to recover damages the plaintiff must prove “special damages,” or specific monetary loss. If the people who heard the slander do not act in a way to cause harm to the slandered person, there is no cause for compensation, which is one of the main goals of tort law.

In most states, an exception to the requirement of special damages occurs if the defa- mation constitutes slander per se, statements so inherently harmful that general damages are presumed. While the exact wording of the categories of slander per se varies slightly among the states, slander per se generally includes claims that the plaintiff (1) has a loath- some, communicable disease (traditionally venereal disease or leprosy); (2) has committed a crime for which imprisonment is a possibility; (3) is professionally incompetent; or (4) if a woman, is unchaste (although in most states today where this category is still recognized, it usually applies only to underage girls).

Case 8-1 illustrates how a plaintiff attempted to use defamation per se. As you read the decision, think of how it might be applicable to the case described in the opening scenario.

6 Restatement (Second) of Torts, sec. 568A.

In the fall of 2001, shortly after the terrorist attacks on the World Trade Center and the Pentagon, someone mailed letters laced with anthrax to several news organizations and members of Congress. Nicholas Kristof wrote a regu- lar column for the editorial page of The New York Times. During the spring and the summer of 2002, Kristof wrote several columns criticizing the FBI’s investigation of the anthrax mailings. From May through July 2002, Kristof focused his attention on the FBI’s handling of informa- tion pertaining to a man he called “Mr. Z.” In August of 2002, Kristof identified Mr. Z as Dr. Steven J. Hatfill, a research scientist employed by the Department of Defense. Kristof wrote:

[T]rained bloodhounds were given scent packets preserved from the anthrax letters and were intro- duced to a variety of people and locations. This month, they responded strongly to Dr. Hatfill, to his apartment, to his girlfriend’s apartment and even to his former girlfriend’s apartment, as well as to res- taurants that he had recently entered. . . .

On July 13, 2004, Hatfill filed suit asserting a claim for defamation. Hatfill alleged, among other things, that “[d]efendants’ false and reckless public identification of Dr. Hatfill with the anthrax mailings, both directly and by

implication from the manner in which his personal and professional background were presented in the ‘Mr. Z’ columns, constituted a false factual allegation of terror- ist and homicidal activity and impugned Dr. Hatfill’s good name as a citizen, a physician and a biomedical researcher to a reasonable reader.” The district court dismissed Hat- fill’s suit on grounds that it failed as a matter of law because Kristof’s columns, when read in their entirety and in con- text, could not reasonably be read as accusing Hatfill of being responsible for the anthrax attacks. Hatfill appealed.

JUDGE SHEDD : Count One alleges that The Times pub- lication of Kristof’s columns defamed Hatfill by implying that Hatfill was involved in the anthrax mailings. Under Virginia law, a plaintiff seeking to recover for defamation per se must allege a publication of false information con- cerning the plaintiff that tends to defame the plaintiff’s rep- utation. See Chapin v. Knight-Ridder, Inc., 993 F.2d 1087, 1092 (4th Cir. 1993). . . .

Under Virginia law, the following kinds of statements are actionable as defamation per se: (1) statements that “impute to a person the commission of some criminal offense involv- ing moral turpitude, for which the party, if the charge is true, may be indicted and punished,” (2) statements that “impute that a person is infected with some contagious disease,

STEVEN J. HATFILL v. THE NEW YORK TIMES COMPANY AND NICHOLAS KRISTOF FOURTH CIRCUIT COURT OF APPEALS 416 F.3D 320 (4TH CIR. 2005)

CASE 8-1

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[continued]

Hatfill’s complaint adequately alleges that Kristof’s columns, taken together, are capable of defamatory meaning. The columns did not describe any other actual or potential target of investigation, and they recounted detailed informa- tion pertaining to Hatfill alone. Once Kristof named Hatfill as Mr. Z (and perhaps even before that time), a reasonable reader of his columns could believe that Hatfill had the motive, means, and opportunity to prepare and send the anthrax let- ters in the fall of 2001; that he had particular expertise with powder forms of anthrax, the type used in the mailings; that his own anthrax vaccinations were current; that he was the prime suspect of the biodefense community as well as federal investigators; that he had failed numerous polygraph exami- nations; that specially trained bloodhounds had “responded strongly” to Hatfill, his apartment, and his girlfriends apart- ment but not to anyone else or any other location; and that Hatfill was probably involved in similar anthrax episodes in recent years. Based on these assertions, a reasonable reader of Kristof’s columns likely would conclude that Hatfill was responsible for the anthrax mailings in 2001.

. . . Because Krisof’s columns, taken together, are capa- ble of defamatory meaning under Virginia law, the district court erred in dismissing Count One.

REVERSED and REMANDED.

where if the charge is true, it would exclude the party from society,” (3) statements that “impute to a person unfitness to perform the duties of an office or employment of profit, or want of integrity in the discharge of duties of such an office or employment,” and (4) statements that “prejudice such person in his or her profession or trade.” Carwile v. Richmond Newspapers, Inc., 196 Va. 1 82 S.E.2d 588, 591 (Va. 1954).

It is not always clear whether particular words actually charge a person with a crime of moral turpitude or unfit- ness for employment or the like, but the general rule of interpretation is that “allegedly defamatory words are to be taken in their plain and natural meaning and to be under- stood by courts and juries as other people would understand them, and according to the sense in which they appear to have been used.” Id. At 591-92. A defamatory charge may be made expressly or by “inference, implication or insinua- tion.” Id. At 592. . . .

Hatfill contends that Krisof’s columns defamed him by imputing to him the commission of crimes of moral turpitude, namely, the murders of five people who were exposed to the anthrax letters. If the columns fairly can be read to make such a charge, then they are defamatory per se. . . .

Chinese law treats defamation similarly to U.S. law. First, the Chinese courts determine whether there is a defamatory statement. Second, the statement must be published in writing, made orally, or communicated by gestures or signs. Third, the statement must clearly identify a particular person. However, in China, defamation can be either a civil or a criminal action.

If you say your boss is a tyrant or your roommate is a slob, are you in danger of being sued for defamation? Probably not, because such statements are really subjective opinions not capable of being proved. As such they are generally not actionable.

One of the important elements of defamation is that the defamatory statement must be damaging to someone’s reputation, as the Case Nugget illustrates.

The increase in communication over the Internet has presented new questions for the law of defamation to answer. First, does a false statement made over the Internet constitute defamation? Second, if it does, who can be held liable?

Why did the court conclude that Kristof’s columns were capable of defamatory meaning? Do you agree with the rea- sons that led to the ruling? Why or why not?

What fundamental issue does this case address? Does the court’s decision seem to prefer one value over another? If so, do you see this preference as justified? Why or why not?

ETHICAL DECISION MAKING CRITICAL THINKING

Which set of stakeholders would you weigh the heaviest in deciding a case of this type? Why would you raise their interests above those of other relevant parties?

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The court first attempted to answer these issues in the case of Cubby v. CompuServ,7 in which CompuServ was sued because of defamatory statements published on one of the forums available through its online information service. In holding CompuServ not liable, the court made an analogy between an online information service provider and a book- store, saying, “CompuServ’s CIS product is in essence an electronic, for profit library.” The court went on to say that once CompuServ decides to carry a given publication such as a news forum, it has little or no editorial control over that forum. It would therefore be no more feasible for CompuServ to examine every publication it carries for defamatory mate- rial than it would be for libraries or booksellers to do so.

Since Cubby was decided, the Communications Decency Act of 1996 8 was passed. One section gives immunity to providers of interactive computer services for liability they might otherwise incur on account of material disseminated by them but created by others. This immunity is illustrated in the E-Commerce box later in this chapter.

Another situation that addresses the issues surrounding communication over the Inter- net is that of Whole Foods chairman and CEO John Mackey and his anonymous postings on Yahoo Finance. For almost eight years, Mackey made postings on Yahoo Finance mes- sage boards under the pseudonym “Rahodeb” (an anagram of his wife Deborah’s name). In his postings, Mackey often talked about how great Whole Foods, its stock, and even the company’s CEO (himself) were. However, on the message boards Mackey also made several negative comments about Whole Foods’ rival, Wild Oats. Mackey criticized Wild Oats’ management and even went so far as to mention that he couldn’t understand why any company would want to acquire the Wild Oats business “at its then-current stock price.” The CEO’s negative comments were particularly shocking because in February 2007, Whole Foods made a bid to purchase Wild Oats.

The Federal Trade Commission opposed the acquisition, fearing that the merger would create a monopoly in the organic grocer sector. Thus, in an effort to halt Whole Foods’

Can You Defame a Person Who Has No Good Reputation to Be Harmed?

Thomas P. Lamb v. Tony Rizzo U.S. Court of Appeals for the Tenth Circuit 391 F.3d 1133 (2004)

The state of Kansas incarcerated Thomas P. Lamb over 30 years ago. He is serving three consecutive life sentences for two counts of first-degree kidnapping and one count of first-degree murder. In July 2001, newspaper reporter Tony Rizzo wrote two articles about Lamb’s convictions and upcoming parole hearing. When Lamb’s request for parole was subsequently denied, he sued Rizzo in Kansas state court, asserting, among other things, that Rizzo’s articles contained “lies and false information” that caused Lamb to be denied parole.

Rizzo filed a motion to dismiss, attaching to it numerous newspaper articles chronicling Lamb’s criminal history. In the motion, Rizzo contended that Lamb was libel-proof as a mat- ter of law; in other words, Lamb’s public reputation at the time

CASE NUGGET

the articles were published was so diminished with respect to a specific subject (his kidnapping and murder convictions) that he could not be further injured by allegedly false statements on that subject. Because damage to reputation is the heart of a defa- mation action in Kansas, argued Rizzo, Lamb’s claims must be dismissed.

The district court dismissed Lamb’s complaint for failure to state a claim on which relief could be granted. Lamb appealed.

In upholding the dismissal, the appellate court said:

[T]he facts surrounding Mr. Lamb’s case fit within the Kansas Supreme Court’s description of when the [libel- proof] doctrine might apply. Mr. Lamb . . . was convicted long before Mr. Rizzo’s allegedly defamatory articles were published. Thus, Mr. Lamb had already suffered from a lowered reputation in the community due to his prior con- victions for the crime alleged in the publication or for a similar crime.

Clearly, a plaintiff’s reputation is an important factor in deter- mining whether a defamation case will be successful.

7 77b F. Supp. 135 (1991).

8 47 U.S.C. § 230.

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purchase of Wild Oats, the FTC launched an investigation into the acquisition. It was during the FTC investigation that officials uncovered Mackey’s double-life as online poster Rahodeb. People began to question whether Mackey had been purposely trying to talk down Wild Oats and its stock, and wondered if there was an agenda behind his constant boasting of Whole Foods. Concerns about the legality of Mackey’s behavior led to further examination by the Securities and Exchange Commission. In the end, Mackey was cleared of any wrongdoing. However, Whole Foods did change its code of conduct policy, and the company now prohibits officials from posting business-related information on Internet message boards. 9

A person accused of defamation can raise two defenses: truth and privilege. Truth is frequently considered an absolute defense. That is, the defendant cannot be held liable for defamation, regardless of whether damages result, if the statement made was true. If I say Bill is a convicted felon and he is, I have not committed defamation. Under ordinary circumstances, the fact that I thought a statement was true is not a defense. If I honestly believe Bill is a convicted felon and I tell others he is but he is not, then I have committed slander, despite my sincere belief in the truth of what I have said.

Privilege is an affirmative defense in a defamation action. An affirmative defense, you may recall from Chapter 7, occurs when the defendant admits to the accusation but argues there is a reason he should not be held liable.

A privilege is either absolute or conditional. A person with absolute privilege cannot be sued for defamation for any false statements made, regardless of intent or knowledge of their falsity. Absolute privilege arises in only a limited number of circumstances. The speech and debate clause of the U.S. Constitution gives absolute privilege to individuals speaking on the House and Senate floors during congressional debate because Congress wants to get to the truth of matters before it, and if people testifying had to fear being sued, they might be afraid to testify.

Absolute privilege also arises in the courtroom during a trial. Again, we do not want people to fear testifying in court, so we prohibit their being sued for whatever occurs within the courtroom.

Conditional privilege is the second type. Under conditional privilege, a party will not be held liable for defamation unless the false statement was made with actual malice, 10

that is, with either knowledge of its falsity or reckless disregard for its truth. 11

9 Heather Havenstein, “Whole Foods Handcuffs Execs on Web Postings,” ComputerWorld, November 12, 2007; Lev Grossman, “The Price of Anonymity,” Time 170, no. 5, pp. 47–49; and Mark Hamstra, “Investor Calls for Mackey to Leave,” Supermarket News 55, no. 31, p. 6. 10 Restatement (Second) of Torts, sec. 580A. 11 New York Times Co. v. Sullivan, 376 U.S. 254 (1964).

Liability of Online Service Providers in Canada

In Canada, there have not yet been any landmark cases or any leg- islation to clearly establish the liability of online service providers (OSPs) for content they disseminated but did not originate. Cur- rently, an OSP being sued under such circumstances in Canada would have to rely on the existing Canadian libel code’s defense of innocent dissemination, which will succeed if the defendant dem- onstrates all the following:

COMPARING THE LAW OF OTHER COUNTRIES

a. The defendant does not know of the libel contained in the work published or authored by him or her.

b. There was no reason for the defendant to suppose the work he or she authored or published would be libelous.

c. It was not negligence on the defendant’s part that he or she did not know the work contained libelous material.

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Businesspersons should be most concerned about the conditional privilege that arises with respect to job recommendations. To encourage honest assessments of former employ- ees, this privilege protects an employer who makes a false statement about a former worker: The employer will not be held liable as long as the statement was made in good faith and only to those with a legitimate interest in the information.

Another conditional privilege is the public figure privilege. Public figures are those in the public eye, typically politicians and entertainers. Because they have a significant impact on our lives, we want to encourage free discussion about them, so we do not hold people liable for making false statements about them as long as the statements were not made with malice. This privilege does not unfairly burden public figures, because their position lets them easily respond publicly to any false claims through appropriate outlets. In the opening scenario, Dr. Bongiovi argued on appeal that Dr. Sullivan was a public figure by nature of his profession. If Bongiovi could establish that Sullivan was a public figure, Sullivan would have to show that Bongiovi acted with actual malice while making the statements to the patient.

Some believe a conditional privilege should apply when the defamatory statement is posted on the Internet, because the person defamed can respond in the same forum with minimal effort. Thus, there is less need for the stronger legal protection we ordinarily give. Relaxing defamation standards on the Internet can encourage people to speak their minds freely. Thus far, however, no such privilege has been established. When a person is found to have committed defamation on an online bulletin board or Web site, damages can be significant. For example, a jury awarded a university professor $3 million when a former student accused him of being a pedophile on a Web site she maintained. 12

Privacy Torts. The fact that truth is an absolute defense to a defamation action does not mean people are free to reveal everything they know. Four distinct torts, collectively called invasion of privacy, protect the individual’s right to keep certain things out of public view even if they are true. The four privacy torts are (1) false light, (2) public disclosure of private facts, (3) appropriation for commercial gain, and (4) intrusion on an individual’s affairs or seclusion.

False light is closely related to defamation and occurs when publicity about a person creates an impression about that individual that is not valid. It could involve attributing characteristics or beliefs to a person that she does not possess or creating the impression that an individual has taken certain actions he has not taken. Sometimes tabloids publish articles that may lead to false-light claims, like the one that was filed by Nellie Mitchell when a newspaper published a story about a 101-year-old Australian newspaper-delivery woman who had to quit her job when she became pregnant. The problem was that they illustrated the story with a picture of 96-year-old Nellie Mitchell, a woman living in a small town in Arkansas, who had spent most of her adult life as a newspaper carrier, She sued for, among other claims, false light, and recovered $650,000 in compensatory dam- ages and $850,000 in punitive damages. 13

A false-light claim can be defended against using public figure privilege; however, that defense is not absolute. The creators (World Wrestling Enterprises, Inc., Vincent McMahon, and Titan Sports, Inc.) of a DVD documentary about a professional wrestler known as “Warrior” believed they were safe against his lawsuit, which alleged defamation and false light. However, because some of the statements on the DVD were about Warrior’s

12 See Paul J. Martin, “North Dakota Jury Awards $3M for Internet Defamation,” Lawyers Weekly USA, www.lawyersweeklyusa. com/usanews040802a.cfm (accessed April 8, 2002). 13 Nellie Mitchell v. Globe Inc. D/B/A “Sun,” U.S. District Court, W. D. Arkansas, 786 F. Supp. 791 (1992).

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personal life, specifically his relationship with his father, the court found that the false-light claims could not all be dismissed. The court decided that statements that presented Warrior’s private life in a false light should be treated as if they were statements about a private person rather than a public figure. 14

Public disclosure of private facts occurs when someone publicizes a private fact about another that a reasonable person would find highly offensive. 15 The individual must have not waived his or her right to privacy. Publication of information about someone’s sex life or failure to pay debts would fall under this tort.

Appropriation for commercial gain occurs when someone uses another person’s name, likeness, voice, or other identifying characteristic for commercial gain without that person’s permission. 16 Many businesses may choose to use celebrities in their advertisements as a way to appeal to consumers. However, when companies use a celebrity’s likeness or image without his or her consent, they open themselves up to potential litigation and liability. For example, Woody Allen believed that American Apparel appropriated his image when they used an image of him from the movie Annie Hall in their billboards. Allen sued for $20 million, but ended up settling the day before the case was to go to trial for $5 million. 17

Another illustration occurred in April 2008, when Disney star Brenda Song, of the tele- vision show The Suite of Zack & Cody, sued Vibe Media, Inc., and its owner after discov- ering that the company had used her image in an advertisement without her consent. The advertisement in question was for an escort service and featured Brenda’s picture next to a caption that read “Hawaiin[sic] beauty. Come get lei’d.” In the text of the advertise- ment, Brenda’s name was never mentioned; however, the image was undoubtedly hers. The lawsuit filed by Brenda Song thus alleged emotional distress and commercial misap- propriation of her image. In March 2009, Song won her suit, and Vanessa Sean, the woman accused of actually taking Brenda’s image from the Internet, was ordered to pay the young actress $16,000. 18

The final privacy tort is intrusion on an individual’s affairs or seclusion, which occurs when someone invades a person’s solitude, seclusion, or personal affairs when the person has the right to expect privacy. 19 Examples include wiretapping and using people’s passwords to gain access to their e-mail messages. Installing two-way mirrors in a women’s dressing room at a gym or store constitutes an invasion of privacy because people should be able to expect a certain degree of privacy in a dress- ing room.

Entertainers often allege invasion-of-privacy claims. For example, Actress Joan Collins sued the Globe for invasion of privacy when it took pictures of her and a male friend. However, editors and owners often claim that the public “demands” these invasions of privacy. As evidence they point out the higher circulation that results from sensational pictures.

False Imprisonment. False imprisonment occurs when an individual is confined or restrained against his or her will for an appreciable period of time. The imprisonment may occur by (1) physical restraint, such as tying someone to a chair, (2) physical force,

18 http://news.yahoo.com/s/eonline/20090305/en_celeb_eo/80799> (accessed March 5, 2009); and www.gantdaily.com/news/12/ ARTICLE/45490/2009-03-05.html> (accessed March 5, 2009).

14 Ultimate Creations, Inc. v. McMahon, 515 F. Supp. 2d 1060 (D. Ariz. 2007).

16 Restatement (Second) of Torts, sec. 652C. 17 http://cityroom.blogs.nytimes.com/2009/05/18/american-apparel-settles-lawsuit-with-woody-allen/?scp = 1&sq = %22woody %20allen%22&st = cse .

15 Restatement (Second) of Torts, sec. 652D.

19 Restatement (Second) of Torts, sec. 652B.

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such as forcibly pinning someone against a wall, (3) a threat to use immediate physical force, or (4) refusal to release the plaintiff’s property. The use of moral pressure is not enough to establish a false imprisonment. Suppose the Pushy Toy Company is holding a “training session” for new moms, really a thinly veiled demonstration of new products, in a conference room. People are told they are free to leave at any time. Once Hillary realizes what is going on, she decides to go. As she approaches the exit, the CEO of Pushy Toys tells her that only a terrible mother would leave early but she is free to leave if she wants to be a terrible mother. The moral pressure the CEO is using, although ethically repugnant, does not constitute false imprisonment as Hillary is still free to leave.

Because retailers and security guards are the usual defendants in false-imprisonment cases as a result of their need to sometimes detain and question a suspected shoplifter, this tort is known as the “shopkeeper’s tort.” Retailers are protected under “shopkeeper’s privilege,” but the suspect cannot be held an unreasonable length of time, and questioning must be reasonable.

Claims of false imprisonment are not limited to suits against retailers or security guards. For example, three ambulance drivers recently filed a false-imprisonment suit against a local psychiatric center because the crisis center locked them in and would not allow them to leave. The center claimed that the drivers had committed certain improprieties when delivering a violent girl to the crisis center.

Proving damages in a false-imprisonment case is not easy. If the physical restraint caused harm requiring medical treatment, such damages would be clear, but most cases do not include physical harm. Typically, plaintiffs request compensation for time lost from work and for pain and suffering from mental distress and humiliation.

Intentional Infliction of Emotional Distress. Sometimes called the “tort of outrage,” intentional infliction of emotional distress occurs when someone engages in outrageous, intentional conduct likely to cause extreme emotional distress to another party. For example, if a person calls his former employer and falsely says her son was just arrested for a double homicide after a botched robbery attempt, most courts would find that behavior outrageous enough to satisfy the first element of the tort.

Before damages are awarded in some jurisdictions, the plaintiff must demonstrate injury through physical symptoms directly related to the emotional distress. For instance, in the above example, if the employer fainted upon hearing the news, hitting her head on the table and cutting it as she passed out, she would have physical symptoms sufficient to justify a recovery. Other physical symptoms from emotional distress include headaches, a sudden onset of high blood pressure, hives, chills, inability to sleep, and inability to get out of bed.

Case 8-2 illustrates this tort.

Defamation of Public Figures in the United Kingdom

As you know from your reading, the media in the United States can print false information about public figures without being liable if they can demonstrate they did so without malice. In the United Kingdom, public figures about whom false statements have been made have a much easier time winning a libel case.

All a public figure, or any other libel plaintiff, must do to win a case against the media in the United Kingdom is demonstrate

COMPARING THE LAW OF OTHER COUNTRIES

that the defamatory statement was communicated in the United Kingdom and his or her reputation was damaged as a result. The only defenses are (1) the statements are true or (2) the statements were made in Parliament or court. The burden of proving truth is on the defendant.

If a statement was originally broadcast by a U.S. company and rebroadcast in the United Kingdom without the consent of the originator, the U.S. company may still be held liable in the U.K. court.

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On February 5, 2001, Cindy Lourcey was working as a postal carrier for the United States Postal Service and encountered Charles Scarlett and his wife, Joanne Scarlett, who was nude from the waist up, in the middle of the street. When Lourcey stopped her vehicle to provide assistance, Scarlett told her his wife was having a seizure. As Lourcey used her cell phone to call 911 for help, Charles Scarlett pulled out a pistol and shot his wife in the head. He then turned and faced Lourcey, pointed the pistol at his own head, pulled the trigger, and killed himself.

As a result of Scarlett’s conduct, Lourcey alleges she suffered post-traumatic stress disorder and major depres- sion and was unable to return to work. In addition, she suffered physical injury and impairment, mental injury and impairment, pain and suffering, medical expenses, lost wages, and lost earning capacity. Lourcey brought suit against Scarlett’s estate for intentional infliction of emo- tional distress.

The Estate of Charles Scarlett moved to dismiss the complaint because Scarlett’s conduct was not outrageous. Following a hearing, the trial court granted the motion and dismissed the complaint. The Court of Appeals reversed the trial court’s judgment, however, and remanded the case to the trial court for further proceedings on the claims for intentional infliction of emotional distress. The Estate sub- sequently appealed.

JUDGE ANDERSON: When reviewing the trial court’s dismissal of a complaint, we accept the factual allegations contained in the complaint as true. The issue presents a question of law, which we review de novo without accord- ing a presumption of correctness to the conclusions reached below. If the factual allegations state a claim upon which damages can be awarded, dismissal is inappropriate.

The defendant first argues the trial court properly dis- missed the complaint for failure to state a claim for inten- tional infliction of emotional distress because the conduct of Charles Scarlett was not “outrageous” as a matter of law. The defendant asserts “life is full of scenes of tragedy” and argues “there was no outrageous conduct directed towards Lourcey.”

The plaintiffs respond the complaint states a claim for intentional infliction of emotional distress based on the actions of Charles Scarlett, which were outrageous.

We begin the analysis of these issues by first examining the elements required for intentional infliction of emotional

distress. To state a claim for intentional infliction of emo- tional distress, a plaintiff must establish: (1) the defendant’s conduct was intentional or reckless; (2) the defendant’s con- duct was so outrageous it cannot be tolerated by civilized society; and (3) the defendant’s conduct resulted in serious mental injury to the plaintiff.

In describing these elements, we have emphasized it is not sufficient that a defendant “has acted with an intent which is tortious or even criminal, or he has intended to inflict emotional distress.” A plaintiff must in addition show the defendant’s conduct was “so outrageous in character, and so extreme in degree, as to go beyond all possible bounds of decency and to be regarded as atrocious, and utterly intoler- able in a civilized community.”

Applying the foregoing principles, we conclude the alle- gations in the plaintiffs’ complaint, when accepted as true, state a claim for intentional infliction of emotional distress. The complaint alleges Charles Scarlett’s conduct was inten- tional and it caused Cindy Lourcey serious mental injury in the form of post-traumatic stress disorder, depression, and related problems. Moreover, the complaint describes con- duct that is “outrageous” under the standards discussed in Bain and Miller. This conduct, which occurred in Lourcey’s immediate presence and involved her as a participant, was not simply a tragedy common to daily life as asserted by the defendant. Indeed, the complaint clearly alleges conduct that was outrageous in character, extreme in degree, beyond all possible bounds of decency, and utterly intolerable in a civilized society.

In reaching this conclusion, we need not address the defendant’s argument that a claim for intentional inflic- tion of emotional distress under Tennessee law requires the alleged outrageous conduct be “directed at” the plaintiff. Assuming there is such a requirement, a question we do not decide today, the allegations in the plaintiffs’ complaint, when accepted as true, demonstrate Scarlett’s conduct was directed at Cindy Lourcey. The complaint states Charles Scarlett told Lourcey his wife was having a seizure and he knew Lourcey was seeking help in response to his statement. The complaint further states Lourcey was in close proxim- ity when Scarlett shot his wife and Scarlett turned to face Lourcey before shooting himself in the head. Accordingly, we conclude the plaintiffs’ complaint states a claim upon which relief could be granted pursuant to Tennessee law for intentional infliction of emotional distress.

AFFIRMED.

CINDY R. LOURCEY ET AL. v. ESTATE OF CHARLES SCARLETT SUPREME COURT OF TENNESSEE, AT NASHVILLE 146 S.W.3D 48 (2004)

CASE 8-2

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[continued]

Misuse of Legal Procedure. Three separate torts protect those unreasonably subjected to litigation—malicious prosecution, wrongful civil proceedings, and abuse of process. These torts serve two functions. They proactively limit frivolous litigation, and they try to rectify harm done to a party through inappropriate litigation.

The first two of these torts, malicious prosecution and wrongful civil proceedings, serve similar functions. Both seek to compensate those wrongfully charged with either criminal or civil matters. Successful plaintiffs are entitled to damages for legal fees related to the improperly brought litigation; harm to reputation, credit, or standing caused by the false claims; and any emotional distress caused by the improper litigation.

Abuse of process is more general and applies to both criminal and civil matters in which a legal procedure is misused to achieve a different goal than it intends. For example, Ben and Jennifer are recently divorced; Ben owes Jennifer alimony as part of the divorce settlement. As retaliation, he sues her for slandering him to his business partners. Ben’s attorney offers to settle out of court if Jennifer will drop the alimony requirement from the divorce settlement. Regardless of whether Ben wins in court, Jennifer can file abuse- of-process charges against him in civil court because legal proceedings for slander are not intended to be used as mitigating devices for divorce disputes.

Exhibit 8-3 summarizes the intentional torts against persons.

INTENTIONAL TORTS AGAINST PROPERTY Trespass to Realty. The tort of trespass to realty, also called trespass to real prop- erty, occurs when a person intentionally (1) enters the land of another without permission; (2) causes an object to be placed on the land of another without the landowner’s permis- sion; (3) stays on the land of another when the owner tells him to depart; or (4) refuses to remove something he placed on the property that the landowner asked him to remove. 20

It is no defense to argue that you thought you had a legal right to be on the property or you thought it belonged to someone else. The intent refers to intentionally being on that particular piece of land. 21 In a recent unusual case heard in a small claims court in

How is this case largely dependent on the use of specific definitions of particular terms? How good are the definitions used?

What assumption allows for existing entities to be held responsible for the actions of deceased individuals? Espe- cially in a case such as this, in which the plaintiff was present as a matter of random chance (an “act of God,” if you will)—a situation out of the control of those now held responsible—what reasoning allows for assignment of culpability?

