SOLUTIONS MANUAL for Introduction to Business Law 6th Edition by Jeffrey Beatty, Susan Samuelson & P by StudyGuide

Chapter 1

INTRODUCTION TO LAW Unit 1 – The Legal Environment Chapter 1 – Introduction to Law* Chapter Overview Chapter Theme The principles discussed in this book are practical. Neither the book nor the course is a theoretical exercise. The law will affect students, regardless of their careers, whether they want it to or not. The more students understand the law, the more they can use it productively. Approaching the Teaching of Law Whether teaching in an undergraduate or MBA program students generally fall into one of four categories: (1) those who do not intend law as a career but approach the material with an open mind; (2) those in whom the course kindles a strong interest in law, who for the first time consider law as a career; (3) those who enter the course with a strong interest in law and plan to attend law school ; and (4) those who are in the course only because their program requires it. The instructor’s job is to try to engage students in all four categories. Students in categories (2) and (3) may be more willing to explore the nuances of legal principles and see connections between legal topics. Students in categories (1) and (4) may respond most favorably to practical applications of the law, such as understanding the law governing employment or landlord/tenant relationships.

Issues for Discussion Complexity It is often frustrating to students, citizens, and even lawyers that law is so complex. Anglo-American legal history consists, in part, of a clash of powerful, competing interests: property ownership, ethics, raw power, business practices, personal responsibility, social mores, and the need for predictability, to list a few. To understand the interplay of these forces is to understand why law is complicated. Ambiguity A related point is that many students—indeed, many non-lawyers—dislike the law’s ambiguity. They want to learn “the law” as a set of rules with unvarying application, and are uncomfortable with the “what if” scenarios through which lawyers learn to apply legal principles. Students must learn that law acquires meaning only through application. If students, especially those in categories (1) and (4) above, leave the course with greater understanding of why the law is ambiguous, why a lawyer’s first response to a question about the law is often “it depends,” then the instructor should consider it a success. Competing Interests From a newspaper article about a legal issue, students should identify two or more competing interests. In an article about tobacco litigation, they might compare the tobacco companies’ property interest in a profitable commodity, the companies’ obligation to divulge what they knew concerning nicotine, the personal responsibility of those who chose to smoke, the state’s interest in reducing medical costs, the *Case citations appear here; footnotes appear in text only.

Unit 1 The Legal Environment

companies’ right to free speech (advertising), the federal government’s interest in regulating smoking, and the state’s obligation to protect children. The more important the legal issue, the less likely there is a simple solution to make everyone happy. Experience with Lawyers If one is teaching graduate students or others who have actual business experience working with lawyers, it can be an excellent introduction to the course to elicit the pros and cons of those experiences. One fun way to do so is to ask students “why lawyers are great” and “why lawyers are frustrating.” Typical reasons given for “why lawyers are great:” “They help me avoid getting into trouble;” “They help to get me out of trouble;” and, “I can blame things on them.” Typical reasons given for “why lawyers are frustrating: “They are expensive;” “They make everything too complicated;” “They are slow;” “They don’t respond to my questions;” “They tell me what I don’t want to hear;” and, “They don’t know how to give “yes or no” answers.”

1-1 EXPLORING THE LAW The strong reach of the law touches nearly everything we do, especially at work. At work, a mid— level manager might face issues of harassment of a subordinate by a coworker (employment law), negotiating a contract with a game developer (contract law), researching to see whether similar games already exist which might diminish her ability to market the new game (intellectual property law), a worker who may be using drugs (constitutional law and employment law), potential liability for injury caused by an employee on drugs (tort law and agency law). Law is also essential. Every society of historical record had some legal system. Our legal system is largely based upon other English model, but many other societies contributed ideas. The law is intriguing. When a large verdict is rendered, people ask whether the jury’s decision was right? Did the jury react emotionally? Or perhaps the anger caused by terrible trauma should be a part of a court case.

1-1a Sources of Contemporary Law It would be nice if we could look up “the law” in one book, memorize it, and then apply it but the law is not that simple. Principles and rules of law come from many different sources. Why? We inherited a complex structure of laws from England. And ours is a nation born in revolution and created, in large part, to protect the rights of its people from the government. Federalism: A double-layered system of government, with the national and state governments each exercising important but limited powers. U.S. Constitution: The supreme law of the United States.

United States Constitution America’s greatest legal achievement was the writing of the U.S. Constitution. Any law that conflicts with the U.S. Constitution is void. The Federal Constitution establishes:

Branches of Government The Founding Fathers sought a division of government power, not wanting all power centralized in anyone. The Constitution divides legal authority into three pieces:

Chapter 1 Introduction to Law

Legislative power is the ability to create new laws; it is balanced by executive power of the veto and judicial power of interpretation and determination of validity. Article I creates Congress, comprised of a Senate and a House of Representatives. Executive power is the authority to enforce laws; it is balanced by the legislative power to override a veto and to impeach and the judicial power to interpret. Article II makes the president the Commanderin-Chief. Judicial power is the power to interpret laws and determine their validity; it is balanced by the executive power to appoint justices and legislative power to approve justice nominees. Congress can also amend the Constitution with the approval of the states. It is often every bit as important as the ability to create laws in the first place. For instance, the Supreme Court ruled that privacy provisions of the Constitution protect a woman’s right to abortion, although neither the word “privacy” nor “abortion” appears in the text of the Constitution.1 At times, courts void laws altogether. In 2016, the Supreme Court struck down a Texas law regulating abortion clinics and the doctors who worked in them. The Court found that those rules created an undue burden for Texas women by causing many clinics to close and making abortions unreasonably difficult to obtain.

Checks and Balances The authors of the Constitution also wanted to give each part of the government some power over the other two branches. They wanted to create a system that, without broad agreement, would tend towards inaction. The president can veto Congressional legislation. Congress can impeach the president. The Supreme Court can void laws passed by Congress. The president appoints judges, but they must be approved by the Senate. Congress can override the Supreme Court by amending the Constitution. The president and Congress influence the Supreme Court by controlling who is placed on the court in the first place. Many of these checks and balances will be examined in more detail later in the text.

Fundamental Rights The Constitution also grants many of our most basic liberties, generally found in the amendments to the Constitution. The First Amendment guarantees the rights of free speech, free press, and the free exercise of religion. The Fourth, Fifth, and Sixth protect the rights of any person accused of a crime. Other Amendments ensure that the government treats all people equally, and that it pays for any property it takes from a citizen.

Statutes Statute: A law created by a legislature. The Constitution gives to the Congress the power to pass laws on various subjects. A proposed law is called a bill; a bill created by a legislature that has become law is called a statute.

Common Law Stare decisis: The principle that precedent is binding on later cases. The collective body of court decisions throughout history comprise the common law. Judges of all courts below the Supreme Court will refer to previous cases (precedent) to rule on present cases. The principle that precedent is binding on later cases is called stare decisis, meaning, “let the decision 1

Unit 1 The Legal Environment

stand.” But note that precedent is binding only on lower courts, which can be quite beneficial. In 1896, the Supreme Court decided that segregation was legal under certain conditions.2 In 1954, faced with the same issue, the court changed its mind.3

Court Orders Sometimes judges issue court orders on a particular person or entity. This may be an order to do something or an order to refrain from some action.

Administrative Law Administrative agencies are created by Congress or by an order of the President. Their purpose is to carry out the day-to-day work of enforcing the statutes passed by Congress. Agencies have the power to create regulations, which are as binding as laws.

1-1b Classifications Criminal and Civil Law Criminal law: Concerns behavior so threatening that society prohibits it. Civil law: Regulates the rights and duties between parties. Criminal law concerns behavior so threatening that society outlaws it altogether. The government itself prosecutes the wrongdoer. The victim is not in charge of the case, although she may appear as a witness. The government will seek to punish the defendant with a prison sentence, a fine, or both. If there is a fine, the money goes to the state, not to the injured party. Civil law is different, and most of this book is about civil law. The civil law regulates the rights and duties between parties. It does not involve guilt or punishment, two legal concepts with which students are likely most familiar Chapter 6 addresses criminal law. Some conduct involves both civil and criminal law, as we will see in the Pub Zone case.

Law and Morality Law and morality are clearly different yet obviously related. Often the law duplicates what all of us would regard as a moral position. But we have had laws that we now clearly regard as immoral. Finally, there are legal issues where the morality is less clear. We have had laws that we now clearly regard as immoral. Seventy-five years ago, a factory owner could legally fire a worker for any reason at all, including, for example, her religion. Finally, there are legal issues where the morality is not so clear. Suppose you serve alcohol to a guest who becomes intoxicated and then causes an automobile accident, seriously injuring a pedestrian? Should you, the social host, be liable? This is an issue of tort liability which we will examine in Chapter 9. Students will have the opportunity to re=examine their own moral beliefs, when we cover Chapter 2 on ethics.

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Plessy v. Ferguson, 163 U.S. 537 (1896). Brown v. Board of Education of Topeka, 347 UJ.S. 483 (1954). © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1 Introduction to Law

1-1c Working with the Book’s Features Analyzing a Case A law case is the decision a court has made in a civil lawsuit or criminal prosecution. Cases are the heart of the law and an important part of this book. Reading them effectively takes practice. This chapter’s opening scenario is fictional, but the following real case involves a similar situation. Who can be held liable for the assault?

Analysis Plaintiff: The party who is suing. Defendant: The party being sued. Holding: A court’s decision Reverse: To declare the lower court’s ruling wrong and voice Remand: To send a case back down to a lower court. Affirm: To uphold a lower court’s ruling.

The case name is “Kuehn v. Pub Zone.” Karl Kuehn is the plaintiff, who is suing. The Pub Zone is the defendant, and is being sued. The next line gives the legal citation, which indicates where to find the case in a law library. We explain in the footnote how to locate a book if you plan to do research.4

Case: Kuehn v Pub Zone, C364 N.J. Super, 301, Court of New Jersey, 2003 Facts: Maria Kerkoulas owned the Pub Zone bar, frequented by many motorcycle gangs, and knew from her own experience and conversations with police that some of the gangs, including the Pagans, were dangerous and prone to attack customers for no reason. Kerkoulas posted a sign prohibiting any motorcycle gangs from entering the bar while wearing “colors,” that is, gang insignia. Based on her experience, she believed that gangs without their colors were less prone to violence. Rhino, Backdraft, and several other Pagans pushed past the bouncer wearing colors and approached the bar. Although she saw their colors, Kerkoulas served them one drink. They later moved towards the back of the pub, and Kerkoulas believed they were departing. In fact, they followed a customer named Karl Kuehn to the men’s room, where without any provocation they savagely beat him, causing serious injuries. Kuehn sued the Pub Zone. The jury awarded him $300,000 in damages. The trial court judge overruled the jury’s verdict and granted judgment for the Pub Zone, meaning that the tavern owed nothing. The judge ruled that the pub’s owner could not have foreseen the attack on Kuehn, and had no duty to protect him from an outlaw motorcycle gang. Kuehn appealed. Issue: Did the Pub Zone have a duty to protect Kuehn from the Pagans’ attack?

If you want to do legal research, you need to know where to find particular legal decisions. A citation is the case‟s “address,” which guides you to the official book in which it is published. [See the text for the entire footnote.] © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

Holding: Yes. Whether a duty exists depends upon an evaluation of a number of factors including the nature of the underlying risk of harm, the opportunity and ability to exercise care to prevent the harm, the comparative interests of, and the relationships between or among the parties, and, based on considerations of public policy and fairness, the societal interest in the proposed solution. Since the possessor [of a business] is not an insurer of the visitor’s safety, he is ordinarily under no duty to exercise any care until he knows or has reason to know that the acts of the third person are occurring, or are about to occur. He may, however, know or have reason to know, from past experience, that there is a likelihood of conduct on the part of third persons in general which is likely to endanger the safety of the visitor, even though he has no reason to expect it on the part of any particular individual. The totality of the circumstances presented in this case give rise to a duty on the part of the Pub Zone to have taken reasonable precautions against the danger posed by the Pagans as a group. There was no reason to suspect any particular Pagan of violent conduct, but Kerkoulas knew the gang collectively had engaged in random violence. Thus, Kerkoulas had knowledge, as the result of past experience and from other sources, that there was a likelihood of conduct on the part of third persons in general that was likely to endanger the safety of a patron at some unspecified future time. A duty to take precautions against the endangering conduct thus arose. Question: What kind of case is this, civil or criminal? Answer: Civil. Question: What is the difference? Answer: In a civil suit, one party is suing the other. In a criminal prosecution, the government is seeking to punish someone for conduct that society will not tolerate. Question: Who is the plaintiff (the party who is suing) and who the defendant (the party being sued)? Answer: Kuehn is the plaintiff and Pub Zone is the defendant. Question: What is the key issue in this civil suit? Answer: Whether Pub Zone had a duty to protect Kuehn. Question: Why does Pub Zone claim it had no duty to Kuehn? Answer: Pub Zone argued that the attack was unforeseeable and that Pub Zone was not responsible for guaranteeing the personal safety of its patrons. Question: What did the trial court conclude? Answer: Although the jury found in favor of Kuehn and awarded him $300,000 in damages, the trial court judge overruled the verdict and damage award and granted judgment for Pub Zone. Question: What did the appellate court decide? Answer: That Pub Zone did have a duty to protect Kuehn. The court reinstated the jury verdict and damage award. Question: Why did the court decide that Pub Zone had a duty? Answer: Kerkoulas’ sign prohibiting patrons from wearing gang colors, and the Pub Zone’s practice of calling police when patrons violated this rule, showed the Pub’s awareness of the risk of violence of such gangs. Kerkoulas also knew that the Pagans had participated in past acts of random violence. Thus, Pub Zone had a duty to take precautions against such violence. Question: What should Pub Zone have done to satisfy its duty?

Chapter 1 Introduction to Law

Answer: Enforce its existing rules. Despite Pub Zone’s policy against gang colors, Kerkoulas allowed the Pagans to remain in the bar and drink. Train bouncers and all other staff to be aware of patrons from whom such violence is foreseeable. If such patrons refuse to leave the club when asked, Pub Zone should be consistent in calling the police to address the problem.

Exam Strategy This feature gives the student practice analyzing cases the way lawyers do – and the way they must on tests. Law exams are different from most others because you must determine the issue from the facts provided. See below for an example.

You Be the Judge Many cases involve difficult decisions for juries and judges. Often both parties have legitimate, opposing arguments. Most chapters will have a feature called, “You Be the Judge,” in which the facts of a case are presented, but not thte court’s holding. We leave it to the students to debate and decide which position is stronger, or add their own arguments to those given.

You Be the Judge: Del Lago Partners, Inc. v. Smith5 Note: There are two reasons for using this case. First is to introduce students to the “You Be the Judge” feature. There is one such case in almost every chapter. The text provides the facts and issue and then, in place of the court’s holding, gives competing arguments for the two sides. The text’s authors wrote the arguments, often based on majority and/or dissenting opinions in the case. Since students do not have the “answer,” they are forced to think for themselves. An instructor can use these cases in many ways: Divide the class in two and assign each side to argue for one of the parties. Have students vote on the outcome before and after revealing the court’s holding. 5

Unit 1 The Legal Environment

Require students to prepare a short paper giving their own “holding.” Have one or two students argue each side before the “court” (the professor and remaining students). The second reason for using this case is that it builds on the issue of negligence introduced in the Kuehn v Pub Zone case, above. This time, the court confronts not only the question of whether a duty is owed, but also whether the injury was foreseeable. Facts: It was late night at the Del Lago hotel bar. Bradley Smith and 40 of his closest fraternity brothers had been partying there for hours. Around midnight, guests from a wedding party made a rowdy entrance. One of Smith’s friends brashly hit on a young woman in the wedding party, infuriating her date. Verbal confrontations ensued. For the next 90 minutes, the fraternity members and the wedding party exchanged escalating curses and threats, while the bartender looked on and served drinks. Until… the inevitable occurred. Punches were thrown. Before Smith knew it, someone placed him in a headlock and threw him against a wall. As dozens fought, the bar manager fumbled to call hotel security, but realized he did not even have the phone number. When security eventually arrived, the free-for-all had ended … and Smith had suffered a fractured skull, among other serious injuries. Smith sued Del Lago for negligence. He argued that the hotel was liable because it knew that the brawl was imminent and could have easily prevented it by calling security or ejecting the angry drunks. The lower court agreed. The hotel appealed. You Be the Judge: Did the hotel have a duty to protect Smith from imminent assault? Argument for the Plaintiff-Appellant (Hotel): Your honors, my client did nothing wrong. The Del Lago staff did not create the danger. Smith was a grown man who drank voluntarily and joined the right knowing that he was at risk for injury. The hotel did not owe a duty to someone who engages in such reckless behavior. And let’s face it: Accidents happen, especially at a bar late at night. Moreover, a bar owner cannot possibly monitor the words exchanged between patrons that may lead to a fight. The law has developed sensibly. People are left to decide for themselves whether to jump into a dangerous situation. Smith made his decision, and Del Lago should not be held accountable for his poor choices. Argument for the Defendant-Appellee (Smith): Your honors, Del Lago had a moral and legal duty to protect its guests from this obvious and imminent assault. When a business has knowledge of something that poses an unreasonable risk of harm to its patrons, it has a duty to take reasonable action to reduce or eliminate that risk. The hotel knew that a fight was going to break out, and should have taken the proper precautions to protects guests form that foreseeable danger. During the 90 minutes of escalating tensions, the bar staff continued to serve alcohol, ignored the blatant risks, and did not even call security. When the bar staff finally decided to call for help,, they did not even have the number. It was too little, too late. The establishment had already breached its duty of care to protects its guests from foreseeable harm. Holding: The court of appeals affirmed the judgment of the Court of Appeals, upholding the decision of the jury. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1 Introduction to Law

Question: Did the hotel owe a duty to the patron who was injured? Answer: Yes, in this case, the hotel owed a duty to the patron because it had reason to know that an imminent risk of harm existed. Question: How did it breach this duty? Answer: For an hour and a half, the hotel knowingly served rowdy and drunk rivals who were engaged in repeated and aggressive verbal and physical confrontations, which resulted in a full-scale brawl The staff observed, but did nothing to reduce the hostility, which was unreasonable in the circumstances. Injury was foreseeable. Question: What is the key issue in this civil suit? Answer: The key issue is whether the injury to a patron was foreseeable. Question: What factors impose a duty of care upon such an establishment? Answer: When the establishment knows or has reason to know of an unreasonable risk of harm. In this case, the hotel had actual and direct knowledge that a violent brawl was imminent between drunk, belligerent patrons, and had ample time and means to defuse the situation. Question: Did the hotel breach its duty? Answer: Yes, despite escalating verbal disputes and shoving between the groups over the course of 90 minutes, the hotel took no action, continued to serve drinks and did not call security until it was too late.

Chapter Conclusion We depend upon the law to give us a stable nation and economy, a fair society, and a safe place to live and work. But while law is a vital tool for crafting the society we want, there are no easy answers about how to create it. In a democracy, we all participate in the crafting. A working knowledge of the law can build a successful career – and a solid democracy.