ETHICAL DECISION MAKING CRITICAL THINKING

What values are responsible for permitting someone to recover damages from a dead person?

20 Restatement (Second) of Torts, sec. 158.

21 Restatement (Second) of Torts, sec. 164.

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Westchester County, a plaintiff sued for trespass to realty when the defendant entered the plaintiff’s property, from which he had previously been barred, to serve a reply affidavit for another legal action. Arguing that the defendant could not dictate how legal papers are served, the plaintiff sued for $3,000 in compensatory, nominal, and punitive damages. While the court ruled that the defendant committed trespass to realty, it awarded only nominal damages in the sum of $1.

Because guests are welcome, they are not considered trespassers. However, a guest who is asked to leave and refuses immediately becomes a trespasser with no right to be on the property. If charges are brought, the person cannot raise the defense of being a guest.

A trespasser is also liable for damages she might cause to the property and cannot hold an owner liable for damages she sustained while on the property. However, courts now typically maintain that owners owe a reasonable duty to anyone who may end up on their property. The specifics of the duty vary by jurisdiction and by the status of the parties. In some jurisdictions (although this is rare), owners may be liable to trespassers injured while trying to steal from them.

Exhibit 8-3 Intentional Torts against Persons

Assault Placing another in fear or apprehension of an immediate, offensive bodily contact. Assault occurs if reasonable apprehension exists, regardless of fear.

Battery Making an intentional, unwanted, and reasonably offensive bodily contact.

Defamation Intentionally publicizing or communicating to a third party a false statement harmful to an individual’s reputation. Defamation is referred to as slander if oral and libel if written.

Public disclosure of private facts

Publicizing a private fact about another that a reasonable person would find highly offensive; a type of privacy tort.

False light Creating an impression that is not valid, such as attributing to a person characteristics or beliefs he or she does not hold; a type of privacy tort.

Appropriation for commercial gain

Using another person’s name, likeness, voice, or other identifying characteristic for commercial gain without that person’s permission; a type of privacy tort.

Intrusion on an individual’s affairs or seclusion

Invading a person’s solitude, seclusion, or personal affairs when the person has the right to expect privacy; a type of privacy tort.

False imprisonment Confining or restraining a person against his or her will for an appre- ciable period of time. The imprisonment may occur by physical restraint, physical force, threats to use immediate physical property, or refusal to release the plaintiff’s property.

Intentional infliction of emotional distress

Engaging in outrageous, intentional conduct likely to cause extreme emotional distress to another party.

Misuse of legal procedure

Misusing a legal procedure to achieve a goal other than the one for which the process was intended to be used; includes the torts of malicious prosecution, wrongful civil proceedings, and abuse of process.

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E-COMMERCE AND THE LAW

Tort Law versus Criminal Law to Improve the Online Personals Industry

Suppose your ex-boyfriend posed as you on a number of online personals sites, such as iwantu.com . He posted what he described as your rape fantasies and listed your name and address. He then encouraged men to act out your fantasies in person. Would you be afraid? How might criminal law respond? Could tort law also help you? In a real case in 1992, Gary Dellapenta, the ex-boyfriend, was sentenced to six years in prison for violating California’s then new cyberstalking law.

If someone were threatening you as Dellapenta threatened his ex-girlfriend, you might want the creator of the Web site and/ or an Internet service provider to assist you in pulling the posts before harm occurs. Unfortunately, Internet service providers are

exempt from liability under tort law if they fail to respond to your concerns. The Communications Decency Act of 1996 outlined this exemption.

You might be able to pursue the creator of the Web site, depending on how the facts play out and on your state’s law. You might be able to sue for defamation, false-light invasion of privacy, negligence, and/or intentional infliction of emotional distress. You will face an uphill battle, though, in meeting your burden of proof. In the mid-1990s, Ken Zeran brought tort claims against a radio station that broadcast untrue information suggesting he was sell- ing T-shirts and other items with insensitive remarks about the Oklahoma City bombing of a federal building. Zeran was unable to prove any of the torts he alleged. Perhaps as cyberstalking becomes more prevalent, and more frightening, tort law will change to pro- vide more protection to victims.

Private Nuisance. A private nuisance occurs when a person uses her property in an unreasonable manner that harms a neighbor’s use or enjoyment of his property. 22 Exam- ples include subjecting a neighbor to flooding, vibrations, excessive noise, or smoke.

Trespass to Personal Property. A person commits trespass to personal property, also called trespass to personalty, by temporarily exerting control over another’s personal property or interfering with the owner’s right to use it. The trespasser is responsible for damages to the property and to the owner. 23 If I take Eloy’s bike from his garage and use it for a week, I have committed trespass to personalty. If I return the bike with a flat tire, I must compensate Eloy for the cost of repairing the tire and any other expenses that resulted from my actions. If the bike was Eloy’s only way to get to work, I would be responsible for his lost wages.

Conversion. Conversion occurs when a person permanently removes personal prop- erty from the owner’s possession and control. 24 The owner usually recovers damages for the full value of the converted item, plus any additional damages resulting from the loss. It is not a defense to argue that you believed you had a legal claim to the goods. For example, if Brittany accidentally takes Melvin’s suitcase believing it to be hers and then loses it, she is still liable for conversion.

Moreover, the possession of stolen goods also makes a person liable for conversion. Therefore, buying goods in good faith without knowledge of any impropriety also is not a defense. Even a person who bought the goods believing the purchase was legal is liable to the legal owner.

An illustration of conversion comes from a recent case heard in Westchester County Supreme Court. An amateur race-car driver left her race car at a service station. While it was in the service station’s possession, an employee with a known drinking problem apparently drove the car, got into an accident, and totally destroyed it. The car could never

22 Restatement (Second) of Torts, sec. 821D.

23 Restatement (Second) of Torts, sec. 218.

24 Restatement (Second) of Torts, sec. 222A.

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Chapter 8 Tort Law 199

be returned to the condition it was in when brought to the station. The owner sued for conversion and recovered the value of the car in damages.

Legal Principle: When a person temporarily deprives another of the use and enjoyment of his personal property, a trespass to property occurs; if that deprivation becomes permanent, conversion has occurred.

INTENTIONAL TORTS AGAINST ECONOMIC INTERESTS All businesspersons should be familiar with the torts against economic interest. The five most common torts against economic interests, frequently referred to as “business torts,” are disparagement, intentional interference with contract, unfair competition, misappro- priation, and fraudulent misrepresentation. The first, disparagement, is similar to defama- tion, because both torts involve the making of a false statement, but it is different because it is a tort designed to protect one’s property interests, whereas defamation is designed to protect one’s reputational interests.

The plaintiff in a disparagement case must prove that the defendant published a false statement of a material fact about the plaintiff’s product or service that resulted in a loss of sales. When such statements are criticisms of the quality, honesty, or reputation of the busi- ness or product, the tort is sometimes called slander of quality (if spoken) or trade libel (if printed). If the statements relate to ownership of the business property, it is slander of title.

Damages for disparagement are ordinarily based on a decrease in profits linked to the publication of the false statement. A less common method is to demonstrate that the plain- tiff had been negotiating a contract with a third party who lost interest shortly after publi- cation of the false statement. The profits the plaintiff would have made on the contract are the damages.

Some interesting variations of the tort of disparagement have developed. For example, in 2007, California became the 13th state to recognize the tort of food disparagement, which critics call “veggie libel.” Such laws provide ranchers and farmers with a cause of action when someone knowingly makes false, damaging statements about a food product. The California law was drafted in response to an incident during 2006 in which Taco Bell executives wrongly identified green onions grown at Boskovich Farms in Oxnard as the source of an E. coli outbreak that sickened 70 of the fast-food chain’s customers.

The most famous veggie-libel lawsuit was filed by a cattle rancher against talk-show host Oprah Winfrey and one of her guests. During the broadcast at issue, Oprah said the conversation they were having about the possibility of contracting disease from meat had caused her to give up eating hamburgers. Shortly after the show aired, the price of cattle futures fell. Oprah and her guest were sued under the Texas veggie-libel law, which says anyone who knowingly makes a false claim that a perishable food product is unsafe may be required to pay damages to the producer of the product. The jury decided there was no liability, because the statements were merely the parties’ opinions, not knowingly false statements of fact.

With the growing use of technology, it seemed inevitable that a computer-related disparagement tort would evolve, and it has. Disparagement by computer occurs when (1) erroneous information from a computer about a business’s credit standing or reputation impairs the business’s ability to obtain credit and (2) the computer information’s owner fails to correct the incorrect information in a timely manner.

Intentional Interference with Contract. Another tort against economic inter- ests is the tort of intentional interference with contract. To successfully bring this claim,

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the plaintiff must prove (1) a valid and enforceable contract between the two parties existed; (2) the defendant knew of the existence of the contract and its terms; (3) the defen- dant intentionally undertook steps to cause one of the parties to breach the contract; and (4) the plaintiff was injured as a result of the breach. 25

Clear liability is placed on third parties for inducing a party to an existing contract to breach it. However, a third party might also be liable for inducing a party to pull out of a prospective contract before it is formed. Because the essence of business is competition, simply offering a better deal is not enough to create liability. However, using illegal means to cause another party not to enter into a contract does create liability for interfering with contractual relations. 26

Liability for intentional interference with a contract is most common in recruitment, when one employer knows that an employee has a contract for a set period of time with another employer, yet tries to lure that employee away anyway.

Several damage remedies are available when a third party interferes with a contract. Injured parties may recover for what was directly lost through the breached contract and any losses suffered related to the breached contract, in addition to damages for emotional distress and harm to reputation. 27

Unfair Competition. The tort of unfair competition exists because U.S. law pro- tects businesses acting on the profit motive. Thus, when someone enters an industry with the sole intent of driving another firm out of business, the law punishes this act as unfair competition. For example, if Ali’s is the only jewelry store in town, Mark cannot set up a store that makes no profits just to drive Ali out of business so that Mark’s friend can open a legitimate jewelry store once Ali’s has been eliminated. The line between unfair com- petition and legitimate competition can be hard to determine. In a recent case, Overstock. com believed that pop-up advertisements from a competing Web site, SmartBargains, were unfair competition. SmartBargains had pop-ups that appeared when users went to Overstock.com . However, because the pop-ups were in separate browser windows, and did not contain any deception or attempt to confuse consumers between Overstock.com and SmartBargains, the court ruled in favor of SmartBargains. Having pop-up advertisements for a competing business appear on your Web site constitutes legitimate competition rather than unfair competition. 28

Fraudulent Misrepresentation. Fraudulent misrepresentation occurs when a party uses intentional deceit to facilitate personal gain. To prove this tort occurred, the injured party must demonstrate all the following:

1. Someone knowingly, or with reckless disregard for the truth, misrepresented material facts and conditions.

2. The defendant intended to have other parties rely on the misrepresentations.

3. The injured party reasonably relied on the misrepresentations.

4. The injured party suffered damages because of this reliance.

5. A direct link exists between the injuries suffered and a reliance on the misrepresentations. 29

25 Restatement (Second) of Torts, sec. 766.

26 Restatement (Second) of Torts, sec. 766B.

27 Restatement (Second) of Torts, sec. 774A.

28 Overstock.com, Inc. v. SmartBargains, Inc., 192 P.3d 858 (Utah 2008).

29 Restatement (Second) of Torts, sec. 525.

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As in the criminal act of fraud, in the civil act of fraudulent misrepresentation a party materially misrepresents something and thereby causes another party to suffer damages. Typically, fraudulent misrepresentation applies only to the misrepresentation of material facts. However, when a party with expert knowledge regarding a specific matter states an opinion, any party reasonably relying on the statement, although it is an opinion and not fact, may recover damages under the tort of fraudulent misrepresentation.

Exhibit 8-4 summarizes the intentional torts against economic interest.

Damages Available in Tort Cases Three types of damages are available in tort cases: compensatory, nominal, and punitive (see Exhibit  8-5 ). You will see this system of classifying damages again when we talk about damages in other contexts, such as in cases of breach of contract.

COMPENSATORY DAMAGES Because the primary objective of tort law is to compensate victims, the primary type of damages is compensatory damages, designed to compensate the victim for all the harm caused by the person who committed the tort, often called the tortfeasor. While we seem to hear a lot about “runaway jury” awards, the median jury award for personal injury cases from 1998 to 2004 was $35,298. That amount actually fell from $37,086 in 2003 to $35,000 in 2004. 30

Compensatory damages are typically rewarded for pain and suffering, costs of repair- ing damaged property, medical expenses, and lost wages. For example, in the opening scenario, Dr. Sullivan won compensatory damages because he lost a client, and the related monies from the surgery, as a result of Dr. Bongiovi’s defamatory statement. Surpris- ingly, attorney fees are not recoverable as compensatory damages, despite the fact that most plaintiffs could not bring an action against the tortfeasor without hiring an attorney.

Exhibit 8-4 Intentional Torts against Economic Interest

Disparagement Publishing a false statement of a material fact about a business’s product or service that results in a loss of sales; includes the torts of slander of quality, slander of title, trade libel, and food disparagement.

Intentional interference with contract

Inducing a party to a contract to breach it. The plaintiff must prove that a valid and enforceable contract between the two parties existed; the defendant knew of the existence of the contract and its terms; the defen- dant intentionally undertook steps to cause one of the parties to breach the contract; and the plaintiff was injured as a result of the breach.

Unfair competition Entering an industry with the sole intent of driving another firm out of business.

Misappropriation Using another person’s name, likeness, voice, or other identifying charac- teristic for commercial gain without that person’s permission.

Fraudulent misrepresentation

Intentionally using a false statement to deceive another who reasonably relies on the deception to facilitate personal gain.

LO3

What types of damages are available in tort

cases?

30 JVR news release, www.juryverdictresearch.com/Press_Room/Press_releases/Verdict_study/verdict_study41.html (accessed October 10, 2006).

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Because the plaintiffs in personal injury cases must usually pay their attorneys anywhere from one-third to one-half of their recovery, some argue that compensatory damages fail to meet the intended goal of properly compensating victims. Others point out that one way plaintiffs can, in essence, recover their attorney fees is by increasing their pain and suffer- ing damages enough to cover these expenses.

NOMINAL DAMAGES Nominal damages are a small amount of money given to recognize that a defendant did indeed commit a tort in a case where the plaintiff suffered no compensable damages. A plaintiff may receive nominal damages by simply failing to prove actual damages. Nominal damages, however, can sometimes be important because if a party is awarded nominal damages, the court may also require that the losing party pay all the court costs, which may include attorney fees (if allowed), as well as the costs of discovery and expert- witness fees.

PUNITIVE DAMAGES Punitive damages are awarded both to punish conduct that is extremely outrageous and to deter similar activity by the defendant and others. Juries usually consider the egregious- ness or willfulness of the tort and the wealth of the defendant. Obviously, the more wrong- ful the nature of the defendant, the greater the desire to send a message that such behavior will not be tolerated; and the greater the defendant’s wealth, the higher the damages must be in order to be significant.

While many groups, including consumer advocates, see the threat of large punitive damages against manufacturers as a good method for encouraging them to produce the safest possible products, others disagree. They believe that no threat beyond compensatory damages is required and that the main effect of punitive damages is to discourage innova- tion by manufacturers who fear the risk of producing a defective product that could cost them millions in punitive damages.

Since the late 1970s, insurance companies and tort reform groups have been trying to limit punitive damages and get the courts to strike them down as unconstitutional viola- tions of defendants’ due process rights. The 1994 Supreme Court case of Honda Motor Company v. Oberg 31 provided their first judicial victory. It was a limited victory, however,

Exhibit 8-5 Types of Tort Damages TYPE PURPOSE AMOUNT

Compensatory To make the plaintiff whole again

An amount equivalent to all losses caused by the tort, including compensation for pain and suffering, but not attorney fees.

Nominal To recognize that the defendant committed a tort against the plaintiff

A trivial amount, typically $1 to $5.

Punitive To punish the defendant and deter future wrongdoers

An amount based on two factors: the sever- ity of the wrongful conduct and the wealth of the defendant.

31 114 S. Ct. 2331 (1994).

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because of two aspects of the case. First, the punitive damages were over 500 times the compensatory damages, extraordinarily rare. Second, the state law under which the dam- ages were awarded was the only one in the country with no provision for judicial review of the amount of punitive-damage awards, and it was the denial of this safeguard that violated the due process clause. Thus, Oberg did not provide much guidance about when punitive damages were so excessive as to violate due process.

A few years later, however, in BMW v. Gore, 32 the Supreme Court set forth a test that a number of commentators thought would substantially curb punitive-damage awards. The Court said three factors should be considered in determining whether an award was grossly excessive: “the degree of reprehensibility of the nondisclosure; the dispar- ity between the harm or potential harm suffered by [the plaintiff] and his punitive dam- ages award; and the difference between this remedy and the civil penalties authorized or imposed in comparable cases.” However, a 1999 study found that the year after BMW v. Gore, punitive-damage awards across the country were not reduced any more frequently than the year before. 33 ( Exhibit  8-6 lists several cases that resulted in major punitive- damage awards.)

Since BMW v. Gore, the Supreme Court has continued to encourage the courts to care- fully scrutinize punitive-damage awards. In the 2001 case of Cooper Industries, Inc. v. Leatherman Tool Group, Inc., 34 the high court ruled that appellate courts must review the trial court’s decision on the constitutionality of an award de novo, meaning they should no longer give deference to the trial court’s determination that the jury award was not uncon- stitutionally excessive and uphold it, unless there was a clear abuse of discretion on the part of the trial court judge.

In the 2003 case State Farm v. Campbell, 35 the Supreme Court once again addressed the issue of how to properly determine punitive damages. The Campbells had won a jury verdict for $1 million in compensatory damages and $145 million in punitive damages after State Farm failed to settle what was clearly a valid claim. The high court ruled that punitive-damage awards should bear some relationship to the actual harm caused and not focus on the wealth of the defendants. While refusing to say what ratio of compensatories to punitives was acceptable, the Court did say that “in practice, few awards exceeding a single-digit ratio between punitive and compensatory damages, to a significant degree, will satisfy due process.” 36 The Court also stated that damages should not focus on deterrence based on wealth, or on actions unrelated to the case at hand. Case 8-3 demonstrates how the courts are applying these guidelines today.

Even though we now have more guidance from the Supreme Court as to when puni- tive damages will be allowed, it is not always easy to predict what a court will do in any given case. For example, the appellate court in California upheld a $28 million punitive-damage award against Philip Morris in a case where compensatory damages were only $850,000. The court acknowledged that under State Farm, a presumption exists that a ratio of punitives to compensatories significantly greater than 9 to 1 violates due process, but in this case the “extreme reprehensibility” of Philip Morris’s conduct in marketing its cigarettes and the “scale and profitability” of its misconduct justified the 33-to-1 ratio. 37

32 BMW of North America v. Ira Gore, Jr., 116 S. Ct. 1589 (1995).

33 James Dam, “Large Punitives Mostly Upheld, but $5B Award Overturned,” Lawyer’s Weekly USA, November 12, 2001, p. A1.

34 532 U.S. 424 (2001).

35 123 S. Ct. 1513 (2003).

36 Ibid., p. 1524.

37 “$28M Punitive Award Upheld in Cigarette Smoker, Recent Decisions,” Lawyer’s Weekly USA, May 8, 2006, p. 6.

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CASE JURY AWARD ULTIMATE RESOLUTION

Romo v. Ford Motor Co., 99 Cal. App. 4th 1115 (2002)

The Romo family was in an accident in which their 1978 Ford Bronco rolled over. The top of the Bronco collapsed and shattered, killing three family members and seriously injuring the other three. The jury awarded the Romos more than $6 million in compensatory damages and $290 million in punitive damages.

After several appeals, the jury verdict was lowered to under $3 million.

Liebeck v. McDonald’s, 787 A.2d 443 (1994)

A jury awarded Stella Liebeck $2.9 million in dam- ages, including $2.7 million in punitive damages, for extensive burns she received when she spilled 170-degree coffee on her legs. Part of the reason for the high punitive-damage award was the fact that McDonald’s had prior knowledge of other customers receiving burns from the excessively hot coffee.

The trial court reduced the original jury award to $640,000. Subsequently, the parties settled out of court for an undisclosed amount.

Gober v. Ralphs Grocery Company, 128 Cal. App. 4th 648 (2005)

In the largest sexual harassment jury verdict in the United States, the jury awarded six plaintiffs $30.6 million in damages,approximately $30 million of which was punitive damages.

The judge reduced the verdict to approximately $8 million, in light of State Farm v. Campbell. Both parties appealed to the supreme court of California, but the court denied review.

Robinson v. State Farm Idaho, 2000 WL 1877745

A plaintiff’s insurance company, State Farm, was found to have acted in bad faith when it refused to cover injuries she sustained in an auto acci- dent by claiming they must have been caused by something else. The company’s refusal was ostensibly based on a recommendation from an independent company that reviewed the plaintiff’s medical records, but she demonstrated that State Farm had a practice of referring claims to that company, knowing no payment would be recommended. The jury awarded punitive damages of $9.5 million, 95 times the amount of the compensatory damages.

The award was appealed and subsequently upheld by the Idaho Supreme Court.

Williams v. Philip Morris, Inc., 2002 U.S. Dist. LEXIS 13522 (2002)

Williams’s estate brought a fraud and negligence suit against Philip Morris after Williams died of lung cancer. The jury awarded Williams’s estate $820,000 in compensatory damages and $79.5 million in punitive damages.

The trial judge reduced the damages to $32 million. The Oregon court of appeals affirmed the original $79.5 million verdict. The state supreme court vacated the decision and remanded the case to be decided in light of State Farm v. Campbell. The Oregon court of appeals subsequently ruled the $79.5 million award was lawful under State Farm.

In re Exxon Valdez, 9th Cir. Court of Appeals, 2009

In 1989, the worst oil spill in our nation’s history occurred due to the negligence of the captain of the Exxon Valdez. When the ship ran into ice, the hull burst and leaked 10.8 million gallons of oil into Prince William Sound. Clean up costs ultimately totaled $2.5 billion. The jury awarded $5 billion in punitive damages to a class of 32,000 fishermen, Alaska natives, business owners, and other litigants in 1996.

The court of appeals ordered Exxon Mobil Corp. to pay $507.5 million in punitive damages, plus 5.9 percent interest running from the 1996 trial judgment. The amount is equal to the compensatory damages provided in the settlement agreement of the case, consistent with an earlier U.S. Supreme Court ruling that in maritime cases, punitive damages should be no more than the compensa- tory, or actual, damages. That 1-to-1 ratio was a new legal standard for punitive awards in maritime cases.

Exhibit 8-6 Some Major Punitive-Damage Awards

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important indicium of the reasonableness of a punitive damages award. . . . The Court laid out a list of five criteria that lower courts must consider in determining the reprehen- sibility of a defendant’s conduct: the harm caused was phys- ical as opposed to economic; the tortious conduct evinced an indifference to or a reckless disregard of the health or safety of others; the target of the conduct had financial vulnerabil- ity; the conduct involved repeated actions or was an isolated incident; and the harm was the result of intentional malice, trickery, or deceit, or mere accident. The existence of any one of these factors weighing in favor of a plaintiff may not be sufficient to sustain a punitive damages award; and the absence of all of them renders any award suspect.  .  .  . [T]he physical harm suffered by Mr. Clark weighs strongly in favor of finding Chrysler’s conduct reprehensible. After considering the four other factors, however, we conclude that the factors as a whole show that Chrysler’s conduct was not sufficiently reprehensible to warrant a $3 million punishment.

.  .  . The second guidepost is the disparity between the actual or potential harm inflicted on the plaintiff and the punitive damage award.  .  .  . [B]ecause the compensatory damage award here is not particularly large, a 1:1 ratio is inappropriate. . . . But due to the lack of several of the repre- hensibility factors, any ratio higher than 2:1 is unwarranted. Accordingly, we conclude that a ratio of approximately 2:1 would comport with the requirements of due process.

The third guidepost is the difference between the puni- tive damage award and the civil or criminal penalties that could be imposed for comparable misconduct. .  .  . Given State Farm’s focus on civil penalties, however, we now con- clude that a $3 million punitive damage award is excessive in light of comparable civil penalties. Denial of Chrysler’s motion for remittitur REVERSED and REMANDED with instructions to enter a punitive

damage award of $471,258.26.

CLARK v. CHRYSLER CORPORATION U.S. COURT OF APPEALS FOR THE SIXTH CIRCUIT 2006 U.S. APP. LEXIS 2435

CASE 8-3

Charles Clark was fatally injured in an automobile accident when he pulled into an intersection in front of an oncoming vehicle and collided with it. He was not wearing a seat belt and was consequently ejected from his vehicle. His wife sued Chrysler, claiming that its pickup truck was defectively and negligently designed.

After a three-day trial, the jury rendered a unanimous verdict in favor of Mrs. Clark on claims of strict liability, negligence, and failure to warn. The jury found Chrysler and Mr. Clark each 50% at fault, returning a verdict of $471,258.26 in compensatory damages and $3,000,000 in punitive damages. The court entered a judgment against Chrysler for $3,235,629.13, reflecting 50% of the compen- satory damages plus the $3 million punitive damages award. After a series of appeals, the last being an appeal of the trial court’s motion to deny the defendant’s motion for remittitur, the case finally landed at the Circuit Court of Appeals on the issue whether the jury verdict was constitutionally excessive.

JUDGE JANE A. RESTANI: . . . The Court in State Farm elaborated on the three Gore guideposts that courts must consider when reviewing punitive damage awards. Namely, (1) the degree of reprehensibility of the defendant’s miscon- duct; (2) the disparity between the actual or potential harm suffered by the plaintiff and the punitive damage award; and (3) the difference between the punitive damages awarded by the jury and the civil penalties authorized or imposed in comparable cases. . . . In light of State Farm . . . we conclude that the $3 million award here is constitutionally excessive. An application of the Gore guideposts to the facts of this case reveals that a punitive damage award approximately equal to twice the amount of compensatory damages, or $471,258.26, would comport with the requirements of due process.

With respect to the first Gore guidepost, State Farm emphasized that the degree of reprehensibility is the most

The decision that the punitive-damage award was excessive in this case was primarily based on the interpretation of sev- eral ambiguous words in the judge’s opinion. What are they? Would different interpretations of these words change the court’s ruling?

ETHICAL DECISION MAKING CRITICAL THINKING

What values are guiding the judge’s decision that the punitive- damage award was excessive? Do you think the values pro- moted by the decision are appropriate for the situation? Why or why not?

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Legal Principle: In general, in deciding whether to strike down a punitive-damage award as unconstitutional, the court will look at (1) the degree of reprehensibil- ity of the defendant’s misconduct; (2) the disparity between the actual or potential harm suffered by the plaintiff and the punitive damage award; and (3) the difference between the punitive damages awarded by the jury and the civil penalties authorized or imposed in comparable cases.

Attempts to curb punitive-damage awards are being made not only in the courts but also in the legislatures with so-called tort reform legislation. The one successful piece of tort reform legislation at the national level is the Class Action Fairness Act (CAFA), signed into law by President Bush in February 2005 to limit the conditions under which class action suits can be brought, as opposed to limiting damage awards. CAFA grants original jurisdiction to the federal courts over any civil action in which (1) the amount in controversy is in excess of $5 million, (2) the action is brought as a “class action” with at least 100 class members, and (3) any one of the plaintiffs is a citizen of a state different from that of any defendant, and two-thirds or more of the class members and the primary defendant are not citizens of the state in which the action was filed.

Therefore, even actions originated as state actions will fall into the original jurisdiction of the federal courts if all the above criteria are met. Once there, CAFA deems that all cases failing to meet federal requirements for class action suits will be immediately dismissed, even if previously accepted under state law. As such, CAFA is designed to limit the number of large, interstate class action suits.

Whether CAFA will fulfill its purpose is not yet certain. According to the Federal Judi- cial Courts Center, as recently as four months after the act went into force, the number of federal tort and contract class actions sharply increased from an average of 10.48 per day to 11.96, and the number of cases removed from state court increased from 18 percent of all class actions to 23 percent. 38

Punitive Damages in Canada

Those who believe the United States tort system is in need of reform with respect to its treatment of punitive damages may look to their Canadian neighbors with envy. Punitive-damage awards in Canada are both rare and small. A 1990 study of punitive- damage awards in Ontario found that the highest was $50,000 and the majority less than $25,000; the median award was approximately 20 percent of the compensatory-damage award in the case.

Following English common law, Canadian courts have tra- ditionally restricted punitive damages to two situations: cases of

COMPARING THE LAW OF OTHER COUNTRIES

oppressive, arbitrary, or unconstitutional actions by government servants and cases in which the defendant’s conduct was calculated to have made a profit in excess of compensatory damages. In 1989, the Canadian Supreme Court recognized that punitive damages could also be awarded for conduct deserving punishment because of its “harsh, vindictive, reprehensible, and malicious manner.”