Matching Questions Match the following terms with their definitions: _____A. Statute _____B. Administrative agencies _____C. Common law legislature _____D. Stare decisis _____E. United States Constitution

1. Law created by judges 2. Let the decision stand 3. A law passed by Congress or a state 4. The supreme law of the land 5. The IRS, the EPA, the FCC, the SEC

Answers: A. Is 3 B. Is 5 C. Is 1 D. Is 2 E. Is 4

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Circle T for true or F for false: (Correct answers are bolded) 1. T F The idea that current cases must be decided based on earlier cases is called legal positivism. 2. T F Civil lawsuits are brought to court by the injured party, but criminal cases must be prosecuted by the government. 3. T F Congress established the federal government by passing a series of statutes. 4. T F The federal government has three branches: executive, legislative, and administrative. 5. T F Law is different from morality, but the two are closely linked.

Multiple Choice Questions 1. More U.S. law originates from one country than from any other. Which country? A. France B. England C. Germany D. Spain E. Canada Answer: B. 2. Under the United States Constitution, power that is not expressly given to the federal government is retained by: A. The courts B. The Congress C. The Founders D. The states and the people E. International treaty Answer: D 3. Judges use precedent to create what kind of law? A. Common law B. Statutes C. National Law D. Local law E. Empirical law Answer: A 4. If Congress creates a new statute with the president’s support, it must pass the idea by a ____________ majority vote in the House and the Senate. If the President vetoes a proposed statute and the Congress wishes to pass it without his support, the idea must pass by a ____________ majority vote in the House and Senate. A. simple; simple B. simple; two-thirds C. simple; three-fourths D. two-thirds, three-fourths © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1 Introduction to Law

Answer: B. – >50% to pass initially (a simple majority), 2/3 if an override is necessary.

5. What part of the Constitution addresses most basic liberties? A. Article I B. Article II C. Article III D. The amendments Answer: D

Case Questions 1. Union organizers at a hospital wanted to distribute leaflets to potential union members, but hospital rules prohibited leafleting in areas of patient care, hallways, cafeterias, and any areas open to the public. The National Labor Relations Board (NLRB) ruled that these restrictions violated the law and ordered the hospital to permit the activities in the cafeteria and coffee shop. The NLRB cannot create common law or statutory law. What kind of law was it creating? Answer: Administrative law. As an administrative agency, the NLRB has the authority and jurisdiction to create such regulations in furtherance of its agency mission and mandate. 2. The stock market crash of 1929 and the Great Depression that followed were caused in part because so many investors blindly put their money into stocks they knew nothing about. During the 1920s, it was often impossible for an investor to find out what a corporation was planning to do with its money, who was running the corporation, and many other vital facts. Congress responded by passing the Securities Act of 1933, which required a corporation to divulge more information about itself before it could seek money for a new stock issue. What kind of law did Congress create? Explain the relationship between voters, Congress, and the law. Answer: Congress created a statutory law, as authorized by Article II of the Constitution. As for the relationship between voters, Congress, and the law, students may posit that voters elect to Congress members who agree with what they believe, or at least, hope to do so. But of course, answers will vary. Voters who are disappointed in what their representatives have done may vote them out at the next opportunity. 3. ETHICS The greatest of all Chinese lawgivers, Confucius, did not esteem written laws. He believed that good rulers were the best guarantee of justice. Does our legal system rely primarily on the rule of law or the rule of people? Which do you instinctively trust more? Answer: Hopefully, students will recognize that the rule of law provides more safety, security and justice than a reliance on the current ruler. But as to which they instinctively trust more, answers will vary. 4. Lance, a hacker, stole 15,000 credit card numbers and sold them on the black market, making millions. Police caught Lance, and two legal actions followed, one civil and one criminal. Who will be © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

responsible for bringing the civil case? What will be the outcome if the jury believes that Lance was responsible for identity thefts? Who will be responsible for bringing the criminal case? What will be the outcome if the jury believes that Lance stole the numbers? Answer: The civil cases will be brought by the victims of identity theft, and the outcome of a successful case against Lance would be some type of monetary award for damages suffered. The criminal case will be brought by state prosecutors and the outcome would be imprisonment for Lance. 5. The father of an American woman killed in the Paris terrorist attacks sued Twitter, Facebook, and YouTube, alleging the sites knowingly allowed terrorists to recruit members, raise money, and spread extremist propaganda. The sites defended themselves by saying that their policies prohibit terrorist recruitment and that, when alerted to it, they quickly remove offending videos. What type of lawsuit is this – criminal or civil? What responsibilities, if any, should social media sites have for the spread of terrorism? Answer: The case is a civil case, but answers will vary as to the scope of the responsibilities social media sites should have for the spread of terrorism.

Discussion Questions 1. Do you believe that there are too many lawsuits in the United States: If so, do you place more blame for the problem on lawyers or on individuals who go to court? Is there anything that would help the problem, or will we always have large numbers of lawsuits? Answer: Answers will vary. 2. In the 1980s, the Supreme Court ruled that it is legal for protesters to burn the American flag. This activity counts as free speech under the Constitution. If the Court hears a new flag-burning case in this decade, should it consider changing its ruling or should it follow precedent? Is following past precedent something that seems sensible to you: a. always b. usually c. sometimes d. rarely e. never Answer: Answers will vary. 3. When should a business be held legally responsible for customer safety? Consider the following statements, and circle your opinion. a. A business should keep customers safe from its own employees Strongly agree agree neutral disagree strongly disagree b. A business should keep customers safe from other customers Strongly agree agree neutral disagree strongly disagree c. A business should keep customers safe from themselves. (Example: an intoxicated customer who can no longer walk straight) Strongly agree agree neutral disagree strongly disagree

Chapter 1 Introduction to Law

d. A business should keep people outside its own establishment safe if it is reasonable to do so. Strongly agree agree neutral disagree strongly disagree

Answer: Answers will vary. 4. In his most famous novel, The Red and the Black, the French author Stendhal (1783-1842) wrote: “Prior to laws, what is natural is only the strength of the lion, or the need of the creature suffering from hunger or cold, in short, need.” Do you agree with Stendhal? Without laws, would society quickly crumble? Answer: Answers will vary. 5. Should judges ignore their life experiences, political leanings, and feelings when making judicial decisions? Do you think it is possible? Answer: Answers will vary.

Suggested Additional Assignments Research Students should pick up an issue of any newspaper and find ten articles dealing with legal issues. The articles might refer to contract disputes, negligence suits, international trade agreements, statutory debates in Congress, environmental conflicts, employment issues, and so on. If researching articles in the classroom, make the search competitive—time how quickly students can find ten articles, or see who can find the most articles in two minutes. Students should select an article that interests them and be prepared to discuss it. Poll At the beginning of a course, it can be useful to get a feel for student attitudes about law and lawyers. The instructor might copy and distribute this poll on the first day, have students collate the responses, and chart the results on the board as a prelude to discussion. Strongly Agree: 5

Neutral: 3

Strongly Disagree: 1

1. A system of laws is essential in a democratic society. 2. The American legal system is one of the best in the world. 3. Lawyers are among the most dishonest people in the United States. 4. Lawyers are paid too much. 5. Being on a jury is a waste of time. 6. Juries frequently award absurdly high © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

judgments 7. It is fairly easy to manipulate the legal system. 8. The legal system often abuses large corporations. 9. Other nations do a better job than the United States of resolving disputes. 10. The typical business executive has more integrity than the average lawyer.

Unit 1 – The Legal Environment Chapter 2 - Ethics and Corporate Social Responsibility Chapter Overview Chapter Theme Ethical behavior refers to how people should behave. Ethical behavior offers significant advantages. Society as a whole benefits; executives who behave ethically have happier, more fulfilled lives; and unethical behavior can destroy a company and the individuals who engage in it. An important point to remember is that while laws represent society’s view of basic ethics rules, some laws permit behavior that some feel is wrong and criminalize acts that some feel are right. It is also important for students to examine ethical issues from a variety of points of view and for them to develop their own Life Principles—the rules by which they live their own lives. They should always remember that every ethics decision they make shows their actual Life Principles, even if this doesn’t match what they say. Eating is one of life’s most fundamental needs and greatest pleasures. Yet all around the world many people go to bed hungry. Food companies have played an important role in reducing hunger by producing vast quantities of food cheaply. So much food, so cheaply that, in America, one in three adults and one in five children are obese. Some critics argue that food companies bear responsibility for this overeating because they make their products too alluring. Many processed food products are calorie bombs of fat (which is linked to heart disease), sugar (which leads to diabetes), and salt (which causes high blood pressure). What obligation do food producers and restaurants have to their customers? After all, no one is forcing anyone to eat. Do any of the following examples cross the line into unethical behavior? 1. Increasing Addiction. Food with high levels of fat, sugar, and salt not only taste better, they are also more addictive. Food producers hire neuroscientists who perform MRIs on consumers to gauge the precise level of fat, sugar, and salt that will create the most powerful cravings, the so-called “bliss point.” To take one example, in some Prego tomato sauces, sugar is the second most important © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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ingredient after tomatoes. Did you know you were getting two heaping teaspoons of sugar in a small serving of pasta sauce? 2. Increasing Quantity. Food companies also work hard to create new categories of products that increase the number of times a day that people eat and the amount of calories in each session. For example, they Note: Some case citations appear here; footnotes appear in text only. have created a new category of food that is meant to be more than a snack but less than a meal, such as Hot Pockets. But some versions of this product have more than 700 calories, which would be a lot for lunch, never mind for just a snack. *** Food executives argue that they are just providing what consumers want. 3. Increasing Calories. Uno Chicago Grill serves a macaroni and cheese dish that, by itself, provides more than two-thirds of the calories that a moderately active man should eat in one day, and almost three times the amount of saturated fat. *** Should restaurants serve items such as these? If they do, what disclosure should they make? 4. Targeting Poorer Countries. Because of health concerns, consumption of sweetened soft drinks in the U.S. is declining. In response, soda companies have dramatically increased their marketing budgets in lower income countries such as Brazil and China. Much of this marketing focuses on children. These countries struggle to provide health care to their populations even without the additional burden that soft drinks create. 5. Funding Dubious Science. Both the soft drink and sugar industries generously fund scientific research. Is that good news? Studies they have financed are much more likely to find that there is no connection between sodas and weight gain. ***How likely is it that everyone who drinks a Coke will go out and walk the three miles it would take to burn off those calories?

2-1 WHY STUDY ETHICS? The law dictates how a person must behave. This chapter examines ethics, how people should behave. However, laws may permit behavior that some feel is wrong, and it may criminalize acts that some feel are right. Research shows that people who think about the right rules for living are less likely to do wrong. Ethics: How people should behave Ethics Decision: Any choice about how a person should behave that is based on a sense of right and wrong Life Principles: The rules by which you live your life Life Principles should include personal rules on: 1. Lying 2. Stealing 3. Cheating 4. Applying the same or different standards at home and at work 5. Your responsibility as a bystander when you see other people doing wrong © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Specific is better than general. Some Life Principles focus not so much on right versus wrong but rather serve as a general guide for living a happier, more engaged life. It is important to think through your Life Principles now, so that you will be prepared when facing ethics dilemmas in the future.

2-1a Ethics in Business Nobel-prize winning economist Milton Friedman (1912-2006) famously argued that a corporate manager’s primary responsibility is to the owners of the organization, that is, to shareholders. Unless the owners explicitly provide otherwise, managers should make the company as profitable as possible while also complying with the law. Others have argued that corporations should instead consider all company stakeholders, not just shareholders. Stakeholders include employees, customers, and the communities and countries in which a company operates. This choice can create an obligation to such broad categories as “society” or “the environment” After 20 first-graders and 6 educators were shot to death at the Sandy Hook Elementary School in Newtown, Connecticut, General Electric Co. (GE) stopped lending funds to shops that sell guns. Many of GE’s employees lived in the area, and some had children in Sandy Hook. GE was putting its employees ahead of its investors. As we will see in this chapter, managers face many choices in which the most profitable option is not the most ethical choice. When profitability increases and, with it, a company’s stock price, managers benefit because their compensation is often tied to corporate results, either explicitly or through ownership of stock and options. That connection creates an incentive to do the wrong thing. Conversely, making the ethical choice will sometimes lead to a loss of profits or even one’s job.

2-1b Why Be Ethical? Society as a Whole Benefits from Ethical Behavior John Akers, the former chairman of IBM, argued that without ethical behavior a society could not be economically competitive. In short, ethical behavior builds trust, which is important in all of our relationships. Ethical Behavior Makes People Happier A study revealed that the secret to long-term happiness is having good relationships with a spouse, family, and friends. It is difficult to maintain good relationships while behaving unethically. Managers want to feel good about themselves and the decisions they have made; they want to sleep well at night. Their decisions – to lay off employees, recall defective products, burn a cleaner fuel – affect people’s lives. Bad decisions are painful to remember. Ethical Behavior Provides Financial benefits A company with a good reputation can pay employees less and charge consumers more. Conversely, unethical behavior causes financial harm. Conversely, unethical behavior causes financial harm: companies caught engaging in socially irresponsible or illegal activities typically suffer a significant decline in stock price. Unethical behavior can also cause other, subtler damage; unethical behavior in the workplace may reduce productivity, job stability and profits.

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Although there is no guarantee that ethical behavior pays in the short or long run, there is evidence that the ethical company is more likely to win financially.

2-2 THEORIES OF ETHICS When making ethics decisions, people sometimes focus on the reason for the decision – they want to do what is right. If they think it is wrong to lie, then they will tell the truth, no matter the consequence. In other cases, people think about the outcome of their actions. They will do whatever it takes to achieve the right result. This choice, between doing right and getting the right result – has been the subject of much philosophical debate.

2-2a Utilitarian Ethics In 1863, Englishman John Stuart Mill (1806-73) wrote Utilitarianism. To Mill, a correct decision is one that maximizes overall happiness and minimizes overall pain, thereby producing the greatest net benefit. As he put it, his goal was to produce the greatest good for the greatest number of people. Risk management and cost-benefit analysis are examples of utilitarian business practices. Critics of utilitarianism argue that it is very difficult to measure utility accurately, at least in the way that one would measure distance or the passage of time. And let’s face it, not all lives are of equal value to us. If forced to make a choice, a parent might decide to sacrifice ten strangers in exchange for his own child’s life. Furthermore, a focus on outcome can justify some really terrible behavior. After the 9/11 terrorist attacks, Americans debated the acceptability of torture. Is it ethical to torture a terrorist with the hope of obtaining the details of an upcoming attack?

2-2b Deontological Ethics Deontological: From the Greek word for obligation; the duty to do the right thing, regardless of the result Categorical imperative: An act is only ethical if it would be acceptable for everyone to do the same thing Proponents of deontological ethics believe that utilitarians have it all wrong, and that the results are not as important as the reason for making it. Deontological is from the Greek word for obligation, the duty to do the right thing, regardless of the result. To a deontological thinker, the ends do not justify the means. The best-known proponent of the deontological model was an eighteenth-century German philosopher Immanuel Kant. Kant believed in the categorical imperative, arguing that you should not do something unless you would be willing to have everyone else do it, too. Kant also believed that human beings possess a unique dignity, and that it is wrong to treat them as commodities, even if such a decision maximizes overall happiness. The problem with this belief is that the ends do matter.

2-2c Rawlsian Justice Life Prospects: The circumstances into which we are born Veil of ignorance: The rules for society that we would propose if we did not know how lucky we would be in life’s lottery © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Difference principle: Rawls’ suggestion that society should reward behavior that provides the most benefit to the community as a whole. The circumstances people are born in to dramatically affect their outcomes. John Rawls (1921-2002) was an American philosopher who referred to these circumstances as life prospects. Life prospects are the opportunities one has at birth, based on one’s natural attributes and initial place in society. In Rawls’ view, luck matters as much as hard work. Rawls argued that we should think about what rules for society we would propose if we faced a “veil of ignorance.” In other words, what type of society would we create if we did not know whether we would be one of life’s winners or losers? Second, we should apply the difference principle, Rawls’s suggestion that society should reward behavior that provides the most benefit to the community as a whole. In thinking about ethics decisions, it is worth remembering that many of us have been winners in life’s lottery and that the unlucky also deserve opportunities.

2-2d Front Page Test When faced with a difficult decision, think about how you would feel if your actions went viral – on YouTube, Facebook, or on the front page of national newspapers. Would that help you decide what to do? The Front Page test is not completely foolproof. There are times you might have legitimate reasons to do something private.

2-2e Moral Universalism and Relativism Moral universalism: A belief that some acts are always right or always wrong, Moral relativism: A belief that a decision may be right even if it is not in keeping with one’s own ethical There are at least two types of moral relativism: cultural and individual. To cultural relativists, what is right or wrong depends on the norms and practices in each society. To individual relativists, people must develop their own ethics rules. And what is right for me might not be good for you.

2-3 Ethics Traps Ethics traps create great temptation to do what we know to be wrong or fail to do what we know to be right. These traps include:

2-3a Money A powerful lure because most people believe that they would be happier if they had more, but that is not necessarily true. Also, money is a way of keeping score.

2-3b Competition Humans are social animals who cannot help but compare themselves with other people. And, researchers have found that the mere process of negotiating the price of a product reduces a person’s sense of morality. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2-3c Rationalization If I don’t do it, someone else will. I deserve this because… They had it coming. I am not harming a person – it is just a big company. This is someone else’s responsibility The Fudge Factor Duke Professor Dan Ariely found in his groundbreaking research that almost everyone is willing to cheat, at least on a small scale. Deep down, most of us want to be better than the other guy. I Did It for Someone Else People who breach ethics often say they did it for their families; Ariely found that if someone else benefits, the cheating increases. The Slippery Slope So many truly awful outcomes begin with that first step down the slippery slope. How easy is it to rationalize, “Just this once.”

2-3d We Can’t Be Objective About Ourselves People are not objective when comparing themselves to others. In making a decision that affects you, it is important to remember that you are unlikely to be objective.

2-3e Moral Licensing Moral licensing: After doing something ethical, many people then have a tendency to act unethically.

2-3f Conflicts of Interest Small gifts are surprisingly influential in creating such conflicts because the recipients do not make conscious effort to overcome any bias these tokens may create. Larger gifts raise awareness of the potential conflict. In short, if ethical decisions are your goal, it is better to avoid all conflicts of interest - both large and small.

2-3g Conformity Warren Buffet: The five most dangerous words in business may be: “Everyone’s doing it.” Evidently many people believe that if everybody else is doing it, then it must be okay.

2-3h Following Orders When someone in authority issues orders, even to do something clearly wrong, it is very tempting to comply. Fear of punishment, the belief in authority figures, and the ability to rationalize, all play a role.

2-3i Euphemisms and Reframing “Smoothing earnings” sounds a lot better than “cook the books” or “commit fraud” The launch of the space shuttle Challenger was reframed from an engineering question about safety to a management question about pleasing the customer; as a result, the shuttle exploded 73 seconds after launch. Make sure the framing of the issue is correct. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2-3j Lost in a Crowd When in a group, people are less likely to take responsibility because they assume (hope?) that someone else will. Bystanders are much more likely to react to potential wrongs if they are alone and have to form an independent judgment. In a business, if everyone is lying to customers, etc., it is tempting to go with the flow.

2-5k Short-Term Perspective Often, people make unethical decisions because they are thinking short-term. What appears to be a short-term solution could lead to a long-term problem that could lead to bankruptcy and prison time. Optimism Bias: A belief that the outcome of an event will be more positive than the evidence warrants.