Two reasons seem to explain the differences between Cana- dian and U.S. treatment of punitive damages. First, Canadians see something undignified about the flamboyant punitive-damage awards in the United States. Second, civil juries are less common in Canada, and, in general, judges tend to be more conservative than juries in making punitive-damage awards.

38 Marcia Coyle, “Class Action Changes Bring Quick Impact,” National Law Journal, October 2, 2006, p. 6.

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Plastic Surgeon Defamation On appeal, Dr. Bongiovi argued that Dr. Sullivan was a public figure and as a result the jury should have been instructed that actual malice had to be shown. The supreme court of Nevada held that Sullivan did not qualify as a public figure because he “did not voluntarily interject himself into a public [medical] controversy.” Additionally, the court found that the awarded compensatory and punitive damages were proper. Sullivan had lost income as the result of Bongiovi’s statement, and the compensatory damages were equivalent to the income lost. According to the court, the punitive-damage award was “reasonable and pro- portionate to the amount of harm to Sullivan” and would adequately serve as a deterrent. The district court ruling was affirmed.

CASE OPENER WRAP-UP

absolute privilege 191

abuse of process 196

actual malice 191

appropriation for commercial gain 193

assault 186

battery 186

compensatory damages 201

conditional privilege 191

conversion 198

defamation 187

disparagement 199

false imprisonment 193

false light 192

food disparagement 199

fraudulent misrepresentation 200

intentional interference with contract 199

intentional infliction of emotional distress 194

Intentional torts 185

intrusion on an individual’s affairs or seclusion 193

malicious prosecution 196

negligent torts 185

nominal damages 202

private nuisance 198

public disclosure of private facts 193

public figure privilege 192

punitive damages 202

slander of quality 199

slander of title 199

strict-liability torts 185

tort 184

tortfeasor 201

trade libel 199

trespass to personalty 198

trespass to realty 196

unfair competition 200

wrongful civil proceedings 196

Key Terms

Introduction to Tort Law

Summary of Key Topics Tort: A civil wrong giving the injured party the right to bring a lawsuit against the wrongdoer to recover compensation for injuries.

Goals of tort law: 1. Compensate innocent persons who are injured.

2. Prevent private retaliation by injured parties.

3. Reinforce a vision of a just society.

4. Deter future wrongs.

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Intentional torts occur when the defendant takes an action intending that certain consequences will result or knowing they are likely to result.

Negligent torts occur when the defendant fails to act in a responsible way and thereby subjects other people to an unreasonable risk of harm.

Strict-liability torts occur when the defendant takes an action that is inherently dangerous and cannot be undertaken safely.

Intentional torts against persons:

• Assault is the placing of another in fear or apprehension of an immediate, offensive bodily contact.

• Battery is an intentional, unwanted, offensive bodily contact.

• Defamation is the intentional publication (or communication to a third party) of a false statement harmful to an individual’s reputation.

• Public disclosure of private facts is the publicizing of a private fact about another that a reasonable person would find highly offensive.

• False light is the creation of an impression that is not valid, such as attributing to a person characteristics or beliefs he or she does not hold.

• Appropriation for commercial gain is the use of another person’s name, likeness, voice, or other identifying characteristic for commercial gain without that person’s permission.

• Intrusion on an individual’s affairs or seclusion is the invasion of a person’s solitude, seclusion, or personal affairs when the person has the right to expect privacy.

• False imprisonment is confining or restraining a person against his or her will for an appreciable period of time.

• Intentional infliction of emotional distress is engaging in outrageous, intentional conduct that is likely to cause extreme emotional distress to another party.

• Misuse of legal procedure is the misuse of a legal procedure to achieve a goal other than the one for which the process was intended to be used.

Intentional torts against property:

• Trespass to realty is the temporary exertion of control over another’s personal property or interference with the owner’s right to use it.

• Private nuisance is the use of one’s property in an unreasonable manner that harms a neighbor’s use or enjoyment of his property.

• Trespass to personalty occurs when one person deprives another of the temporary possession of his personal property.

• Conversion is the permanent removal of personal property from the owner’s possession.

Intentional torts against economic interest:

• Disparagement is the publishing of a false statement of a material fact about a business’s product or service that results in a loss of sales.

• Intentional interference with a contract occurs when a valid and enforceable contract between two parties exists; the perpetrator knows of the existence of the contract and its terms; the perpetrator intentionally undertakes steps to cause one of the parties to breach the contract; and the other party is injured as a result of the breach.

• Unfair competition occurs when a business enters an industry with the sole intent of driving another firm out of business.

• Misappropriation is the use of another person’s name, likeness, voice, or other identifying characteristic for commercial gain without that person’s permission.

• Fraudulent misrepresentation is the intentional use of a false statement to deceive another who reasonably relies on the deception to facilitate personal gain.

Intentional Torts

Classification of Torts

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Should Punitive Damages Be More Strictly Limited?

Point / Counterpoint

1. Distinguish the three types of damages available in tort cases.

2. Explain why some people see punitive damages as a necessary aspect of our tort system, while others want to restrict their availability.

3. List five intentional torts, and explain the elements needed to prove each.

4. Randy Senna owned Wildwood Fascination par- lor, an arcade game on the boardwalk in Wild- wood. His rival, Walter Florimont, owned Olympic

Questions & Problems

Damages Available in Tort Cases

Compensatory damages are an award that puts the plaintiff in the position he or she would have been in had the tort not occurred.

Nominal damages are a minimal amount that signifies the defendant’s behavior was wrongful but caused no harm.

Punitive damages are damages that punish the defendant and deter such conduct in the future.

YES NO

Excessive punitive damages are fundamentally unfair.

Tort law is supposed to be a way to compensate victims; punitive damages are not a normal part of this system. They are quasi-criminal in nature, designed to punish the defendant. And they reward a plaintiff with, in some cases, riches far beyond what any reasonable person would see as compensation. The possibility of huge punitive-damage awards has turned tort cases into litigation lotteries over lawsuits brought in hopes of striking it rich.

If punitive damages were more reasonable, patients could not sue the phone company for publishing false infor- mation about a physician that led to a botched liposuction or sue NBC because a Fear Factor episode about eating rats made a viewer “dizzy and lightheaded and caused him to vomit and run into a doorway.” Sure, damage awards have fallen since the BMW and State Farm cases, but they were so exorbitant that they could hardly have gone any higher! Besides, the fact that they have fallen does not mean that they have fallen to reasonable levels.

Further, juries get so emotionally caught up in some of these cases that it is often impossible for them to be objec- tive or fair.

Unfair punitive-damage awards can also ruin a defen- dant’s good name and run target companies out of busi- ness. We need more stringent standards for punitive damages to bring predictability, efficiency, and fairness to our civil justice system.

The BMW standard strikes a fair balance, protecting the interests of consumers and firms.

In the 20 years before the BMW case, courts handed down huge punitive-damage awards, some exceeding $100 mil- lion. But we have since seen the court’s three-pronged test result in much lower awards, generally below a 9-to-1 ratio of punitive to compensatory damages.

In the top 10 jury verdicts of 2005, awards were sig- nificantly lower than those in 2004 and earlier. There is no need to further limit punitive damages; they are now rea- sonably related to the harm caused and still large enough to deter behavior.

Punitive damages now fill two important functions. First, they allow a significantly harmed plaintiff to recover costs and attorney fees. Without the possibility of large punitive-damage awards, the plaintiff may not actually be compensated for losses because so much of the recovery goes to attorneys and litigation costs.

Second, punitive damages perform a necessary deter- rence function without posing unreasonable risk to potential defendants. If corporations no longer fear punitive-damage awards, they will lose some of their motivation to produce safe products and behave as responsible citizens.

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Enterprises, located nearby on the boardwalk in North Wildwood. To keep his client base, Senna promised that prize tickets won at his Seaside Heights parlor would be honored at the Wildwood location. Soon afterward, Senna learned that staff members at Florimont’s Olympic Enterprises were telling Olympic’s boardwalk customers that Senna would not honor the prize tickets that he had issued. Senna asked Florimont to restrain his employ- ees from “bad-mouth[ing]” him and his business with false and derogatory comments. According to Senna, however, Florimont’s employees continued to verbally assail his business.

Within a few months, Senna closed his Wild- wood Fascination parlor, only to resurrect it in 2000 under the name of Flipper’s Fascination. On dates in July, August, and September 2003, Florim- ont’s employees broadcast over a public address system to his boardwalk customers that Senna was “dishonest” and “a crook,” charging that he “ ‘ran away and screwed all of his customers in Seaside.’ ” As they had done several years earlier, Florimont’s employees accused Senna of having left his Seaside Heights customers with worthless prize tickets— tickets he would not honor in Wildwood—and warned that he would cheat his customers again.

Senna filed a civil complaint alleging that Florimont and his employees defamed Senna and tortiously interfered with his ability to conduct business at Flipper’s Fascination. Senna demanded compensatory and punitive damages. The trial court granted summary judgment in favor of Florim- ont. Senna appealed. Were Florimont’s comments enough to defame Senna’s business? Why or why not? [ Senna v. Florimont, 958 A.2d 427 (N.J. 2008).]

5. Erica Aponte, age seven, attended Thanksgiving dinner at the home of Michael and Deborah Castor, her aunt and uncle. Following dinner, Erica, accompanied by her cousin, went outside and crawled under/through an electric wire fence that enclosed Castor’s horse paddock area. Erica was subsequently kicked in the face by Castor’s horse, sustaining injury. Teresa Aponte, Erica’s mother, filed suit against Castor, seeking damages for Erica’s injuries. Castor filed a motion for summary judg- ment, arguing that because Erica did not have per- mission to leave the house or enter the paddock area, and did so without her parents’ or Castor’s knowledge, Erica was a trespasser and, therefore,

he should not be held liable for her injuries. Aponte responded that Erica was a social guest, not a tres- passer; Castor should have warned Aponte regard- ing the dangerous nature of the horse; and genuine issues of material fact existed that would preclude the granting of summary judgment. The trial court granted summary judgment. Aponte appealed. How did the court rule on appeal? Why? [ Aponte v. Castor, 155 Ohio App. 3d 553 (2003).]

6. Anthony Caruso lived in Mohican Historic Housing from 1998 to 2001, when he died. The Mohican His- toric Housing Association was aware Margherita Del Core was Caruso’s next of kin, his sister. Although Mohican had been informed that Del Core was Caruso’s next of kin, it did not respond to efforts by the hospital to obtain that informa- tion after his death. In the absence of that infor- mation, the hospital arranged for Caruso’s burial in a pauper’s grave. Four months later, Mohican informed Del Core of the death. Del Core filed suit against Mohican for, among other things, inflict- ing extreme emotional distress upon her by not informing her in a timely manner about her broth- er’s death so that she could have arranged a proper funeral. The trial court granted Mohican’s motion to dismiss, and Del Core appealed. Is Mohican liable for an intentional infliction of emotional dis- tress? Should Mohican have informed Del Core sooner regarding her brother’s death? [ Del Core v. Mohican Historic Housing Assocs., 81 Conn. App. 120 (2004).]

7. Dr. Timothy Brown is a licensed medical doctor certified in dermatology and anatomic and clini- cal pathology. Brown started a dermatology prac- tice and thereafter maintained an advertisement in Dex’s Yellow Pages directory, under the subhead- ing “Dermatology (skin).” Brown later began to offer liposuction in his office, after receiving some limited informal training in how to perform that procedure. Brown placed a second advertisement in Dex’s Yellow Pages—this time under the sub- heading “Surgery, Plastic and Reconstructive.” The new advertisement stated that Brown was “Board Certified”—without specifying any area of cer- tification. Brown added the new advertisement at the urging of a Dex sales representative, Mueller. Mueller said that the “plastic and reconstruction surgery” subheading in the Yellow Pages would be the best place to reach the desired target market.

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Mueller also said that the advertisement should identify Brown as “board certified,” because “patients were expecting a [board-certified] plastic surgeon to do these techniques.”

Knepper was considering cosmetic liposuction surgery. She consulted the “Surgery, Plastic and Reconstructive” subheading in the Yellow Pages and saw Brown’s advertisement, believing him to be a plastic surgeon because of the location of his ad and the board-certified designation that appeared after his name. Knepper decided to retain Brown, and he performed a liposuction procedure on her. After the procedure, Knepper contacted Brown’s office to report continuing pain and “misshapen- ness,” and Brown performed two more liposuction procedures in an unsuccessful attempt to repair the damage. Knepper eventually sued Brown and Dex. Brown later settled with Knepper, leaving her fraud claim against Dex for intentional misrepresenta- tion. The jury returned a $1.58 million verdict for the plaintiff, which the trial court reduced by the amount of Knepper’s settlement with Brown. Dex appealed, arguing that Knepper failed to prove her claims. How did the court rule on appeal? What does Knepper need to demonstrate to win her claim for intentional misrepresentation? [ Knepper v. Brown, 345 Or. 320 (2008).]

8. In 1997 an Alaskan citizen contacted the Alaska Department of Health to inquire about the health implications of ozone-generating air purifiers. The Health Department asked Dr. Lori Feyk to investi- gate the possible health risks and report back. After researching the topic, she was asked to prepare a report of her findings as a health bulletin to dis- tribute. The bulletin, entitled “Ozone Generators— Warning—Not for Occupied Spaces,” stated that ozone “is a potent lung irritant that can cause respi- ratory distress, and levels of ozone that clean air effectively are unsafe to human health.” Further, the bulletin cited a Minnesota case in which the state found Alpine Industries, an ozone-generator producer, “guilty of fraud and antitrust laws by making false and misleading claims about the effi- cacy and safety of ozone-generating Alpine puri- fiers.” Alpine Industries filed suit against Feyk for libel. Create a defense for Feyk in this suit. [ Alpine Industries v. Feyk, 22 P.3d 445 (2001).]

9. Plaintiff Wilspec, a U.S. company, and defendant DunAn, a Chinese corporation, design, produce,

and sell parts for air-conditioning (AC) units. They entered into a three-year contract under which DunAn would make specified parts for AC units with the Wilspec name on them. The defendant knew that these parts were to be sold in North America under the Wilspec name and that Wilspec would be the exclusive distributor for the products to AC manufacturers in North America. Wilspec alleged that while the contract was in force, DunAn engaged in intentional interference with contrac- tual relations by soliciting the sale of the same kind of AC parts to Wilspec’s customers in North America and by making disparaging remarks to those same customers regarding Wilspec’s ability to perform. Wilspec sued Dun An for intentional interference with contractual relations, seeking both compensatory and punitive damages. Do you believe Wilspec is entitled to such damages? Why or why not? [ Wilspec Technologies, Inc. v. DunAn Holding Group Co., 204 P.3d 69 (Sup. Ct. Okla. 2009).

10. Michael Buchanan went shopping in Maxfield Enterprises Inc.’s store, which is located on Melrose Avenue in Los Angeles. Buchanan did not know, at the time he entered the store, that celebri- ties Jennifer Lopez and Ben Affleck were also in the store, shopping. Less than 20 minutes after Buchanan entered the store, Maxfield store man- ager Jacqueline Sassoon asked Buchanan to leave the store. When Buchanan asked Sassoon for an explanation, she refused to give a reason. When Buchanan became angered, Maxfield store secu- rity placed him under a citizen’s arrest. Two local sheriff’s deputies, on hand because of Affleck and Lopez, handcuffed Buchanan and escorted him into the Maxfield parking lot. Because of the pres- ence of Lopez and Affleck, the parking lot was “thronged” with TV and other media reporters and film crews. Buchanan was led, handcuffed, straight into the media circus. After Buchanan was walked around the store parking lot, Sassoon told the depu- ties she did not want Buchanan arrested after all. The deputies removed the handcuffs and Buchanan was free to leave. Excerpts from television and print media purported to report that a stalker had shadowed Lopez and Affleck in the Maxfield store and the stalker was removed from the scene by police officers who had responded to a call from the store about the stalker. Buchanan sued Maxfield

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Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

for invasion of privacy, alleging that the defendant invaded his right to privacy by parading him, hand- cuffed, before the media and, as a result of this, that he suffered injury to his reputation, as well as mental anguish and emotional distress. Buchanan also sued for false imprisonment and intentional

infliction of emotional distress. Maxfield filed a motion to dismiss, which was granted by the trial court. Buchanan appealed. Was Buchanan success- ful on appeal? What must he prove to be successful in his claims? [ Buchanan v. Maxfield Enterprises, Inc., 130 Cal. App. 4th 418 (2005).]

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Gas Station Liability

In March 2003, Nodiana Antoine and Anjail Muhammad moved in together. While the two women were living together, a friend of Antoine observed that Muhammad would become upset if she saw Antoine with another woman. On several occasions, the friend heard Muhammad threaten to harm Antoine and observed scratches and bruises on Antoine’s arms and chest. In the weeks preceding May 25, 2003, Antoine and Muhammad moved out of their home and were living out of Muhammad’s car.

On the morning of May 25, Muhammad parked her car at a restaurant in Marietta, Georgia, where she and Antoine began to argue about a lost battery. As a result of the argu- ment, Antoine told Muhammad that she wanted out of the relationship and began walking away from the car. Muhammad followed Antoine, and the argument continued.

The two women eventually reached a Chevron gas station where Pamela Robinson was sitting in her car. Robinson later told police that Muhammad had her fist wrapped tightly in the shirt of Antoine and was holding Antoine close to her. Robinson went inside to have the cashier activate her gas pump. While inside, Robinson told the cashier that the two women were arguing and asked that the cashier call the police. The cashier then activated the pump where Muhammad and Antoine were arguing.

Negligence and Strict Liability 9

1 What are the elements of negligence?

2 What are the doctrines that help a plaintiff establish a case of negligence?

3 What are the defenses to a claim of negligence?

4 What are the elements of strict liability?

C H A P T E R

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

G S i Li bili CASE OPENER

PA R

T 1

  The Legal Environm

ent of B usiness

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Outside, Muhammad used the pump to douse Antoine with gasoline. After leaving the gas station, Muhammad pulled Antoine back to the car they had left at the restaurant. Muhammad found a cigarette lighter in the car, struck it five or six times, and set Antoine on fire. After being taken to the hospital, Antoine died several weeks later as a result of the burns she had suffered.

Antoine’s mother brought suit against the Chevron gas station, alleging that the gas station’s employee had negligently activated the gas pump for her daughter’s attacker, which had ultimately resulted in her daughter’s death. The district court ruled in favor of the mother, awarding her damages totaling $3,500,000, but it reduced the damages by 25 percent when it found the daughter 25 percent liable. The gas station appealed. 1

1. Suppose you are the judge in this case. Do you think that the gas station had a duty of care to protect Antoine? Why or why not?

2. Why do you think the court ruled that Antoine was 25 percent liable? Do you agree with the court’s decision? Why or why not?

The Wrap-Up at the end of the chapter will answer these questions.

Introduction to Negligence and Strict Liability In the previous chapter we discussed intentional torts, wrongs in which an individual took an action that he or she should have known would harm another person. In this chap- ter, we consider two other types of torts: negligent and strict-liability torts. These torts are generally committed when an individual fails to maintain a duty of care to another individual.

Suppose Ross uses a piece of wood to smack Joey, the mailman, on the face. Ross has committed battery. If Ross is building a tree house in his yard, however, and accidentally drops a piece of wood on Joey, who is delivering Ross’s mail, Ross’s action lacks intent, so there is no battery. Yet he might be negligent.

Allegations of negligence are made in a wide variety of circumstances. For example, people have alleged negligence when incidents of teenage violence occurred. The par- ents of Marcos Delgado, Jr., filed a claim of negligence against a movie theater when it admitted 13-year-old Raymond Aiolentuna without an adult to the R-rated movie Dead Presidents. After the movie, Aiolentuna emerged from the theater, walked one block, and shot Delgado. Delgado’s parents argued that the movie theater was negligent because it did not enforce the movie ratings system. The court, however, ruled in favor of the movie theater. 2 In another instance, the families of the victims of the 1999 Col- umbine school shootings in Colorado sued the two alleged shooters and the gun manu- facturer for negligence. What exactly is required to establish a successful negligence claim?

In this chapter, we begin by examining the elements of negligence. Then we consider the methods that courts have adopted to help plaintiffs make successful negligence claims. Next, we examine the defenses that defendants to negligence claims can raise. Finally, we consider strict-liability torts.

2 Delgado v. American Multi-Cinema Inc., 99 C.D.O.S. 4772, Los Angeles Superior Court (1999).

1 Tracye Currie v. Chevron U.S.A., Inc., Chevron Station, Inc., 2008 U.S. App. LEXIS 4269 (6th Cir. 2008).

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Elements of Negligence Negligence is behavior that creates an unreasonable risk of harm to others. In contrast to intentional torts, which result from a person’s willfully taking actions that are likely to cause injury, negligent torts involve the failure to exercise reasonable care to protect another’s person or property.

Sometimes, however, harm occurs because an individual suffers an unfortunate accident, an incident that simply could not be avoided, even with reasonable care. For example, suppose Jonathan is driving on the highway when he suffers a stroke. Because of the stroke, he crashes into two other vehicles. He is not, however, liable for damages caused by the accident. Yet if Jonathan had some type of warning that the stroke was going to occur, he might be liable for the accident.

To win a negligence case, the plaintiff must prove four elements: (1) duty, (2) breach of duty, (3) causation, and (4) damages. (See Exhibit 9-1 .) A plaintiff who cannot establish all four of these elements will be denied recovery.

DUTY The plaintiff must first establish that the defendant owes a duty to the plaintiff. In some particular situations, the law specifies the duty of care one individual owes to another. In most cases, however, the courts use the reasonable person standard to determine the defen- dant’s duty of care. The reasonable person standard is a measurement of the way mem- bers of society expect an individual to act in a given situation. To determine the defendant’s duty of care, the judge or jury must determine the degree of care and skill that a reasonable person would exercise under similar circumstances. The judge or jury then uses this stan- dard to evaluate the actions of the individual in the case.

Let’s return to the Chevron gas station case in the opening scenario. What duty of care do you think a reasonable person in the position of the gas station clerk would owe Antoine in the opening scenario?

When courts attempt to determine whether a reasonable person would have owed a duty to others, they consider four questions:

1. How likely was it that the harm would occur?

2. How serious was the harm?

3. How socially beneficial was the defendant’s conduct that posed the risk of harm?

4. What costs would have been necessary to reduce the risk of harm?

In many situations, it is far from clear what a reasonable person would do. For example, if a reasonable person saw an infant drowning in a shallow swimming pool, what would

Exhibit 9-1 Elements of Negligence To prove negligence, a plaintiff must demonstrate:

1. Duty: The standard of care a reasonable person owes another. 2. Breach of duty: Failure to live up to the standard of care. 3. Causation: (a) Actual cause (cause in fact)—the determination that the plaintiff’s harm was

a direct result of the defendant’s breach of duty; and (b) proximate cause (legal cause)—the extent to which, as a matter of policy, the defendant will be held liable for the consequences of his actions.

4. Damages: A compensable loss suffered by the plaintiff.

LO1

What are the elements of negligence?

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she do? In most situations like this one, the law holds that individuals have no duty to rescue strangers from perilous situations.

In some cases, however, the courts hold that individuals have a duty to aid strangers in certain types of peril. For example, if Sam negligently hits Janice with his car and, as a result, Janice is lying in the street, Sam has a duty to remove her from that dangerous posi- tion. Similarly, employers have a special duty to protect their employees from dangerous situations.

The courts generally hold that landowners have a duty of care to protect individuals on their property. Similarly, businesses have a duty of care to customers who enter busi- ness property. It is important, therefore, for future business managers to be knowledgeable about this duty. Businesses should warn customers about risks they may encounter on busi- ness property. Some risks, however, are obvious, and businesses need not warn customers about them. For example, a business need not inform customers that they could get a paper cut from the pages of a book.

The courts generally hold that businesses have a duty of care to protect their customers against foreseeable risks about which the owner knew or reasonably should have known. For example, in Haywood v. Baseline Construction Company, a woman who tripped over lumber on the front porch of the House of Blues restaurant in Los Angeles sued for neg- ligence. The business’s attempt to warn customers by marking the lumber with yellow construction tape was insufficient to avoid the determination of negligence; the woman was awarded $91,366 in damages.

Businesses and corporations are also obligated to provide products to consumers that are safe from foreseeable harm or injury. Failure to care for customers’ safety can mean serious legal and financial repercussions for business owners and CEOs, especially if a company knowingly offers products or services that contain defects. For example, in early 2009, the Centers for Disease Control (CDC) traced hundreds of reported cases of salmonella-related sickness back to food products containing peanut substances manufac- tured by Peanut Corporation of America. Upon further investigation by the Food and Drug Administration (FDA), documents revealed that Peanut Corporation knew that its products tested positive for salmonella, on multiple occasions, over a time period of nearly two years. Rather than taking preventive measures to guarantee that its tainted peanut prod- ucts didn’t reach the public, Peanut Corporation instead decided to ship the contaminated goods.

So far, Peanut Corporation of America’s bad judgment has resulted in 9 deaths and over 600 reported cases of illness. Many families of those who died or fell ill from the salmo- nella outbreak caused by Peanut Corporation are now filing suit and claiming negligence on the part of the company for turning a blind eye to laboratory results that confirmed salmonella’s existence in its products. Other companies, such as Kellogg and King Nut, which manufactured products using peanut substances provided by Peanut Corporation, are finding themselves included in the lawsuits. Peanut Corporation has since shut down all its manufacturing plants and has filed for Chapter 7 bankruptcy. The FDA and the FBI have launched a criminal investigation and are looking into the activities of Peanut Corpo- ration of America. 3

Sometimes it can be difficult to tell when there is a duty of care between a business and its customers. For example, a man brought a negligence suit against AT&T, his cellular

3 http://minnesota-lawyer.com/death-attorney/pritzker-law-firm-files-lawsuit-against-peanut-corporation-of-america/ ; “FDA Inves- tigates PCA Plant for Salmonella Contamination,” Candy Industry 174, no. 2 (February 2009), p. 12; and www.newsinferno.com/ archives/4793.

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phone provider, for not providing information about the cell phone’s calls when he was searching for his missing mother. Ernest Frey had bought the cell phone for his mother after seeing an advertisement about the enhanced safety brought about by carrying a cell phone. When his mother went missing, he contacted the police and then AT&T to find out the location of any recent calls made from her phone. A call had been made, but AT&T refused to give Ernest Frey the location of the call without a subpoena. By the time Ernest’s mother was found, after a subpoena had been issued for the cellular tower loca- tion, she was dead from a fatal injury. The U.S. district court refused to dismiss the case and found that there might be both a contractual duty of care to Ernest and his mother and a common law duty of care because the representative from AT&T was made aware of the urgency of the situation and the danger to Ernest’s mother. Although previous cases involving landline telephone companies were found to lack a duty of care, the district court decided that there were enough important differences between landline and cellular telephones, as well as between the specifics of this case and the previous cases, to merit review by a trial court. 4

Professionals have more training than ordinary people. Thus, when professionals are serving in their professional capacity, courts generally hold that they have a higher duty of care to clients than does the ordinary person. A professional cannot defend against a negligence suit by claiming ignorance of generally accepted principles in her or his field of expertise. Clients who feel that they have suffered damages as a result of a profes- sional’s breach of her duty of care can bring a negligence case against her. These actions are referred to as malpractice cases, and they are discussed in greater detail in Chapter 11.

BREACH OF DUTY Once the plaintiff has established that the defendant owes her a duty of care, she must prove that the defendant’s conduct violated that duty. This violation is called a breach of duty. For example, the driver of an automobile owes the other passengers in his car a duty of care to obey traffic signs. If he fails to stop at a stop sign, he has violated his duty to follow traffic signs and has therefore breached his duty of care. Once a duty of care has been established, it seems as if determining whether a breach of that duty occurred

4 Frey v. AT&T Mobility, Inc., 2008 U.S. Dist. LEXIS 72335 (N.D. Okla. 2008).

E-COMMERCE AND THE LAW

Negligence on the Internet

A commonly offered explanation for the increasing occurrence of violence is the increased violence portrayed in the media. Some plaintiffs try to hold owners of certain Web sites liable under negli- gence theories for violent acts committed by teenagers. For exam- ple, in James v. Meow Media, a 14-year-old boy took six guns to school and shot three of his classmates to death. The parents of the deceased classmates brought suit against several Internet Web sites and the creators and distributors of various video games. The parents argued that these defendants had a duty of ordinary care to the slain girls.

The courts have been consistent, however, in finding that it was not foreseeable that a boy who played certain video games and viewed certain Web sites would murder three of his classmates. In similar cases, courts have ruled that defendants (such as Web-site owners, creators and distributors of video games, and directors and producers of movies) do not have a duty to protect a person from the criminal acts of a third party unless there is a special relation- ship that requires that the defendant act with that duty.

Although it appears that Web-site owners, manufacturers, and pro- ducers will not be held liable, plaintiffs continue to bring suits against these groups of people. Can you think of an argument for why these groups of people might owe a duty of care to these plaintiffs?