2-3l Blind Spots Bob Dylan: “How many times can a man turn his head and pretend that he just doesn’t see?” We all have a tendency to ignore blatant evidence that we would rather not know.

2-3m Lying: A Special Case We are taught from an early age that we must tell the truth. Yet research shows that we tell between one and two lies a day. When is lying acceptable? What are your Life Principles on lying?

2-3n Ethics Case: Truth (?) in Borrowing Rob is in the business of buying dental practices. He finds solo practitioners, buys their assets, signs them to a long-term contract and then improves their management and billing processes so effectively that both he and the dentists are better off. Rob has just found a great opportunity with a lot of potential profit. There is only one problem. The bank will not give him a loan to buy the practice without checking the dentist’s financial record. Her credit rating is fine, but it turns out that she filed for bankruptcy 20 years ago. That event no longer appears on her credit record but, on the form it required her to sign, the bank asked about all bankruptcies. She is perfectly willing to lie. Rob refused to turn in the form with a lie. But when the bank learned about the bankruptcy, it denied his loan even though her bankruptcy in no way affects his ability to pay the loan. And the incident is ancient history - the dentist’s current finances are strong. Subsequently four other banks also refused to make the loan. Rob is feeling pretty frustrated. He figures the return on this deal would be 20 percent. Everyone would benefit – the dentist would earn more, her patients would have better technology, he could afford a house in a better school district, and the bank would make a profit. There is one more bank he could try. Questions: 1. Should Rob file loan documents with the bank, knowing the dentist has lied? Answer: Answers will vary. This is a very tempting transaction for Rob. He may also believe the banks are being unreasonable, since her prior bankruptcy will not affect his ability to repay the loan. He may justify submitting the loan documents with the dentist’s lie to this last bank. But another danger is that banks often talk to each other, and this new one may find out about all of the prior © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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refusals to grant the loan, and demand to know why. Rob may be tempted to take a chance that that will not happen, and that no one will look up bankruptcy records from 20 years ago. 2. Who would be harmed by this lie? Answer: Arguably, no one. Or perhaps everyone involved, including Rob. If banks can no longer trust his documented applications, they might refuse to lend for future purchases, endangering his business. 3. What rationalizations might Rob use? Answer: He might argue that if he doesn’t do it, someone else will. He might argue that he (and his client) deserve this because…; He might argue that he is not hurting a person (or even the bank). 4. What if Rob pays back the loan without incident? Was the lie still wrong? Do the ends justify the means? Answer: Answers will vary. If one believes that submitting the loan documents with the lie is wrong, then the ends do not justify the means. If one believes that no one is harmed by submitting the loan documents with the lie, rationalization is at play. 5. What is your Life Principle about telling lies? When is making a misrepresentation acceptable? To protect someone’s life or physical safety? To protect a job? To protect another person’s feelings? To gain an advantage? When others are doing the same? When it makes sense from a cost-benefit perspective? Answer: Answers will vary. 6. Do you have the same rule when lying to protect yourself, as opposed to benefiting others? Answer: Answers will vary.

2-3o Avoiding Ethics Traps Three practices can help you avoid these pitfalls. 1) Slow down. 2) Do not trust your first instinct. 3) Remember your Life Principles.

2-3p Reacting to Unethical Behavior When faced with unethical behavior in your organization, y8ou have three choices: Loyalty Exit Voice

2-4 APPLYING THE PRINCIPLES Having thought about ethics principles and traps, you now need to apply them to situations that are similar to those you are likely to face in your life.

2-4a Personal Ethics in the Workplace Should you behave in the workplace the way you do at home, or do you have a separate set of ethics for each part of your life? What if your employees behave badly outside of work—should that affect their employment?

2-4b Ethics Case: Weird Wierdsma Beatrix Szeremi immigrated to the U.S. from Hungary. But her American dream turned into a nightmare when she married Charles Wierdsma. He repeatedly beat her and threatened to suffocate and drown © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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her. Ultimately, he pleaded guilty to one felony count and went to jail. Despite his son’s guilt, Thomas Wierdsma pressured his daughter-in-law to drop the charges and delete photos of her injuries from her Facebook page. When she refused, he threatened her and her lawyer that he would report her to immigration officials (although she was in the country legally with a green card). Father and son discussed how they could wrongfully get her deported. Thomas also testified in a deposition that it was not bad to lie to a federal agency. “It happens all the time,” he said. Thomas Wierdsma is the senior vice president at The GEO Group, Inc. Research indicates that CEOs who break the law outside of the office are more likely to engage in workplace fraud. Although their legal infractions – driving under the influence, use of illegal drugs, domestic violence, even speeding tickets – were unrelated to their work, they seemed to indicate a disrespect for the rule of law and a lack of self-control. Questions: 1. What would Kant and Mill say is the right thing to do in this case? What is the result under the Front Page test? 2. What ethics traps might Wierdsma’s boss face in this situation? 3. What is your Life Principle? What behavior are you willing to tolerate in the interest of profitability? 4. If you were the CE?O of Thomas Wierdsma’s company, would you fire him? Impose some other sanction? 5. Which is worse – Wierdsma’s threatening his daughter-in-law or stating that it is acceptable to lie to a federal agency? 6. Would you fire a warehouse worker who behaved this way? 7. GEOP runs prisons and immigration facilities for the government. Does that fact change any of your answers? 8. Wierdsma’s woes were reported in major newspapers, and his statement about lying to a federal agency was on YouTube. Do these facts change any of your answers? Answers will vary. Students should be encouraged to state their opinions and support their positions with material from the text.

2-4c The Organization’s Responsibility to Society Many products can potentially cause harm to customers or employees. Does it matter if they willingly accept exposure to these products? What constitutes informed agreement? What is the company’s responsibility to those who are unwittingly harmed by its products?

2-4d Ethics Case: Up in Smoke James is on the management team of a health insurance company called HIC. At a team meeting, the CEO announces that from now on, HIC will not hire smokers, and all employees will be regularly tested for nicotine. This policy would reduce the firm’s expenses (an estimated $4,000/smoker each year) while increasing productivity (no smoking breaks, fewer sick days). In addition, the policy will encourage healthy choices by employees and the community as a whole – people will quit smoking to work at HIC. The CEO is convinced that society will benefit if smoking is “de-normalized.” He also believes this policy will enhance HIC’s position as a progressive enterprise, setting a good example for other businesses. Already, many companies in the medical industry are instituting such policies.

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Although James does not smoke, he is troubled by this new policy. HIC is located in a city with high rates of unemployment and poverty, as well as a large minority population. He is familiar with the following data:

Group Native Americans People living below Poverty level People with less than a High school education Unemployed

Percent of Adults Who Smoke 42 36

Group

Asian women People living above poverty level College graduates

Full-time employed

Percent of Adults Who Smoke 8 22.5 12 28

James fears that the policy will prevent HIC from hiring the very people who need jobs the most. Also, he knows that nicotine is highly addictive and that many people who want to stop smoking struggle to do so. Lifestyle choices affect a whole range of illnesses, including diabetes, cancer, heart disease, and sexually transmitted diseases. Is it fair to single out smokers for punishment? While only one-tenth of the company’s workers smoke, two-thirds are overweight or obese, which also increases health costs. Even some healthy activities may increase costs – the CEO had been injured in a bike accident. Should the company refuse to hire overweight and cyclist groups as well? To complicate James’ decision, the CEO tends to resent employees who disagree with him. If James speaks out against the nonsmoking policy, his job prospects could be damaged.

Questions: 1. What would Mill, Kant, and Rawls have said about the CEO’s plans? About what James should do? Answer: Mill would have calculated the costs and benefits of this approach. If the impact on the community was severe, then perhaps that would outweigh the benefit to shareholders. Kant believed that humans possess a unique dignity. Perhaps the non-smoking plan would violate that dignity. Perhaps the right thing to do is to take care of the community. Rawls would be concerned about the very different life prospects that many in the community faced. And that if we had some chance of waking up tomorrow as a poor, unemployed smoker in this community, we would not want to be foreclosed from good jobs. Is it worth it to James to risk his job over this issue? Kant would say that he should do the right thing regardless. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The CEO clearly thinks that this new policy will enhance the organization’s reputation. Will it? 2.

What would have been the result if James had applied the Front Page test? Answer: Which headline would James prefer? – that he spoke out against a policy that would very likely hurt the community and its residents – or if he did not speak, and it came to light that he might have prevented the CEO’s action if he had spoken? If we assume the action by the CEO could have been prevented by James’ speaking out, then he would prefer taking action. But would the CEO have changed his mind? It is doubtful. 3. What would you do? Answers will vary. Students should be encouraged to state their opinions and support their positions with material from the text.

2-4e The Organization’s Responsibility to Its Employees Organizations cannot be successful without good workers. In many circumstances the shareholder and stakeholder modules agree that employees should be treated well. Disgruntled workers are likely to be unmotivated and unproductive. But sometimes, looking out for employees may not lead to higher profits. In these cases, does an organization have a duty to "take care" of its workers? The shareholder model says no; the stakeholder model takes the opposite view.

2-4f Ethics Case: The Storm After the Storm Yanni is the CEO of Butterfly, Inc., which manufactures tractors. A tornado recently destroyed one of the company’s plants which was near Farmfield, Arkansas, a town with a population of roughly 5,000 people. Farmfield is a two-hour drive from the nearest city, Little Rock. The good news is that insurance payout will cover the full cost of rebuilding. The bad news? Manufacturing plants are much more expensive to build and operate in the U.S. than overseas. Yanni has asked Adam and Zoe to present the pros and cons of relocating to someplace cheaper. Adam says, “If we rebuild overseas, our employees will never find equivalent jobs. We pay $20/hour, and the other jobs in town are mostly minimum-wage. And remember how some of the guys worked right through Christmas to set up for that new model. They have been loyal to us –we owe them something in return. Going overseas is not just bad for Farmfield or Arkansas, it’s bad for the country. Zoe responds, “That is the government’s problem, not ours. We’ll pay to retrain the workers, which h, frankly, is a generous offer. Our investors get a return of 4%; the industry average is closer to 8%. If we act like a charity to support Farmfield, we could all lose our jobs. It is our obligation to do what’s best for our shareholders – which, in this case, happens to be what’s right for us, too.” Questions: 1. What ethics traps does Yanni face in this situation? 2. Do you agree with Zoe’s argument that it is the government’s responsibility to create and protect American jobs and that it is a CEO’s job to increase shareholder wealth? 3. Imagine that you personally own shares in Butterfly, Inc. Would you be upset with a decision to rebuild the manufacturing plant in the U.S? 4. If you were in Yanni’s position, would you rebuild the plant in Arkansas or relocate overseas? 5. What is your Life Principle on this issue? Would you be willing to risk your job to protect your employees? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answers will vary. Students should be encouraged to state their opinions and support their positions with material from the text.

2-4g An Organization’s Responsibility to Its Customers Customers are another group of essential stakeholders. A corporation must gain and retain loyal buyers if it is to stay in business for long. Treating customers well usually increases profits and helps shareholders. But when, if ever, does an organization go too far? Is a leader acting appropriately when she puts customers first in a way that significantly diminishes the bottom line? The shareholder model says no. What do you say?

2-4h Ethics Case: Mickey Weighs In Disney decided that only healthy foods could be advertised on its children’s television channels, radio stations, and websites. Candy, fast food, and sugared cereals were banned from its parks. Its characters could no longer associate with unhealthy foods. No more Mickey Pop=-Tarts or Buzz Lightyear Happy Meals. Said Disney chairman, Robert Iger, “Companies in a position to help with solutions to childhood obesity should do just that.” This decision caused Disney to lose revenue, but also enhanced its reputation, at least with parents, who increasingly seek healthy food options for their children. And Disney also profited from license fees it received for the use of a Mickey Check logo on healthy food in grocery aisles and restaurants. Questions: 1. What is Disney’s obligation to its young customers? 2. What would Mill or Kant have said? What is the result under the Front Page test? 3. What ethics traps does Disney face? 4. Does this information make you more likely to buy Disney products or allow your children to watch Disney TV? 5. What is your Life Principle? How much profitability (or income) would you be willing to give up to protect children you do not know? Answers will vary. Students should be encouraged to state their opinions and support their positions with material from the text.

2-4i Organization’s Responsibility to Overseas Workers Industrialization has always been the first stepping stone out of dire poverty—it was in England in centuries past, and it is now in the developing world. Eventually, higher productivity leads to higher wages. When you look at the levels of infant mortality and education in Taiwan, South Korea, and India—three countries that started at the same economic level—you see that the countries that embraced sweatshops are in much better standing in these areas. In theory, then, sweatshops might not be all bad. But are there limits?

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“Riots, Suicides and More,” blares an internet headline about a FoxConn factory where iPhones and other Apple products are assembled, Apple is not alone in facing supplier scandals. So have Nike, CocaCola, and Gap, among many others. Do companies have an obligation to the employees of their suppliers? If so, how can they, or anyone, be sure what is really going on in a factory on the other side of the world? Professor Richard Locke of MIT has studied supply chain issues. His conclusions: 

The first step that many companies took to improve working conditions overseas was to establish a code of conduct and then conduct audits. These coercive practices do not work, and compliance is at best sporadic.



A more collaborative approach worked better – when the auditors sent by multinationals saw their role as less of a police officer and more as a partner, committed to problem-solving and sharing of best practices.

What would you do if you were a manager in the following circumstances: 

In clothing factories, workers often remove the protective3 guards from their sewing machines because the guards slow the flow of work. As a result, many workers suffer needle punctures. Factories resist the cost of buying new guards because the workers just take them off again. Is there a solution?



Timberland and Hewlett-{Packard have recognized that selling large numbers of new products creates great variation in demand and therefore pressure factory workers to work overtime. What can a company do to reduce this pressure?

Answers will vary. Students should be encouraged to state their opinions and support their positions with material from the text.

2-4k Corporate Social Responsibility (CSR) Corporate social responsibility: An organization’s obligation to contribute positively to the world around it. We know companies have a duty not to cause harm. But does an organization have a corporate social responsibility—that is, an obligation to contribute positively to the world around it? Do businesses have an affirmative duty to do good? Harvard Professor Michael Porter has written that CSR often benefits a company. However, in Porter’s view, a company should not undertake a CSR project unless it is profitable for the company in its own right, regardless of any secondary benefits the company may receive from, say, an improved reputation.

2-4l Ethics Case: The Beauty of a Well-Fed Child Cosmetic companies often use gift-with-purchase offers to promote their products. For example, with any $35 Estee Lauder purchase at Nordstrom’s, you can choose a free gift of creams and makeup valued at $135, plus a designer cosmetic bag. But Clarins has put a new spin on these offers with what it calls “gift with purpose.” Spend $75 on Clarins items at Macy’s and you will receive free products and the companies will provide school meals to © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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children in need. Clarins and Macy’s hope that cosmetic buyers, many of whom are women with children, will find this opportunity to feed children particularly compelling. Questions: 1. If you were an executive at Clarins or Macy’s, what would you want to know before approving this promotion? 2. Would you approve this promotion if it were not profitable on its own account? How much of a subsidy would you be willing to grant? Answers will vary. Students should be encouraged to state their opinions and support their positions with material from the text.

Chapter Conclusion Many times in their lives, students will be tempted to do something that they know in their heart of hearts is wrong. Referring to their own Life Principles, and being aware of potential traps will help them to make the right decisions. But they must be able to afford to do the right thing. Everyone should have a reserve fund to cover six months’ living expenses. Too often, people make the wrong or illegal choice for financial reasons.

Matching Questions Match the following terms with their definitions: _____A. Shareholder model _____B. Stakeholder model _____C. Utilitarianism _____D. Deontological ethics _____E. John Rawls

1. Requires doing “the greatest good for the greatest number” 2. Thought that society should try to make up for people’s different life prospects 3. Requires business decisions that maximize the owners’ return on investment 4. Focuses on the reasons for which decisions are made 5. Requires business leaders to consider employees, customers, communities, and other groups when making decisions

Answers: F. 3 G. 5 H. 1 I. 4 J. 2

Unit 1 The Legal Environment

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 6. T F Immanuel Kant was a noted utilitarian thinker. 7. T F The shareholder model requires that business leaders consider the needs of employees when making decisions. 8. T F Modern China has experienced slower economic growth than did England during the Industrial Revolution. 9. T F John Stuart Mill’s ideas are consistent with business use of risk management and costbenefit analyses 10. T F John Rawls believed that everyone should have the same income.

Multiple Choice Questions 1. Milton Friedman was a strong believer in the _____________ model. He _______________ argue that a corporate leader's sole obligation is to make money for the company's owners. A. shareholder; did B. shareholder; did not C. stakeholder; did D. stakeholder; did not Answer: A. Milton Friedman believed that if shareholder and stakeholder interests conflict, the company should act in the best interest of the shareholders. 2. Which of the following wrote the book Utilitarianism and believed that ethical actions should “generate the greatest good for the greatest number”? A. Milton Friedman B. John Stuart Mill C. Immanuel Kant D. John Rawls Answer: B. 3. Which of the following believed that the dignity of human beings must be respected, and that the most ethical decisions are made out of a sense of duty or obligation? A. Milton Friedman B. John Stuart Mill C. Immanuel Kant D. John Rawls Answer: C.

Chapter 1 Introduction to Law

4. With which of the following statements would Kant have agreed? A. it is ethical to tell a lie if necessary to protect an innocent person from great harm. B. it is ethical to tell a lie if the benefit of the lie outweighs the cost. C. it is wrong for some people to have greater opportunities than others. D. it is wrong to tell a lie. Answer: D. 5. The following statement is true: A. The majority of people are honest most of the time. B. Even people who do not believe in God are more likely to behave honestly after reading the Ten Commandments. C. Most people are accurate when comparing themselves to others. D. People make their best ethical decisions instinctively, rather than thinking through a problem. Answer: B.

Case Questions 1. Senate investigators found that executives at JPMorgan Chase & Co. lied to investors and the public. Also, traders, with the knowledge of top management, changed risk limits to facilitate more trading and then violated even these higher limits. Executives revalued the bank’s investment portfolio to reduce apparent losses. The bank’s internal investigation failed to find this wrongdoing. Into what ethics traps did these JPMorgan Chase & Co.’s employees fall? What options did the executives and traders have for dealing with this wrong-doing? Answer: JPMorgan Chase & Co.’s employees fell into the ethics traps of money, rationalization, conformity, following orders, and getting lost in a crowd. Executives and traders could either choose loyalty, exit, or voice to deal with this wrong-doing. 2. Located in Bath, Maine, Bath Iron Works builds high-tech warships for the Navy. Winning Navy contracts is crucial to the company’s success—it means jobs for the community and profits for the shareholders. Navy officials held a meeting at Bath’s offices with its executives and those of a competitor to review the specs for an upcoming bid. Both companies desperately wanted to win the contract. After the meeting, a Bath worker realized that one of the Navy officials had left a folder on a chair labeled: “Business Sensitive.” It contained information about the competitors’ bid that would be a huge advantage to Bath. William Haggett, the Bath CEO, was notified about the file just as he was walking out the door to give a luncheon speech. What ethics traps did he face? How could he avoid these traps? What would result if he considered Mill, Kant, or the Front Page test? What should he do? How would you give voice to your values in this situation? Answer: Haggett ordered the file to be copied. By the time he got back from lunch, the company president had found out about the file and ordered the copy destroyed. But by then, other Bath executives had had a chance to examine the file. Haggett, personally returned the file to the Navy, but by then it was too late. The Navy considered banning Bath from bidding on its contracts, which would have meant the end of the company. Haggett resigned. A much beloved CEO and an © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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important figure in Maine, he had worked at Bath for 28 years and his father had been a pipe-fitter there. The pitfalls were being in a hurry, money. 3.