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would be a simple task. Kathleen Turner believed that when she was hit by a foul ball at a baseball game there had been a clear breach of duty by the stadium. The Nevada Supreme Court found that Mandalay Sports Entertainment and the Las Vegas 51s had a limited duty of care to their patrons, which they fulfilled by putting up barriers in areas of high risks and providing written and audio announcements about the danger of foul balls. So, although there was a duty of care, that duty of care was fulfilled and the defendants were not negligent. 5

CAUSATION Causation is the third element of a successful negligence claim, and it has two separate elements: actual cause and proximate cause. The plaintiff must prove both elements of causation to be able to recover damages.

The first element, actual cause (also known as cause in fact ), is the determination that the defendant’s breach of duty resulted directly in the plaintiff’s injury. The courts com- monly determine whether a breach of duty actually caused the plaintiff’s injury by asking whether the plaintiff would have been injured if the defendant had fulfilled his or her duty. If the answer is no, then the actual cause of the plaintiff’s injury was the defendant’s breach. Actual cause is sometimes referred to as “but-for” causation because the plaintiff argues that the damages she suffered would not have occurred but for (except because of) the actions of the defendant. For example, in the Chevron case in the opening scenario. Antoine’s mother argued that but for the gas station cashier’s activation of the fuel pump her daughter would be alive.

Proximate cause, sometimes referred to as legal cause, refers to the extent to which, as a matter of policy, a defendant may be held liable for the consequences of his actions. In most states, proximate cause is determined by foreseeability. Proximate cause is said to exist only when both the plaintiff and the plaintiff’s damages were reasonably foreseeable at the time the defendant breached his duty to the plaintiff. Thus, if the defendant could not reasonably foresee the damages that the plaintiff suffered as a result of his action, the plaintiff’s negligence claim will not be sustained because it lacks the element of proximate causation.

For example, if a defective tire on a vehicle blows out, it is foreseeable that the driver may lose control and hit a pedestrian. It is not foreseeable, however, that the pedestrian may be a scientist carrying a briefcase full of chemicals that may explode on impact, caus- ing a third-floor window to shatter and injuring an accountant at his desk. In most states, the accountant would not succeed if he sued the tire manufacturer for negligence. The tire failure is not considered a proximate cause of the accountant’s injury because the con- tents of the pedestrian’s briefcase were highly unusual. The pedestrian, however, would be eligible to recover damages from the tire manufacturer because hitting a pedestrian is a foreseeable consequence of tire failure. Thus, the defect in the tire is a proximate cause of the pedestrian’s injury.

Let’s return to the Chevron scenario at the beginning of this chapter. The gas station argued that Muhammad’s actions were not foreseeable. Do you think Muhammad’s actions were foreseeable?

Palsgraf v. Long Island Railroad Company is one of the most well-known cases address- ing the issue of proximate cause (see Case 9-1).

5 Turner v. Mandalay Sports Entertainment, LLC, 180 P.3d 1172 (Nev. 2008).

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Mrs. Palsgraf was waiting for a train on a platform of a railroad. When a different train came into the station, two men ran to get on that train before it left the station. While one of the men safely reached the train, the other man, who was carrying a package, jumped on the already moving train but seemed as though he was going to fall off the train. The guard on the moving train tried to help pull the man onto the train, while another guard off of the train pushed the man from behind. Consequently, his small package wrapped in newspaper, which contained fireworks, fell upon the rails, causing the fireworks to explode. The shock of the explosion dislodged scales at the other end of the platform, and the falling scales hit Mrs. Palsgraf, causing injuries for which she brought suit against the railroad.

JUDGE CARDOZO: Nothing in the situation gave notice that the falling package had in it the potency of peril to per- sons thus removed. Negligence is not actionable unless it involves the invasion of a legally protected interest, the vio- lation of a right. “Proof of negligence in the air, so to speak, will not do.” If no hazard was apparent to the eye of ordinary vigilance, an act innocent and harmless, at least to outward seeming, with reference to her, did not take to itself the quality of a tort because it happened to be a wrong, though apparently not one involving the risk of bodily insecurity, with reference to someone else. “In every instance, before negligence can be predicated of a given act, back of the act must be sought and found a duty to the individual complain- ing, the observance of which would have averted or avoided the injury.” “The ideas of negligence and duty are strictly correlative” (Bowen, L. J., in Thomas v. Quartermaine, 18 Q. B. D. 685, 694).

The argument for the plaintiff is built upon the shifting meanings of such words as “wrong” and “wrongful,” and shares their instability. What the plaintiff must show is “a wrong” to herself, i.e., a violation of her own right, and not merely a wrong to someone else, nor conduct “wrongful” because unsocial, but not “a wrong” to any one. We are told that one who drives at reckless speed through a crowded city street is guilty of a negligent act and, therefore, of a

wrongful one irrespective of the consequences. Negligent the act is, and wrongful in the sense that it is unsocial, but wrongful and unsocial in relation to other travelers, only because the eye of vigilance perceives the risk of dam- age. If the same act were to be committed on a speedway or a race course, it would lose its wrongful quality.  .  .  . [W]rong is defined in terms of the natural or probable, at least when unintentional ( Parrot v. Wells-Fargo Co. [The Nitro-Glycerine Case], 15 Wall. [U.S.] 524). . . . Here, by concession, there was nothing in the situation to suggest to the most cautious mind that the parcel wrapped in newspa- per would spread wreckage through the station. If the guard had thrown it down knowingly and willfully, he would not have threatened the plaintiff’s safety, so far as appearances could warn him. His conduct would not have involved, even then, an unreasonable probability of invasion of her bodily security. Liability can be no greater where the act is inadvertent.

Negligence, like risk, is thus a term of relation. Negli- gence in the abstract, apart from things related, is surely not a tort, if indeed it is understandable at all. . . . Negligence is not a tort unless it results in the commission of a wrong, and the commission of a wrong imports the violation of a right, in this case, we are told, the right to be protected against interference with one’s bodily security. But bodily security is protected, not against all forms of interference or aggres- sion, but only against some. One who seeks redress at law does not make out a cause of action by showing without more, that there has been damage to his person. If the harm was not willful, he must show that the act as to him had pos- sibilities of danger so many and apparent as to entitle him to be protected against the doing of it, though the harm was unintended. Affront to personalty is still the keynote of the wrong.

The law of causation, remote or proximate, is thus for- eign to the case before us. The question of liability is always anterior to the question of the measure of the consequences that go with liability. If there is no tort to be redressed, there is no occasion to consider what damage might be recovered if there were a finding of a tort.

REVERSED and COMPLAINT DISMISSED.

PALSGRAF v. LONG ISLAND RAILROAD COMPANY NEW YORK COURT OF APPEALS 248 N.Y. 33 (1928)

CASE 9-1

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The decision in Palsgraf set out the rule of foreseeability that is followed by most states today. However, a different definition of proximate cause is followed in a small minor- ity of states. Courts in a few states do not distinguish actual cause from proximate cause. In these states, if the defendant’s action constitutes an actual cause, it is also considered the proximate cause. Therefore, in these few states, both the pedestrian-scientist and the third-floor accountant would be able to recover damages from the tire manufacturer in the previous example.

Legal Principle: Proximate cause is defined in the majority of states as foresee- ability of both the plaintiff and his or her injury, whereas in the minority of states proximate cause is the same as actual cause.

DAMAGES Damages are the final required element of a negligence action. The plaintiff must have sustained compensable injury as a result of the defendant’s actions. Because the purpose of tort law is to compensate individuals who suffer injuries as a result of another’s action or inaction, a person cannot bring an action in negligence seeking only nominal damages. Rather, a person must seek compensatory damages, or damages intended to reimburse a plaintiff for her or his losses.

In typical negligence cases, courts rarely award punitive damages, or exemplary dam- ages, which are imposed to punish the offender and deter others from committing similar offenses. Instead, courts usually award punitive damages in cases in which the offender has committed gross negligence, an action committed with extreme reckless disregard for the property or life of another person.

Plaintiff’s Doctrines The plaintiff has the burden of proving all four elements of a negligence case. Direct evi- dence of negligence by the defendant, however, is not always available. For example, there may have been no witnesses to the negligent conduct and other evidence may have been destroyed. Therefore, two doctrines have been adopted by courts to aid plaintiffs in estab- lishing negligence claims : res ipsa loquitur and negligence per se.

RES IPSA LOQUITUR Res ipsa loquitur literally means “the thing speaks for itself.” The plaintiff uses this doc- trine to allow the judge or jury to infer that more likely than not, the defendant’s negligence

Why does the court believe that Mrs. Palsgraf should not be awarded damages? Are you persuaded by these reasons? Why or why not?

ETHICAL DECISION MAKING CRITICAL THINKING

Think about the WPH process of ethical decision making. It may seem unfair that Mrs. Palsgraf was unable to collect damages for her injuries. Study the list of values or pur- poses for a decision. Which value do you think the court was upholding through its decision? Which value is in conflict with this favored value? With which value do you most agree?

LO2

What are the doctrines that help a plaintiff establish a case of negligence?

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On August 14, 2002, DeBusscher was shopping in a Sam’s Club store in Roseville, Michigan, accompanied by her three children. At the time, her son Nathan was seven years old, her daughter Miranda was four, and her daughter

Autumn was three. While DeBusscher was shopping, her son walked next to the shopping cart and her two daugh- ters sat inside the cart. While lifting Autumn out of the cart, she heard Nathan say: “There’s nothing in it.” Within

BARBARA DEBUSSCHER v. SAM’S EAST, INC. SIXTH CIRCUIT COURT OF APPEALS 505 F.3D 475 (2007)

CASE 9-2

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was the cause of the plaintiff’s harm, even though there is no direct evidence of the defendant’s lack of due care. To establish res ipsa loquitur in most states, the plaintiff must demonstrate that:

1. The event was a kind that ordinarily does not occur in the absence of negligence.

2. Other responsible causes, including the conduct of third parties and the plaintiff, have been sufficiently eliminated.

3. The indicated negligence is within the scope of the defendant’s duty to the plaintiff.

Proof of these three elements does not require a finding of negligence, however; it merely permits it. Once the plaintiff has demonstrated these three elements, the burden of proof shifts to the defendant, who must prove that he was not negligent to avoid liability.

One of the earliest uses of res ipsa loquitur was the case of Escola v. Coca Cola. 6 In that case, the plaintiff, a waitress, was injured when a bottle of Coca-Cola that she was remov- ing from a case exploded in her hand. From the facts that (1) bottled soft drinks ordinarily do not spontaneously explode and (2) the bottles had been sitting in a case, undisturbed, in the restaurant for approximately 36 hours before the plaintiff simply removed the bottle from the case, the jury reasonably inferred that the defendant’s negligence in the filling of the bottle resulted in its explosion. The plaintiff therefore recovered damages without direct proof of the defendant’s negligence. Plaintiffs in numerous accident cases have subsequently used the doctrine where there has been no direct evidence of negligence. The defendant’s best response to this doctrine is to demonstrate other possible causes of the accident.

Case 9-2 illustrates a plaintiff’s attempt to use res ipsa loquitur.

6 24 Cal. 2d 453, 150 P.2d 436 (1944).

Negligence in Germany

German law is concerned with the defendant’s ability to foresee, understand, and avoid danger. Both mental and physical capabili- ties are taken into account. For example, the duty-of-care standard stipulates that “physical and mental disabilities or defects, panic, or confusion” exempt the defendant from being found negligent. Also, although the distinction is not recognized by a statute, the

COMPARING THE LAW OF OTHER COUNTRIES

courts distinguish between conscious and unconscious negligence. Conscious negligence requires knowledge that the offense is about to occur and that it is an actual offense. Unconscious negligence occurs when the defendant is either unaware that the act consti- tutes an offense or unaware that the act is occurring at all. In such cases, the defendant is found not guilty by reason of unconscious negligence.

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moments, a portable basketball goal that was on display fell on DeBusscher, struck her head, and pinned it between the backboard and the rim.

DeBusscher filed a claim against Sam’s East, Inc., a sub- sidiary of Walmart, for medical expenses, pain and suffer- ing, loss of income and earning capacity, and mental and emotional suffering based on a claim of negligence. The district court granted summary judgment to the store after concluding that DeBusscher failed to produce sufficient evi- dence that the store caused the accident or had notice of an unsafe condition that resulted in her injuries. DeBusscher appealed to the Sixth Circuit.

JUDGE GILMAN: . . . DeBusscher’s claim is essentially a res ipsa loquitur claim based on the following syllogism: properly secured basketball goals do not fall over in ordi- nary circumstances, whether or not touched by a seven-year- old child; this goal did fall over; therefore, it must not have been properly secured.

The Michigan Supreme Court has previously issued somewhat ambiguous statements regarding the doctrine of res ipsa loquitur. Compare Mircham v. City of Detroit, 355 Mich. 182, 94 N.W.2d 388, 393 (Mich. 1959).  .  . . None- theless, in 1987, the Michigan Supreme Court formally recognized what had become a practical reality: “Whether phrased as res ipsa loquitur or circumstantial evidence of negligence, it is clear that such concepts have long been accepted in this jurisdiction. The time has come to say so. We, therefore, acknowledge the Michigan version of res ipsa loquitur which entitles a plaintiff to a permissible inference of negligence from circumstantial evidence.” Jones v. Porretta, 428 Mich. 132, 405 N.W.2d 863, 872 (Mich. 1987).

“The major purpose of the doctrine of res ipsa loquitur is to create at least an inference of negligence when the plain- tiff is unable to prove the actual occurrence of a negligent act.” Id. Under Michigan’s version of the doctrine of res ipsa loquitur, the plaintiff must establish that

(1) [t]he event must be of a kind which ordinarily does not occur in the absence of someone’s negligence,

(2) [t]he event must have been caused by an agency or instru- mentality within the exclusive control of the defendant,

(3) The event must not have been due to any voluntary action or contribution on the part of the plaintiff, and

(4) [e]vidence of the true explanation of the event must be more readily accessible to the defendant than to the plaintiff.

Wilson, 309 N.W.2d at 905. . . .

In the present case, the basketball goal was on display in a Sam’s Club store. Evidence in the record demonstrates that Sam’s East knew that customers might touch the basketball goal in some manner and that the base of the basketball goal required a ballast in order to be stable. Moreover, a basket- ball goal should not tip over simply because a seven-year- old child touches it. . . .

The record also indicates that DeBusscher herself did not contribute to the accident. She testified that she had lifted her daughter, Autumn, and set her in front of the shopping cart immediately prior to the basketball goal falling upon her. Under these circumstances, evidence of the true expla- nation for the accident was more readily accessible to Sam’s East than to DeBusscher . The store maintained exclusive possession of the basketball goal both before and after the accident, removed it from the display floor after it fell on DeBusscher , and sent it to the Claims Department. Checking the ballast level would have been a simple enough matter, but Heck [the manager] testified that he did not undertake even this basic investigative task.

Accordingly, despite her counsel’s failure to include in the record readily available and admissible evidence of causation, DeBusscher has made the required showing for a claim of res ipsa loquitur. This showing renders the dis- trict court’s grant of summary judgment erroneous. The fact that a portable basketball goal on display in a store should not fall over if properly maintained, even if “touched” by a seven-year-old child, raises an inference of negligence on the part of the store and shifts the burden of rebutting that inference to the defendant. . . .

.  .  . DeBusscher in fact did provide sufficient evidence that Sam’s East and its employees failed to monitor the bal- last level in the base of the basketball goal and that the store employees knew that the base required ballast in order to be properly secured.

. . . Viewing this evidence in the light most favorable to DeBusscher , as we must do when considering the store’s motion for summary judgment, a reasonable inference can be drawn that the basketball goal fell because its base was not properly secured. A reasonable factfinder could thus determine that an improperly filled base created a safety hazard within the store that was the proximate cause of DeBusscher’s injuries.

In reaching this conclusion, we do not mean to imply that a jury will necessarily find for DeBusscher. She might or might not prevail on the merits. But we do conclude that the district court erred in ruling on these facts that no reasonable jury could find in DeBusscher’s favor.

REVERSED and REMANDED.

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To see how paying and receiving a negligence judgment relates to income taxation, please see the Connecting to the Core activity on the text Web site at www.mhhe.com/kubasek2e.

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Business owners need to be mindful when selecting employees to work for their companies. When an employee engages in unlawful actions, it is the business owner who may actually end up in costly litigation. For example, when trash collector Christopher McCowen was found guilty for the murder and rape of well-known fashion writer Christa Worthington, the family of the deceased filed a $10 million lawsuit against his employer, Cape Cod Disposal. Worthington’s family alleged that Donald Horton, the owner of Cape Cod Disposal, failed to use reasonable care when hiring McCowen and negligently sent the former criminal to collect Worthington’s trash at her home. A background check after the murder revealed that McCowen had a violent past that included burglary, grand theft, felony assault, and trafficking of stolen property. Additionally, McCowen had been issued several restraining orders for threats against women. In 2007, Horton and the Worthington family settled for an undisclosed amount. Business owners may avoid negligent hiring and wrongful-death claims by using proper preemployment screening techniques. Many com- panies utilize background checks, call references, and verify previous employment to safe- guard themselves and their employees against potential injury and liability. 7

NEGLIGENCE PER SE Negligence per se (literally, “negligence in or of itself ”) is another doctrine that helps plaintiffs succeed in negligence cases. Negligence per se applies to cases in which the defendant has violated a statute enacted to prevent a certain type of harm from befalling a specific group to which the plaintiff belongs. If the defendant’s violation causes the plaintiff to suffer from the type of harm that the statute intends to prevent, the violation is deemed negligence per se. The plaintiff does not have to show that a reasonable person would exercise a certain duty of care toward the plaintiff. Instead, the plaintiff can offer evidence of the defen- dant’s violation of the statute to establish proof of the negligence.

For example, if Ohio passes a statute prohibiting the sale of alcohol to minors, and a minor runs a red light and kills two pedestrians while driving under the influence of alco- hol sold to him illegally, the liquor store’s violation of the statute prohibiting the sale of alcohol to minors establishes negligence per se on the part of the store. The families of the pedestrians do not need to establish that a reasonable person would have a duty not to sell alcohol to a minor. The Case Nugget provides another illustration of negligence per se.

A defendant who complies with legislative statutes, however, can still be held liable if a reasonable person would have exercised a more stringent duty of care toward the plaintiff. The legislative statutes are minimum, not sufficient, standards for behavior.

7 www.nytimes.com/2006/11/17/us/17cape.html ; www.boston.com/news/local/articles/2005/05/18/cape_writers_family_sues_over_ death/ ; and www.entrepreneur.com/tradejournals/article/161024244.html (all accessed March 3, 2009).

What evidence does the court give for its conclusion that the plaintiff could have used res ipsa loquitur? Are you per- suaded by this evidence? Why or why not?

ETHICAL DECISION MAKING CRITICAL THINKING

Suppose you were a business manager for the store when this case was first brought to the store’s attention. The plain- tiff’s attorney has contacted you, claiming that the store in this case was negligent. What would your response to the plaintiff’s attorney be?

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Before examining the defenses against negligence claims, compare the definition of negligence in the United States with its definition in South Africa, as described in the Comparing the Law of Other Countries box.

SPECIAL PLAINTIFF’S DOCTRINES AND STATUTES In addition to recognizing res ipsa loquitur and negligence per se, some states have estab- lished other doctrines or statutes to aid plaintiffs in negligence suits. For example, suppose an airplane taxiing at Reagan National Airport in the winter runs off the runway and into the Potomac River due to the negligence of the airline. Some bystanders observe the crash and jump into the water to rescue the crash survivors. If any of the bystanders are injured while attempting to rescue the survivors, many courts will hold the airline liable for their injuries under what is known as the danger invites rescue doctrine.

Many states have also enacted statutes to aid plaintiffs in successfully establishing specific kinds of negligence claims. For instance, many states have dram shop acts, which allow bartenders and bar owners to be held liable for injuries caused by individuals who become intoxicated at the bar. Other states have passed laws that hold hosts liable for injuries caused by individuals who became intoxicated at the hosts’ homes.

Defenses to Negligence The courts’ doctrines of res ipsa loquitur and negligence per se help the plaintiff in a negligence case, but the courts permit certain defenses that relieve the defendant from liability even when the plaintiff has proved all four elements of negligence. Defendants can successfully rebut negligence claims with contributory negligence, comparative negli- gence, assumption of the risk, and other special negligence defenses.

CONTRIBUTORY NEGLIGENCE Contributory negligence, a defense once available in all states but replaced today in some states by the defense of comparative negligence (discussed in the next section), applies in cases in which the defendant and the plaintiff were both negligent. The defen- dant must prove that (1) the plaintiff’s conduct fell below the standard of care needed to prevent unreasonable risk of harm and (2) the plaintiff’s failure was a contributing cause to the plaintiff’s injury. How can defendants use contributory negligence in a case?

A Clear Illustration of Negligence Per Se

O’Guin v. Bingham County 122 P.3d 308 (Sup. Ct. Idaho 2005)

Shaun and Alex O’Guin cut across a field on their way home from school and entered the back of a landfill that was not fenced off, despite a law that required it to be fenced. A portion of a wall of the landfill collapsed, killing the boys. The boys’ parents sued the county that operated the landfill, alleging that failure to have the landfill properly fenced constituted negligence per se.

CASE NUGGET

The court agreed, explaining that the following four elements of negligence per se had been met: (1) The statute or regulation clearly defines the required standard of conduct, (2) the statute or regulation must have been intended to prevent the type of harm the defendant’s act or omission caused, (3) the plaintiff must be a member of the class of persons the statute or regulation was designed to protect, and (4) the violation must have been the proxi- mate cause of death.

LO3

What are the defenses to a claim of negligence?

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Some defense lawyers argue that if a plaintiff involved in a car accident failed to wear her seat belt, that failure constitutes contributory negligence because her action contributed to her injuries.

If the defendant successfully proves contributory negligence, no matter how slight the plaintiff’s negligence, the plaintiff will be denied any recovery of damages. Because this defense seems unfair, many states have adopted the last-clear-chance doctrine. This doc- trine allows the plaintiff to recover damages despite proof of contributory negligence as long as the defendant had a final clear opportunity to avoid the action that injured the plaintiff.

For example, suppose that Samantha and Nicole, in their cars, are facing each other while stopped at a red light. The light turns green, and Nicole starts to turn left at the intersection. Samantha sees Nicole start to turn, but she still continues to travel straight through the intersection and crashes into Nicole’s car. Although Samantha had the right-of-way at the intersection, she could have avoided hitting Nicole’s car by brak- ing or swerving. Thus, according to the last-clear-chance doctrine, Nicole could recover damages.

Legal Principle: If the court finds that (1) the plaintiff’s conduct fell below the standard of care needed to prevent unreasonable risk of harm and (2) the plaintiff’s failure was a contributing cause to the plaintiff’s injury, the defendant will not be liable for the plaintiff’s injuries unless the plaintiff can prove that the defendant had the last opportunity to avoid the accident.

COMPARATIVE NEGLIGENCE The adoption of the last-clear-chance doctrine, however, leaves many situations in which an extremely careless defendant can cause a great deal of harm to a plaintiff who is barred from recovery due to minimal contributory negligence. Thus, most states have replaced the contributory negligence defense with either pure or modified comparative negligence.

According to a pure comparative negligence defense, the court determines the per- centage of fault of the defendant. The defendant is then liable for that percentage of the plaintiff’s damages.

Courts calculate damages according to modified comparative negligence in the same manner, except that the defendant must be more than 50 percent at fault before the plaintiff can recover.

Negligence in South African Law

South Africa’s legal system is a combination of selected legal traditions—from Roman to Dutch to German. The Roman actiones legis Aquiliae influences South Africa’s statutes concerning liability. Under this Roman tradition, certain cases concerning liability man- date the presence of culpa, or negligence. South African law dic- tates that individuals can be found negligent in three different ways.

Negligence is first defined as failure to observe an accepted standard of conduct. In other words, individuals must exercise care and foresight with regard to others. A failure to do so indicates

COMPARING THE LAW OF OTHER COUNTRIES

negligent behavior. Second, negligence is determined by whether the defendant could have prevented the consequent damages. The law expects individuals to take precautions to avoid harm or dam- age. Finally, South African law outlines the extent to which one can be found negligent in a crisis situation. In such instances, individu- als have a duty to do what is “reasonably” expected. Because of the obvious ambiguity associated with this definition, South African law cites the American “doctrine of sudden emergency” as a stan- dard for determining negligence in crisis situations. Encompassing all three of these definitions is an implicit duty of the individual to take precautions to prevent harm.

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226 Part 1 The Legal Environment of Business

Let’s return to the Chevron case in the opening scenario. The court found that Antoine was 25 percent liable. In other words, although the court ruled that the gas station was neg- ligent in activating the pump that resulted in Antoine’s being doused in gasoline, Antoine stayed in a relationship that was prone to violence. As a result, the district court reduced its damage award.

Twenty-eight states have adopted modified comparative negligence, thirteen have adopted pure comparative negligence, and nine have adopted contributory negligence. Every state has adopted one of these three defenses. Thus, the parties to a negligence suit cannot choose among them.

ASSUMPTION OF THE RISK Another defense available to defendants facing negligence claims is called assumption of the risk. To use this defense successfully, a defendant must prove that the plaintiff volun- tarily and unreasonably encountered the risk of the actual harm the defendant caused. In other words, the plaintiff willingly assumed as a risk the harm she suffered. There are two types of this defense. Express assumption of the risk occurs when the plaintiff expressly agrees (usually in a written contract) to assume the risk posed by the defendant’s behavior. In contrast, implied assumption of the risk means that the plaintiff implicitly assumed a known risk.

The most difficult part of establishing this defense is showing that the plaintiff assumed the risk of the actual harm she suffered. A 1998 case against the Family Fit- ness Center illustrates an unsuccessful attempt to use assumption of the risk as a defense against a negligence claim. 8 In that case, the plaintiff was injured when a sauna bench on which he was lying collapsed beneath him at the defendant’s facility. The trial court granted summary judgment in favor of the defendant on the basis of assumption of the risk. The plaintiff had signed a contract that included the following provision: “Buyer is aware that participation in a sport or physical exercise may result in accidents or injury, and Buyer assumes the risk connected with the participation in a sport or exercise and represents that Member is in good health and suffers from no physical impairment which would limit their use of FFC’s facilities.” The appellate court overturned the trial court’s decision because the type of injury the plaintiff suffered was not the type of risk he had assumed. The court held that anyone signing a membership agreement could be deemed to have waived any hazard known to relate to the use of the health club facilities, such as the risk of a sprained ankle due to improper exercise or overexertion, a broken toe from a dropped weight, injuries due to malfunctioning exercise or sports equipment, or injuries from slipping in the locker-room shower. No patron, however, could be charged with realistically appreciating the risk of injury from simply reclining on a sauna bench. Because the collapse of a sauna bench, when properly used, is not a “known risk,” the court concluded that the plaintiff did not assume the risk of this inci- dent as a matter of law.

Case 9-3 illustrates the successful use of assumption of the risk as a defense. Compare this case to the action against the Family Fitness Center to see whether you agree with the different outcomes in the two cases.

Legal Principle: If the plaintiff voluntarily and unreasonably encountered the risk of the actual harm the defendant caused, the defendant may raise the defense of assumption of the risk to avoid liability.

8 Leon v. Family Fitness Center, Inc., 61 Cal. App. 4th 1227 (1998).

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When Jason Jones enrolled at Auburn University in 1993, he chose to become a pledge of the Kappa Alpha fraternity. Within two days, Jones began to experience hazing by fra- ternity members. Hazing activities included the following: (1) digging a ditch and jumping into it after it was filled with water, urine, feces, dinner leftovers, and vomit; (2) receiv- ing paddlings to his buttocks; (3) eating foods such as pep- pers, hot sauce, and butter; (4) being pushed and kicked; (5) doing chores for fraternity members; (6) appearing at 2 a.m. “meetings” where pledges would be hazed for sev- eral hours; and (7) “running the gauntlet,” in which pledges would run down a hallway and flight of stairs while fra- ternity members would push, kick, and hit them. Although Jones was aware that 20–40% of the pledges dropped out of the pledge program, Jones remained in the program until he was suspended from the university for poor academic performance. In 1995, Jones sued the national and local Kappa Alpha organization, alleging negligence, assault and battery, negligent supervision, and various other claims. He argued that he suffered “mental and physical injuries” as a result of the hazing. For the negligence claims, the trial court granted summary judgment for Kappa Alpha. The trial court argued that Jones assumed the risk of hazing because he voluntarily entered the organization and could have quit at any time. Jones appealed, and the Court of Civil Appeals reversed the negligence ruling, reasoning that the peer pres- sure associated with fraternity life prevented Jones from vol- untarily withdrawing from the pledge class. Kappa Alpha appealed.

JUSTICE SEE: Assumption of the risk has two subjective elements: (1) the plaintiff’s knowledge and appreciation of the risk; and (2) the plaintiff’s voluntary exposure to that risk.  .  . . [I]n order to find, as a matter of law, that Jones assumed the risk, this Court must determine that reasonable persons would agree that Jones knew and appreciated the risks of hazing and that he voluntarily exposed himself to those risks.