Each year, the sale of Girl Scout cookies is the major fund-raiser for local troops. But because the organization was criticized for promoting such unhealthy food, it introduced a new cookie, Mango Cremes with Nutrifusion. It promotes this cookie as a vitamin-laden, natural whole food. “A delicious way to get your vitamins.” But these vitamins are a minuscule part of the cookie. The rest has more unhealthy fat than an Oreo. The Girl Scouts do much good for many girls. And to do this good, they need to raise money. What would Kant and Mill say? What about the Front Page test? What do you say? Answer: Mill would say that the benefit of selling the cookie is greater than the harm. Kant would say that it is the wrong thing to do. The Girl Scouts would not want this information on the front page.

4. E The CEO of Volkswagen set an ambitious goal: to triple sales in the United States and become the largest car manufacturer in the world. Employees listened carefully because the CEO had a reputation for punishing those who did not make their goals. Then the VW engineers realized that the emissions equipment on the company’s cars could not meet tough U.S. standards. Fixing the equipment would take time, raise costs, and reduce sales. The engineers believed that other car companies had the same problem. Instead of fixing the equipment, an engineer figured out how to install software that would cheat on the emissions tests. Engineers predicted that the chance of being discovered was low, and executives thought the cost of being caught would be manageable. (Indeed, the company continued on its cheating ways, even after it knew that regulators were investigating.) VW produced 11 million cars with this deceptive software. After the company was caught, it spent $18 billion on fines, legal costs, and car repairs. Its sales and stock price plummeted and it faced criminal investigations. Into what traps did these VW employees fall? Answer: Answers will vary. But ethics traps include money, competition, rationalization, following orders, and a short term perspective. 5. I was a plant manager at a factory that used a lot of steel equipment. When a piece of equipment failed and was not worth repairing, it was sold for scrap. Plant managers usually kept the scrap money for themselves without telling headquarters. The money was considered an unofficial bonus. (After all, the equipment was no longer functional, and plant managers are underpaid.) I felt a little uncomfortable taking the money, but my boss warned me that, if I didn’t, I would make the other plant managers look bad. I could have paid off my credit card debt with that money but, instead, I hosted an employee BBQ and bought work boots for the low-wage workers. Did I do the right thing? What traps did I face? Answer: Answers will vary.

Discussion Questions 1. A vice president from the customer service team told me that the company’s largest customer was going to be conducting an on-site audit. The customer would be particularly interested in seeing the dedicated computing equipment that was part of their contract. As it turns out, we did not have any dedicated computing equipment. The past director of my area had, on multiple occasions, simply © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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lied. To survive the audit, the VP asked me to lie and also to put fake labels on some of the machines to show the customer. If I didn’t agree, I knew the VP would be furious, and we might lose this client. What would Kant and Mill say? What is the difference between a long-term versus a short-term perspective? Answer: Answers will vary. 2. Darby has been working for 14 months at Holden Associates, a large management consulting firm. She is earning $95,000 a year, which sounds good, but does not go very far in New York City. It turns out that her peers at competing firms are typically paid 20% more and receive larger annual bonuses. Darby works about 60 hours a week, more if she is traveling. A number of times she has had to reschedule her vacation or cancel personal plans to meet client deadlines. She hopes to go to business school in a year and has already begun the application process. Holden has a policy that permits any employee who works as late as 8:00 P.M. to eat dinner at company expense. The employee can also take Uber home. Darby is in the habit of staying until 8:00 P.M. every night, whether or not her workload requires it. She then orders enough food for dinner, with leftovers for lunch the next day. She has managed to cut her grocery bill to virtually nothing. Sometimes she invites her boyfriend to join her for dinner. As a student, he is always hungry and broke. Darby often uses the Holden Uber to charge a ride back to his apartment, although the cost is twice as high as to her own place. Darby has also been known to return online purchases through the Holden mailroom on the company dime. Many employees do that, and the mailroom workers do not seem to mind. Is Darby doing anything wrong? What ethics traps is she facing? What would your Life Principle be in this situation? Answer: Answers will vary. 3. Steve supervises a team of account managers. One night at a company outing, Lawrence, a visiting account manager, made some wildly inappropriate sexual remarks to Maddie, who is on Steve’s team. When she told Steve, he was uncertain what to do, so he asked his boss. She was concerned that if Steve took the matter further and Lawrence was fired or even disciplined, her whole area would suffer. Lawrence was one of the best account managers in the region, and everyone was overworked as it was. She told Steve to get Maddie to drop the matter. Just tell her that these things happen, and Lawrence did not mean anything by it. What should Steve do? What ethics traps does he face? What would be your Life Principle in this situation? What should Maddie do? Answer: Answers will vary 4. Many people enjoy rap music at least in part because of its edgy, troublemaking vibe. The problem is that some of this music could cause real trouble. Thus, Ice-T’s song “Cop Killer” generated significant controversy when it was released. Among other things, its lyrics celebrated the idea of slitting a policeman’s throat. Rick Ross rapped about drugging and raping a woman. Time Warner Inc. did not withdraw Ice-T’s song but Reebok fired Ross over his lyrics. One difference: Time © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Warner was struggling with a $15 billion debt and a depressed stock price. Reebok at first refused to take action but then singing group UltraViolet began circulating an online petition against the song and staged a protest at the main Reebok store in New York. What obligation do media companies have to their customers? What factors matter when making a decision about the content of entertainment? Answer: Answers will vary. 5. You are negotiating a new labor contract with union officials. The contract covers a plant that has experienced operating losses over the past several years. You want to negotiate concessions from labor to reduce the losses. However, labor is refusing any compromises. You could tell them that, without concessions, the plant will be closed, although that is not true. Is bluffing ethical? Under what circumstances? What would Kant and Mill say? What is the result under the Front Page test? What is your Life Principle? Answer: Answers will vary. 6.

What percentage of your income should you donate to charities? Which charities are most worthwhile? Peter Singer, a Princeton professor, argues that people should give away one-third of their income to worthy charities. But, when entertainment mogul David Geffen donated $100 million to renovate a New York concert hall, Singer said that he could not understand “how anyone could think that giving to the renovation of a concert hall that could impact the lives of generally well-off people living in Manhattan and well-off tourists that come to new York could be the best thing that you could do with $100 million.” He added that a donation of less than $100 million could restore sight to someone who is blind. To what theory of ethics is Professor Singer subscribing? Do you agree with him? What obligation do you have to help others? What is the best way to help others? Answer: Answers will vary.

Chapter 3 – International Law* Chapter Overview Chapter Theme Throughout the ages, people have asked, “What is international law?” In Chapter 1, we learned that it is a system of rules that predictably regulates our behavior, secures our rights and balances government power. But International law is different. It has no single source of law or enforcement mechanism. It is a hodgepodge of different actors, legal systems, and cultures. As a result, some people wonder whether international law exists at all. But it does exist, and is important to study, because our globalized world is more and more dependent on it each day.

3-1 International Law: Public Versus Private Public International Law: Rules and norms governing relationships among states and international organizations. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Private International Law: International rules and standards applying to cross-border commerce. International law consists of rules and principles that apply to the conduct of states,6 international organizations, businesses, and individuals across borders. The two branches of international law are public and private. Public international law consists of the rules and norms governing relationships among states and international organizations. It governs the law of war, acquisition of territory, disputes among nations, shared resources, and basic human rights for people. Private international law consists of the international rules and standards applying to cross-border commerce. It applies to private parties (such as businesses and individuals) in international commercial and legal transactions. It deals with two fundamental issues: Which law applies to a private agreement? How will people from one country settle their private disputes with parties on foreign soil?

3-2 Actors in International Law Because international law must balance the interests and rules of many different people, organizations, and states, there are many significant actors. The United Nations is one of the most important.

3-2a The United Nations In 1945, 50 nations signed the Charter of the United Nations, binding themselves to its terms and obligations. Today, 193 countries are members of the United Nations. The UN Charter sets out the organization’s governance:   

The Secretariat administers the day-to-day operations of the U.N. The General Assembly is the UN’s lawmaking body, composed of all of its member nations, which propose and vote on resolutions. The Security Council is charged with maintaining international peace.

Much of the UN’s work is done through its Specialized Agencies and related organizations. The following agencies, which operate under the UN’s umbrella, have great impact on world business:    

The World Bank’s mandate is to end poverty by encouraging development The International Monetary Fund (IMF) aims to foster worldwide economic growth and financial stability The World Intellectual Property Organization (WIPO) was established to promote the protection of intellectual property The UN Commission on International Trade Law (UNCITRAL) aims to harmonize international business law by proposing model legislation.

3-2b The International Court of Justice International Court of Justice: The judicial branch of the United Nations.

Throughout the chapter, the authors use “state” to have the same meaning as “country” and “nation.” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The UN opened the doors of the International Court of Justice (ICJ), also known as the World Court, in 1946. The ICJ is the judicial branch of the United Nations. It is comprised of 15 elected judges from 15 countries representing the world’s principal legal systems.   

Only countries can be a party to litigation before the ICJ. The ICJ only has jurisdiction over states that have agreed to be bound by its decisions.7 The court has no enforcement power.8

3-2c International Chamber of Commerce Incoterms: A series of three-letter codes used in international contracts for the sale of goods. The International Chamber of Commerce (ICC) is the world’s largest global business organization. Its purpose is to facilitate international business. To that end, the ICC advocates on matters of international business policy and develops uniform rules to aid cross-border transactions. In 1936, the organization first proposed the Incoterms, a series of three-letter codes commonly used in international contracts for the sale of goods. Note that the ICC does not make law. Instead it proposes rules whose adoption is voluntary. The International Court of Arbitration (ICA) is a forum for international dispute resolution, run by the ICC.

3-2d Sovereign Nations Sovereignty: Each government has the absolute authority to rule its people and its territory. Each nation is sovereign, meaning that only that nation’s government has the absolute authority to rule its people and its territory. Under this principle, states are prohibited from interfering in each other’s legislative, administrative, or judicial activities.

Sovereign Immunity Foreign Sovereign Immunities Act: A U.S. statute that provides that American courts generally cannot entertain suits against foreign governments. Sovereign immunity holds that the courts of one nation lack the jurisdiction (power) to hear suits against foreign governments.

Waiver: A lawsuit is permitted against a foreign country that waives its immunity, that is, voluntarily gives up this protection.

Commercial Activity: A plaintiff in the United States can sue a foreign country engaged in commercial, but not political, activity.

Case Concerning Military and Paramilitary Activities in and Against Nicaragua (Nicaragua v. United States of America, 1986 L.C.J. 14 (June 27). 8 Avena and Other Mexican Nationals (Mexico v. United States of America), 2004 L.C.J. 12 (Mar. 31). © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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3-3 The World’s Legal Systems The great majority—roughly 84 percent—of the world is governed by legal systems that take a very different approach from our own.

3-3a Common Law Stare decisis: The principle that legal conclusions must be reached after an analysis of past judgments. The United States and former British colonies (including Australia, Canada, and India) inherited the common law system from England. The hallmarks of common law are the use of an adversarial process of dispute resolution presided over by an impartial judge, the doctrine of stare decisis9, and the use of a jury to determine questions of fact. The hallmarks of the common law are:   

The use of an adversarial process of dispute resolution presided over by an impartial judge. The doctrine of stare decisis, which requires judges to base their decisions on prior cases. The use of a jury to determine questions of fact.

3-3b Civil Law More than 70 percent of the world’s population is subject to civil law, including most European countries, Russia, Central and South America, China, large swaths of Asia, and parts of Africa.10 The main principle of civil law is that the law is found primarily in the statute books, or codes. The main characteristics of the civil code tradition are:   

The use of an inquisitorial process of dispute resolution, in which the judge acts as interrogator and investigator; judges rely more on written submissions than on lawyers’ oral arguments. Courts base their judgments on the code and on the writings of law professors. Civil code systems do not use juries.

3-3c Islamic Law Shari’a law: Islamic law Ijtihad: The process of Islamic legal and religious reasoning. More than one-fifth of the world’s population lives under legal systems influenced by the religion of Islam. Islamic law, also known as shari’a, is a legal system most commonly found in Africa, Asia, and the Middle East. 11 Early Islamic scholars gave definitive guidelines and interpretations on shari’a using a 9

Stare decisis is Latin for “to let the decision stand.” Note that “civil law,” as referred to in this chapter, is a legal system based on codes (i.e., civil law versus common law systems). In common law systems such as ours, the same term is also used to describe contract, tort, and other areas of private law (i.e., civil law versus criminal law). 11 Shari’a means “path” in Arabic. 10

Unit 1 The Legal Environment

reasoning process known as ijtihad,12 Shari’a is based on the Muslim holy book, the Koran and the teachings and actions of the Prophet Muhammed. Some of its important principles are that the payment and collection of interest is prohibited because it causes unfair enrichment.13 and the concept 14 of gharar prohibits any contract gain that is not clearly outlined at the time of contract. Gharar is the Islamic prohibition on risk and deception. The following case may come as a surprise because most people do not realize that U.S. courts can apply foreign law to resolve disputes. The parties filed suit in a U.S. court, even though the dispute was governed by Shari’a law:

Case: Saudi Basic Industries Corporation v. Mobil Yanbu Petrochemical Company Inc. and Exxon Chemical Arabia, Inc. Facts: Saudi Basic Industries Corporation (SABIC) was a Saudi Arabian corporation owned by the Saudi government. In the 1970s, it entered into joint ventures with Mobil and Exxon, under contracts governed by Saudi law. The agreements forbade the participants from charging a “mark-up” on any products purchased for the joint venture, but SABIC violated this provision for two decades. ExxonMobil and SABIC sued each other in federal court in Delaware for breach of contract and tort.15 Because the Delaware court was required to apply Saudi law, the judge brought in notable experts in shari’a law for instruction. The jury found SABIC liable for Saudi tort of usurpation (ghasb) and awarded ExxonMobil $416 million. SABIC appealed to the Delaware Supreme Court for a new trial, arguing that that the trial court’s application of Saudi law was flawed. Issue: Did the U.S. court err in its application of shari’a law? Excerpts from Justice Jacobs’s Decision: In Saudi Arabia, Islamic law (shari’a), which is a fundamentally religious law based on both the Q’uran and the model behavior of the Prophet Muhammed, is the law of the land. Although early Islamic law scholars eventually coalesced into various guilds or schools, only four of those guilds have survived in modern times: the Hanbali, the Hanafi, the Shafi’i and the Maliki. In Saudi Arabia, the judges are instructed to rule exclusively in accordance with the teachings of the Hanbali guild. The Saudi law system differs in critically important respects from the system of legal thought employed by the common law countries, including the United States. Perhaps most significant 12

Ijtihad is Arabic for “independent reasoning” of “effort.” Ijtihad is Arabic for “independent reasoning” or “effort.” 14 Gharar is Arabic for “deceptive uncertainty” and is the basis for other prohibitions in Islamic finance, such as risky deals whose outcome is unknown. 15 Exxon and Mobil entered into separate contracts with SABIC, but by the time of this lawsuit had merged to form one company named ExxonMobil. 13

Chapter 1 Introduction to Law

is that Islamic law does not embrace the common-law system of binding precedent and stare decisis. Indeed, in Saudi Arabia, judicial decisions are not in themselves a source of law, and with minor exceptions, court decisions in Saudi Arabia are not published or even open to public inspection. The trial judge was keenly mindful of this distinctive characteristic of Saudi law. Instead of relying upon statutes or decisional precedent to discern the law applicable to a particular case, judges in Saudi Arabia must “first and last navigate within the boundaries” of the Hanbali school’s authoritative works, which are the scholarly treatises. Using these writings as guides, Saudi judges identify a spectrum of possibilities on any given question, rather than a single ‘correct’ answer. Thus, in this highly different legal environment, the predominate factor in determining the Saudi law on a given issue is the study and analysis, or ijtihad, that a judge brings to bear in each particular case. To state it in different terms, the critical inquiry is whether the proper analytical procedures are followed in reaching the results. The judge made exceptional efforts to ensure that she was fully informed of the Hanbali teachings. Before trial, the parties presented [her] with seven reports from four Saudi law experts. [She also] retained an independent expert, who conduct[ed] additional research in Saudi Arabia. After reviewing a total of nine reports and more than 1,000 pages of testimony, the judge then held a day-long pretrial hearing, to [hear] live testimony from [the experts]. Only after this extensive process did the trial court undertake to determine the disputed elements of ghasb. It is remarkable that SABIC, having [purposefully] selected this forum instead of a Saudi Court, knowing the United States legal system is dramatically different than the Saudi legal system, comes forward after a verdict against it to claim that no American judge is qualified to interpret and apply Saudi law. This is particularly incredible in light of SABIC’s vehement argument that this case should be tried by a U.S. judge. For the foregoing reasons, the judgment of the Superior Court awarding damages to ExxonMobil is affirmed. Question: What is the predominate factor in determining the Saudi law on a given issue? Answer: The study and analysis, or ijtihad, that a judge brings to bear in each particular case. To state it in different terms, the critical inquiry is whether the proper analytical procedures are followed in reaching the results. Question: Which four guilds in Saudi Arabia have survived into modern times? Answer: The Hanbali, the Hanafi, the Shafi’i and the Maliki. Question: Which of these guilds are judges in Saudi Arabia instructed to rule exclusively in accordance with? Answer: The Hanbali. Bonus Notes: As we see from this case, the world and the law are increasingly internationalized. Greater interaction among societies has led to convergence among some © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

legal traditions. In particular, common law and civil law systems have borrowed significant concepts from each other.  Common law countries exhibit a trend toward codification. In the U.S., many laws, notably in intellectual property, bankruptcy, banking securities, and tax, are statutebased. The Uniform Commercial Code (UCC) now applies to contracts for the sale of goods in the U.S., an area of law previously governed only by common law. 

Civil law countries have begun to take precedents into account. One study found that German courts followed precedent in all but 12 out of 4,000 decisions. 16 Spain has enacted laws making the rulings of higher courts binding in lower courts. 17

3-4 Sources and Applicability of International Law This section outlines the three major sources of international law: treaties, custom, and general principles of law.

3-4a Sources of International Law Treaty: An agreement between two or more states that is governed by international law. A treaty is an agreement between two or more states that is governed by international law.  A bilateral treaty is between two countries. A multilateral treaty involves three or more countries.  A convention is a treaty on a specific issue that affects all the participants, like the UN Convention on Contracts for the International Sale of Goods.  A treaty is said to be adopted when those who have drafted it agree that it is in final form.  A treaty is ratified when a nation indicates its intent to be bound by it. To take effect in the U.S., treaties must be approved by at least two-thirds of the Senate.  A treaty enters into force when it becomes legally binding on its signatories. This date may be specified in the treaty or it may be the date on which the treaty receives a certain number of ratifications. This section examines treaties that are critical to international business.

GATT. GATT is the General Agreement on Tariffs and Trade GATT is a massive international treaty that has been negotiated on and off since the 1940s as nations have sought to eliminate trade barriers and bolster commerce. To strengthen this treaty, GATT signatories created the World Trade Organization (WTO) in 1995. Its mandate is to stimulate international commerce and resolve trade disputes. GATT and the WTO are founded on the following principles: World Trade Organization (WTO): An international organization whose mandate is to lower trade barriers. Most favored nation: WTO/GATT requires that favors offered to one country must be given to all member nations. 16 17

T. Lundmark, “Stare decisis in der Rechtssprechung des Bundesverfassungsgerichts.” Rechstheorie (1999). Ley Orgánica 6/1985, de 1 de julio, del Poder Judicial § © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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National treatment: The principle of nondiscrimination between foreigners and locals. The WTO tries to promote free trade by limiting countries’ efforts to unfairly protect their domestic industries. Among the techniques that countries use (and the WTO tries to limit) are:   

Customs duties: taxes imposed on goods when they enter a country Excise taxes: taxes levied on a particular activity, such as the purchase of wine or cigarettes Nontariff barriers: such as quotas on the amount of a particular good that can be imported

The WTO is empowered to settle trade disputes between its member states. If a country refuses to comply with the WTO’s ruling, affected nations may retaliate by imposing punitive tariffs or other measures.

Regional Trade Agreements Regional trade agreements (RTAs): Treaties that reduce trade restrictions and promote common policies among member nations. Regional Trade Agreements reduce trade restrictions and promote common policies among member nations who are located near each other. Today, RTAs cover more than half of international trade.

NAFTA North American Free Trade Agreement (NAFTA): A treaty that reduced trade barriers among Canada, the United States, and Mexico. In 1993, the United States, Canada, and Mexico signed the North American Free Trade Agreement (NAFTA), a treaty that reduced trade barriers among Canada, the United States, and Mexico. The principal goal was to eliminate almost all trade barriers between the three nations.

GATS and TRIPS General Agreement on Trade in Services (GATS): A treaty on transnational services. Agreement on Trade Related Aspects of Intellectual Property (TRIPS): A treaty on intellectual property. The General Agreement on Trade in Services (GATS) is a treaty on transnational services. It extends the WTO/GATT principles to transnational services. The Agreement on Trade Related Aspects of Intellectual Property (TRIPs) is a treaty on intellectual property.18 The WTO administers both of these treaties.

Case: United States—Measures Affecting the Cross-Border Supply of Gambling and Betting Services, WT/DS285/ARB WTO Arbitral Body, 2007 Facts: Antigua is a small Caribbean nation. When it began hosting gambling websites, its economy thrived, boosted by U.S. gamblers. But when the United States started criminally prosecuting Internet 18

Unit 1 The Legal Environment

gambling, Antigua’s profits plummeted. The United States had the right to take this step, but it had to do so consistently—treating foreign and domestic sites the same. The problem was that it allowed Internet betting on horseracing within its borders. Antigua challenged U.S. gambling laws in the WTO, arguing that they discriminated against foreign betting services. Both the United States and Antigua were members of GATS, under which each agree to free trade (including nondiscrimination and national treatment) in online services. A WTO panel ruled that the United States’ inconsistent gambling laws violated GATS and ordered that it bring them into compliance. Two years passed and the U.S. government did not act. Frustrated, Antigua requested permission from the WTO to suspend its obligations to the United States under TRIPs. This suspension would mean that Antigua could freely use, reproduce, and distribute any U.S.-copyrighted, trademarked, or patented works—a real blow to the U.S. entertainment, pharmaceutical, and technology industries. The United States objected and submitted the matter to a panel of WTO experts. Issue: When one WTO Member refuses to comply with a WTO ruling, can the injured Member retaliate by suspending its duties under another treaty? Excerpts from the WTO Arbitrator’s Decision: Antigua considers it unconscionable for the United States to have done nothing to come into compliance in the time that it should have, and now requests to be authorized to suspend [its] obligations under the TRIPS Agreement. Antigua, a developing country, is by far the smallest WTO Member to have made a request for the suspension of concessions and realizes the difficulty of providing effective countermeasures against the world’s dominant economy. When a complaining party wishes to seek suspension in another agreement than that in which a violation was found, it must prove that (1) it is not effective for it to suspend the same agreement and (2) that the circumstances are serious enough to suspend obligations under another agreement. Antigua considers that suspension of obligations in [GATS] would most likely impair the already limited options available to Antiguan citizens while having virtually no impact on the United States at all. The trade disparity [between the countries] is so great that United States service providers would suffer little harm at all, if any, while Antiguan consumers would be forced to scramble for replacement services at uncertain cost. The volume of its imports from the United States in services is nowhere near sufficient to absorb the level of suspension of concessions that it is entitled to. In order to demonstrate the seriousness of the circumstances, Antigua first presents some basic figures comparing the population, size, GDP, exports and imports of the United States and Antigua, which illustrate a considerable disparity in all of these areas. Antigua also highlights that it has extremely limited natural resources and very limited arable land, such that it cannot produce sufficient agricultural products to satisfy domestic needs, let alone for export.

Chapter 1 Introduction to Law

Antigua further notes that its economy has become highly dependent on tourism and associated services. Third, Antigua highlights the need to diversify its economy, and that in order to do this it has tried to develop trade in services, including trade in remote gambling. In our view, the various considerations highlighted by Antigua are such as to exacerbate the difficulties in finding a way to suspend obligations in an effective manner under the GATS. Accordingly, we find that Antigua may seek to suspend obligations under the TRIPS Agreement. Question: When a complaining party wishes to seek suspension in another agreement than that in which a violation was found, what must it prove? Answer: It must prove that (1) it is not effective for it to suspend the same agreement and (2) that the circumstances are serious enough to suspend obligations under another agreement. Question: What is the smallest WTO member? Answer: Antigua. Question: What does the acronym WTO stand for? Answer: World Trade Organization.

Bonus Case: Avenues in Leather, Inc. v. U.S., 423 F.3d 1326, Court of Appeals for the Federal Circuit, 2006 Facts: Avenues in Leather (Avenues) imported Calcu-Folios, which are 13 inches tall by 11 inches wide and 1.5 inches deep. They are made of paperboard covered in plastic with a padded handle. It is zippered on three sides and contains an interior sleeve, several small pockets, a calculator, and threering binder. The Customs Service (Customs) classified the Calcu-Folio under tariff heading 4202 which covers “trunks, suitcases, vanity cases, attaché cases, briefcases, school satchels, and similar containers”. Avenues claims the Calcu-Folios should be classified under tariff heading 4820 which covers “binders, folders, file covers, memorandum pads, letter pads and similar articles”. Heading 4820 imposes a 3% tariff and heading 4202 imposes a 20% tariff. Avenues sued and the Court of International Trade found for Avenues. Customs appealed. Issue: Was the Calcu-Folio properly classified as a briefcase or a binder? Holding: Judgment affirmed. Avenues testified that the Calcu-Folio was designed as an organizational aid for taking notes, thus it is more like a “portfolio” or a flat case designed to hold papers. Customs argued that Calcu-Folios was more like a “briefcase,” emphasizing the container elements of the good, and introducing evidence of the marketing of the good for business travel. Customs also argued that the good can be used to carry non-paper personal and business items. Heading 4202 contains a list of specific items, and the general phrase “similar articles.” For a good to be considered a “similar article” that good must share the same essential purpose as those listed under the heading.

Unit 1 The Legal Environment

Although the Calcu-Folio may be used to carry small items, the internal carrying space is only 1 inch, thus making it unsuitable for carrying newspapers, books, and other objects that are normally carried in the items listed in heading 4202. The Court agrees with the Court of Internal Trade’s finding that the characteristics of the Calcu-Folio most closely resemble an article of stationery and fall within heading 4820. While the memo pad is an item specifically listed under heading 4820, most of the other characteristics of the good pertain to writing or written documents. Question: Why did Avenues Leather challenge the Customs Service classification of these costumes? Answer: Because under the Customs classification Avenues would pay a 20% tariff on the goods. If classified under 4820, Avenues would pay a much reduced 3%. Question: I thought the U.S. Customs Service stamped passports and looked in your luggage when you reenter the U.S. Why is it up to the Customs Service to distinguish between “briefcase” and “binder?” Answer: The Customs Service also has the job of classifying merchandise entering the U.S.—that is, deciding what the goods are, and what duties and import restrictions apply to them. Question: How did the Customs Service decide the nature of the Calcu-Folios in this case? Answer: It looked at the good and focused on the “container” aspect of the Calcu-Folio to determine that its primary purpose was as a container. Question: Why didn’t the court agree with that classification? Answer: Because the Calcu-Folio was too small to carry anything a briefcase would contain, like a newspaper or books. Also, because of the attached memo pad, the Court agreed with Avenues that the purpose was as an article of stationery.

CISG The United Nations Convention on Contracts for the International Sale of Goods (CISG) aims to make sales law more uniform and predictable—and to make international contracting easier. This treaty governs more than two-third of the world’s trade. The most important provisions are:       

It applies to contracts for the sale of commercial goods, but not to consumer goods It applies automatically when contracts are formed between two parties located in different signatory countries Contracting parties can opt out, but they must clearly state so in their contract. International sales contracts do not need to be in writing. Contracting parties must be flexible and fair. A buyer can avoid payment under a contract only after giving the seller notice and an opportunity to remedy. Countries may use their own national laws to (1) replace some CISG provisions, or (2) fill in the blanks on issues that the CISG does not cover at all.

In the following case, each country had different contract rules and divergent interpretations of the CISG. The result was a huge mess. Which law applies?

Chapter 1 Introduction to Law

Case: Forestal Guarani S.A. v. Daros International, Inc. 613 F.3d 395 United Stated Court of Appeals for the Third Circuit, 2010 Facts: Forestal Guarani S.A., in Argentina, entered into an oral agreement to sell wooden finger-joints to Daros International, Inc. in New Jersey.19 Forestal sent Daros the products but Daros declined to pay the full amount. When Forestal sued Daros in the U.S. for breach of contract, Daros denied owing anything because, under New Jersey sales law, the contract would have had to be in writing to be enforceable. Further, it claimed, Argentina had not accepted the CISG’s elimination of the writing requirement when it ratified the CISG. Since the contract was not in writing, it was also possible that Argentine law applied. The district court dismissed Forestal’s claim because the parties’ agreement was not in writing. Forestal appealed. Issue: Which law applied to this contract—the CISG, Argentine law, or New Jersey law? Excerpts from Judge Fisher’s Decision: The CISG applies to contracts of sale of goods between parties whose places of business are in different States when the States are Contracting States. Because both the United States, where Daros is based, and Argentina, where Forestal is based, are signatories to the CISG and the alleged contract at issue involves the sale of goods, the CISG governs Forestal’s claim. The CISG dispenses with certain formalities associated with proving the existence of a contract. Specifically, a contract of sale need not be evidenced by writing and it may be proved by any means, including witnesses. [But the] elimination of formal writing requirements does not apply in all instances in which the CISG governs. A Contracting State whose legislation requires contracts of sale to be evidenced by writing may at any time make a declaration that [that rule] does not apply where any party has his place of business in that State. The United States has not made [such a] declaration. Argentina, however, has opted out of [this CISG rule]. There is no dispute here that Forestal’s contract with Daros was verbal at best, so we could feasibly apply both New Jersey and Argentine law. In the end, we think it unwise to engage in a largely speculative exercise about the viability of Forestal’s claim under either jurisdiction’s law. Because these issues deserve a full airing, we conclude that remand is a better course of action. Question: What types of contracts does the CISG apply to? Answer: Contracts of sale of goods between parties whose place of business are in different States when the States are Contracting States. Question: What formalities associated with proving the existence of a contract does the CISG dispense with? Answer: A contract of sale need not be evidenced by writing, and it may be proved by any means, including witnesses. 19

A finger joint is a method of attaching two pieces of wood. Rectangular cut-outs are made in the end of each piece. Then the pieces are joined together so that the cut-outs on one piece fit the projections on the other. It is as if you bent your fingers at the knuckle and then slid your hands together. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

Question: When does the elimination of a formal writing requirement by the CISG not apply? Answer: A Contracting State whose legislation requires contracts of sale to be evidenced by writing may at any time make a declaration that the rule does not apply where any party has his place of business in that State.

Custom and General Principles of Law Customary international law: international rules that have become binding through a pattern of consistent, longstanding behavior. Jus cogens: When rule of customary international law becomes a fundamental legal principle across all nations, it cannot be changed by custom or practice. 20 Today, courts recognize a custom as binding international law if:   

It is widespread and widely accepted, It is longstanding, and Nations follow it out of a sense of obligation to each other.

3-4b Interaction of Foreign and Domestic Laws Application of U.S. Law Abroad Extraterritoriality: The power of one country’s laws to reach activities outside of its borders. Application of U.S. Law Abroad Countries sometimes look to other nations for models when developing laws; however, that doesn’t mean they want these nations to impose their laws in other countries. Extraterritoriality is the power of one nation to impose its laws in other countries.21 As a general rule, U.S. statutes do not apply abroad, unless they specifically state that they do.

In our modern world, sometimes borders are irrelevant. Or are they? What should happen when the government wants access to information on a foreign server? You make the call.

You Be the Judge Case: Microsoft Corp. v. United States, 829 F.3d 197, USCA, 2nd Circuit, 2016 Facts: The Stored Communications Act (SCA) protects the privacy of electronic communications stored by service providers (that is, by companies offering an internet connection). This statute prohibits the government from accessing a user’s electronic files without a warrant supported by probable cause. But because Congress passed the statute in 1986 – before the use of the internet was so widespread – it did not specifically state whether or not the statute applied overseas. 20

Jus cogens means “compelling law” in Latin. Extraterritoriality can also refer to exemption from local laws. For example, ambassadors are generally exempt from the law of the nation in which they serve. 21

Chapter 1 Introduction to Law

Microsoft, a U.S. corporation, operates Outlook.com, a free web-based email service. When Microsoft customers send and receive Outlook emails, the company stores the emails on a network of servers housed in datacenters spread over 40 countries. Microsoft’s system automatically determines which datacenter will store emails based on the user’s self-reported country code. Once the data transfer is complete, Microsoft deletes all information associated with the account from its U.S.-based servers. A federal judge issued an SCA warrant ordering Microsoft to disclose the contents of a particular user’s email account. Because those emails were located in its Dublin datacenter, Microsoft refused to comply, arguing that the SCA did not apply to data housed abroad The lower court disagreed and ordered Microsoft to comply with the warrant. The Company appealed. You Be the Judge: Does the SCA authorize the U.S. government to obtain emails stored exclusively on foreign servers? Argument for Microsoft: Your honors, the presumption against extraterritorial application of U.S. statutes is strong: Unless Congress specifically states that a statute applies overseas, courts must presume that it does not. The information sought in this case is stored in Dublin. Enforcing the warrant would be an unlawful application of the SCA and an intrusion on the privacy of Microsoft’s customer. Argument for the Government: Nothing in the SCA’s text, structure, purpose, or history indicates that Congress wanted to limit where electronic records could be seized. Preventing SCA warrants from reaching foreign servers would seriously impede U.S. law enforcement efforts. A wrongdoer could easily shield illegal content from the police just by reporting a different country code – a result that the SCA could not have intended. Holding: The Appeals Court held that the government could not compel Microsoft (or other Internet Service Providers) to turn over data stored overseas, even with a warrant. Question: In this case, the main issue was a question of extraterritoriality. What does extraterritoriality mean? Answer: Extraterritoriality is the power of one nation to impose its laws on other countries. Question: Did the statute involved, the Stored Communications Act, say whether or not it applied extraterritorially? Answer: No, it did not. However, it became law before the Internet was widely used. Question: Do you think the court made the right decision in this case? Answer: Answers will vary.

Unit 1 The Legal Environment

U.S. Recognition and Enforcement of Foreign Judgments Foreign recognition: Means that a foreign judgment has legal validity in another country. Foreign enforcement: Means that the court system of a country will assist in enforcing or collecting on the verdict awarded by a foreign court. Most U.S. states have adopted the Uniform Foreign Money Judgments Recognition Act to determine when courts will recognize foreign judgments.

Arbitration Arbitration: A binding process of resolving legal disputes by submitting them to a neutral third party. The New York Convention: Widely accepted treaty on the court enforcement of arbitral awards. Parties who want to avoid courts altogether generally opt for arbitration.

Essential Clauses in International Contracts International business brings great reward, but it also carries significant risk associated with distance, language, politics, culture, and different legal systems. However, some of these risks can be controlled by carefully thinking about contract terms beforehand. To ensure that you do not end up with a judgment you cannot enforce, be sure to consider the following when you negotiate international deals: 

Choice of Law: Which Law Governs? It is essential to negotiate which country’s law will control. How to compromise? Perhaps by choosing a neutral law, not the law of either country.



Choice of Forum: Where Will the Case Be Heard? This can be a significant part of a contract, because legal and court systems are dramatically different in terms of speed, cost, transparency, and trustworthiness.

 Choice of Language and Currency. Language counts because legal terms seldom translate literally. Currency is vital because the exchange rate may alter between the signing and payment.

Chapter Conclusion International law is increasingly relevant to our globalized business world. While it was once the domain of nations, today it affects individuals, businesses, and groups all over the world. As the world gets smaller, these issues will become more and more pressing.

Matching Questions Match the following terms with their definitions: _____A. GATT 1. A trade agreement between Mexico, the United States, and Canada _____B. NAFTA 2. The World Court _____C. TRIP 3. An international convention that governs the sale of goods _____D. CISG 4. A treaty that governs trade _____E. ICJ 5. A treaty that governs intellectual property © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1 Introduction to Law

Answers: K. 4 L. 1 M. 5 N. 3 O. 2

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 11. T F The ICC makes international law. 12. T F States can opt out of ICJ jurisdiction. 13. T F The CISG requires parties to negotiate internationally in good faith. 14. T F Incoterm rules define terms used in international contracts. 15. T F The WTO settles disputes involving individuals, businesses, or countries.

Multiple Choice Questions 1. For which of the following activities can a foreign sovereign be sued? A. Operating a factory dangerously B. Issuing a law that discriminates against a certain group C. Suspending the civil rights of its people D. None of the above Answer: A. 2. Outdoor Technologies (an Australian company) obtained a judgment for $500,000 against Silver Star (a Chinese company) in a court in Australia. Silver Star owned property in Iowa so Outdoor filed suit in Iowa to collect the judgment. Which of the following statements is true? A. Outdoor cannot collect in the United States a judgment that was issued by an Australian court. B. Outdoor cannot collect in the United States because Silver is not an American company. C. Outdoor can collect in the United States if the Australian court was fair and proper. D. Outdoor can collect in the United States, because both the United States and Australia have common law systems. Answer: C. 3. The President negotiates a defense agreement with a foreign government. To take effect, the agreement must be ratified by which of the following? A. Two-thirds of the House of Representatives B. Two-thirds of the Senate C. The Supreme Court D. A and B E. A, B, and C Answer: B.