First, KA and its members argue that Jones knew and appreciated the risks inherent in hazing. . . . Jones’s deposi- tion indicates that before he became a KA pledge he was unfamiliar with the specific hazing practices engaged in at KA, but that the hazing began within two days of his becom- ing a pledge; that despite the severe and continuing nature of the hazing, Jones remained a pledge and continued to participate in the hazing activities for a full academic year; that Jones knew and appreciated that hazing was both illegal

and against school rules; and that he repeatedly helped KA cover up the hazing by lying about its occurrence to school officials, his doctor, and even his own family. Given Jones’s early introduction to the practice of hazing and its hazards, and in light of his own admission that he realized that hazing would continue to occur, the trial court correctly determined that reasonable people would conclude that Jones knew of and appreciated the risks of hazing.

Second, in addition to establishing that Jones both knew of and appreciated the risk, KA and the individual defen- dants argue that Jones voluntarily exposed himself to the hazing. Jones responds by arguing that a coercive environ- ment hampered his free will to the extent that he could not voluntarily choose to leave the fraternity. The Court of Civil Appeals, in reversing the summary judgment as to KA and the individual defendants, stated that it was not clear that Jones voluntarily assumed the risk of hazing, because, that court stated:

In today’s society, numerous college students are confronted with the great pressures associated with fraternity life and . . . compliance with the initiation requirements places the students in a position of functioning in what may be construed as a coercive environment.

With respect to the facts in this case, we disagree.  .  . . The record indicates that Jones voluntarily chose to con- tinue his participation in the hazing activities. After numer- ous hazing events, Jones continued to come back for more two o’clock meetings, more paddlings, and more gauntlet runs, and did so for a full academic year. Auburn Univer- sity officials, in an effort to help him, asked him if he was being subjected to hazing activities, but he chose not to ask the officials to intervene. Jones’s parents, likewise acting in an effort to help him, asked him if he was being sub- jected to hazing activities, but he chose not to ask his par- ents for help.

Moreover, we are not convinced by Jones’s argument that peer pressure created a coercive environment that pre- vented him from exercising free choice. Jones had reached the age of majority when he enrolled at Auburn University and pledged the KA fraternity. We have previously noted: “College students and fraternity members are not children. Save for very few legal exceptions, they are adult citizens, ready, able, and willing to be responsible for their own actions.” Thus, even for college students, the privileges of liberty are wrapped in the obligations of responsibility.

EX PARTE EMMETTE L. BARRAN II I SUPREME COURT OF ALABAMA 730 SO. 2D 203 (1998)

CASE 9-3

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SPECIAL DEFENSES TO NEGLIGENCE Many states have additional ways to defend against a claim of negligence. For example, laws in some states hold that people in peril who receive voluntary aid from others cannot hold those offering aid liable for negligence. These laws, commonly called Good Samari- tan statutes, attempt to encourage selfless and courageous behavior by removing the threat of liability.

The defendant in a negligence suit can also avoid liability by establishing a supersed- ing cause. A superseding cause is an unforeseeable event that interrupts the causal chain between the defendant’s breach of duty and the damages the plaintiff suffered. For exam- ple, suppose Jennifer is improperly storing ammonia in her garage when a meteor strikes her garage, spilling the ammonia into a stream nearby. Will, living downstream, drinks water from the stream and becomes dangerously ill. Because the meteor was unforeseeable, Jennifer is not liable for Will’s injuries, even though she breached her duty of care to Will.

Superseding causes allow the defendant to avoid liability because they are evidence that the defendant’s breach of duty was not the proximate cause of the plaintiff’s injuries. In other words, superseding causes disprove the causation element necessary to sustain a negligence claim.

Strict Liability Strict liability is liability without fault. The law holds an individual liable without fault when the activity in which she engages satisfies three conditions: (1) It involves a risk of

Jones realized that between 20% and 40% of his fellow pledges voluntarily chose to leave the fraternity and the haz- ing, but he chose to stay. See Prosser & Keeton, The Law of Torts 491 (“Where there is a reasonably safe alternative open, the plaintiff’s choice of the dangerous way is a free one, and may amount to assumption of the risk.  .  . .”). As a respon- sible adult in the eyes of the law, Jones cannot be heard to argue that peer pressure prevented him from leaving the very hazing activities that, he admits, several of his peers left.

Jones’s own deposition testimony indicates that he believed he was free to leave the hazing activities:

Q: You didn’t have to let this [hazing] happen to you, did you? A: No. Q: And you could have quit at any time?

A: Yes. Q: But yet you chose to go through with what you have described here in your complaint with the aspirations that you were going to become a brother in the Kappa Alpha Order? You were willing to subject yourself to this for the chance to become a member of the brotherhood .  .  . were you not? A: Yes.

We conclude that Jones’s participation in the hazing activities was of his own volition. The trial court correctly determined that reasonable people could reach no conclu- sion other than that Jones voluntarily exposed himself to the hazing.

REVERSED and REMANDED.

Is there any important missing information that might influ- ence your thinking about the court’s conclusion that Jones participated in the hazing activities of his own volition? Why is this missing information important?

ETHICAL DECISION MAKING CRITICAL THINKING

Return to the WPH process of ethical decision making. Which stakeholders are affected by the court’s decision? Why are these people affected?

LO4

What are the elements of strict liability?

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serious harm to people or property; (2) it is so inherently dangerous that it cannot ever be safely undertaken; and (3) it is not usually performed in the immediate community. Instead of banning these activities, the law allows people to engage in such activities but holds them liable for all resulting harm.

Inherently dangerous activities include dynamite blasting in a populated area and keeping animals that have not been domesticated. If an animal has shown a “vicious propensity,” strict liability applies and the owner of the animal is responsible for any injuries suffered in an attack by the animal. 9 If an individual keeps an animal that has not shown vicious propensity, he has a duty to warn and protect individuals who come into contact with the animal. As you will see in the next chapter, in today’s society, strict liability has had an enormous impact on cases involving unreasonably dangerous products.

9 Schwartz v. Armand ERPF Estate, 688 N.Y.S.2d 55 (Sup. Ct., App. Div., N.Y. 1999).

Gas Station Liability On appeal the gas station argued that Muhammad’s actions were not foreseeable and Antoine could have avoided the consequences by leaving Muhammad long before May 25. The appellate court found that there was sufficient evidence to find that the gas station cashier could have reasonably foreseen negative consequences prior to activating the pump. When the cashier activated the pump, she could see the women arguing, Robinson had warned her about the argument, and the cashier did not see a car or gasoline container near the pump. Additionally, the court ruled that the district court was correct in reducing the damage award by only 25 percent on the basis of Antoine’s liability. Although the gas station tried to argue that Antoine was entirely liable for the consequences, her actions only put her at the gas station; it was the gas station clerk who activated the pump. The appellate court upheld the district court decision.

CASE OPENER WRAP-UP

actual cause 218

assumption of the risk 226

compensatory damages 220

contributory negligence 224

dram shop acts 224

Good Samaritan statutes 228

gross negligence 220

last-clear-chance doctrine 225

modified comparative negligence 225

negligence per se 223

negligence 215

proximate cause 218

punitive damages 220

pure comparative negligence 225

reasonable person standard 215

res ipsa loquitur 220

strict liability 228

unfortunate accident 215

Key Terms

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When an individual fails to maintain a duty of care to protect other individuals, negligence and strict liability may occur.

Duty: The standard of care that the defendant (i.e., a reasonable person) owes the plaintiff.

Breach of duty: The defendant’s lack of maintaining the standard of care a reasonable person would owe the plaintiff.

Causation: The defendant’s conduct (breach of duty) that led to the plaintiff’s injury.

Damages: Compensable injuries suffered by the plaintiff.

Res ipsa loquitur: Doctrine that permits the judge or jury to infer that the defendant’s negligence was the cause of the plaintiff’s harm in cases in which there is no direct evidence of the defendant’s lack of due care.

Negligence per se: Doctrine that permits a plaintiff to prove negligence by offering evidence of the defendant’s violation of a statute that has been enacted to prevent a certain type of harm.

Contributory negligence: A defense that allows the defendant to entirely escape liability by demon- strating any degree of negligence on the part of the plaintiff that contributed to the plaintiff’s harm.

Comparative negligence: A defense that allows the liability to be apportioned between plaintiff and defendant in accordance with the degree of responsibility each bears for the harm suffered by the plaintiff.

Assumption of the risk: A defense that allows the defendant to escape liability by establishing that the plaintiff engaged in an activity fully aware that the type of harm he or she suffered was a possible consequence of engaging in that activity.

Persons who engage in activities that are so inherently dangerous that no amount of due care can make them safe are strictly liable, regardless of the degree of care they used when undertaking the activity.

Summary of Key Topics Introduction to Negligence and Strict Liability

Elements of Negligence

Plaintiff’s Doctrines

Defenses to Negligence

Strict Liability

Point / Counterpoint

Should Negligence Law Hold All Individuals to the “Reasonable Person” Standard?

NO YES

One major problem with the reasonable person standard is that it fails to set up clear rules to which individuals can conform their behavior. “Reasonableness” varies tremen- dously from one person to another; what one person consid- ers reasonable, another considers unnecessary. Unclear laws also discourage efficiency because both the plaintiff and the defendant may believe they are likely to be victorious in court and thus have little incentive to settle. When the law is clear, individuals have a better idea of the strength of their case, and those with poor chances of victory have an incen- tive to settle and thereby avoid costly litigation expenses.

The law should certainly concern itself with fairness to defendants, but that concern is only half the story. The law also ought to concern itself with fairness to plaintiffs. A plaintiff who gets run over by a high school dropout is no less injured than a plaintiff who gets run over by a professor. Yet an individualized negligence standard might allow the second plaintiff to recover but not the first. Civil society requires a certain absolute level of care from all its members, regardless of their individual predispositions.

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In addition, the reasonable person standard holds all individuals to the same duty of care, regardless of their individual characteristics. This standard is unfair to indi- viduals who exercise all the possible care of which they are capable yet whose level of care still does not meet the reasonable person standard. Alternatively, individuals can exercise levels of care that they know create a substantial likelihood of harm to others yet the care satisfies the rea- sonable person standard. Thus, the reasonable person stan- dard functions like a regressive tax. To promote fairness to all defendants, tort law ought to take into account indi- vidualized factors. Instead of asking whether the defendant has behaved reasonably, the law ought to ask whether the defendant has behaved reasonably given his or her indi- vidual characteristics, including age, education, gender, wealth, and so on.

Moreover, a more individualized standard in negligence law would tend to decrease, not increase, the clarity of the law. An injured defendant would have to ascertain the plaintiff’s individual characteristics to determine the likeli- hood of victory in court, and more variables mean more uncertainty. Who owes a higher standard of care: a college- educated yet poor defendant or a high school–educated yet rich defendant? If the law wants to promote uniformity, consistency, and stability, it ought to use a uniform stan- dard, not a more individualized one.

Finally, it is not clear how individualized characteris- tics of a defendant would count. How does a defendant’s gender affect the standard of care to which the law will hold him or her? If women are held to a different standard of care than men, is the law making a statement about the relative reasonableness of men and women?

1. Explain the differences between contributory and comparative negligence.

2. Explain the relationship between negligence per se and res ipsa loquitur.

3. Explain the purpose of Good Samaritan statutes.

4. List and describe the elements that must be proved for a successful strict-liability claim.

5. Mary Dobsa owned a home in Biloxi, Mississippi, in which she and Neil Paul resided. Countrywide Home Loans, Inc., was the mortgage lender on the home. Before financing and in accordance with the National Flood Insurance Act, Countrywide selected Landsafe to determine whether Dobsa’s home was located in a federal flood zone. Dobsa paid for Landsafe’s services. Landsafe indicated that the home was not situated in a flood-hazard area. Accordingly, Countrywide provided financ- ing without requiring Dobsa to obtain flood insurance through the National Flood Insurance Program. Unfortunately, Hurricane Katrina struck and caused substantial damage to this residence for which no flood insurance coverage existed. It was then learned that the home was actually located in a flood-hazard area. Dobsa and Paul sued Landsafe, alleging negligence and negligent misrepresenta- tion. The district court granted Landsafe’s motion for summary judgment. Dobsa appealed. How did

the court rule on appeal? Why? [ Paul v. Landsafe Flood Determination, Inc., 550 F.3d 511 (5th Cir. 2008).]

6. Dr. Robert Lee Berry worked for Lakeview Anes- thesia Associates but was fired when Lakeview dis- covered that he was practicing medicine under the influence of narcotics. Berry sought employment elsewhere and obtained a job as an anesthesiologist at Kadlec Medical Center. Kadlec hired Berry in part due to positive written employment references from Lakeview, which did not disclose Berry’s drug problem. Then, while under the influence of narcotics, Berry improperly administered an anes- thetic to a patient, causing her to suffer extensive brain damage. The patient’s family brought a suc- cessful malpractice suit against Kadlec. Kadlec, in turn, brought a negligence suit against Lakeview, alleging that Lakeview breached its duty to dis- close Berry’s prior adverse employment history. How do you think the court ruled in this case? Why? [ Kadlec Med. Ctr. v. Lakeview Anesthesia Assocs., 2005 U.S. Dist. LEXIS 9221 (2005).]

7. Mashantucket Pequot Gaming Enterprise owned a casino that Scanlon was patronizing. Scanlon was viewed on a security camera standing on a box on a balcony. Two security guards went to investigate because they were concerned for the customer’s safety. Scanlon told the guards he was

Questions & Problems

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fine, and that he had just talked another patron out of committing suicide on that very spot. The guards still did not want him standing on the box, so walked Scanlon out of that area and into the main mall area of the casino. After they left him, Scanlon evidently went back to where he had been and jumped, killing himself. His heirs sued the casino for negligently causing the death of Scanlon by not taking steps to prevent him from committing suicide. The casino filed a motion to dismiss. How do you think the court ruled in this case and why? Scanlon v. Mashantucket Pequot Gaming Enterprise, 2009 WL 4188488 (Mash. Pequot Tribal Ct., 2009)

8. David Burton smoked Camel cigarettes for 43 years, and, in 1993, he developed serious circulatory prob- lems in his legs. His doctor informed him that smoking was causing his circulatory problems. Two other doctors confirmed his doctor’s diag- nosis and recommended vascular bypass surgery, which Burton underwent unsuccessfully. After the operation, Burton had both of his legs amputated below the knee. Burton brought suit against the R. J. Reynolds Tobacco Company, alleging that the company negligently failed to warn him of the health hazards caused by smoking. R. J. Reynolds argued that it did not have a duty to warn Burton of the hazards that smoking posed to his health. What do you think? Should R. J. Reynolds be found neg- ligent? Why? [ Burton v. R. J. Reynolds Tobacco Co., 397 F.3d 906 (2005).]

9. David Glenn Koch and Roderick Cook were employees of International Tentnology Corpora- tion (InTents), a company that provides and installs equipment for events and parties. InTents set up a tent for the Chile Pepper Festival that is held in an open field at the University of Arkansas. Koch and Cook, as well as four other employees of InTents, were moving a large, fully assembled hexagonal tent across the field. To avoid a temporary mesh fence in their path, they attempted to lift the tent over it. The aluminum center support pole of the tent hit an energized overhead power line and three of the men, including Koch and Cook, were fatally electrocuted. Three others were severely injured. The administrators of the estates of Koch and Cook sued Southwestern Electric Power Company (SWEPCO). SWEPCO maintains and

operates the power line traversing the field. The line is at least 25 feet above the ground and com- plies with National Electric Safety Code clearance requirements. The line was installed at a time when the area was much more rural than it is today, and the estates contend that SWEPCO was negligent in not elevating, burying, or insulating the line now that the field is occasionally used for major pub- lic events. The district court granted SWEPCO’s motion for summary judgment on the ground that it had had no legal duty because it had not received written notification that work would be occurring near the power line. The estates appealed, con- ceding that no notification was sent to the utility but arguing that SWEPCO owed the decedents a duty of care. Did SWEPCO owe any duty of care to anyone using the field for public events? Was the failure to change the line enough to constitute negligence? Why? [ Koch v. Southwestern Electric Power Co., 544 F.3d 906 (8th Cir. 2008).]

10. Ginger Klostermeier was a regular customer of the In & Out Mart in Lucas County, Ohio. On May 29, 1998, she went to the store to purchase lottery tick- ets but fell immediately upon entering the door. The clerk helped Klostermeier up, and Klostermeier made her purchase. Klostermeier was later treated for injuries sustained to her upper body, including a broken left arm. Klostermeier suffered from mul- tiple sclerosis, although it was in remission at the time of her fall. Examination of and research into the door revealed that the closer had been replaced on November 3, 1997, and that the door Klostermeier had used to enter the store took an average of 1.602 seconds to close. This is in noncompliance with the Americans with Disabilities Act, which states that doors must have a minimum closing time of 3 seconds to accommodate persons with disabili- ties. Klostermeier sued the store and the installer of the door closer. One of Klostermeier’s claims was negligence per se, because the door violated the Americans with Disabilities Act. The trial court and the court of appeals both ruled that the store was not guilty of negligence per se, although for dif- ferent reasons. Can you articulate possible reasons why violation of the Americans with Disabilities Act does not constitute negligence per se? [ Ginger R. Klostermeier v. In & Out Mart, Inc., et al., 2001 Ohio App. LEXIS 1499 (2001).]

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Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

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C H A P T E R

Product Liability 10

1 What are the theories of liability in product liability cases?

2 What is market share liability?

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

CASE OPENER Is Human Sperm Subject to Product Liability Laws?

Many single women and married couples use donated sperm to conceive children each year. In 1994, Pennsylvania resident Donna Donovan decided to use donated sperm from Idant Laboratories, a New York sperm bank that emphasized (1) its screening process far exceeded mandated standards and (2) its rigorous screening process ensured that donors had a good genetic history. After using sperm from Idant Laboratories, Donovan gave birth to a girl, Brittany, in 1996. Donovan began noticing abnormalities in Brittany’s develop- ment, and Brittany was soon diagnosed as a Fragile X baby. Fragile X is a genetic muta- tion that causes a range of mental and physical impairments, such as learning disabilities, mental retardation, and behavior disorders. A genetic test for Fragile X was developed in 1992. In 1998, genetic tests showed that the sperm from Idant Laboratories was the car- rier of the Fragile X defect. In July 2008, Donovan and Brittany brought suit against Idant Laboratories for selling defective sperm.

1. What do you think the outcome of Donovan’s case was?

2. Should the sale of sperm be considered the sale of a product?

3. How do product liability issues affect you?

The Wrap-Up at the end of the chapter will answer these questions.

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1 Bureau of Justice Statistics, “Civil Justice Survey of State Courts: Tort Breach and Jury Trials in State Courts, 2005,” November 2009, http://bjs.ojp.usdoj.gov/content/pub/pdf/tbjtsc05.pdf.

LO1

What are the theories of liability in product

liability cases?

Chapter 10 Product Liability 235

Breast implants, Ford Explorers, cigarettes, pet food, fast food, fingers in fast food— all of these topics have been the subject of product liability suits. According to the U.S. Department of Justice’s Bureau of Justice Statistics, approximately 5 percent of state tort trials in 2005 involved product liability issues. 1 Approximately 25 percent of these tri- als addressed toxic substances, such as asbestos, tobacco, chemicals, and other toxic sub- stances. The median award to plaintiffs in state court product liability cases that went to trial was $500,000. If a company manufactures or sells a product, it should expect to be a party to a product liability lawsuit.

In this chapter, we examine the legal theories commonly used by plaintiffs in product liability cases, along with some of the defenses that are used against these cases. By under- standing the law of product liability, you may be less likely to take actions that would lead you and your company into costly litigation.

Theories of Liability for Defective Products Product liability law is based primarily on tort law. There are three commonly used theo- ries of recovery in product liability cases: negligence, strict product liability, and breach of warranty. A plaintiff may bring a lawsuit based on as many of these theories of liability as apply to the plaintiff’s factual situation. While a plaintiff must establish different elements under each of these theories, the plaintiff must generally show two common elements: (1) that the product is defective, and (2) that the defect existed when the product left the defendant’s control.

How might a product be defective? Suppose you select a glass bottle of Diet Coke at the grocery store. When you grab the bottle, it shatters in your hand and severely cuts your thumb. Most bottles of soda do not shatter when touched; thus, there must have been a problem in the manufacture of this particular bottle. When an individual product (e.g., the shattered Diet Coke bottle) has a defect making it more dangerous than the other identical products (the 200 other Diet Coke bottles at the grocery store), this individual product has a manufacturing defect.

Given your severe cut from the Diet Coke bottle, you get into your car to drive to the hospital. Unfortunately, someone rear-ends your car; the crash causes your driver’s seat to bend backward such that you hit your head on the backseat and suffer a serious neck injury. The design of the driver’s seat allowed the seat to bend backward, and all driver’s seats in this type of car have the same design. When all products of a particular design are defective and dangerous, these products have a design defect.

Because of the pain associated with your neck injury and lacerated thumb, you take a new over-the-counter pain reliever. You read and follow the instructions on the box and take two pills. However, you begin to feel incredibly ill. You rush to the hospital and dis- cover that you are experiencing negative side effects from the pain reliever because it has interacted with some of your other medications. You had carefully read the instructions and warnings, but you did not see anything about drug interactions. A product may be defective if a manufacturer fails to provide adequate warnings about potential dangers associated with the product.

In summary, a product may be defective because of a manufacturing defect, a design defect, or inadequate warnings. As you read the chapter, think about how these types of defects fit in with the three theories of liability: negligence, strict liability, and breach of warranty.

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NEGLIGENCE To win a case based on negligence, the plaintiff must prove the four elements of negligence explained in Chapter 9: (1) The defendant manufacturer or seller owed a duty of care to the plaintiff; (2) the defendant breached that duty of care by supplying a defective product; (3) this breach of duty caused the plaintiff’s injury; and (4) the plaintiff suffered actual injury.

Prior to the landmark 1916 case of MacPherson v. Buick Motor Co., negligence was rarely used as a theory of recovery for an injury caused by a defective product because of the difficulty of establishing the element of duty. Until that case, the courts said that a plain- tiff who was not the purchaser of the defective product could not establish a duty of care, because one could not owe a duty to someone with whom one was not “in privity of con- tract.” Being in privity of contract means being a party to a contract. Because most consum- ers do not purchase goods directly from the manufacturers, product liability cases against

manufacturers were rare before the MacPherson case. Following MacPherson, any foreseeable plaintiff can

sue a manufacturer for its breach of duty of care. Foresee- able plaintiffs include users, consumers, and bystanders. Moreover, foreseeable plaintiffs can bring a case against retailers, wholesalers, and manufacturers. However, retailers and wholesalers can satisfy their duty of care by making a cursory reasonable inspection of a product when they receive it from the manufacturer.

Negligent Failure to Warn. To bring a success- ful case based on negligent failure to warn, the plaintiff must demonstrate that the defendant knew or should have known that without a warning, the product would be dangerous in its ordinary use, or in any reasonably

McDonald’s Coffee is Hot!

Liebeck v. McDonald’s Corp. No. D-202 CV-93-02419

One of the most famous product liability cases is the McDonald’s coffee-cup case. Stella Liebeck, a 79-year-old woman, spilled a cup of McDonald’s coffee in her lap. She sued McDonald’s, and in 1994, a jury awarded her almost $3 million in damages. Many people cite the case as an example of the need for product liability law reform; however, they either intentionally or inadvertently omit a discussion of the facts of the case:

• Liebeck spilled the entire cup of coffee in her lap.McDonald’s required that its franchises serve coffee at 180 to 190 degrees Fahrenheit. Liquid at this high temperature causes third- degree burns in two to seven seconds. Liebeck suffered third- degree burns on her skin that required skin grafting. She was in the hospital for eight days and required two years of treat- ment for the burns.

CASE NUGGET

• Liebeck asked McDonald’s to cover her medical costs and settle the case for $20,000; McDonald’s offered $800. She filed the lawsuit after McDonald’s refused to raise its offer from $800.

• Through documents produced by McDonald’s, Liebeck discov- ered that between 1982 and 1992, McDonald’s had received over 700 complaints about the temperature of the coffee. Some of these complaints discussed burns in varying degrees of severity, and McDonald’s had previously received claims arising from burn complaints for over $500,000.

• Before the beginning of the jury trial, a retired judge, who was serving as a mediator, recommended that the parties settle the case for $225,000. McDonald’s refused.

• While the jury awarded Liebeck $200,000 in compensatory damages and $2,700,000 in punitive damages, the court reduced the damages award to $160,000 in compensatory damages (finding Liebeck 20 percent at fault in the spill) and $480,000 in punitive damages. The parties ultimately settled the case for an undisclosed amount under $600,000.

How do these facts affect your thinking about product liability law?

Prior to these required warning labels on cigarette packages, one basis for suing the tobacco industry was failure to warn.

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foreseeable use, yet the defendant still failed to provide a warning. For example, the Tenth Circuit recently affirmed a trial court decision in which a smoker was awarded approxi- mately $200,000 from R. J. Reynolds Tobacco, which before 1969 had negligently failed to warn smokers of the harm associated with smoking cigarettes. No duty to warn exists for dangers arising either from unforeseeable misuses of a product or from obvious dangers. A producer of razor blades, for example, need not give a warning that a razor blade may cut someone. Courts often consider the likelihood of the injury, the seriousness of the injury, and the ease of warning when deciding whether a manufacturer was negligent in failing to warn. To the extent that a company is aware of potential harm associated with reasonably foreseeable uses of its products, the safest course of action for the company is to identify this harm to the consumers as a warning.

When providing a warning, the manufacturer must ensure that the warning will reach those who are intended to use the product. For example, if parties other than the original purchaser will be likely to use the product, the warning should be placed directly on the product itself, not just in a manual that comes with the product. Picture warnings may be required if children, or those who are illiterate, are likely to come into contact with the product and risk harm from its use.

Products such as drugs and cosmetics are often the basis for actions based on negli- gent failure to warn because the use of these products frequently causes adverse reactions. When the user of a cosmetic or an over-the-counter drug has a reaction to that product, many courts find that there is no duty to warn unless the plaintiff proves that (1) the prod- uct contained an ingredient to which an appreciable number of people would have an adverse reaction; (2) the defendant knew or should have known, in the exercise of ordinary care, about the existence of this group; and (3) the plaintiff’s reaction was due to his or her membership in this abnormal group.

Other courts, however, use a balancing test to determine negligence in such cases. They weigh the degree of danger to be avoided with the ease of warning. For example, in 1994, a jury awarded over $8.8 million to a man who suffered permanent liver damage as a result of drinking a glass of wine with a Tylenol capsule (the award was reduced to $350,000 due to a statutory cap). As early as 1977, the company knew that combining a normal dose of Tylenol with a small amount of wine could cause massive liver damage in some people, but the company failed to put a warning to that effect on the label because such a reaction was rare. Through the balancing test, the court found that the degree of potential harm was sub- stantial and that it would have been relatively easy to place a warning on the product label.

Negligence Per se. As you know from Chapter 9, a statute violation that causes the harm that the statute was enacted to prevent constitutes negligence per se. This doctrine is also applicable to product liability cases based on negligence. When a law establishes label- ing, design, or content requirements for products, the manufacturer has a duty to meet these requirements. Failure by the manufacturer to meet those standards means that the manufacturer

Negligence in Japan

Proving a manufacturer’s negligence in Japan sounds similar to proving negligence in the United States. In Japan, the burden of proof is on the consumer, who must show that the manufacturer violated the “duty of care, which is the duty to foresee harmful

COMPARING THE LAW OF OTHER COUNTRIES

results and the duty to avoid their occurrence.” However, courts or arbitration committees (the preferred forum for settling a prod- uct liability dispute in Japan) favor settling on the manufacturer’s behalf. Therefore, proving that a manufacturer could foresee the results is especially difficult.

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has breached its duty of reasonable care. If the plaintiff can establish that the failure to meet such a standard caused injury, the plaintiff can recover under negligence per se.

Damages. Damages that are recoverable in negligence-based product liability cases are the same as those in any action based on negligence: compensatory damages and punitive damages. As you should recall from Chapter 8, compensatory damages are those designed to make the plaintiff whole again; they cover items such as medical bills, lost wages, and compensation for pain and suffering. While this list of recoverable harms may seem “obvious” to us, not all countries allow such extensive recovery. For example, in German product liability cases, consumers do not have a right to recover damages for pain and suffering or for emotional distress. Punitive damages are meant to punish the defendant for extremely harmful conduct. The amount of the punitive-damage award is determined by the wealth of the defendant and the maliciousness of the action.

In 2009–2010, Toyota announced that millions of its cars would be recalled due to acceleration and braking problems. As of February 2010, dozens of product liability law- suits had been filed against Toyota. Some of these cases were claims against Toyota to recover damages for the reduced value of their cars. Specifically, before the recall, Toyota owners claim that they could resell their cars at a certain price; after the recall, this price was several thousand dollars lower. In fact, the Kelley Blue Book reported that the resale value of Toyota models fell 1 to 3 percent in just one week following certain recalls. 2

Legal Principle: The plaintiff in a product liability case may recover compensa- tory damages, designed to provide compensation for provable losses; and punitive damages, an amount awarded to punish the defendant.