Unit 1 The Legal Environment

4. Lynn is an author living in Nevada. She contracted with a company in China, which promised to print her custom children’s books. After receiving Lynn’s payment, the company disappeared without performing. Lynn wants to sue for fraud, but the contract does not say anything about which country’s law will be used to resolve disputes. Both China and the United States are signatories of the CISG. Will the CISG apply in this case? A. Yes, because both countries are signatories. B. Yes, because the parties did not opt out of the CISG. C. No, because the contract does not involve goods. D. No, because the CISG does not establish rules for fraud. Answer: C. 5. Austria, Indonesia, and Colombia are all members of the WTO. If Austria imposes a tariff on imports of coffee beans from Colombia, but not from Indonesia, is it in violation of WTO principles? A. Yes, the WTO prohibits tariffs. B. Yes, the WTO prohibits excise taxes. C. Yes, Austria is violating the WTO’s most favored nation rules. D. No, the WTO’s most favored nation rules permit Austria to do this. Answer: C.

Case Questions 1. A Saudi Arabian government-run hospital hired American Scott Nelson to be an engineer. The parties signed the employment agreement in the United States. On the job, Nelson reported that the hospital had significant safety defects. For this, he was arrested, jailed, and tortured for 39 days. Upon his release to the United States, Nelson sued the Saudi government for personal injury. Can Nelson sue Saudi Arabia? Answer: Based on Saudi Arabia v. Nelson (US S. Ct. 1993). The Supreme Court found that FSIA applied to immunize Saudi Arabia from the suit. While employing someone is a commercial activity, the Court reasoned that the injury stemmed from his arrest. Since a private citizen cannot jail someone, this is purely a governmental activity. 2. The Instituto de Auxilios y Viviendas is a government agency of the Dominican Republic. Dr. Marion Fernandez, the general administrator of the Instituto and Secretary of the Republic, sought a loan for the Instituto. She requested that Charles Meadows, an American citizen, secure the Instituto a bank loan of $12 million. If he obtained a loan on favorable terms, he would receive a fee of $240,000. Meadows secured a loan on satisfactory terms, which the Instituto accepted. He then sought his fee, but the Instituto and the Dominican government refused to pay. He sued the government in United States District Court. The Dominican government claimed immunity. Comment. Answer: The suit arose out of a loan agreement. Since this is activity that an individual can engage in, the Dominican government is not immune. 3. Many European nations fear the effects of genetically modified foods, so they choose to restrict their importation. The EU banned the entry of these foods and subjected them to strict labeling requirements. Does this policy contravene the principles of WTO/GATT? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1 Introduction to Law

Answer: The US challenged this practice and WTO ruled that GM food had to be allowed into the EU. The WTO held that no scientific evidence supported the EU’s fears and therefore the regulation unduly burdened trade. 4. Boston Scientific (BSC), an American multinational, hired Carnero to work in its Argentine subsidiary. Carnero was paid in pesos, and his contract was governed by Argentine law. After BSC fired Carnero, he sued in the United States, claiming that the company terminated him for blowing the whistle on its accounting fraud. If this allegation was true, BSC would be in violation of an American statute, the Sarbanes-Oxley Act (SOX). BSC argued that, because SOX made no mention of extraterritorial application, it did not apply to overseas employees. Should SOX apply to an employee of a U.S. subsidiary working abroad? Answer: Citing the “well-established presumption against the extraterritorial application of Congressional statutes.” the Court declined to extend whistleblower protection to overseas workers of U.S. corporations. 5. Chateau, a Canadian winery, contracted over the phone to buy 1.2 million wine corks from Sabate USA, the U.S. subsidiary of Sabate France. The parent company shipped the corks from France to Canada, along with a pre-printed invoice. The invoice contained a forum selection clause providing that any dispute would be heard in a French court. When Chateau realized that the corks altered the taste of its wine, it sued Sabate in California for breach of contract. Chateau argued that the forum selection clause was not part of the original deal. Furthermore, it had an enforceable oral agreement with Sabate USA, which was governed by the CISG because both Canada and the United States were signatories. Did the CISG govern the dealings between Chateau and Sabate USA? If so, did the contract between Chateau and Sabate USA have to be in writing? Was the forum selection clause enforceable against Chateau? Answer: Yes, the CISG did govern the dealings between the parties, and the agreement did not have to be in writing, as oral contracts were sufficient. But the forum selection clause, the court ruled, was a later attempted modification of an existing contract, and therefore, unenforceable.

Discussion Questions 1. After reading this chapter, do you believe that international law exists? Has your concept of law and legal rules changed? Answer: Answers will vary. 2. After the 9/11 terrorist attacks, the U.S. government imprisoned suspected terrorists in Guantanamo Bay, Cuba. Officials argued that these detainees did not enjoy constitutional rights because they were not on U.S. soil, even though they were held by Americans. Are the freedoms guaranteed by the U.S. Constitution reserved for U.S. citizens on U.S. soil or do they apply more broadly? Answer: In Boumediene v. Bush, 553 U.S. 723 (2008), the Supreme Court held that the Constitution protected the rights of noncitizens outside U.S. borders.

Unit 1 The Legal Environment

3. The United Kingdom has not signed the CISG. Until recently, major world traders like Japan and Brazil had refused to sign. Imagine that you are a legislator from one of these countries. What might your objections be to ratifying a treaty on sales law? Answer: Answers may include the following:  Legal uncertainty caused by introducing a new set of rules of sale  Who will interpret new rules and how? These broadly formulated rules contain many undefined and new terms which have to be developed in the international arena by courts and arbitral tribunals and no principles of stare decisis.  The introduction of foreign solutions to well-known problems  The absence of certain underlying principles  The law is robbed of its flexibility and is fossilized in a code which is almost impossible to change. The integrity of the Convention is threatened by diverse interpretational approaches and tradition. 4. Generally speaking, should the United States pass laws that seek to control behavior outside the country? Or, when in Rome, should our companies and subsidiaries be allowed to do as the Romans do? Answer: Answers will vary. 5. What responsibility, if any, does the United States have to obey international law? Is it any different from other countries’ responsibility to uphold international law? Why or why not? Answer: Answers will vary.

Suggested Additional Assignments Interview: An Importer Students should locate a local businessperson who imports goods or sells imported goods. Why does she choose to deal in imported goods? What advantages do the goods give her over domestic goods? What problems has she encountered? What advice would she have for an entrepreneur who plans to sell imported goods? Research: School Spirit and Child Labor Some universities are responding to the tragedy of child exploitation by refusing to license the school logo to any apparel company that uses child labor. Duke University was one of the first, and other schools soon followed. Other apparel makers have similarly decided to insist on adult-made goods. Divide the class into groups of three or four students. Each group should be assigned to a college, university, or clothing brand name. The group’s responsibility is to contact the assigned organization and track down who makes its apparel and what, if any, steps it has taken to ensure that children do not manufacture the goods.

Chapter 1 Introduction to Law

Chapter 4 – Constitutional, Statutory, Administrative, and Common Law* Chapter Overview Chapter Theme The United States Constitution, the greatest legal document ever written, is a series of compromises about the power of government. The compromises affect every citizen and company in the nation, every day. Statutory law is created by legislators, both federal and state. Administrative agencies create their own rule and interpret them, and judges rely on previous decisions to rule on current cases; such is the common law.

4-1 Constitutional Law 4-1a Government Power The Constitution of the United States is the greatest legal document ever written. No other written constitution has lasted so long, governed so many, or withstood such challenge. It is short and easy to read; the language is general, so subject to interpretation. No law can conflict with it. The interpretation of its provisions has changed. It has stayed relevant in the face of changing social mores, times, and technology. Its versatility is striking. The Constitution is a series of compromises about power.

Separation of Powers: The Framers did not want too much power in any single place. One method of limiting power was to create a national government divided into three branches, each independent and equal. Each branch would act as a check on the power of the other two. Article I of the Constitution created a Congress, which was to have legislative, or lawmaking, power. Article II created the office of president, defining the scope of executive, or enforcement, power. Article III established judicial, or interpretive, power by creating the Supreme Court and permitting additional federal courts.

Federalism: The national government was to have considerable power, but it would be limited. Article I, Section 8, describes the issues on which Congress may pass statutes. If an issue is not on the list, Congress has no power to legislate.

4-1b Power Granted Congressional Power: Congress wields tremendous power. Recall that voters in all 50 states elect representatives to serve in Congress. Congress is comprised of the House of Representatives (435 voting members, more from populous states), and the Senate (100 members, 2 from each state). Its members create statutes that influence our jobs, money, health care, military, communications, and virtually everything else. Article I, section 8 is a critically important part of the Constitution. It lists the 18 types of statutes that Congress is allowed to pass, such as imposing taxes, declaring war and coining money.

Unit 1 The Legal Environment

Interstate Commerce Commerce Clause: The part of Article I, Section 9, that gives Congress the power to regulate commerce with foreign nations and among states.

Does the Commerce Clause allow Congress to force people into commerce? See the case below, regarding the Patient Protection and Affordable Care Act, which was upheld by the U.S. Supreme Court in June 2012.

Case: National Federation of Independent Business v. Sebelius, 576 U.S. ___, 132 S. Ct. 2566, United States Supreme Court, 2012 Facts: In 2010, Congress enacted the Patient Protection and Affordable Care Act (the Act), which aimed to increase the number of Americans covered by health insurance and decrease the cost of health care. The part of the Act called the “individual mandate” required most Americans to maintain health insurance coverage, or else pay a penalty. Thirteen states challenged the individual mandate, arguing that Congress had violated the Commerce Clause of the Constitution. The lower courts agreed and the Supreme Court granted certiorari. Issue: Did the Affordable Care Act violate the Commerce Clause? Decision: No. Although Congress does not have the power to make Americans purchase health insurance, it is authorized under the Constitution to impose a tax on the uninsured. Reasoning: Under the Commerce Clause, Congress may regulate interstate commerce and activities that substantially affect it. The government argued that Congress could order most Americans to buy health insurance because if only the old or sick made this purchase, rates would increase and, as a result, affect interstate commerce. But requiring people to buy something is fundamentally different from regulating people who voluntarily decide to participate in commerce. Forcing individuals into commerce is beyond the federal government’s authority under the Commerce Clause. However, Congress also has the power to tax. And in many ways, the individual mandate is just a tax on the uninsured. It makes going without insurance just another thing the government taxes, like buying gasoline or earning income. And, like a tax, it is paid to the Treasury and produces some revenue for the government. In sum, the federal government cannot make people buy health insurance, but it can tax those who do not. The individual mandate is constitutional, because it can reasonably be interpreted as a tax. Question: What was the issue in this case? Answer: The issue was whether Congress had authority, under the Commerce Clause, to require people to purchase health insurance. Question: Where is the Commerce Clause found? Answer: Article I, Section 8 of the U.S. Constitution. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Did the Supreme Court hold that Congress did have that power under the Commerce Clause? Answer: No. The court held that the Commerce Clause would not enable Congress to require people to enter into commerce. Question: Then the law was declared unconstitutional? Answer: No, it was declared constitutional under a different Congressional power - the power to tax. Question: What was the Court’s reasoning? Answer: The Court ruled that Congress was within its authority to tax people who declined to buy health insurance, as it taxes other activities, including buying gasoline or earning income.

Executive Power The basic job of the president is to enforce the nation’s laws. Three of the president’s key powers concern appointment, legislation, and foreign policy. Appointment: The president nominates the heads of most administrative agencies, and those choices dramatically influence what issues the agencies choose to pursue and how aggressively they do so. Legislation: The president and the president’s advisors propose bills to Congress and lobby hard for their passage. The executive also has veto power. Foreign Policy: The president conducts the nation’s foreign affairs, coordinating international efforts, negotiating treaties, and so forth. The president is also the commander-in-chief of the armed forces. Judicial Power Article III of the Constitution creates the Supreme Court and permits Congress to establish lower courts within the federal court system. Federal courts have two key functions: adjudication and judicial review. Adjudicating Cases: The federal court system hears criminal and civil cases Judicial review: Refers to the power of federal courts to declare a statute or governmental action unconstitutional and void.

You Be the Judge: Kennedy v. Louisiana 128 S.Ct. 2641, United States Supreme Court, 2008. Facts: Patrick Kennedy raped his eight-year-old stepdaughter. A forensic expert testified that the girl’s injuries were the most severe he has ever witnessed. The jury also heard evidence that the defendant had raped another eight-year-old. Kennedy was convicted of aggravated rape, because the victim was under twelve years old.

Unit 1 The Legal Environment

The jury voted to sentence Kennedy to death, which was permitted by the Louisiana statute. The state supreme court affirmed the death sentence and Kennedy appealed to the United States Supreme Court. He argued that the Louisiana statute was unconstitutional. The Eighth Amendment prohibits cruel and unusual punishment, which includes penalties that are out of proportion to the crime. Kennedy claimed that capital punishment was out of proportion to rape and thus violated the Eighth Amendment. Six states have passed laws permitting capital punishment for child rape, though the remaining 44 states had not. Louisiana argued that the statute did not violate the amendment and that the voters must be allowed to express their abhorrence of so evil an act. You Be the Judge: Did the Louisiana statute violate the Constitution by permitting the death penalty in a case of child rape? Is it proper for the Supreme Court to decide this issue? Argument for Kennedy: The court’s interpretation of the Constitution must evolve with society. The Eighty Amendment requires that punishment be proportionate to the crime. A national consensus opposes the death penalty for any crime other than murder. Capital punishment exists in 36 states, but only six of those states allow it for child rape. No state has executed a defendant for rape since 1964. As horrifying as child rate is, society merely brutalizes itself when it sinks to the level of capital punishment for a crime other than murder. There are also policy reasons to prohibit this punishment. Children may be more reluctant to testify against perpetrators if they know that a prosecution could lead to execution. Also, a young child may be an unreliable witness for a case where the stakes are so high. It is the responsibility of this court to nullify such a harmful law. Argument for Louisiana: Child rape is one of the most horrifying of crimes. The defendant damages a young person, destroys her childhood, and terrifies a community. Only the severest of penalties is sufficient. Six states have recently passed statutes permitting capital punishment in these cases. It is possible that a consensus is developing in favor of the death penalty for these brutal assaults. If the court strikes down this law, it will effectively stifle a national debate and destroy any true consensus. Kennedy argues that capital punishment might be bad policy - but that is a question for voters and legislatures, not for courts. Obviously, the citizens of Louisiana favor this law. If they are offended by the statute, they have the power to replace legislators who support it. The court should leave this issue to the citizens. That is how a democracy is intended to function. Excerpts from Justice (Anthony) Kennedy’s Writing of the Majority Opinion: The Eighth Amendment mandates that the State’s power to punish be exercised within the limits of civilized standards. Evolving standards of decency that mark the progress of a maturing society counsel us to be most hesitant before interpreting the Eighth Amendment to allow the extension of the death penalty, a hesitation that has special force where no life was taken in the commission of the crime. Consistent with evolving standards of decency and the teachings of our precedents we conclude that, in determining whether the death penalty is excessive, there is a distinction between intentional firstdegree murder on the one hand and nonhomicide crimes against individual persons, even including child rape, on the other. The latter crimes may be devastating in their harm, as here, but in terms of moral © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1 Introduction to Law

depravity and of the injury to the person and to the public, “they cannot be compared to murder in their” severity and irrevocability. Louisiana reintroduced the death penalty for rape of a child in 1995. Five states have since followed Louisiana’s lead: Georgia, Montana, Oklahoma, South Carolina, and Texas. By contrast, 44 states have not made child rape a capital offense. As for federal law, Congress in the Federal Death Penalty Act of 1994 expanded the number of federal crimes for which the death penalty is a permissible sentence, including certain non-homicide offenses; but it did not do the same for child rape or abuse. [The court concludes that there is a national consensus against imposing the death penalty for rape, and strikes down the Louisiana statute.] Justice Alito, dissenting: If anything can be inferred from state legislative developments, the message is very different from the one that the Court perceives. In just the past few years, five states have enacted targeted capital child-rape laws. Such a development would not be out of step with changes in our society’s thinking. During that time, reported instances of child abuse have increased dramatically; and there are many indications of growing alarm about the sexual abuse of children. [The judgment of the Louisiana Supreme Court should be affirmed.] Question: Does Article III grant the power to the U.S. Supreme Court to overturn the law enacted by the Louisiana legislature? Answer: No. Question: Then, how is the U.S. Supreme Court able to overturn Louisiana’s statute? Answer: Through its use of judicial review. Question: Do you favor the majority opinion or the dissenting opinion by Justice Alito? Answer: Answers will vary. Question: Should voters have the final say, or the Supreme Court? Answer: Answers will vary.

4-1c Protected Rights The original Constitution was silent about the rights of citizens. This alarmed many, who feared that the new federal government would have unlimited power over their lives. So, in 1791, the first ten amendments, known as the Bill of Rights, were added to the Constitution, guaranteeing many liberties directly to individual citizens. First Amendment: Protects freedom of speech. Fourth Amendment: Protects against illegal searches. Fifth Amendment: Ensures due process. Sixth Amendment: Demands fair treatment for defendants in criminal prosecutions. Fourteenth Amendment: Guarantees equal protection of the law.

First Amendment: Free Speech The First Amendment states that “Congress shall make no law…abridging the freedom of speech…” The Framers believed democracy would work only if the members of the electorate were free to talk, argue, listen, and exchange viewpoints in any way they wanted. “Speech” includes symbolic conduct. Does that mean flag burning is permissible? The following case is about that issue.

Unit 1 The Legal Environment

Case: Texas v. Johnson 491 U.S. 397, 109 S. Ct. 2533, 1989 U.S. LEXIS 3115 United States Supreme Court, 1989 Facts: Outside the Republican National Convention in Dallas, Gregory Johnson participated in a protest against policies of the Reagan administration. Participants gave speeches and handed out leaflets. Johnson burned an American flag. He was arrested and convicted under a Texas statute that prohibited desecrating the flag, but the Texas Court of Criminal Appeals reversed on the grounds that the conviction violated the First Amendment. Texas appealed to the United States Supreme Court. Issue: Does the First Amendment protect flag burning? Decision: The First Amendment protects flag burning. Reasoning: The First Amendment literally applies only to “speech,” but this Court has already ruled that the Amendment also protects written words and other conduct that will convey a specific message. For example, earlier decisions protected a student’s right to wear a black armband in protest against American military actions. Judged by this standard, flag burning is symbolic speech. Texas argues that its interest in honoring the flag justifies its prosecution of Johnson, since he knew that his action would be deeply offensive to many citizens. However, if there is a bedrock principles underlying the First Amendment, it is that the government may not prohibit the expression of an idea simply because society finds it offensive. The best way to preserve the flag’s special role in our lives is not to punish those who feel differently, but to persuade them that they are wrong. We do not honor our flag by punishing those who burn it because in doing so we diminish the freedom that this cherished emblem represents. Comment: In dissent, Justice Rehnquist wrote: “In holding this Texas statute unconstitutional, the court ignores Justice Holmes’ familiar aphorism that ‘a page of history is worth a volume of logic.’ For more than 200 years, the American flag has occupied a unique position as the symbol of our Nation, a uniqueness that justifies a governmental prohibition against flag burning in the way respondent Johnson did here.” Questions for those who agree that the First Amendment protects flag burning:  Isn’t it very painful for veterans of foreign wars, some permanently disabled, to see someone burn the flag that they fought for?  Did Johnson contribute any valuable ideas when he burned the flag?  If he contributed nothing, why should a state be forced to permit his actions?  If the majority of a state’s citizens want to outlaw flag burning, why shouldn’t they be allowed to? Questions for those who argue that the First Amendment does not protect flag burning:  If a state could outlaw flag burning, could it also outlaw burning a copy of the Constitution? A photograph of the flag? A cross? A photograph of the President?

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 

Even if some people regard the flag as special, why should their opinion be the law of the land? Doesn’t the anger created by flag burning indicate that it is effective speech? Should we outlaw effective speech and permit only speech that offends no one?

4-1d Fifth Amendment: Due Process and the Takings Clause Procedural Due Process: Ensures that before the government takes liberty or property, the affected person has a fair chance to oppose the action. Takings Clause: Prohibits a state from taking private property for public use without just compensation. The Due process clause and the takings clause together state: “No person shall be…deprived of life, liberty, or property without due process of law; nor shall private property be taken for public use, without just compensation.”

The Takings Clause: Eminent domain: The power of the government to take private property for public use. A regulation that denies all beneficial use of property is a taking and requires compensation.

4-1e Fourteenth Amendment: Equal Protection Clause Equal Protection Clause: Requires that the government must treat people equally. Regulations based on gender, race, or fundamental rights are generally void.

4-2 Statutory Law Statutes: Laws passed by Congress or state legislatures.

4-2a Committee Work Bill: A proposed statute. Congress is organized into two houses, the House of Representatives and the Senate. Either house may originate a proposed statute, which is called a bill. After a bill is proposed it is sent to the committee that specializes in that subject. Bills are proposed because of:   

New Issue, New Worry: When some employers began requesting that job candidates disclose their Facebook passwords as a condition of employment, a public outcry ensued. Various members of Congress proposed legislation designed to end this new practice. Unpopular Judicial Ruling: If Congress disagrees with a judicial interpretation of a statute, the legislators may pass a new statute to modify or “undo” the court decision. Criminal Law: When legislators perceive that social changes have led to new criminal acts, they may respond with new statutes. The rise of internet fraud has led to many new statutes outlawing such things as computer trespass and espionage, fraud in the use of cell phones, identity theft, and so on. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4-3 Common Law Common law: Legal precedents created by appellate courts. The common law is judge-made law. It is the sum total of all the judicial decisions that have not been overturned by appellate courts. We focus on appellate courts because they are the only ones to make r4ulings or determinations of law.

4-3a Stare Decisis Stare decisis: Means “let the decision stand” and describes the practice of courts following prior decisions.

4-3b Bystander Cases The U.S. inherited from England a simple rule about a bystander’s obligations: You have no duty to assist someone in peril unless you created the danger. “With the human side of the question courts are not concerned. It is the omission or negligent discharge of legal duties only which come within the sphere of judicial cognizance.***” Union Pacific RR v. Cappier (1903). Later, an exception: “****we hold that where+ a servant suffers serious injury, or is suddenly stricken down in a manner indicating the immediate and emergent need of aid to save him from death or serious harm, the master, if present is in duty bound to take such reasonable measures as may be practicable to relieve him, even though such master be not chargeable with fault in bringing about the emergency.” Carey v. Davis, 190 Iowa 720 (1921) Still later… The Tarasoff exception applies when there is some special relationship, such as therapist-patient. Tarasoff v. Regents of the University of California (1976) This is how the common law often changes: bit by tiny bit. BUT, the bystander rule, that hardy oak, is alive and well. Various initials have been carved into its bark – the exceptions we have seen and some others - but the trunk is strong and the leaves green. Perhaps someday the pr9oliferating exceptions will topple it, but the process of the common law is slow and that day is nowhere in sight.

4-4 Administrative Law “Before beginning this section, please return your seat to its upright position. Stow the tray firmly in the seat back in front of you.” Sound familiar? Administrative agencies affect each of us every day in hundreds of ways. They have become the fourth branch of government.

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Legislative Rules These are the most important agency rules, and they are much like statutes.

Interpretive Rules These rules do not change the law. They are the agency’s interpretation of what the law already requires. But they can still affect all of us.

4-4b Investigation Subpoena: An order to appear at a particular time and place. Subpoena duces tecum: An order to require a person to produce certain documents or things. Agencies do a wide variety of work, but they all need broad factual knowledge of the field they govern. Some companies cooperate with an agency, furnishing information and even voluntarily accepting agency recommendations. Other companies, however, jealously guard information, often because corporate officers believe that disclosure would lead to adverse rules. To force disclosure agencies use subpoenas and searches.

4-4c Adjudication Adjudicate: To hold a formal hearing about an issue and then decide it. Administrative law judge (ALJ): An agency employee who acts as an impartial decision maker. Agencies adjudicate countless cases. A party unhappy with the agency’s decision may appeal to a federal court.

Informational Control and the Public One way in which all of us have some direct control over these ubiquitous agencies is information. Two federal statutes arm us with the power of information: The Freedom of Information Act, and the Privacy Act. Freedom of Information Act (FOIA): Designed to give all of us access to the information that federal agencies are using, and any information they may have about us. Exemption: FOIA does not apply to Congress, the federal courts, or the executive staff at the White House.

You Be the Judge: American Civil Liberties Union v. United States Department of Justice 2016 U.S.App. LEXIS 7308, 2016 WL 1657953, District of Columbia Circuit Court of Appeals, 2016 Facts: Alarmed at the reported use of drones to kill people, the American Civil Liberties Union (ACLU) submitted a broad request under the Freedom of Information Act (FOIA) to the Central Intelligence Agency (CIA). The request sought information on drone strikes, including selection of targets, number of strikes, and number and identity of civilians killed. The CIA denied the FOIA request, arguing that it was exempt from disclosure because drone strikes are intelligence activity, which is part of the agency’s mission. The CIA contended that the disclosure of drone strikes information would imperil national security. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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You Be the Judge: Does FOIA require the disclosure of CIA records on drone strikes? Argument for the ACLU: Your Honors, the CIA is unduly withholding information to which the American public is entitled. First, it is hiding behind the FOIA exemption that protects the disclosure of information about its functioning. The CIA’s principal mission is foreign intelligence, not targeted killing programs like drone strikes. Under the CIA’s interpretation of the national security exemption, it could refuse to provide any information about anything it does because everything in some way relates to foreign activities or national security. Is that the blanket license we want to give the CIA? We only request facts and figures, not state secrets. Argument for the CIA: The law gives the CIA broad power to protect the secrecy and integrity of the intelligence process. Responding to the ACLU’s FOIA request would reveal sensitive information about the CIA’s capabilities, limitations, priorities, and resources. The law protects this information from disclosure for good reason, as its revelation would compromise the Agency’s efforts and endanger Americans. The ACLU’s request goes too far in the name of freedom of information. Holding: The Court ruled that the Agency had satisfied its burden of showing that the records requested were properly classified. Question: Do you agree with the court’s decision? Answer: Answers will vary. Question: How do you balance the needs of the public for information with the needs of security agencies for secrecy? Answer: Answers will vary.

Privacy Act This 1974 statute prohibits federal agencies from giving information about an individual to other agencies or organizations without written consent. There are exceptions, but overall this act has reduced the government’s exchange of information about us “behind our back.”

Chapter Conclusion The legal battle over power never stops. When may a state outlaw waterfront development? Prohibit symbolic speech? Other issues are just as thorny, such as when a bystander is liable to assist someone in peril, or whether a government agency may subpoena corporate documents. Some of the questions will be answered by that extraordinary document, the Constitution, while others require statutory, common law, or administrative responses. There are no easy answers because there has never been a democracy so large, so diverse or so powerful.

Matching Questions Match the following terms with their definitions: _____A. Statute 1. The power of federal courts to examine the constitutionality of statutes and acts of governments. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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_____B. Equal Protection Clause

2. The part of the Constitution that requires compensation in eminent domain cases. 3. The rule that requires lower courts to decide cases based on precedent. 4. The act of an administrative agency creating a new rule. 5. A law passed by a legislative body. 6. Generally prohibits regulations based on gender, race, or fundamental rights.

_____C. Judicial review _____D. Takings Clause _____E. Stare decisis _____F. Promulgate

Answers: P. 5 Q. 6 R. 1 S. 2 T. 3 F. 4

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 16. T F The government may not prohibit a political rally, but it may restrict when and where the demonstrators meet. 17. T F The Due Process Clause requires that any citizen is entitled to a jury trial before any right or property interest is taken. 18. T

F The government has the right to take a homeowner’s property for a public purpose.

19. T

F A subpoena is an order punishing a defendant who has violated a court ruling.

20. T F A bystander who sees someone in peril must come to that person’s assistance, but only if he can do so without endangering himself or others. 21. T F Administrative agencies play an advisory role in the life of many industries but do not have the legal authority to enforce their opinions.

Multiple Choice Questions 1. Colorado passes a hotel tax of 8 percent for Colorado residents and 15 percent for out-0of-state visitors. The new law: A. Is valid, based on the Supremacy Clause B. Is void, based on the Supremacy Clause C. Is valid, based on the Commerce Clause. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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D. Is void, based on the Commerce Clause. E. Is void, based on the Taking Clause. Answer: D. 2. Suppose a state legislature approves an education plan for the next year that budgets $35 million for boys’ athletics and $25 million for girls’ athletics. Legislators explain the difference by saying, “In our experience, boys simply care more about sports than girls do.” The new plan is: A. Valid. B. Void. C. Permissible, based on the legislators’ statutory research. D. Permissible, but probably unwise. E. Subject to the Takings Clause. Answer: B. 3. Congress has passed a new bill, but the president does not like the law. What could happen next? A. The president must sign the bill whether he likes it or not. B. The president may veto the bill, in which case it is dead. C. The president may veto the bill, but Congress may attempt to override the veto. D. The president may ask the citizens to vote directly on the proposed law. E. The president may discharge the Congress and order new elections. Answer: C. 4. Which of these is an example of judicial review? A. A trial court finds a criminal defendant guilty. B. An appeals court reverses a lower court’s ruling. C. An appeals court affirms a lower court’s ruling. D. A federal court declares a statute unconstitutional. E. A congressional committee interviews a potential Supreme Court justice. Answer: D. 5. What is an example of a subpoena? A. A court order to a company to stop polluting the air. B. A court order requiring a person being deposed to answer questions. C. A federal agency demands various internal documents from a corporation. D. The president orders troops called up in the national defense. E. The president orders Congress to pass a bill on an expedited schedule. Answer: C. 6. If information requested under FOIA is not exempt, an agency has _____ to comply with the request. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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A. 10 days B. 30 days C. 3 months D. 6 months Answer: A.

Case Questions 1. In the early 1970s, President Richard Nixon became embroiled in the Watergate dispute. He was accused of covering up a criminal break-in at the national headquarters of the Democratic Party. Nixon denied any wrongdoing. A United States District Court judge ordered the president to produce tapes of conversations held in his office. Nixon knew that complying with the order would produce damaging evidence, probably destroying his presidency. He refused, claiming executive privilege. The case went to the Supreme Court. Nixon strongly implied that even if the Supreme Court ordered him to produce the tapes, he would refuse. What major constitutional issue did this raise? Answer: The constitutional issue is judicial review. Since Marbury v. Madison, 5 U.S. 137 (1803), federal courts have insisted that they have the power to review acts of the other two branches. The Supreme Court ruled that while there was a limited executive privilege, it did not include the right to withhold evidence in a criminal investigation. When the Supreme Court did in fact order Nixon to produce the tapes, he hesitated . . . but obeyed. The tapes he produced destroyed his credibility and his political base, and he became the first president to resign his office. But the principle of judicial review was affirmed. 2. Carter was an employee of the Sheriff’s office in Hampton, Virginia. When his boss, Sheriff Roberts, was up for reelection against Adams, Carter “liked” the Adams campaign’s Facebook page. Upon winning reelection, Sheriff Roberts fired Carter, who then sued on free speech grounds. Is a Facebook “like” protected under the First Amendment? Answer: This question is based on Bland v. Roberts (4th Circuit, 2013). The district court had held that “merely liking a Facebook page is insufficient speech to merit constitutional protection,” but the Fourth Circuit disagreed. 3. The year is 1964. Ollie’s BBQ is a family-owned restaurant located on a state highway in Georgia, 11 blocks from an interstate highway. The restaurant does not allow African-Americans to eat inside; they must get takeout. More than half of the food serviced in the restaurant had passed through interstate commerce. According to Title II of the Civil Rights Act of 1964, the federal government has the right to prohibit racial discrimination in hotels, restaurants, and other public facilities because local activities have a substantial effect on interstate commerce. The owner of Ollie’s BBQ argues that his business is local and has no impact on interstate commerce. Whose argument will win? Answer: The U.S. Supreme Court ruled that discrimination in restaurants posed significant burdens on “the interstate flow of food and upon the movement on products generally,” and further imposed restrictions on blacks who traveled from state to state. Congress’s solution to this problem

Unit 1 The Legal Environment

was appropriate and within its bounds to regulate state commerce. Katzenbach v. McClung, 375 U.S. 294, (1964). 4. The federal Defense of Marriage Act (DOMA) defined marriage as a union between a man and a woman. As a result, same-=sex couples were not eligible for the federal marriage benefits given to heterosexual couples. Edith Windsor and Thea Spyer had been together for 40 years, and married for two, when Spyer died. Because of DOMA, the federal government did not treat Windsor as a surviving spouse for purposes of estate taxes, so she was presented with a tax bill for $363,000. If she had been married to a man, she would not have owed any taxes. Windsor challenged the statute claiming the government had violated her right to equal protection. Should she win? Answer: Yes, and she did. The statute clearly treated same-sex couples who were married differently from heterosexual couples who were married, and denied the former the same benefits of the laws to them based on their same-sex marriage status, which was a denial of equal protection under the Constitution. United States v. Windsor, 570 U.S. ____ (2013) 5. The FDA issued regulations requiring tobacco companies to put graphic warning images on their packages. The mandatory images included a corpse after an autopsy, a smoker’s damaged lung, and a man exhaling smoke out of a hole in his neck, among others. What recourse do tobacco companies have if they want to challenge the FDA’s rule? Answer: The tobacco companies could file suit against the FDA, challenging the legality or constitutionality of the regulations. The FDA gained the authority to regulate the tobacco companies when Congress passed the Tobacco Control Act. The tobacco companies challenged that law and lost. But when they challenged the constitutionality of the regulations themselves, charging that they were in violation of their First Amendment free speech rights, the Court agreed, and the regulations were stricken. The government did not appeal that ruling. R.J. Reynolds Tobacco Co. v. U.S. Food and Drug Administration, 696 F.3d 1205, U.S. Ct. App, Dist. Of Columbia Circuit (2012)

Discussion Questions 1. Consider the doctrine of stare decisis. Should courts follow past rulings, or should they decide cases anew each time, without regard to past decisions? For example, should Texas v. Johnson stand because it is precedent, or should the justices take a “fresh look” at the issue of flag burning? Answer: Answers will vary. 2. Should administrative agencies be able to “tell business what to do”? Do you favor administrative regulations on the environment, safety, and discrimination, or do they amount to “big government”? Answer: Answers will vary. 3. Gender discrimination currently receives “intermediate” Fourteenth Amendment scrutiny. Is this right? Should gender receive “strict” scrutiny as does race? Why or why not? Answer: Answers will vary. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. During live national coverage of a Super Bowl halftime show, Justin Timberlake tore off part of Janet Jackson’s shirt, exposing her breast for nine-sixteenths of a second. Television network CBS called it a “wardrobe malfunction,” but the “malfunction coincidentally occurred just as Timberlake was singing the lyrics, “Gonna have you naked by the end of this song.” The FCC fined CBS $550,000, but the network challenged the fine in court. The appeals court held that CBS did not have to pay because the FCC did not have a clear policy on momentary displays of nudity. Do you agree with this conclusion? Do you think the incident was intentional or truly accidental? If it was intentional, should CBS have known better, regardless of FCC policies? If it was accidental, should CBS still be held accountable? Should it matter if it was intentional or accidental? Answer: Answers will vary. 5. Should the law require restaurant employees to know and employ the Heimlich maneuver to assist a choking victim? If they do a bad job, they could cause additional injury. Should it permit them to do nothing at all? Is there a compromise position? What social policies are most important? Answer: Answers will vary.

Suggested Additional Assignments Interview: Civil Rights Students should interview three people to determine their views about two issues: flag burning and boy-girl wrestling. One person should be over 50 years old, one person should have been born and raised in a foreign country, and one person should be a member of a different political party from the student herself. The student should ask about the legality and morality of each issue and whether current laws or practices should be changed. The student should remain neutral in the interview and should outline the views of all the people and be prepared to report them in class. Research: The Internet and Free Speech Students should find an Internet site that contains speech or pictures that they consider outrageous or disgusting. The sites, for example, might use hate speech directed at racial or religious groups, offer graphic illustrations of violence, or display pornography. Students should download and print, if possible, the example they choose. They should write a two-paragraph argument urging that such material be banned from the Internet, an opposing argument, and their own conclusion about whether or not to outlaw the material. Research: Constitutional Rights Students should find an article in a newspaper, magazine, or through the internet about a business confronting a constitutional issue that typically we associate with human beings, such as free speech, freedom of religion, eminent domain, due process, and searches and seizures. Constitutional rights generally protect only against governmental acts, state and federal. The “people” who are protected include citizens, and, for most purposes, corporations. The great majority of these rights also extend to citizens of other countries who are in the United States. On March 1, 2006, this story appeared in the media: © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

Americans apparently know more about The Simpsons than they do about the First Amendment. Far more Americans can identify Lisa, Marge, Maggie, Homer, and Bart than the First Amendment freedoms. Only one in four Americans can name more than one of the five freedoms guaranteed by the First Amendment (freedom of speech, religion, press, assembly, and petition for redress of grievances.) But more than half can name at least two members of the cartoon family, according to a survey. (“Study: More know ‘The Simpsons’ than First Amendment rights,” The USA Today, Mar 1, 2006 http://www.usatoday.com/news/nation/2006-03-01-freedom-poll_x.htm ; Simpsons ‘trump, First Amendment, BBC News, Mar 1, 2006 http://news.bbc.co.uk/2/hi/americas/4761294.stm) Some students will readily demonstrate this deplorable state of affairs. They will parrot words to the effect that “freedom of speech is the bedrock upon which this country was founded” and then fail to recognize speech that the First Amendment obviously protects. They are willing to ban speech if it is upsetting, provokes a strong reaction in others, or criticizes the President. One goal in the section on protected rights is to teach students not only what the Bill of Rights says, but what it means. Texas v Johnson and Barnes v Glen Theatre, Inc. are excellent cases for provoking spirited discussion about protected speech.

Chapter 5 – Dispute Resolution* Chapter Overview Chapter Theme The process of litigation may influence the outcome of a dispute as strongly as the substantive law. That is all the more reason to use preventive law, and stay out of court.