Defenses to a Negligence-Based Product Liability Action. The defenses to negligence discussed in the previous chapter are available in product liability cases based on negligence. A common defense in such cases is that the plaintiff’s own failure to act reasonably contributed to the plaintiff’s own harm. This negligence on the part of the

Failure to Warn about Food

Pelman v. McDonald’s 237 F. Supp. 2d 512 (S.D.N.Y 2003)

Consumers have recently been bringing cases that attempt to hold others liable for their health problems allegedly caused by unhealthy food. In Pelman v. McDonald’s, the plaintiffs alleged that McDonald’s failed to warn customers of the “ingredients, quantity, qualities and levels of cholesterol, fat, salt and sugar content and other ingredients in those products, and that a diet high in fat, salt, sugar and cholesterol could lead to obesity and health problems.” Judge Sweet originally dismissed the plaintiffs’ claims, stating his decision was guided by the principle that legal consequences should not attach to the consumption of hamburgers and other fast-food fare unless consumers are unaware of the dangers of eating such food. He determined that consumers know, or should reasonably know, the potential negative health effects associated with eating fast food. The plaintiffs filed an amended complaint, asserting that

CASE NUGGET

McDonald’s engaged in a scheme of deceptive advertising that in effect created the impression that McDonald’s food products were nutritionally beneficial and part of a healthy lifestyle. In September 2006, Judge Sweet refused to dismiss the plaintiffs’ claims, and as of February 2010, the case was still moving forward as a class action.

Similarly, in Gorran v. Atkins Nutritionals, Inc., Jody Gorran argued that he developed heart disease by following the Atkins diet, which encourages dieters to limit carbohydrates such as bread, rice, and pasta while increasing meat, cheese, eggs, and other high-protein (and high-fat) foods. * According to Gorran’s com- plaint, Atkins Nutritionals promoted the health benefits of its diet while knowing that some people were “fat-sensitive” and subject to adverse health effects, yet Atkins failed to warn the public. The court determined that as long as the food was sold in a condition anticipated by the consumer, it was not a defective product simply because it could negatively affect the consumer’s health.

* “Judge Rebuffs Atkins’ Second Bid to Dismiss Dieter’s Lawsuit,” Andrews Product Liability Litigation Reporter 16, no. 1 (2005), p. 2.

2 Nick Bunkley, “Some Toyota Owners Voice an Eroding Loyalty,” The New York Times, February 7, 2010.

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plaintiff allows the defendant to raise the defense of contributory, comparative, or modi- fied comparative negligence, depending on which defense is accepted by the state where the case arose. Remember, in a state that allows the contributory negligence defense, proof of any negligence by the plaintiff is an absolute bar to recovery. In a state where the defense of pure comparative negligence is allowed, the plaintiff can recover for only that portion of the harm attributable to the defendant’s negligence. In a modified comparative negligence state, the plaintiff can recover the percentage of harm caused by the defendant as long as the jury finds the plaintiff’s negligence responsible for less than 50 percent of the harm.

A closely related defense is assumption of the risk. This defense arises when a consumer knows that a defect exists but still proceeds unreasonably to make use of the product, creat- ing a situation in which the consumer has voluntarily assumed the risk of injury from the defect and thus cannot recover. To decide whether the plaintiff did indeed assume the risk, the trier of fact may consider such factors as the plaintiff’s age, experience, knowledge, and understanding, as well as the obviousness of the defect and the danger it poses. When a plaintiff knows of a danger but does not fully appreciate the magnitude of the risk, the applicability of the defense is a question for the jury to determine.

Another common defense is misuse of the product. The misuse must be unreasonable or unforeseeable. When a defendant raises the defense of product misuse, the defendant is really arguing that the harm was caused not by the defendant’s negligence but by the plain- tiff’s failure to properly use the product.

The state-of-the-art defense is used by a defendant to demonstrate that his alleged negli- gent behavior was reasonable, given the available scientific knowledge existing at the time the product was sold or produced. If a case is based on the defendant’s negligent defective design of a product, the state-of-the-art defense refers to the technological feasibility of producing a safer product at the time the product was manufactured. In cases of negligent failure to warn, the state-of-the-art defense refers to the scientific knowability of a risk associated with a product at the time of its production. This is a valid defense in a negli- gence case because the focus is on the reasonableness of the defendant’s conduct. How- ever, the state of scientific knowledge at the time of production, and the lack of a feasible way to make a safer product, does not always preclude liability. The court may find that the defendant’s conduct was still unreasonable because even in its technologically safest form, the risks posed by the defect in the design so outweighed the benefits of the product that the reasonable person would not have produced a product of that design.

Suppose a defendant designs a product to comply with federal safety regulations regard- ing that product. That defendant may attempt to argue that compliance with federal laws is a defense to state tort law because the state tort law is preempted by a federal statute designed to ensure the safety of a particular class of products. The Supreme Court recently issued a ruling on whether a state tort claim was preempted because the FDA had approved the drug label (see Case 10-1).

Product Misuse in Japan

Like the United States, Japan also addresses situations in which the consumer misuses a defective product. In Japan, such a situation is called comparative negligence. The negligence of both the defendant and the plaintiff is taken into account when determining the distribution of damages. The leading case of comparative negligence is that of Miyahara v. Matsumoto Gas

COMPARING THE LAW OF OTHER COUNTRIES

Company. In this case, the defendant purchased a gas stove from Matsumoto. A faulty rubber nose valve caused the stove to start a fire, resulting in extensive damage to Miyahara’s home. An investigation after the fire, however, showed that Miyahara had failed to close the valve before going to sleep the evening of the fire. Consequently, both he and the gas company were found negligent. The cost of the damages was split between the two parties.

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drug product,” it may make the labeling change upon filing its supplemental application with the FDA; it need not wait for FDA approval.

Wyeth argues that the CBE regulation is not implicated in this case because a 2008 amendment provides that a manu- facturer may only change its label “to reflect newly acquired information.” Resting on this language, Wyeth contends that it could have changed Phenergan’s label only in response to new information that the FDA had not considered.

Wyeth could have revised Phenergan’s label even in accordance with the amended regulation. As the FDA explained in its notice of the final rule, “newly acquired information” is not limited to new data, but also encom- passes “new analyses of previously submitted data.” The rule accounts for the fact that risk information accumulates over time and that the same data may take on a different meaning in light of subsequent developments. Levine . . . present[ed] evidence of at least 20 incidents prior to her injury in which a Phenergan injection resulted in gangrene and an amputa- tion. After the first such incident came to Wyeth’s attention in 1967, it notified the FDA and worked with the agency to change Phenergan’s label. In later years, as amputations continued to occur, Wyeth could have analyzed the accu- mulating data and added a stronger warning about IV-push administration of the drug.

[A]bsent clear evidence that the FDA would not have approved a change to Phenergan’s label, we will not con- clude that it was impossible for Wyeth to comply with both federal and state requirements.

Impossibility preemption is a demanding defense. On the record before us, Wyeth has failed to demonstrate that it was impossible for it to comply with both federal and state requirements. The CBE regulation permitted Wyeth to uni- laterally strengthen its warning, and the mere fact that the FDA approved Phenergan’s label does not establish that it would have prohibited such a change.

Wyeth also argues that requiring it to comply with a state-law duty to provide a stronger warning about IV-push administration would obstruct the purposes and objectives of federal drug labeling regulation. Levine’s tort claims, it maintains, are preempted because they interfere with “Con- gress’s purpose to entrust an expert agency to make drug labeling decisions that strike a balance between competing objectives.” We find no merit in this argument, which relies on an untenable interpretation of congressional intent and an overbroad view of an agency’s power to preempt state law.

Diana Levine, a professional musician, sought treatment for her migraine headaches and was given an injection of Wyeth’s antinausea drug, Phenergan. While the drug was supposed to be injected directly into Levine’s vein through a method called the IV-push method, the drug entered an artery instead. Consequently, Levine developed gangrene and had to have her right hand and entire forearm ampu- tated. She incurred substantial medical expenses and could no longer perform as a professional musician. At trial, Levine argued that Wyeth’s labeling was defective because although it warned of the danger of gangrene and amputa- tion following inadvertent intra-arterial injection, it failed to instruct clinicians to use the IV-drip method of intra- venous administration instead of the higher-risk IV-push method. The jury agreed with Levine. Wyeth argued that the judge should overturn the jury verdict because Levine’s claim was preempted because the drug’s label had been approved by the Food and Drug Administration. The judge rejected Wyeth’s argument, and the Vermont Supreme Court upheld that ruling, holding that the federal regulations cre- ated a floor and not a ceiling and Wyeth could have warned against IV-push administration. Wyeth appealed to the U.S. Supreme Court, making 2 arguments: (1) it was impossible to comply with both its state and federal law obligations and (2) Levine’s common-law claims stand as an obstacle to the accomplishment of Congress’ purposes in the Food, Drug and Cosmetic Act (FDCA).

JUSTICE STEVENS: The .  .  . question presented is whether federal law preempts Levine’s claim that Phener- gan’s label did not contain an adequate warning about using the IV-push method of administration. Wyeth first argues that Levine’s state-law claims are preempted because it is impossible for it to comply with both the state-law duties underlying those claims and its federal labeling duties. The FDA’s premarket approval of a new drug applica- tion includes the approval of the exact text in the proposed label. Generally speaking, a manufacturer may only change a drug label after the FDA approves a supplemental appli- cation. There is, however, an FDA regulation that permits a manufacturer to make certain changes to its label before receiving the agency’s approval. Among other things, this “changes being effected” (CBE) regulation provides that if a manufacturer is changing a label to “add or strengthen a contraindication, warning, precaution, or adverse reaction” or to “add or strengthen an instruction about dosage and administration that is intended to increase the safe use of the

WYETH v. LEVINE UNITED STATES SUPREME COURT 555 U.S. ______ , 2009, 129 S.CT. 1187 (2009)

CASE 10-1

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[continued]

Wyeth contends that the FDCA establishes both a floor and a ceiling for drug regulation. Wyeth relies .  .  . on the preamble to a 2006 FDA regulation governing the content and format of prescription drug labels. In that preamble, the FDA declared that the FDCA establishes “both a ‘floor’ and a ‘ceiling,’ ” so that “FDA approval of labeling . . . pre- empts conflicting or contrary State law.” It further stated that certain state-law actions, such as those involving failure-to- warn claims, “threaten FDA’s statutorily prescribed role as the expert Federal agency responsible for evaluating and regulating drugs.” . . .

[T]he FDA’s 2006 preamble does not merit deference. When the FDA issued its notice of proposed rulemaking in December 2000, it explained that the rule would “not con- tain policies that have federalism implications or that pre- empt State law.” In 2006, the agency finalized the rule and, without offering States or other interested parties notice or opportunity for comment, articulated a sweeping position on

the FDCA’s preemptive effect in the regulatory preamble. The agency’s views on state law are inherently suspect in light of this procedural failure.

In short, Wyeth has not persuaded us that failure-to-warn claims like Levine’s obstruct the federal regulation of drug labeling. Congress has repeatedly declined to preempt state law, and the FDA’s recently adopted position that state tort suits interfere with its statutory mandate is entitled to no weight. Although we recognize that some state-law claims might well frustrate the achievement of congressional objec- tives, this is not such a case.

We conclude that it is not impossible for Wyeth to comply with its state and federal law obligations and that Levine’s common-law claims do not stand as an obstacle to the accomplishment of Congress’ purposes in the FDCA. Accordingly, the judgment of the Vermont Supreme Court is affirmed.

AFFIRMED.

What are the reasons for the Court’s conclusion that Levine’s product liability claims are not preempted?

ETHICAL DECISION MAKING CRITICAL THINKING

Recall the WPH process for ethical decision making. Who are the relevant stakeholders affected by this decision?

Each preemption case requires careful scrutiny of the purpose of the statute. For exam- ple, in Tebbetts v. Ford Motor Co., the plaintiff argued that the 1988 Ford Escort was defectively designed because it did not have a driver’s side air bag. Ford raised the pre- emption defense, arguing that it had complied with federal safety regulations under the National Traffic and Motor Vehicle Safety Act (NTMVSA). Consequently, Ford argued that its compliance preempted recovery under state product liability laws. After consider- ing the legislative history and the law, the court discovered a clause in the law stating that “[c]ompliance with any Federal motor vehicle safety standard issued under this act does not exempt any person from any liability under common law.” Thus, the court ruled that the Tebbetts were not preempted from bringing their product liability action.

Similarly, oil companies have argued that their compliance with the Clean Air Act should not subject them to tort liability for MTBE contamination in groundwater. Through the Clean Air Act, Congress required that oil companies include an oxygenate in gasoline to allow the gasoline to burn more cleanly and thus to improve air quality. MTBE, or methyl tertiary butyl ether, is one type of oxygenate. While everyone expected MTBE to help improve air quality, widespread use of this oxygenate had a negative consequence: It contaminated water. A very small amount of MTBE affects the smell and taste of water. Given these extreme negative consequences, numerous states banned MTBE. Moreover, cities and individuals have sued oil companies to pay for the costs, in the millions of dol- lars, that will be incurred to clean the drinking water. While a few courts have agreed with the oil companies, most cases have held that the Clean Air Act does not preempt tort cases

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242 Part 1 The Legal Environment of Business

because the oil companies had a choice of oxygenates to use. Moreover, the courts state that the problem of water contamination is too far removed from the problem that Congress was trying to address through the Clean Air Act regulations; thus, there is no preemption.

Certain statutory defenses are also available in negligence-based product liability cases. To ensure that there will be sufficient evidence from which a trier of fact can make a deci- sion, states have statutes of limitations that limit the time within which all types of civil actions may be brought. In most states, the statute of limitations for tort actions, and thus for negligence-based product liability cases, varies between one and four years from the date of injury.

Statutes of repose provide an additional statutory defense by barring actions arising more than a specified number of years after the product was purchased. Statutes of repose are usually much longer than statutes of limitations, generally running at least 10 years.

STRICT PRODUCT LIABILITY The requirements for proving strict product liability can be found in Section 402A of the Restatement (Second) of Torts. This section reads as follows:

(1) One who sells any product in a defective condition, unreasonably dangerous to the user or consumer or his family is subject to liability for physical harm, thereby, caused to the ultimate user or consumer, or to this property, if

(a) the seller is engaged in the business of selling such a product, and

(b) it is expected to and does reach the consumer or user without substantial change in the condition in which it was sold.

(2) The rule stated in Subsection (1) applies although

(a) the seller has exercised all possible care in the preparation and sale of his product, and

(b) the user or consumer has not bought the product from or entered into any contrac- tual relation with the seller.

Under strict product liability, courts may hold liable the manufacturer, distributor, or retailer to any reasonably foreseeable injured party. Any reasonably foreseeable injured party includes the buyer; the buyer’s family, guests, and friends; and foreseeable bystanders. The actions of the manufacturer or seller are not relevant; rather, strict product liability focuses on the product. Thus, duty is irrelevant. Courts focus on whether the product was in a “defective condition, unreasonably dangerous” when sold. To succeed in a strict-liability action, the plaintiff must prove three things:

1. The product was defective when sold.

2. The product was so defective that the product was unreasonably dangerous.

3. The product was the cause of the plaintiff’s injury.

As stated earlier, a product may be defective because of (1) a flaw in its manufacturing that led to its being more dangerous; (2) a defective design; or (3) missing or inadequate instruc- tions or warnings that could have reduced or eliminated foreseeable risks posed by the product.

Plaintiffs usually prove that a defect exists by means of (1) experts who testify as to the type of flaw in the product that led to the plaintiff’s injury and/or (2) evidence of the circumstances surrounding the accident that would lead the jury to infer that the accident must have been caused by a defect in the product. Exhibit 10-1 describes how expert opin- ion is used in product liability cases. Case 10-2 illustrates how circumstances can provide a reasonable basis for such an inference.

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Chapter 10 Product Liability 243

Richard Welge, who boarded with Karen Godfrey, liked peanuts on his ice cream sundaes. Godfrey bought a 24-ounce vacuum-sealed plastic-capped jar of Planters peanuts for Welge at K-Mart. To obtain a $2 rebate, Godfrey needed proof of her purchase from the jar of peanuts. She used an Exacto knife to remove the part of the label that contained the bar code and placed the jar on top of the refrigerator for Welge. A week later, Welge removed the plastic seal from the jar, uncapped it, took some peanuts, replaced the cap, and returned the jar to the top of the refrigerator. A week after that, he took down the jar, removed the plastic cap, spilled some peanuts into his

left hand to put on his sundae, and replaced the cap with his right hand. As he pushed the cap down on the open jar, the jar shattered. His hand was severely cut, and became permanently impaired.

Welge filed product liability actions against K-Mart, the seller of the product; Planters, the manufacturer of the peanuts; and Brockway, the manufacturer of the glass jar. Defendants filed a motion for summary judgment after dis- covery. The district judge granted the motion on the ground that the plaintiff had failed to exclude possible causes of the accident other than a defect introduced during the manufac- turing process. The plaintiff appealed.

WELGE v. PLANTERS LIFESAVERS CO. COURT OF APPEALS FOR THE SEVENTH CIRCUIT 17 F.3D 209 (7TH CIR. 1994)

CASE 10-2

Exhibit 10-1 The Battle of the Experts

Expert Opinion in Product Liability Cases

Plaintiffs use experts in product liability cases to show the existence of a flaw or to show that a flaw caused the plaintiff’s injuries. To rebut the plaintiff’s expert opinion, the defense usually hires an expert to show that there is no defect or that the product did not cause the plaintiff’s injuries. These experts frequently battle over the scientific evidence regarding causation.

Expert testimony is used in various types of litigation: drugs, breast implants, automobile accidents, and pollution. Expert opin- ion is generally admissible in a trial if two conditions are met:

1. The subject matter is one in which scientific, technical, or other specialized knowledge would help the finder of fact, and the knowledge is relevant and reliable.

2. The expert offering the testimony is qualified as an expert.

Juries, or even judges, have sometimes been persuaded by an “expert” advocating “junk science.” Junk science may be “biased data, spurious inferences, and logical legerdemain, patched together by researchers whose enthusiasm for discovery and diagnosis outstrips their skill. It is a catalog of every conceivable kind of error: data dredging, wishful thinking, truculent dogma- tism, and now and again, outright fraud.”* In an attempt to reduce the use of junk science in the courtroom, the Supreme Court, in Daubert v. Merrell Dow Pharmaceutical, determined that judges are responsible for assessing expert opinion. It identified four considerations for relevant and reliable opinions:

1. Did the expert use the scientific method?

2. Has the expert’s theory or technique been subjected to peer review and publication?

3. Does the particular technique have a significant rate of error?

4. Is the methodology generally accepted in the scientific community? Expert-witness fees may range from $100 to $1,000 an hour. Experts are usually deposed during litigation, so their time pre-

paring for depositions and trial can easily run into hundreds of hours, which can be quite costly for clients.

 * Peter Huber, Galileo’s Revenge: Junk Science in the Courtroom (New York: Basic Books, 1991).

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[continued]

JUSTICE POSNER: No doubt there are men strong enough to shatter a thick glass jar with one blow. But Welge’s testimony stands uncontradicted that he used no more than the normal force that one exerts in snapping a plastic lid onto a jar. So the jar must have been defective. No expert testimony and no fancy doctrine are required for such a conclusion. A nondefective jar does not shatter when normal force is used to clamp its plastic lid on. The question is when the defect was introduced. It could have been at any time from the manufacture of the glass jar by Brockway (for no one suggests that the defect might have been caused by something in the raw materials out of which the jar was made) to moments before the accident. But testimony by Welge and Godfrey . . . excludes all reasonable possibility that the defect was introduced into the jar after Godfrey plucked it from a shelf in the K-Mart store. From the shelf she put it in her shopping cart. The checker at the check out counter scanned the bar code without banging the jar. She then placed the jar in a plastic bag. Godfrey carried the bag to her car and put it on the floor. She drove directly home, without incident. After the bar code portion of the label was removed, the jar sat on top of the refrigerator except for the two times Welge removed it to take peanuts out of it. Throughout this process it was not, so far as anyone knows, jostled, dropped, bumped, or otherwise subjected to stress beyond what is to be expected in the ordinary use of the product. Chicago is not Los Angeles; there were no earthquakes. Chicago is not Amityville either; no supernatural interventions are alleged. So the defect must have been introduced earlier, when the jar was in the hands of the defendants.

.  .  . [I]t is always possible that the jar was damaged while it was sitting unattended on the top of the refrig- erator, in which event they are not responsible. Only if it had been securely under lock and key when not being used could the plaintiff and Karen Godfrey be certain that noth- ing happened to damage it after she brought it home. That is true—there are no metaphysical certainties—but it leads nowhere. Elves may have played ninepins with the jar of peanuts while Welge and Godfrey were sleeping; but elves could remove a jar of peanuts from a locked cupboard. The plaintiff in a product liability suit is not required to exclude every possibility, however fantastic or remote, that the defect which led to the accident was caused by

someone other than one of the defendants. The doctrine of res ipsa loquitur teaches that an accident that is unlikely to occur, unless the defendant was negligent, is itself circum- stantial evidence that the defendant was negligent. The doctrine is not strictly applicable to a product liability case because, unlike an ordinary accident case, the defendant in a products case has parted with possession and control of the harmful object before the accident occurs. . . . But the doctrine merely instantiates the broader principle, which is as applicable to a products case as to any other tort case, that an accident can itself be evidence of liability.  .  . . If it is the kind of accident that would not have occurred but for a defect in the product, and if it is reasonably plain that the defect was not introduced after the product was sold, the accident is evidence that the product was defective when sold. The second condition (as well as the first) has been established here, at least to a probability sufficient to defeat a motion for summary judgment. Normal people do not lock up their jars and cans lest something happens to damage these containers while no one is looking. The probability of such damage is too remote. It is not only too remote to make a rational person take measures to prevent it; it is too remote to defeat a product liability suit should a container prove dangerously defective.

. . . [I]f the probability that the defect which caused the acci- dent arose after Karen Godfrey bought the jar of Planters pea- nuts is very small—and on the present state of the record we are required to assume that it is—then the probability that the defect was introduced by one of the defendants is very high.

. . . The strict-liability element in modern product liabil- ity law comes precisely from the fact that a seller, subject to that law, is liable for defects in his product even if those defects were introduced, without the slightest fault of his own for failing to discover them, at some anterior stage of production. . . . So the fact that K-Mart sold a defective jar of peanuts to Karen Godfrey would be conclusive of K-Mart’s liability, and since it is a large and solvent firm there would be no need for the plaintiff to look further for a tortfeasor.

. . . Here we know to a virtual certainty (always assuming that the plaintiff’s evidence is believed, which is a matter for the jury) that the accident was not due to mishandling after purchase, but to a defect that had been introduced earlier. REVERSED and REMANDED in favor of the plaintiff.

What are Justice Posner’s reasons for reversing the deci- sion? Do you find his reasons compelling?

ETHICAL DECISION MAKING CRITICAL THINKING

Suppose that the defect had been introduced by Brockway and that corporate management had been aware of the defect but believed the chances of someone’s being hurt were small enough to be negligible. Therefore, Brockway did not inform Planters of the defect. Should it have informed Planters?

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Chapter 10 Product Liability 245

Exhibit 10-2 Impact of the Restatement (Third) of Torts

Section 402A of the Restatement (Second) of Torts is generally the foundation of modern product liability law, but that section has been subject to considerable criticism. In 1998, the criticisms led the American Law Institute to adopt the “Restatement of the Law (Third), Torts: Product Liability,” which is intended to replace Section 402A.

Under the Restatement (Third):

[O]ne engaged in the business of selling or otherwise distributing products who sells or distributes a defective product is subject to liability for harm to persons or property caused by the defect.

The section departs from the Restatement (Second) by holding the seller to a different standard of liability, depending on whether the defect in question is a manufacturing defect, a design defect, or a defective warning.

It is only a manufacturing defect that results in strict liability. A manufacturing defect arises when “the product departs from its intended design,” and liability is imposed regardless of the care taken by the manufacturer.

The Restatement (Third) applies a reasonableness standard to design defects, stating:

[A] product is defective in design when the foreseeable risks of the harm posed by the product could have been reduced or avoided by the adoption of a reasonable alternative design by the seller . . . and the omission of the alternative design renders the product not reasonably safe.

Comments in the Restatement (Third) list a number of factors the court can use to determine whether a reasonable alternative design renders the product not reasonably safe, including:

the magnitude and probability of the foreseeable risks of harm, the instructions and warnings accompanying the product, and the nature and strength of consumer expectations regarding the product, including expectations arising from product portrayal and marketing, . . . the relative advantage and disadvantages of the product as designed and as it alternatively could have been designed, . . . the likely effects of the alternative design on product longevity, maintenance, repair and esthetics, and the range of consumer choice among products.

Thus, the Restatement (Third) has in effect shifted to a risk-utility test.

The Restatement (Third) has likewise adopted a reasonableness standard for defective warnings:

A product is defective because of inadequate instructions or warnings 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 . . . and the omission of the warnings renders the product not reasonably safe.

The potential effects of changes brought about by the newest Restatement have yet to be fully felt. As of 2001, the Restatement (Third) had not been widely adopted by the states.

In Case 10-2, the product had a manufacturing defect, which was fairly straightforward to prove. However, it is sometimes more difficult to prove that a design is defective. States are not in agreement as to how to establish a design defect, and two different tests have evolved to determine when a product is so defective as to be unreasonably dangerous. The first test, set out in the Restatement (Second) of Torts, is the consumer expectations test: Did the product meet the standards that would be expected by the reasonable consumer? This test relies on the experiences and expectations of the ordinary consumer, and thus it is not answered by the use of expert testimony about the merits of the design. See Exhibit 10-2 for an analysis of the difference between the second and third Restatement of Torts.

The second is the feasible alternatives test, sometimes referred to as the risk-utility test. In applying this test, the court focuses on the usefulness and safety of the design and compares it to an alternative design. The exact factors that the court examines are detailed in Case 10-3, which makes explicit the differences between the two tests.

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CASE 10-3

Mr. Prestage’s foot and lower leg were caught in a com- bine manufactured by defendant Sperry–New Holland. He and his wife sued defendant for damages arising out of the accident. Their first cause of action was based on the theory of strict product liability. A jury awarded John $1,425,000 for his injuries and Pam $218,750 for loss of consortium (the ability to engage in sexual relations with one’s spouse). Defendant appealed.

JUDGE PRATHER: .  .  . Two competing theories of strict liability in tort can be extrapolated from our case law. While our older decisions applied a “consumer expectations” analy- sis in products cases, recent decisions have turned on an analy- sis under “risk-utility.” We today apply a “risk-utility” analysis and write to clarify our reasons for the adoption for that test.

Section 402A is still the law in Mississippi. How this Court defines the phrases “defective conditions” and “unrea- sonably dangerous” used in 402A dictates whether a “con- sumer expectations” analysis or a “risk-utility” analysis will prevail. Problems have arisen because our past decisions have been unclear and have been misinterpreted in some instances.

“Consumer Expectations” Analysis .  .  . In a “consumer expectations” analysis, “ordinarily the phrase ‘defective condition’ means that the article has some- thing wrong with it, that it did not function as expected.” Comment g of Section 402A defines “defective condition” as “a condition not contemplated by the ultimate consumer, which will be unreasonably dangerous to him.” Thus, in a “consumer expectations” analysis, for a plaintiff to recover, the defect in a product which causes his injuries must not be one which the plaintiff, as an ordinary consumer, would know to be unreasonably dangerous to him. In other words, if the plaintiff, applying the knowledge of an ordinary consumer,

sees a danger and can appreciate that danger, then he cannot recover for any injury resulting from that appreciated danger.

“Risk-Utility” Analysis In a “risk-utility” analysis, a product is “unreasonably dan- gerous” if a reasonable person would conclude that the danger-in-fact, whether foreseeable or not, outweighs the utility of the product. Thus, even if a plaintiff appreciates the danger of a product, he can still recover for any injury result- ing from the danger, provided that the utility of the product is outweighed by the danger that the product creates. Under the “risk-utility” test, either the judge or the jury can balance the utility and danger-in-fact, or risk, of the product.

A “risk-utility” analysis best protects both the manufac- turer and the consumer. It does not create a duty on the manu- facturer to create a completely safe product. Creating such a product is often impossible or prohibitively expensive. Instead, a manufacturer is charged with the duty to make its product reasonably safe, regardless of whether the plaintiff is aware of the product’s dangerousness. . . . In balancing the utility of the product against the risk it creates, an ordinary person’s ability to avoid the danger by exercising care is also weighed.

Having here reiterated this Court’s adoption of a “risk- utility” analysis for product liability cases, we hold, neces- sarily, that the “patent danger” bar is no longer applicable in Mississippi. Under a “risk-utility” analysis, the “patent danger” rule does not apply. In “risk-utility,” the openness and obviousness of a product’s design is simply a factor to consider in determining whether a product is unreasonably dangerous.

There is sufficient evidence to show that Prestage tried his case under a “risk-utility” analysis. It is also clear from the record that the trial court understood “risk-utility” to be the law in Mississippi and applied that test correctly.

AFFIRMED in favor of plaintiff.

SPERRY–NEW HOLLAND, A DIVISION OF SPERRY CORPORATION v. JOHN PAUL PRESTAGE AND PAM PRESTAGE SUPREME COURT OF MISSISSIPPI 617 SO. 2D 248 (1993)

Why was the risk-utility test viewed as the best method of evaluating this case?

ETHICAL DECISION MAKING CRITICAL THINKING

The risk-utility test allows products to pose a danger to consumers as long as they are reasonably safe. Under which ethical theory would producing such a product be ethical? Under which theory would such production not be ethical?

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Legal Principle: A product liability case based on the theory of strict product liability may be brought when a person is injured by a product with a manufacturing defect that caused that product to be unreasonably dangerous.

Liability to Bystanders. We have been looking thus far at liability to those who are in lawful possession of the defective product. The question arises as to whether strict product liability can be used by someone other than the owner or user of the product. The bystander Case Nugget provides the rationale of one court that chose to allow recovery by a bystander.

Defenses to a Strict–Product Liability Action. Most of the defenses to a negligence-based product liability claim are available in a strict–product liability case. These defenses include product misuse, assumption of the risk, and the lapse of time under statutes of limitations and statutes of repose.

One defense that may not be available in all states, however, is the state-of-the-art defense. Courts have rejected the use of this defense in most strict-liability cases, reason- ing that the issue in such cases is not what the producers knew at the time the products were produced but whether the product was defective and whether the defect caused it to be unreasonably dangerous. For example, the supreme court of Missouri, in a case involv- ing an asbestos claim, said that the state of the art has no bearing on the outcome of a strict-liability claim because the issue is the defective condition of the product, not the manufacturer’s knowledge, negligence, or fault.

The refusal of most courts to allow the state-of-the-art defense in strict-liability cases is consistent with the social policy reasons for imposing strict liability. A reason for imposing strict liability is that the manufacturers or producers are best able to spread the cost of the risk; this risk-spreading function does not change with the availability of scientific knowl- edge. The counterargument is that if the manufacturer has indeed done everything as safely and carefully as available data allow, it seems unfair to impose liability on the defendant. After all, how else could the company have manufactured the product?

WARRANTY Another theory of liability for defective products is breach of warranty. Unlike negligence and strict-liability theories, breach of warranty stems from contract theory rather than tort theory. This theory of liability is established through the Uniform Commercial Code (UCC). A warranty is a guarantee or a binding promise regarding a product. Generally, the product (or the product’s perfor- mance) does not meet the manufacturer’s or seller’s promises.

Warranties may be either express (clearly stated by the seller or manufacturer) or implied (automatically arising out of a transaction). Either type may give rise to liability. Two types of implied warranties may provide the basis for a product liability action: war- ranty of merchantability and warranty of fitness for a particular purpose.

Express Warranty. When a seller makes an affirmative representation about a prod- uct, this representation—an express warranty —becomes part of the bargain. The repre- sentation may be a written or verbal guarantee about the product. For example, a car dealer may make an express statement that the car will work perfectly for the first 30,000 miles. In contrast, a car dealer may engage in vague sales talk (e.g., “This car runs well.”) that does not constitute an express warranty.

Determining whether a statement is a warranty may be a difficult task. In one case, for example, the court considered whether advertising statements constituted a warranty: When a

To see how total quality management relates to prevention of product liability cases, please see the Connecting to the Core activity on the text Web site at www.mhhe.com/kubasek2e.

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consumer was deciding whether to buy a luxury yacht, the seller gave him a brochure with a picture of the yacht along with the following caption: “Offering the best performance and cruising accommodations in its class, the 3375 Esprit offers a choice of either stern drive or inboard power, superb handling and sleeping accommodations for six.” The buyer argued that on the basis of express representations about the yacht in this brochure, he chose to purchase the $150,000 yacht. Later, the yacht had mechanical and electrical problems. The supreme court of Utah concluded that an express warranty is a promise or affirmation of fact. “[T]he photograph and caption contained in Cruisers’ brochure are not objective or specific enough to qualify as either facts or promises; the statements made in the caption are merely opinions, and the photograph makes no additional assertions with regard to the problems of which Boud has complained.” Thus, the court ruled there was no express warranty.

To establish a claim for breach of express warranty, the plaintiff must show that (1) the representation was the basis of the bargain and (2) there was a breach of the representation. Generally, the plaintiff simply has to demonstrate a breach of warranty; she does not have to prove that the occurrence of the breach was the defendant’s fault.

Implied Warranty of Merchantability. When a seller sells a particular kind of goods, there is an implied warranty of merchantability. Merchantability means that the particular goods would be accepted by others who deal in similar goods. Thus, an implied warranty of merchantability means that the goods are fit for the purpose for which they are sold and used. This warranty is found in Article 2, Section 314(2), of the UCC. Under the UCC, for goods to be merchantable, they must meet six conditions:

(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

E-COMMERCE AND THE LAW

User Guides on the Internet

In a footnote in the Sperry–New Holland case, the court relied on Professor John Wade’s article “On the Nature of Strict Tort Liabil- ity for Products” * to list seven factors a trial court may find help- ful when balancing a product’s utility against the risk the product creates:

1. The usefulness and desirability of the product—its utility to the user and to the public as a whole.

2. The safety aspects of the product—the likelihood that it will cause injury and the probable seriousness of the injury.

3. The availability of a substitute product that would meet the same need and not be as unsafe.

4. The manufacturer’s ability to eliminate the unsafe character of the product without impairing its usefulness or making it too expensive to maintain its utility.

5. The user’s ability to avoid danger by the exercise of care in the use of the product.

6. The user’s anticipated awareness of the dangers inherent in the product and their avoidability, because of general public

knowledge of the obvious condition of the product or of the existence of suitable warnings or instructions.

7. The feasibility, on the part of the manufacturer, of spreading the loss by setting the price of the product or carrying liability insurance.

With regard to factor 6, the court’s analysis considered whether warnings included in an owner’s manual were suitable to warn Prestage of the danger of the combine. One of Sperry’s expert wit- nesses testified: “Warnings are a third-rate way of preventing acci- dents. . . . [W]arnings are something that . . . operators read once, and forget.”

Query: Is it possible that as owner’s and user’s manuals become available online, judges and experts will be less sympathetic to the owner or user who says he read the warnings once but then forgot about them? Have you ever misplaced an owner’s or user’s manual and later looked for it online when you needed information about a product? If so, are you more likely to review safety information than you may have been in the past, when it was easy to misplace manuals?

* Mississippi Law Journal 44 (1973), p. 825.

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(d) run, within the variations permitted by the agreement, of even kind, quality and quan- tity 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.

For example, a consumer purchased an “unbreakable” baseball bat that developed cracks after the repeated use of hitting baseballs. The consumer brought suit against the retailer that sold the bat. Given that the bat could not be used for the purpose for which it was intended (i.e., hitting baseballs), the judge relied on the implied warranty of merchantabil- ity to determine that the consumer was entitled to a refund. 3

One of the requirements of this provision is that the seller of the good must be a “mer- chant with respect to goods of that kind” [UCC Section 2-314(1)]. Thus, the seller must deal with the goods in question on a regular or continuous basis. For example, a private individual who places an advertisement in the paper to sell her personal car is not a seller of goods under this section of the UCC.

Contracts for sales of goods frequently contain numer- ous disclaimers, and one of these disclaimers includes the implied warranty of merchantability. If the disclaimer uses the word merchantability, the disclaimer will be upheld for economic losses but not personal injuries.

Implied Warranty of Fitness for a Particular Purpose. When a customer purchases a product for a particular purpose and the seller is aware of this purpose, an implied warranty of fitness for a particular purpose arises. This warranty is found in Article 2, Section 315, of the UCC. The buyer is relying on the seller’s skill and judgment to select the particular goods. Thus, to succeed

Strict Liability for Bystanders

James A. Peterson, Adm’r of the Estate of Maradean Peterson et al. v. Lou Backrodt Chevrolet Co. Appellate Court of Illinois 307 N.E.3d 729 (1974)

A car dealer sold an automobile with a defective brake system. When the defective brakes failed, the driver struck two minors, kill- ing one and injuring the other. The deceased minor’s estate brought a product liability action against the car dealer. The court relied on a statement by the California Supreme Court in Elmore v. American Motors Corp. to allow recovery by bystanders:

CASE NUGGET

If anything, bystanders should be entitled to greater pro- tection than the consumer or user where injury to bystand- ers from the defect is reasonably foreseeable. Consumers and users, at least, have the opportunity to inspect for defects and to limit their purchases to articles manufac- tured by reputable manufacturers and sold by reputable retailers, whereas the bystander ordinarily has no such opportunities. In short, the bystander is in greater need of protection from defective products which are dangerous, and if any distinction should be made between bystanders and users, it should be made . . . to extend greater liability in favor of the bystanders.

3 Dudzik v. Klein’s All Sports, 158 Misc. 2d 72 (N.Y. Just. Ct. 1993).

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When Might Your Company Unexpectedly Be Considered a Seller of Goods?

Nutting v. Ford Motor Company 180 A.D.2d 122 (N.Y.A.D. 1992)

Catherine Nutting was driving her 1984 Mercury Marquis station wagon when the engine stalled, and the car collided with another vehicle. Nutting brought suit against Ford Motor Company, the car manufacturer, and Hewlett-Packard (“HP”), a manufacturer and seller of computer products. Why HP? HP had purchased the car at issue in this case from Ford through a program where HP purchased

CASE NUGGET

approximately 3,200 cars for use by HP employees. After about one and a half years, HP disposed of the cars through an auction con- ducted by its agent. Hi-Way Motors, a used-car dealership owned by Nutting’s father, purchased the car at auction and transferred titled to Nutting. When Nutting brought suit against HP for breach of implied warranty of merchantability, HP argued that it was an occa- sional seller of surplus vehicles. The court disagreed, finding that HP was in the regular business of a used-car dealer and thus was a seller and merchant within the meaning of UCC Section 2-314. You may want to examine the way that your business regularly disposes of surplus equipment or other products to consider whether you could unexpectedly be considered a seller of goods.

on a claim for breach of implied warranty of fitness for a particular purpose, the plaintiff would need to show (1) knowledge—the seller had knowledge of the customer’s specific purpose; and (2) reliance—the customer relied on the seller’s skill and judgment. Unlike the implied warranty of merchantability, which requires that the seller be a merchant of the goods involved, the implied warranty of fitness for a particular purpose applies to a sale of goods regardless of whether the seller qualifies as a merchant.

Exhibit 10-3 summarizes the three theories of product liability.

Market Share Liability In most cases, the plaintiff can identify the manufacturer of a defective product that caused the injury at issue. Sometimes, however, some plaintiffs may not learn of their injuries until years after the injury occurs. By this time, plaintiffs cannot trace the product to any particular manufacturer. Often, a number of manufacturers produced the same product, and the plaintiff would have no idea whose product had been used. A plaintiff may have even used more than one manufacturer’s product.

Before the 1980s, plaintiffs in this situation would have been unable to gain any sort of recovery for their injuries. However, recovery may be possible today because of the market share theory, created by the California Supreme Court in the case of Sindell v. Abbott Laboratories.

In Sindell, the plaintiffs’ mothers had all taken a drug known as diethylstilbestrol (DES) during pregnancies that had occurred before the drug was banned in 1973. Because DES had been produced 20 years before the plaintiffs suffered any effects from the drug their mothers had taken, it was impossible to trace the defective drug back to each manufacturer that had produced the drug causing each individual’s problems. To balance the competing interests of the victims, who had suffered injury from the drug, and the defendants, who did not want to be held liable for a drug they did not produce, the court allowed the plaintiffs to sue all the manufacturers that had produced the drug at the time that the plaintiffs’ mothers had used the drug. Then the judge apportioned liability among the defendant-manufacturers on the basis of the share of the market they had held at the time that the drug had been produced.

This theory has since been used by some other courts, primarily in drug cases. Courts using the market share theory generally require that the plaintiff prove that (1) all defen- dants are tortfeasors; (2) the allegedly harmful products are identical and share the same defective qualities; (3) the plaintiff is unable to identify which defendant caused her injury, through no fault of her own; and (4) the manufacturers of substantially all the defective products in the relevant area and during the relevant time are named as defendants.

LO2

What is market share liability?

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Some states have modified the approach of Sindell. At least one court has held that the plaintiff need sue only one maker of the allegedly defective drug. If the plaintiff can prove that the defendant manufactured a drug of the type taken by the plaintiff’s mother at the time of the mother’s pregnancy, that defendant can be held liable for all damages. However, the defen- dant may join other defendants, and the jury may apportion liability among all defendants.

While the utility of this theory for drug cases is evident, plaintiffs have not been as suc- cessful in extending the theory to products other than drugs. For example, in 2001, plain- tiffs who were unable to identify the maker of the guns that were used to kill their family members were unsuccessful in their attempt to sue a group of manufacturers for negli- gent marketing under the theory of market share liability. However, at least one court has extended the theory to lead carbonate to permit market share liability for lead poisoning.

A related issue is product liability insurance. Start-up companies often have difficulty obtaining product liability insurance because they frequently cannot meet the insurance

Exhibit 10-3 Summary of Product Liability Theories

THEORIES OF LIABILITY

WHO CAN SUE

WHO CAN BE LIABLE DEFENSES DAMAGES

Negligence Any foreseeable plaintiff

Any commercial supplier in the distribution chain (Retailers and sellers can satisfy their duty by a cursory reasonable inspection.)

Assumption of the risk

Personal injuries

Comparative/con- tributory negligence

Property damages

No recovery solely for economic damages

Strict liability Anyone harmed (buyer, user, bystander)

Any commercial supplier in the dis- tribution chain

Assumption of the risk

Personal injuries

Product misuse Property damages

No recovery solely for economic damages

Warranty Privity required (Injured party must be the buyer, the buyer’s family, or the buyer’s guest.)

Any seller Assumption of the risk

Recovery solely for economic damage

Product misuse Disclaimer

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company’s requirements, such as sales totaling a certain amount per year. The cost of the insurance will depend on the purpose of the product. If the product is related to safety or product performance, the product will be more expensive to insure than a product related to a decorative function. Insurance premiums for start-up products could range from $2,500 to $10,000 per year. 4

4 Karen Klein, “When You Can’t Secure Product Liability Insurance,” BusinessWeek, June 9, 2009, www.businessweek.com/ smallbiz/content/jun2009/sb2009069_307233.htm.

Collective Insurance in Scandinavia

The Scandinavian countries of Sweden, Finland, Denmark, and Norway share a unique feature: the role of collective insurance groups in product liability. Manufacturers, producers, and import- ers of similar products form cooperative groups and obtain an insurance policy. For example, in Finland, a voluntary insurance policy group headed by the Finnish Pharmaceutical Insurance Pool enlists pharmaceutical companies as members. To hear the appeals of those seeking damages, the pool appoints a board.

COMPARING THE LAW OF OTHER COUNTRIES

The board follows the basic liability principle of insurance groups, which is that causation, rather than fault or defectiveness, deter- mines compensation.

Pharmaceutical companies find this principle especially appealing because they can admit liability without damaging the name of their products as a whole. Supporters of the insurance system also point out that elimination of the defectiveness require- ment enables product developers to concentrate on improving their products, as opposed to being tied up with product liability cases.

Is Human Sperm Subject to Product Liability Laws? Donovan’s case was the first decision to hold that a sperm bank could be sued under product liability theories for the sperm it provides. 5 One of the issues was whether Pennsylvania or New York law applied to the sale of the sperm. (Donovan and Brittany were Pennsylvania residents, and the sperm came from New York.) Many states, including Pennsylvania and New York, have enacted “blood shield” statutes that prohibit product liability suits based on donated blood. Pennsylvania’s blood shield statute included human tissue other than blood, but New York’s statute shielded blood and its derivatives only. Therefore, Donovan could have a product liability claim in New York but not in Pennsylvania. The court decided that because the screening of the sperm and the formation of the contract occurred in New York, New York law would apply in Donovan’s case and thus, under New York law, the suit could move forward. Another issue was whether Idant provided a service or a product. The court again referred to the blood shield statute and stated that “[u]nder New York law, the sale of sperm is a product and is subject to strict liability.”

The court’s decision did not find that the sperm actually was defective; it simply found that a New York sperm bank could be sued under product liability laws. However, the case raises some interesting questions: Should a laboratory be held responsible for genetic dis- eases for which there are no tests? Do the same standards apply to donated eggs? Suppose Brittany Donovan had children who had the same genetic effects. Would they have any claim against the sperm bank?

CASE OPENER WRAP-UP

5 Donovan v. Idant Laboratories, Case No. 08-4075, Memorandum and Order (E.D. Pa., Mar. 31, 2009).

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Chapter 10 Product Liability 253

design defect 235

express warranty 247

fails to provide adequate warnings 235

implied warranty of merchantability 248

implied warranty of fitness for

a particular purpose 249

manufacturing defect 235

market share theory 250

strict product liability 242

warranty 247

Key Terms

Negligence: Plaintiff must show that (1) the defendant manufacturer or seller owed a duty of care to the plaintiff; (2) the defendant breached that duty of care by supplying a defective product; (3) this breach of duty caused the plaintiff’s injury; and (4) the plaintiff suffered actual injury.

Strict product liability: Plaintiff must show that (1) the product was defective when sold; (2) the product was so defective that the product was unreasonably dangerous; and (3) the product was the cause of the plaintiff’s injury.

Express warranty: The plaintiff must show that (1) the representation was the basis of the bargain and (2) there was a breach of the representation.

Implied warranty of merchantability: The plaintiff must show that the goods are fit for the purpose for which they are sold and used.

Implied warranty of fitness for a particular purpose: The plaintiff must show that the customer purchased a product for a particular purpose and the seller was aware of this purpose.

When plaintiffs cannot trace a product to any particular manufacturer and a number of manufacturers produced the same product, a court may use the theory of market share liability to impose a portion of fault on a number of manufacturers.

Summary of Key Topics Theories of Liability For Defective Products

Market Share Liability

Point / Counterpoint

Should Companies Be Held Strictly Liable for Their Products?

YES NO

Companies, rather than individual consumers, are in the best position to absorb the risk of their products. The manufacturer is in the best position to anticipate the harm the product might cause and has more information regard- ing the product. If a company manufactures and sells a product that seriously harms large numbers of individuals (both consumers and bystanders), the company, rather than the individuals should be responsible for these costs. The company receives all the rewards of selling the product (i.e., the profit) and should thus bear the risks associated with selling the product.

The cost of product liability insurance is so high that com- panies need to add this cost to the price of the product. Consequently, consumers have to pay unnecessarily higher prices for products, and this creates inefficiency in the market. Similarly, manufacturers waste time and resources creating unnecessary warnings on labels (e.g., “Do not eat” warnings on nonfood products). Furthermore, strict liability discourages companies from developing and test- ing new products because of the fear that the product could be faulty. Finally, strict–product liability law incentivizes consumers to improperly use products.

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254 Part 1 The Legal Environment of Business

1. Explain the elements one would have to prove to bring a successful product liability case based on negligence, and identify the available defense.

2. Why would a defendant prefer to be found to have produced a product that was defectively manufac- tured rather than defectively designed?

3. Explain the defenses available in a case based on a theory of strict product liability.

4. Boutte fell asleep at the wheel while driving his car, struck a cement wall, and broke both of his ankles. He sued Nissan Motor Corp., alleging that the improper placement of the lap belt consti- tuted negligent design. In testimony, the plaintiff’s expert explained that a proper seat belt is posi- tioned over the pelvis. Boutte’s seat belt was posi- tioned over his thighs, and the improper placement allowed him to slide forward and injure his ankles. The expert also explained that a passive restraint system, which was used by other manufacturers, would have kept the lap belt in the correct posi- tion. The expert for the manufacturer disagreed and argued that even with a passive restraint system Boutte would have sustained the same injuries. Ini- tially, the jury attributed 84 percent of the fault to the plaintiff. On appeal, the defendant argued that Boutte’s injuries were not a result of the seat belt placement and that the plaintiff’s expert testimony should not have been considered in the trial court. How do you think the appellate court ruled in this case, and why? [ Boutte v. Nissan Motor Corp., 3d Cir. (1995) 48 ALR 5th 86.]

5. National Fulfillment Services was a tenant in an office building owned by Holmes Corporate Center. A fire in the building on February 4, 1992, damaged National Fulfillment’s offices. National Fulfillment filed suit against the providers of fire and burglar alarm services, referred to as ADT, to recover uninsured losses. Among other claims, National Fulfillment alleged strict liability and negligence, claiming that ADT’s alarm failed to alert firefight- ers in a timely manner; thus, more damage was sustained than National Fulfillment had insurance for. ADT noted that its contract was with Holmes Corporate Center, not with National Fulfillment, and that Holmes had a duty to defend ADT against

any lawsuit filed by a nonparty to the agreement. The district court granted summary judgment for ADT. National Fulfillment appealed. Did the court of appeals grant National Fulfillment’s claims of strict liability and negligence, or did it affirm the decision of the district court? Why? [ Krueger Asso- ciates, Inc., Individually and Trading as National Fulfillment Services v. The American District Tele- graph Company of Pennsylvania and ADT Security Systems, Inc., 247 F.3d 61 (2001).]

6. The plaintiff’s son was given St. Joseph’s Aspirin for Children when he had the flu. The aspirin trig- gered Reye’s syndrome, leaving the child a quad- riplegic, blind, and mentally retarded. The aspirin contained a warning, approved by the Food and Drug Administration, about the dangers of giving aspirin to children with the flu. The product was advertised in Spanish in the Los Angeles area, but the warning was not in Spanish. The child’s guard- ians could not read English. Do you believe the court imposed liability on the company for failure of its duty to warn? Why or why not? [ Ramirez v. Plough, Inc., 25 Cal. Rptr. 2d (1993).]

7. Plaintiff Darren Traub was playing a pickup game of basketball on his college campus and tried to dunk the ball, but his hand hit the rim and he fell down, hurting both wrists. He sued the basketball hoop manufacturer and the university, claiming that the rigid rim caused his injury or made it worse. The defendants filed a motion for summary judgment. Do you think it should have been granted? [ Traub v. Cornell, 1998 WL 187401 (N.D. N.Y.) (1998).]

8. In 1991, three-year-old Douglas Moore was play- ing with one of BIC’s lighters. While playing with the lighter, he started a fire that severely injured his 17-month-old brother. BIC Manufacturers Inc. included several child-safety warning labels on their lighters. These labels identified the risk of fire or injury as a result of misusing the product. The lighter provided warnings to adults to “keep out of reach of children” or “keep away from children.” The BIC Corporation had knowledge that its light- ers could be manipulated by children, but it felt that including safety features would significantly increase the cost of the lighter. The Moore family

Questions & Problems

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brought a strict-liability suit against BIC. Explain why strict liability should or should not be appli- cable in this case. [ Price v. BIC Corp., 702 A.2d 330 (Sup. Ct. N.H. 1997).]

9. The federal Organic Foods Production Act and National Organic Program creates uniform federal standards for organic labeling. Under these federal programs, producers of products can become cer- tified as organic. Aurora’s Milk, sold by Aurora Dairy Corp., was certified as organic under these programs. In 2007, the USDA produced a report regarding alleged violations in Aurora’s organic operations, but Aurora’s organic certification was not revoked. The plaintiffs brought suit against Aurora Dairy Corp. for false certification. The defendants argued that the plaintiffs’ claims were preempted. Do you think the defendants were suc- cessful in their preemption argument? [Aurora

Dairy Corp. Organic Milk Marketing and Sales Practices Litigation, Case No. 08-md-01907 (E.D. Mo. 2009).]

10. Donna Bailey was paralyzed from the neck down after her friend’s Ford Explorer, in which she was a passenger, rolled over. The tread on one of the tires on the Explorer, a Firestone tire, had separated. Bai- ley brought suit against both Ford and Bridgestone/ Firestone after the March 2000 accident. In August 2000, Bridgestone/Firestone recalled millions of its tires due to concerns about deaths following tread separations. The Firestone tire on Bailey’s friend’s Explorer was not one of the tires named in the orig- inal Firestone recall. What product liability theories do you think Bailey could use in her suit against Ford and Bridgestone/Firestone? Do you think she was successful? [ Bailey v. Ford Motor Co., No. 00-02303-A (Dist. Ct. Nueces Co., Tex.) 2001.]

Looking for more review material? The Online Learning Center at www.mhhe.com/kubasek2e contains this chapter’s “Assignment on the Internet” and also a list of URLs for more information, entitled “On the Internet.” Find both of them in

the Student Center portion of the OLC, along with quizzes and other helpful materials.

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C H A P T E R

11

Questionable Accounting at WorldCom

Bert C. Roberts, Jr., was chairman of WorldCom’s board of directors. Immediately before that, he had been chairman of MCI, which WorldCom acquired on September 14, 1998, in a transaction valued at $40 billion. The acquisition made WorldCom the second-largest telecommunications company in the world.

Roberts signed a number of required documents filed by WorldCom with the Secu- rities and Exchange Commission (SEC). These included Form 10-K for 1999, 2000, and 2001 and the registration statements for the 2000 and 2001 stock offerings, as well as registration statements filed in connection with WorldCom’s acquisition of SkyTel Communications, Inc., in 1999 and of Intermedia Communications, Inc., in 2001.

On June 25, 2002, WorldCom announced a massive restatement of its financial state- ments for 2001 and the first quarter of 2002. Several weeks later, it entered bankruptcy. WorldCom ultimately made approximately $76 billion in financial adjustments for 2000 and 2001, reducing the company’s net equity from approximately $50 billion to approxi- mately minus $20 billion. It is undisputed that beginning at least as early as 2001, World- Com executives engaged in a secret scheme to misrepresent WorldCom’s financial condition in the company’s filings with the SEC.

CASE OPENER

Liability of Accountants and Other Professionals

1 Under common law, what is the duty of an accountant to his or her clients?

2 Under common law, what is the duty of an accountant to third parties?

3 What is the impact of federal securities law on accountant liability?

4 What is the extent of liability of professionals other than accountants?

LEARNING OBJECTIVES

After reading this chapter, you will be able to answer the following questions:

Th

e Le

ga l E

nv ir

on m

en t

of B

us in

es s

  PA

R T

1

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The facts underlying WorldCom’s June 25 announcement spurred numerous lawsuits. A consolidated class action was brought on behalf of a class of all persons and entities, excluding defendants and certain others affiliated with them or with WorldCom, who were financially injured after they acquired publicly traded WorldCom securities between April 29, 1999, and June 25, 2002. Roberts faced charges under a number of different federal acts regulating securities. 1

1. Who should be liable for the massive loss investors suffered due to the restatement of WorldCom’s financial records?

2. What could Roberts have done to avoid the catastrophe that ensued when WorldCom had to restate its financial statements?

The Wrap-Up at the end of the chapter will answer these questions.

Just as manufacturers and sellers of defective products may be liable for harm caused by their products, professionals who provide substandard services may likewise be liable for the harm they cause. Actions brought against attorneys, lawyers, real estate brokers, doctors, architects, and other professionals are referred to as malpractice actions. Just as product liability cases are based on different legal theories, so are malpractice actions. Most malpractice cases are based on theories of negligence, breach of contract, or fraud.

Because most businesspersons require accounting services, they are more likely to encounter malpractice by an accountant than by other professionals, and so we focus here on accountant liability. Indeed, after a significant amount of responsibility for the bank- ruptcy of the Enron Corporation was placed on the firms that provided its accounting ser- vices, accountants’ role and accountability became a matter of significant public interest.

Currently, there are a number of professional malpractice cases stemming from the recent economic downturn. After people became aware of the role that banks and other financial institutions played in creating artificial assets, many lawsuits were filed in an attempt to punish those seen as responsible. These lawsuits were also an attempt to recoup lost assets. Most of these cases are still in initial stages, but one case, against Banc of America Securities, LLC, was remanded to a lower court by the U.S. Second Circuit Court of Appeals and allowed to progress because the plaintiffs provided a reasonable explana- tion of how Banc of America’s actions were the proximate cause of the plaintiffs’ losses. 2

The trial court has not yet decided the veracity of the claim. Another similar case, against Janus Capital Group, Inc., was reversed and remanded by the U.S. Fourth Circuit Court of Appeals, allowing the case to proceed. 3 The U.S. appeals courts seem to be more willing than the district courts to allow cases to be heard against financial institutions, and this may put many companies at a higher risk of litigation than they had originally believed.

Common Law Accountant Liability to Clients Three primary types of liability are assessed to accountants under the common law: negli- gence, breach of contract, and fraud.

1 In re WorldCom, Inc., Sec. Litig., 2005 U.S. Dist. LEXIS 4193 (2005).

2 Pension Comm. of the Univ. of Montreal Pension Plan v. Banc of Am. Sec. LLC, 2009 U.S. App. LEXIS 12329 (2d Cir. 2009). 3 In re Mutual Funds Investment Litigation, 566 F.3d 111 (4th Cir. 2009).

LO1

Under common law, what is the duty of an

accountant to his or her clients?

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To see how internal controls relate to accountant liability, please see the Connecting to the Core

activity on the text Web site at www.mhhe.com/kubasek2e.

To see how state codes of ethics relate to accountant liability, please see the Connecting to the Core

activity on the text Web site at www.mhhe.com/kubasek2e.

258 Part 1 The Legal Environment of Business

ACCOUNTANT LIABILITY FOR NEGLIGENCE An accountant is liable for negligence if he or she fails to exercise the care of a compe- tent, reasonable professional and that failure causes loss or injury to the client. To prove negligence by the accountant, the plaintiff establishes the basic elements of negligence as discussed in Chapter 9: duty, breach of duty, causation, and damages.

At minimum, the duty of care of the accountant entails compliance with the generally accepted accounting principles (GAAP), established by the Financial Accounting Stan- dards Board (FASB), and the generally accepted auditing standards (GAAS), established by the American Institute of Certified Public Accountants (AICPA). While failure to com- ply with GAAP and GAAS will almost certainly constitute a breach of duty, compliance does not automatically mean the duty of care has been met. In some circumstances, a reasonable, competent accountant would do more than GAAP or GAAS requires. Also, sometimes a state statute or judicial opinion may impose additional legal requirements on accountants beyond GAAP and GAAS.

Generally, unless engaged to detect fraud, an accountant is not a fraud detector unless the fraud is uncovered in the course of exercising reasonable care and skill. An accoun- tant is, likewise, not required to have perfect judgment; she or he will not be held liable simply for errors in judgment that were made in good faith while operating in accordance with GAAP and GAAS. Nonetheless, an accountant who fails to meet these standards or to detect fraud or misconduct that a normal audit would uncover may be held liable for negligence.

Failure to adhere to GAAS can have serious professional repercussions for accoun- tants. For example, John Goldberger, an accountant in Pennsylvania, lost the privilege

of practicing before the SEC because he negligently performed an audit, fail- ing to live up to professional standards and identify fraud. The SEC argued that Goldberger (1) failed to obtain sufficient competent evidence to afford a reasonable basis for his firm’s opinion on the issuer’s financial statements; (2) failed to properly assess whether the issuer’s financial statements were fairly presented in conformity to generally accepted accounting principles; and (3) failed to exercise due professional care in the performance of an audit. 4

When faced with a charge of negligence, an accountant has several defenses. First, the accountant can deny failing to meet the professional standards. Second, regard- less of such failure, an accountant can argue that the failure is not the cause of the client’s loss. Third, in a few states an accountant may argue contributory or comparative negli- gence (as discussed in Chapter 9, under “Defenses to Negligence”).

In addition to asserting a defense to a charge of negligence, accountants can also try to limit their liability. After completing an audit, they issue an opinion letter stating

their assessment of the audited firm. Usually, an unqualified opinion letter is issued. To avoid potential liability, the accountant may make a qualifi- cation or issue a disclaimer as part of the letter, expressing, for instance, doubt about the accuracy of the papers the client presented. Any qualifica- tions or disclaimers must be specific, because broad, general qualifications or disclaimers do not grant protection. Nor does a qualification or disclaimer protect an accountant from liability based on failure to discover fraudulent financial transactions that one properly applying GAAP and GAAS would have discovered.

4 Goldberger v. State Board of Accountancy, 833 A.2d 815 (2003).

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Chapter 11 Liability of Accountants and Other Professionals 259

On occasion, a business may hire an accountant to create an unaudited financial state- ment for some purpose. A financial statement is considered unaudited if no, or insubstan- tial, accounting procedures were used in the compilation of the document. Accountants are not liable for the contents of an unaudited financial statement. Nonetheless, an accountant can still be held liable if he or she fails to clearly mark the financial statement as being unaudited.

ACCOUNTANT LIABILITY FOR BREACH OF CONTRACT When hired to perform a task, the accountant enters into a contract called an engage- ment letter with the client that makes certain explicit and implicit promises. Explicitly, the accountant agrees to perform the contractual tasks. Implicitly, the accountant agrees to complete the work in a competent and professional manner according to professional standards (GAAP and GAAS). Failure to fulfill these explicit and implicit agreements can subject an accountant to liability based on breach of contract. (See Chapter 20 for discus- sion of breach of contracts.)

When an accountant breaches a contract, the client is entitled to recovery for dam- ages that include the cost of obtaining a different accountant and any reasonable and foreseeable damages related to the breach. Suppose Collin, an accountant, breaches his contract to perform an audit for Isis, and as a result her business’s assets drop in value. Isis is entitled to recovery for the cost of hiring another accountant as well as for the loss in value of her assets, which occurred because Collin breached his contract with her.

An accountant who engages in a material breach of contract is not entitled to com- pensation for work completed. However, if the contract is substantially performed and the breach is therefore immaterial, the accountant may be entitled to the full amount of the contractually agreed-on fee minus the amount of damages caused by the breach.

ACCOUNTANT LIABILITY FOR FRAUD An accountant is liable to his or her client for fraud when all the following have occurred:

1. The accountant misrepresented a material fact.

2. The accountant acted with the intent to deceive.

3. The client justifiably relied on the misrepresentation.

4. The client suffered an injury by relying on the fraudulent information.

An accountant who commits fraud is liable to those parties he or she reasonably should have foreseen would be injured through a justifiable reliance on the fraudulent information.

Accountants may be held liable for actual fraud or constructive fraud, depending on the circumstances. Actual fraud exists when the accountant’s actions meet the above cri- teria. Constructive fraud is fraud without fraudulent intent—a plaintiff must prove that the accountant was grossly negligent in performing his or her duties. Evidence of reckless disregard for duty and professional standards can help establish gross negligence and, thus, constructive fraud. Accountants found liable for fraud can be assessed compensatory, as well as punitive, damages. Over the last few years, plaintiffs have been successful in bring- ing fraud suits against accountants under the Racketeer Influenced and Corrupt Organiza- tions (RICO) Act, discussed in Chapter 7.

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Legal Principle: An accountant can be held liable for malpractice under any of three different theories of liability: negligence, breach of duty, or fraud.

Common Law Accountant Liability to Third Parties An important issue in accountant liability that varies by state is whether third parties have any claim against an accountant on the basis of their reliance on negligently prepared financial statements. Third-party liability, as decided by the states, falls into three general groupings: (1) privity or near-privity (the Ultramares rule), (2) foreseen users and classes of users (the Restatement rule), and (3) reasonably foreseeable users. Third-party liability was the focus of the most famous case of accountant legal liability, Ultramares v. Touche,5 discussed below.

LIABILITY BASED ON PRIVITY OR NEAR-PRIVITY (THE ULTRAMARES RULE) In Ultramares v. Touche, Justice Benjamin Cardozo, writing for the highest state court in New York, took a narrow view of which third parties were permissible plaintiffs. Con- cerned that a more liberal rule would subject accountants to a liability of “an indeter- minate amount, for an indeterminate time, to an indeterminate class,” Cardozo held an accountant liable in negligence only to those with whom he or she had privity of contract, meaning the client and anyone for whose “primary benefit” the accounting statements were prepared.

The New York courts have fundamentally continued the Ultramares approach by requiring the accountant’s awareness of the particular use for his or her work product, known reliance on the work product by an identified third party, and conduct by the accountant recognizing his or her awareness of such reliance. This is the near-privity, or primary-benefit, test, and only a few states utilize it because it is viewed as too restrictive. The near-privity requirement was appended to the original privity require- ment in the 1985 New York case Credit Alliance Corp. v. Arthur Andersen & Co. (see Case 11-1).

LO2

Under common law, what is the duty of an accountant to third parties?

5 255 N.Y. 170 (1931).

Liability of Accountants to Third Parties in Canada

As in the United States, in Canada the common law holds accoun- tants liable for negligence in carrying out their duties. The accoun- tant’s duty of care to clients is established by the contractual relationship. What the duty of care should be to nonclients has been a controversial issue, especially regarding a nonclient’s reliance on an auditor’s report.

Under common law in Canada, plaintiffs must prove they rea- sonably relied on an auditor’s report to their detriment. However, in some provinces, securities laws are now providing an important exception for misrepresentations made in a prospectus distributed

COMPARING THE LAW OF OTHER COUNTRIES

by an issuer of securities. The Ontario Securities Act gives purchas- ers of securities in the primary market a right of action for damages against auditors for misrepresentations in their reports, opinions, or statements included in or referred to in the prospectus with the auditors’ filed consent. Purchasers need not prove they relied on the misrepresentation. In 2005, the Ontario Securities Act was amended to expand auditors’ statutory liability to include misrep- resentations in secondary-market disclosures made with the audi- tors’ written consent.

In Quebec, a plaintiff who can prove fault, damage, and a causal link between the two has sufficient grounds for a court to hold the accountant liable.

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Before 1978, Credit Alliance had provided financing to L. B. Smith, Inc., of Virginia, a capital-intensive enterprise that regularly required financing. During 1978, Credit Alli- ance advised Smith that as a condition to extending addi- tional major financing, it would insist upon examining an audited financial statement. Accordingly on two separate occasions Smith provided Credit Alliance with its consoli- dated financial statements, covering itself and its subsidiar- ies. These statements contained an auditor’s report prepared by Arthur Andersen, stating it had examined the statements in accordance with generally accepted auditing standards (“GAAS”) and found them to fairly reflect the financial posi- tion of Smith in conformity with generally accepted account- ing principles (“GAAP”). In reliance upon the statements, Credit Alliance provided substantial amounts in financing to Smith.

In 1980, Smith filed a petition for bankruptcy. By that time, Smith had already defaulted on several millions of dol- lars of obligations to Credit Alliance. In August 1981, Credit Alliance sued for damages lost on its outstanding loans to Smith, claiming both negligence and fraud by Andersen in the preparation of its audit reports. The complaint alleges Andersen knew, should have known, or was on notice that the certified statements were being utilized by Smith to induce companies such as Credit Alliance to make credit available. It is also alleged Andersen knew or recklessly dis- regarded facts that indicated the certified statements were misleading.

Andersen filed a motion to dismiss the complaint. The court concluded Credit Alliance fell within the exception to the general rule that requires privity to maintain an action against an accountant for negligence. Andersen appealed.

JUDGE JASEN: In the seminal case of Ultramares Corp. v Touche (255 NY 170), this court, speaking through the opinion of Chief Judge Cardozo more than 50 years ago, disallowed a cause of action in negligence against a public accounting firm for inaccurately prepared financial statements which were relied upon by a plaintiff having no contractual privity with the accountants. This court distinguished its holding from Glanzer v Shepard (233 NY 236), a case decided in an opinion also written by Cardozo nine years earlier. We explained that in Glanzer, an action in negligence against public weighers had been

permitted, despite the absence of a contract between the parties, because the plaintiff’s intended reliance, on the information directly transmitted by the weighers, created a bond so closely approaching privity it was, in practical effect, virtually indistinguishable there from. This court has subsequently reaffirmed its holding in Ultramares which has been, and continues to be, much discussed and analyzed by the commentators and by the courts of other jurisdictions. This appeal now provides us with the opportunity to re-examine and delineate the principles enunciated in both Ultramares and Glanzer. Inasmuch as we believe a relationship “so close as to approach that of privity” (255 NY, at pp 182–183) remains valid as the predicate for imposing liability upon accountants to non- contractual parties for the negligent preparation of finan- cial reports, we restate and elaborate upon our adherence to that standard today.

The critical distinctions between the two cases were highlighted in Ultramares where we explained:

In Glanzer v. Shepard .  .  . [the certificate of weight], which was made out in duplicate, one copy to the seller and the other to the buyer, recites that it was made by order of the former for the use of the latter. .  .  . Here was something more than the rendition of a service in the expectation that the one who ordered the certificate would use it there- after in the operations of his business as occasion might require. Here was a case where the transmis- sion of the certificate to another was not merely one possibility among many, but the “end and aim of the transaction,” as certain and immediate and deliberately willed as if a husband were to order a gown to be delivered to his wife, or a telegraph company, contracting with the sender of a mes- sage, were to telegraph it wrongly to the damage of the person expected to receive it. .  .  . The inti- macy of the resulting nexus is attested by the fact that after stating the case in terms of legal duty, we went on to point out that .  .  . we could reach the same result by stating it in terms of contract. .  .  . The bond was so close as to approach that of priv- ity, if not completely one with it. Not so in the case at hand [i.e., Ultramares ]. No one would be likely to urge that there was a contractual relation, or even

CREDIT ALLIANCE CORP. v. ARTHUR ANDERSEN & CO. COURT OF APPEALS FOR NEW YORK 65 N.Y.2D 536; 483 N.E.2D 110; 493 N.Y.S.2D 435; 1985 N.Y. LEXIS 15157 (1985)

CASE 11-1

261

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[continued]

Glanzer and White, but, rather, they are intended to preserve the wisdom and policy set forth therein.

In the appeals we decide today, application of the forego- ing principles presents little difficulty. The facts as alleged by Credit Alliance fail to demonstrate the existence of a rela- tionship between the parties sufficiently approaching priv- ity. Though the complaint and supporting affidavit do allege Andersen specifically knew, should have known or was on notice that Credit Alliance was being shown the reports by Smith, Andersen’s client, in order to induce their reliance thereon, nevertheless, there is no adequate allegation of either a particular purpose for the reports’ preparation or the prerequisite conduct on the part of the accountants. While the allegations state Smith sought to induce plaintiffs to extend credit, no claim is made Andersen was being employed to pre- pare the reports with that particular purpose in mind. More- over, there is no allegation Andersen had any direct dealings with Credit Alliance, had specifically agreed with Smith to prepare the report for Credit Alliance’s use or according to Credit Alliance’s requirements, or had specifically agreed with Smith to provide Credit Alliance with a copy or actually did so. Indeed, there is simply no allegation of any word or action on the part of Andersen directed to Credit Alliance, or anything contained in Andersen’s retainer agreement with Smith which provided the necessary link between them. We therefore dismiss the charges against Arthur Andersen.

REVERSED.

one approaching it, at the root of any duty that was owing from the [accountants] now before us to the indeterminate class of persons who, presently or in the future, might deal with the [accountants’ client] in reliance on the audit. In a word, the service ren- dered by the defendant in Glanzer v. Shepard was primarily for the information of a third person, in effect, if not in name, a party to the contract, and only incidentally for that of the formal promisee. ( Ultramares Corp. v Touche, supra, at pp 182–183 [emphasis added].)

Upon examination of Ultramares and Glanzer and our recent affirmation of their holdings in White, certain criteria may be gleaned. Before accountants may be held liable in negligence to noncontractual parties who rely to their det- riment on inaccurate financial reports, certain prerequisites must be satisfied: (1) the accountants must have been aware that the financial reports were to be used for a particular pur- pose or purposes; (2) in the furtherance of which a known party or parties was intended to rely; and (3) there must have been some conduct on the part of the accountants linking them to that party or parties, which evinces the accountants’ understanding of that party or parties’ reliance. While these criteria permit some flexibility in the application of the doc- trine of privity to accountant liability, they do not represent a departure from the principles articulated in Ultramares,

Legal Principle: Under the Ultramares doctrine, an accountant will be held liable in negligence only to those with whom he or she had privity of contract, meaning the cli- ent and anyone for whose “primary benefit” the accounting statements were prepared.

LIABILITY TO FORESEEN USERS AND FORESEEN CLASS OF USERS (THE RESTATEMENT RULE) About half the states have adopted a more expansive approach to accountant liability for negligence to third parties. The Restatement test was codified in the Restatement (Second) of Torts. It holds an accountant liable to known third-party users of the accountant’s work

Think about the judge’s reasoning leading to the conclu- sion that the relationship between Arthur Andersen & Co. and Credit Alliance was not enough to establish privity. Is there any additional information that you would have liked to know to help decide whether Andersen acted negligently?

ETHICAL DECISION MAKING CRITICAL THINKING

What are the values associated with requiring that the rela- tionship between Andersen and Credit Alliance be enough to establish privity? What values would have been in conflict when making the decision? Do you think the values pro- moted by the decision are appropriate for the situation? Why or why not?

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Chapter 11 Liability of Accountants and Other Professionals 263

product and also to those in the limited class whose reliance on the work the accountant specifically foresaw.

The rationale behind the Restatement test is simple: Much of what accountants do is prepare work for parties who are not their clients; therefore, it makes sense for them to owe a duty to these intended receivers. The test extends liability to those people, or the class of people, the accountant foresaw or should have foreseen as being the recipients of and rely- ing on his or her work. Despite the expansion, as Section 552 of the Restatement of Torts explains, accountant liability is not extended to potential investors and the general public.

Assume a client has an accountant certify financial statements as part of a loan appli- cation of Third State Bank. The accountant, aware of this purpose, negligently audits the statements, which overvalue inventory and undervalue liabilities. The client uses the finan- cials not only at Third State Bank but also at Federal State Bank, which makes the loan. When the client defaults on the loan because of too much indebtedness, Federal State can properly sue the accountant for negligence because the bank’s use of the financial state- ments for loan considerations was foreseeable, even if the specific institution was not. The Restatement test is a middle-ground test between the very restrictive, pro-accountant primary-benefit test represented by Ultramares and the liability-expanding reasonably foreseeable users test discussed next.

Legal Principle: Under the Restatement test, an accountant is liable to known third-party users of the accountant’s work product and also to those in the limited class whose reliance on the work the accountant specifically foresaw.

LIABILITY TO REASONABLY FORESEEABLE USERS Very few states have adopted the general negligence standard of accountant third-party liability called the reasonably foreseeable users test. This test holds an accountant liable to any third party who was or should have been foreseen as a possible user of the accountant’s work product and who did in fact use and rely on that work product for a proper business purpose. The justification for this expanded accountant liability was succinctly stated by the New Jersey Supreme Court in a case subsequently overruled by statute:

The responsibility of a public accountant is not only to the client who pays his fee, but also to investors, creditors, and others who may rely on the financial statements which he certifies. . . . The auditor’s function has expanded from that of a watchdog for management to an independent evaluator of the adequacy and fairness of financial statements issued by management to stockholders, creditors and others. 6

The court justified its protection of reasonably foreseeable users on the policy grounds that this approach would encourage accountants to be more careful and thorough and the cost of the increased liability risk, through insurance or otherwise, could be spread among all the accountant’s clients. Courts used similar reasoning as justification for imposing strict product liability.

Legal Principle: Under the reasonably foreseeable users test, an accountant is lia- ble to any third party who was or should have been foreseen as a possible user of the accountant’s work product and who did in fact use and rely on that work product for a proper business purpose.

The Bily decision excerpted in Case 11-2 contains a good discussion of the three theo- ries of the accountant’s legal liability to third parties.

6 Rosenbloom, Inc. v Adler, 461 A.2d 138 (1983).

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scenario occurred, but plaintiff also alleged the auditor knew plaintiff was the client’s principal lender and com- municated directly and frequently with plaintiff regarding its continuing audit reports. The court dismissed plaintiff’s negligence claim in the first case, but sustained the claim in the second.

The New York court promulgated the following rule for determining auditor liability to third parties for negligence:

Before accountants may be held liable in negligence to noncontractual parties who rely to their detri- ment on inaccurate financial reports, certain pre- requisites must be satisfied: (1) the accountant must have been aware that the financial reports were to be used for a particular purpose or purposes; (2) in the furtherance of which a known party or parties was intended to rely; and (3) there must have been some conduct on the part of the accountants linking them to party or parties, which evinces the accountants’ understanding of that party or parties reliance. ( Credit Alliance v. Arthur Andersen & Co., supra, 483 N.E. 2d at p. 118)

Discussing the application of its rule to the cases at hand, the court observed the primary, if not exclusive, “end and aim” of the audits in the second case was to satisfy the lender. The auditor’s direct communications and personal meetings [with the lender] result[ed] in a nexus between them sufficiently approaching privity. In contrast, in the first case, although the complaint did not allege the auditor knew or should have known of the lender’s reliance on its reports: “There was no allegation of either a particular purpose for the reports’ preparation or the prerequisite conduct on the part of the accountants . . . [nor] any allegation [the auditor] had any direct dealings with plaintiffs, and agreed with [the client] to prepare the report for plaintiffs’ use or according to plaintiffs’ requirements, or had specifically agreed with [the client] to provide plaintiffs with a copy [of the report] or actually did so.”

B. Foreseeability Arguing that accountants should be subject to liability to third persons on the same basis as other tortfeasors, Justice Howard Wiener advocated rejection of the rule of Ultra- mares in a 1983 law review article. In its place, he proposed a rule based on foreseeability of injury to third persons. Crit- icizing what he called the “anachronistic protection” given

Plaintiffs purchased stock warrants (rights to purchase) for blocks of Osborne Computer Corp., the manufacturer of the first mass-market portable personal computer. Because of inability to produce a new product line with sufficient speed and the entry of IBM-compatible software into the personal computer market, Osborne filed for bankruptcy shortly after the warrants were issued. Plaintiffs thus received nothing for their investment.

Arthur Young had audited Osborne’s financial statements for the two years preceding the issuance of the warrants and had issued unqualified opinions on their fairness and compliance with Generally Accepted Accounting Principles. Plaintiffs sued Arthur Young for fraud, negligence, and neg- ligent misrepresentation. After a thirteen-week trial in which the plaintiffs’ expert witness alleged forty deficiencies in Arthur Young’s audit and its noncompliance with Generally Accepted Auditing Standards, the jury found Arthur Young liable for professional negligence. Arthur Young appealed based on the jury instructions regarding its liability to third parties.

CHIEF JUSTICE LUCAS: The AICPA’s professional standards refer to the public responsibility of auditors:

A distinguishing mark of a profession is acceptance of its responsibility to the public. The accounting profession’s public consists of clients, credit grant- ors, governments, employers, investors, the busi- ness and financial community, and others who rely on the objectivity and integrity of certified public accountants to maintain the orderly functions of commerce. This reliance imposes a public inter- est responsibility on certified public accountants. [2 AICPA Professional Standards (CCH 1988) §53.01]

[The court then discussed different states’ approaches to the issue of accountant liability to third parties.]

A. Privity of Relationship The New York Court of Appeals restated the law in light of Ultramares, White v. Guarente, and other cases in Credit Alliance v. Arthur Andersen & Co. (1985) 65 N.Y. 2d 536 [493 N.Y.S. 2d 435, 483 N.E. 2d 110]. Credit Alliance sub- sumed two cases with different factual postures: in the first case, plaintiff alleged it loaned funds to the auditor’s client in reliance on audited financial statements which overstated the client’s assets and net worth; in the second, the same

BILY v. ARTHUR YOUNG & CO. SUPREME COURT OF CALIFORNIA 834 P.2D 745 (1992)

CASE 11-2

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[continued]

Under the Restatement rule, an auditor retained to con- duct an annual audit and to furnish an opinion for no par- ticular purpose generally undertakes no duty to third parties. Such an auditor is not informed

of any intended use of the financial statements; but  .  .  . knows that the financial statements, accompanied by an auditor’s opinion, are custom- arily used in a wide variety of financial transac- tions by the [client] corporation, and that they may be relied upon by lenders, investors, shareholders, creditors, purchasers, and the like, in numerous possible kinds of transactions. [The client corpo- ration] uses the financial statements and accom- panying auditor’s opinion to obtain a loan from [a particular] bank. Because of [the auditor’s] negligence, he issues an unqualifiedly favourable opinion upon a balance sheet that materially mis- states the financial position of [the corporation] and through reliance upon it [the bank] suffers pecuniary loss.

Consistent with the text of section 552, the authors con- clude: “[The auditor] is not liable to [the bank].”

Analysis of Auditor’s Liability to Third Persons for Audit Opinions

D. Negligence In permitting negligence liability to be imposed in the absence of privity, we outlined the factors to be considered in making such a decision: “The determination whether in a specific case the defendant will be held liable to a third person not in privity is a matter of policy and involves the balancing of various factors, among which are the extent to which the transaction was intended to affect the plaintiff, the foreseeability of harm to him, the degree of certainty that the plaintiff suffered injury, the moral blame attached to the defendant’s conduct, and the policy of preventing future harm.”

Viewing the problem before us in light of the factors set forth above, we decline to permit all merely foresee- able third party users of audit reports to sue the auditor on a theory of professional negligence. Our holding is pre- mised on three central concerns: (1) Given the secondary “watchdog” role of the auditor, the complexity of the pro- fessional opinions rendered in audit reports, and the dif- ficult and potentially tenuous causal relationships between audit reports and economic losses from investment and credit decisions, the auditor exposed to negligence claims from all foreseeable third parties faces potential liability far out of proportion to its fault; (2) the generally more sophisticated class of plaintiffs in auditor liability classes (e.g., business lenders and investors) permits the effective use of contract rather than tort liability to control and adjust

to accountants by the traditional rules limiting third person liability, he concluded:

Accountant liability based on foreseeable injury would serve the dual functions of compensation for injury and deterrence of negligent conduct. More- over, it is a just and rational judicial policy that the same criteria govern the imposition of negligence liability, regardless of the context in which it arises. The accountant, the investor, and the general pub- lic will in the long run benefit when the liability of the certified public accountant for negligent misrepresentation is measured by the foreseeability standard.

Under the rule proposed by Justice Wiener, “[f]oreseeability of the risk would be a question of fact for the jury to be dis- turbed on appeal only where there is insufficient evidence to support the finding.”

C. The Restatement: Intent to Benefit Third Persons Section 552 of the Restatement Second of Torts covers “Information Negligently Supplied for the Guidance of Oth- ers.” It states a general principle that one who negligently supplies false information “for the guidance of others in their business transactions” is liable for economic loss suffered by the recipients in justifiable reliance on the information. But the liability created by the general principle is expressly lim- ited to loss suffered: “(a) by the person or one of a limited group of persons for whose benefit and guidance he intends to supply the information or knows that the recipient intends to supply it, and (b) through reliance upon it in a transaction that he intends the information to influence or knows that the recipient so intends or in a substantially similar transaction.” To paraphrase, a supplier of information is liable for negli- gence to a third party only if he or she indents to supply the information for the benefit of one or more third parties in a specific transaction or type of transaction identified to the supplier.

The authors of the Restatement Second of Torts offer sev- eral variations on the problem before us as illustrations of sec- tion 552. For example, the auditor may be held liable to a third party lender if the auditor is informed by the client that the audit will be used to obtain a $50,000 loan, even if the specific lender remains unnamed or the client names one lender then borrows from another. However, there is no liability where the auditor agrees to conduct the audit with the express under- standing the report will be transmitted only to a specified bank and it is then transmitted to other lenders. Similarly, there is no liability when the client’s transaction (as represented to the auditor) changes so as to increase materially the audit risk, e.g., a third person originally considers selling goods to the client on credit and later buys a controlling interest in the cli- ent’s stock, both in reliance on the auditor’s report.

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audit services. Other persons may not recover on a pure negligence theory.

There is, however, a further narrow class of persons who, although not clients, may reasonably come to receive and rely on audit reports and whose existence constitutes a risk of audit reporting that may fairly be imposed on the auditor. Such persons are specifically intended beneficiaries of the audit report who are known to the auditor and for whose benefit it renders the audit report. While such persons may not recover on a general negligence theory, we hold they may . . . recover on a theory of negligent misrepresentation.

REVERSED.

the relevant risks through “private ordering”; and (3) the asserted advantages of more accurate auditing and more efficient loss spreading relied upon by those who advo- cate a pure foreseeability approach are unlikely to occur; indeed, dislocations of resources, including increased expense and decreased availability of auditing services in some sectors of the economy, are more probable conse- quences of expanded liability.

For the reasons stated above, we hold that an audi- tor’s liability for general negligence in the conduct of an audit of its client’s financial statements is confined to the client, i.e., the person who contracts for or engages the

Accountants’ and Clients’ Rights When an accountant and a client are engaged in a contract, certain legal rights and issues arise. Two of the most salient rights issues are working papers and accountant-client privilege.

WORKING PAPERS Legal issues involving rights to documents may arise when the audit is complete and a new set of documents, the working papers, has been created. Working papers are the various documents used and developed during an audit, including notes, calcula- tions, copies, memorandums, and other papers constituting the accountant’s work product.

After an audit, the accountant is the legal owner of the working papers. Accountants are advised to maintain all working papers because they can be used as evidence in negligence cases (to show competency of work product). Not only is it wise to keep working papers, but the Sarbanes-Oxley Act of 2002 requires keeping them, for five years starting with the end of the fiscal period in which the audit was conducted. Willful violation results in a fine, imprisonment up to 10 years, or both.

Although the accountant is the legal owner of the working papers, the informa- tion contained within them belongs to the client. Accordingly, the client has a right to access working papers on request. Also, because of the sensitive nature of their con- tents, an accountant may not disclose working papers unless (1) the client consents or (2) the court orders the documents. Improper disclosure of a client’s working papers is unethical.

If you were a justice on the supreme court of a state that had yet to decide which of the three rules to follow in determin- ing the extent of auditors’ liability to third parties, which would you adopt? Why?

ETHICAL DECISION MAKING CRITICAL THINKING

Which stakeholders would primarily benefit from each of the three alternatives?