Proof versus Right Students often confuse whether a person can prove her case at trial with whether she suffered a legal wrong and has a cause of action. For instance, suppose students are considering a simple oral contract, in which Manny offers David $50 to shovel Manny’s driveway, and David accepts. There are no witnesses. David shovels the driveway and Manny refuses to pay. In considering whether Manny’s obvious breach has violated David’s rights under the contract some students will say “no, because David cannot prove there was a contract—it was not in writing and there were no witnesses.” The instructor must explain the difference between whether Manny violated David’s contract rights—he has—and whether David can prove the terms of the contract at trial. Since class discussion more often involves substantive legal rights than burdens of proof, the instructor should make the point that hearing evidence and finding facts is the job of trial courts and then move the discussion to the substantive issue. Litigation: The process of resolving disputes in court. Alternative dispute resolution: Resolving disputes out of court, through formal or informal processes.

Chapter 1 Introduction to Law

The United States has over 50 systems of courts. One nationwide system of federal courts serves the entire country. In addition, each individual state—such as Texas, California, and Florida—has its own court system. The state and federal courts are in different buildings, have different judges, and hear different kinds of cases. Each has special powers and certain limitations.

5-1a State Courts The typical state court system has a single superior court over the lower trial and appellate courts. A few states have two courts at the top level, each with a different purpose. See Exhibit 6.1 for a typical state court system.

Trial Courts Trial courts: Determine the facts of a particular dispute and apply to those facts the law given by an earlier appellate court decision. Jurisdiction: A court’s power to hear a case. Almost all cases start in trial courts, which are endlessly portrayed on television and in film. There is one judge, and there will often (but not always) be a jury. This is the only court to hear testimony from witnesses and receive evidence. Subject matter jurisdiction is a court’s authority to hear a particular type of case. Personal jurisdiction is the legal authority to require the defendant to stand trial, pay judgments, and the like. Personal jurisdiction generally exists if Personal jurisdiction generally exists if:  for individuals, the defendant is a resident of the state in which a lawsuit is filed. For companies, the defendant is doing business in that state.  The defendant takes a formal step to defend a lawsuit. Special appearances do not count as formal steps.  A summons is served on a defendant. The summons must be delivered to the defendant when she is physically within the state in which the lawsuit is filed.

Landmark Case: International Shoe Co. v. State of Washington 22 Facts: Although International Shoe manufactured footwear only in St. Louis, Missouri, it sold its products nationwide. It did not have offices or warehouses in the state of Washington, but it did send about a dozen salespeople there. The salespeople rented space in hotels and businesses, displayed sample products, and took orders. They were not authorized to collect payment from customers. When the State of Washington sought contributions to the state’s unemployment fund, International Shoe refused to pay. Washington sued. The company argued that it was not engaged in business in the state, and, therefore, that Washington courts had no jurisdiction over it. The Supreme Court of Washington ruled that International Shoe did have sufficient contacts with the state to justify a lawsuit there. International Shoe appealed to the United States Supreme Court. 22

Unit 1 The Legal Environment

Issue: Did International Shoe have sufficient minimum contacts in the state of Washington to permit jurisdiction there? Decision: Yes, the company had minimum contacts with the state. Reasoning: Agents for International Shoe have operated continuously in Washington for many years. Their presence has been more than occasional or casual. And the agents’ activities have generated a significant number of sales for the company. Washington’s collection action is directly related to commercially valuable activities that took place within the state’s borders. Due process merely requires reasonable fairness. International Shoe has benefited greatly from activities in Washington, and it faces no injustice if this suit proceeds. The minimum contacts doctrine is satisfied. Affirmed. Question: Why is this case important? Answer: it establishes that minimum contacts with the forum state can enable a court in that state to exert personal jurisdiction over a party consistent with the Due Process clause. Question: What were some of the factors in the decision? Answer: (1) International Shoe had conducted “systematic and continuous” business operations in Washington; (2) a large volume of interstate business for the defendant was created through its agents within the state; (3) the corporation received the benefits and protection of Washington’s laws; and (4) International Shoe had established agents in the state permanently.

Appellate Courts Appellate courts: Higher courts, which generally accept the facts provided by trial courts and review the record for legal errors. . Appellant: The party filing the appeal. Appellee: The party opposing the appeal. Appellate courts are entirely different from trial courts. Three or more judges hear the case. There are no juries, ever. These courts do not hear witnesses or take new evidence. They hear appeals of cases already tried below. Appeals courts generally accept the facts given to them by trial courts and review the trial record to see if the court made errors of law.

5-1b Federal Courts As discussed in Chapter 1, federal courts are established by the U.S. Constitution, which limits what kinds of cases can be brought in any federal court. Two kinds of civil lawsuits are permitted in federal court: federal question cases and diversity cases. See Exhibit 6.2 for a diagram of the Federal court system.

Federal Question Cases Federal question: A claim based on the U. S. Constitution, a federal statute, or a federal treaty. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1 Introduction to Law

Diversity Cases Diversity jurisdiction: A lawsuit in which the plaintiff and defendant are citizens of different states and the amount in dispute exceeds $75,000. The theory behind diversity jurisdiction is that courts of one state might be biased against citizens of another state. To ensure fairness, the parties have the option to use a federal court as a neutral field.

Trial Courts United States District Courts are the primary trial court in the federal system. The nation is divided into about 94 districts, and each has a district court.

Appellate Courts United States Courts of Appeals. These are the intermediate courts of appeals. They are divided into “circuits,” which are geographical areas. There are 11 numbered circuits, hearing appeals from district courts. And, a twelfth, the Circuit Court of Appeals for the District of Columbia which hears appeals from the district court of Washington, D.C., and a Thirteenth Circuit Court of Appeals, known as the Federal Circuit. United States Supreme Court. This is the highest court in the country. There are nine justices on the Court. One justice is the chief justice, and the other eight are associate justices. When they decide a case, each justice casts an equal vote.

Role Play: Finding Facts versus Reading Transcripts Students must understand the critical differences between trial and appellate courts, between hearing evidence and finding facts on the one hand, and determining whether a lower court applied the law correctly on the other. To demonstrate, use the role play script later in this manual. Can the class determine who is telling the truth and who is lying? How did they decide which was which? Students will mention body language, tonal inflection, eye movement, and other factors. Students should note that this is the function of trial courts, to hear evidence and find facts. After this exercise, the instructor should ask students if they could determine the truth merely by reading a transcript of the testimony. The point, of course, is that people rely primarily on non-textual clues to determine truth and falsehood, clues that are not present in an appellate court’s review of a trial court’s decision.

5-2 Litigation 5-2a Pleadings Pleadings: The documents that begin a lawsuit, consisting of the complaint, the answer, and sometimes a reply.

Complaint Complaint: A short, plain statement of the facts alleged and the legal claims made. The plaintiff files in court a complaint, a short, plain statement of the facts she is alleging and the legal claims she is making. The purpose is to inform the defendant of the general nature of the claims and the need to come into court and protect his interests. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

Answer Answer: The defendant’s response to the complaint. Default judgment: A decision that the plaintiff in a case wins without going to trial. Once the complaint and summons are served, the defendant has 20 days in which to file an answer. The answer tells the court and the plaintiff exactly what issues are in dispute. Class Actions Class action: A suit filed by a group of plaintiffs with related claims.

Motion to Dismiss Motion: A formal request to the court that it take some step or issue some order. Motion to dismiss: A request that the court terminate a case because the law does not offer a legal remedy for the plaintiff’s problem.

Case: Ashcroft v. Iqbal, 556 U.S. 662 (2009) Facts: In the months after the 9/11 attacks, the FBI arrested many suspected terrorists, most of whom were Arab Muslim men. Javaid Iqbal, a Pakistani Muslim, was one of them. While he was in prison, guards confined him to his cell 23 hours a day, kicked and punched him, and refused to let him pray. After his release, Iqbal filed a discrimination lawsuit against John Ashcroft, the former Attorney general who was in charge of the antiterrorism investigation. Iqbal’ S pleadings contained the following information: (1) Most of the 9/11 detainees were Arab Muslim men; (2) detainees like Iqbal suffered harsh treatment in prison; and (3) Ashcroft approved the detainment policy. These three facts led Iqbal to conclude that Ashcroft illegally discriminated against the detainees because they were Arab Muslims. Ashcroft moved to dismiss the suit. He argued that Iqbal’s pleading did not contain enough information to show that discrimination was the cause of the detainment. Issue: Did Iqbal’s pleadings contain enough information to go forward? Decision: No. Iqbal did not make a plausible claim, so the suit was dismissed. Reasoning: A pleading must contain enough facts to show that the claim is plausible. The sheer possibility that a defendant has acted unlawfully is not enough. There is an important difference between possible and plausible. Possible means that the illegal activity could have happened; plausible means that there is a credible basis for believing that it did. Iqbal’s complaint only suggests that the Ashcroft, in the aftermath of a devastating terrorist attack, detained suspected terrorists under the tightest security. He offers no facts to support that this was done to discriminate against Arab Muslims. Iqbal would need to add more information to nudge his claim across the line from possible to plausible. Iqbal’s lawsuit is dismissed.

Chapter 1 Introduction to Law

that the pleader is entitled to relief. The pleading standard does not require detailed factual allegations, but it demands more than an unadorned, the-defendant-unlawfully-harmed-me accusation. Question: The court required facts that demonstrated plausibility, not possibility. What is the difference? Answer: One may argue that virtually anything is possible. But probable means likely, a stronger level of proof. If possible were the standard, there would be many more lawsuits. Question: Why did the court set probable as the standard of necessary factual allegations? Answer: In part, to avoid the filing of frivolous lawsuits. Question: Do you think Ashcroft’s policy was in response to the country’s reaction to the attacks of 9/11? Answer: Answers will vary. Question: Do you think the Supreme Court took into account the probable reaction of U.S. citizens if the lawsuit were allowed to proceed? Answer: Answers will vary. Iqbal tells us that a valid complaint must show the court that the plaintiff’s claims are plausible, not just possible. Critics argue that this rule may deny the right to sue to plaintiffs with good claims, who could discover more evidence if allowed to conduct the pre-trial process of discovery. Others applaud the stringent standard because it reduces the number of frivolous cases filed.

5-2b The Discovery Process Discovery: The pre-trial opportunity for both parties to gather information relevant to the case. Few cases are dismissed on the pleadings. Most proceed quickly to the next step. The theory behind civil litigation is that the best outcome is a negotiated settlement and that parties will move toward agreement if they understand the opponent’s case. That is likeliest to occur if both sides have an opportunity to examine most of the evidence the other side will bring to trial. The following are the most important forms of discovery. Interrogatories These are written questions that the opposing party must answer, in writing, under oath Depositions These provide a chance for one party’s lawyer to question the other party or a potential witness, under oath. Lawyers for both parties are present. Deponent: The person being questioned in a deposition. Production of Documents and Materials Each side may ask the other side to produce relevant documents for inspection and copying, to produce physical objects, and for permission to enter on land to make an inspection. Physical and Mental Examination © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

A party may ask the court to order an examination of the other party, if his physical or mental condition is relevant. The parties are entitled to discover anything that could reasonably lead to valid evidence. But the litigant also may want to make the litigation hurt. E-Discovery The internet age changed discovery. Companies send hundreds, or thousands, or millions of emails – every day. Businesses large and small have vast amounts of data stored electronically, and many people post volumes of personal information on social media sites. All of this information is potentially subject to discovery. It is enormously time-consuming and expensive for companies to locate all of the relevant material, separate it from irrelevant or confidential matter, and furnish it.

Discussion of Discovery Discovery in civil litigation is rarely the subject matter for legal dramas on television or in the movies, so the discussion of discovery will be unfamiliar to many students. Students should understand its role in our adversary system as defined in the text: “the best way to bring out the truth is for the two contesting sides to present the strongest case possible to a neutral factfinder.” Forms of discovery include interrogatories, depositions, production of documents and things, physical and mental examination, and e-discovery. The purpose of discovery is to enable the parties to understand their opponent’s case as clearly as possible in order to encourage settlement—by allowing objective appraisal of the strengths and weaknesses of each side—and to allow a trial to uncover all relevant facts with a minimum of surprises. To emphasize these points, students might consider the case of Enviro-Vision v Coastal Insurance Company that is woven throughout the chapter. Question: In Enviro-Vision v Coastal Insurance Company, what critical discovery ruling helps Coastal Insurance? Answer: The judge denies plaintiff’s Interrogatory 18, which sought information concerning other claims that Coastal had denied. Question: Why is the ruling so important? Answer: It ends the plaintiff’s hope for a class action. Without discovery on other claims that the insurer has denied based on alleged suicide, the plaintiffs will never establish the elements of numerosity and commonality essential for class certification. Question: What critical ruling helps plaintiff Beth Smiles? Answer: The judge reduces Coastal’s depositions to only ten. Coastal’s attorney decides not to depose Craig Bergson, who in fact had a discussion with Tony Caruso that may have indicated suicide. If Coastal never learns of that fact through discovery, it is (for legal purposes) as though it never occurred. Question: If Coastal learned of Bergson’s story after it settled the case or lost at trial could it re-open the lawsuit on the grounds it had new information? Answer: Not if the new information was discoverable during discovery, which this was.

Chapter 1 Introduction to Law

Bonus Case: Legends Are Forever, Inc. v. Nike, Inc., 2013 WL 6086461, 2013 U.S. Dist. LEXIS, 164091, U.S. District Court, Northern District, New York, 2013 Facts: Legends are Forever, Inc. (Legends) trademarked the slogan “Legends are Forever.” When Nike used the slogan in an ad campaign featuring basketball player Kobe Bryant, Legends sued Nike. But, during discovery, Legends repeatedly failed to comply with Nike’s reasonable requests. Ultimately, Nike was forced to file a motion to compel Legends to produce the requested documents and witnesses. So, Nike requested more than just discovery: It also asked the court for recovery of all of the costs and fees it incurred in litigating the motion to compel, totaling $25,186.91. This sum included Nike’s attorney’s fees (ranging from $250 to $450 per hour) and all the travel expenses incurred by the two Nike attorneys who attended the hearing on the motion to compel. The court agreed with Nike, granting it both discovery and its fees. Legends challenged the order, arguing that a small company should not have to pay for Nike’s high-priced attorneys. Issue: What is a reasonable penalty for unacceptable behavior during discovery? Excerpts from Magistrate Judge Peebles’s Decision: Discovery in this case has proceeded at an unacceptably slow pace, and Nike has experienced considerable difficulties in obtaining compliance by plaintiff with legitimate discovery demands. An award of costs and attorney's fees is warranted. Now the task of the court shifts to determining the appropriate amount to award. Fee awards are awarded by determining a reasonable fee, reached by multiplying a reasonable hourly rate by the number of reasonably expended hours. When establishing a reasonable rate, courts consider the time and labor required, the novelty of the questions, and the level of skill required to perform the legal service properly [among other factors]. Attorney's fees awarded as sanctions are not intended only as compensation of reimbursement for legal services, but also serve to deter abusive litigation practices and, as such, district courts have discretion in determining the amount of an attorney's fee awarded as sanctions. I conclude that the court should apply the following rates: $350 to $250 per hour. I have reduced the number of hours upon which fees will be awarded for two reasons. First, it appears that several of the entries are excessive, given the description of the work performed. As one example, Nike chose to send two attorneys to the hearing, apparently as a result of a strategic decision. The motion, however, was relatively straightforward and not particularly complex. While Nike certainly retains the prerogative to send multiple attorneys to such a hearing, I decline to award costs and attorney's fees based upon that duplication of effort. Based upon the foregoing, I am awarding attorney's fees in the amount of $11,146.25, In addition to attorney's fees, Nike has also sought recovery of costs representing travel expenses incurred for the hearing. It is appropriate to award the expense associated with *only one of Nike’s attorneys+ travel to the hearing, in the amount of $1,186.57. Plaintiff Legends now complains that, as a small corporation, it would be economically disadvantaged by the award. Nike, however, despite its size and prominence, having been sued, is entitled to the same discovery as any other litigant. When discovery is sought but not provided, it is fair and appropriate to award costs and attorney's fees, notwithstanding the disparity in size of the two parties involved. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

Nike, Inc., is hereby awarded the sum of $12,332.82, representing reasonable costs and attorney's fees associated with having to bring and argue the recent motion to compel discovery. Question: What are three factors a court considers when establishing a reasonable hourly rate for attorney’s fees? Answer: The time and labor required, the novelty of the questions, and the level of skill required to perform the legal service properly. Question: Why is the amount awarded to Nike, $12,332.82, less than the amount it asked for, $25,186.91? Answer: The court used its discretion to reduce both the hourly rate and the number of hours expended. Question: What did the Court say about the argument that Legends will be economically disadvantaged by the award? Answer: Nike, a large corporation, was sued and it is entitled to the same discovery as any other litigant. It is fair and appropriate to award costs and attorney’s fees, notwithstanding the disparity in size of the two parties.

Bonus Case: Stinton v. Robin’s Wood, Inc.23 Facts: Ethel Flanzraich, 78 years old, slipped and fell on property owned by Robin’s Wood and broke her left arm and left leg. Flanzraich sued, claiming Robin’s Wood employee, Anthony Monforte, had negligently painted the stairs on which she fell. Robin’s Wood denied the allegations. The parties agreed to hold depositions on August 4. Flanzraich appeared for the deposition but Robin’s Wood did not furnish Monforte or any other Robin’s Wood representative. The court ordered the deposition of Monforte and Robin’s Wood for April 2. Again, Robin’s Wood did not produce Monforte or any other representative. On July 16, the court ordered Robin’s Wood to produce its representative within 30 days. Again, no one showed for the deposition. On August 18, Flanzraich moved to strike Robin’s Wood’s answer, meaning she would win by default. The company argued that it had made diligent efforts to locate Monforte and force him to appear, but that Monforte no longer worked for Robin’s Wood. The trial judge granted the motion to strike. The only remaining issue was damages: Robin’s Wood owed $22,631 for medical expenses, $150,000 for past pain and suffering, and $300,000 for future pain and suffering. Robin’s Wood appealed. Issue: Did the trial court abuse its discretion by striking Robin’s Wood’s answer? Holding: No. The court found no merit to Robin’s Wood’s claim that the trial judge abused his discretion in striking its answers. Although cases should be heard on the merits whenever possible, a court may invoke a drastic remedy such as striking an answer when a parties’ failure to comply with discovery is willful. The willful nature of Robin’s Wood’s conduct can be inferred from the company’s failure to comply with three court orders and to explain why it did not produce Monforte or any other representative. Had it produced another representative at the deposition, Flanzraich could have questioned the representative 23

Chapter 1 Introduction to Law

about the whereabouts of Monforte, and would have learned information regarding his location because the record indicates that Robin’s Wood had such information. This conduct is especially flagrant here where Flanzraich is elderly. Any delay in the proceedings would have a particularly detrimental effect on her. Moreover, Robin’s Wood failed to explain why they did not produce Monforte for deposition when he was still employed with them.

Question: What standard does the appellate court use to review the trial court’s striking of Robin’s Wood’s answer? Answer: The appellate court asks whether the trial court abused its discretion in striking the answer. It does not ask whether it would have itself stricken the answer on the facts of the case. Question: Why doesn’t the appellate court ask itself that question? Answer: Our legal system grants considerable discretion to trial court judges. It is their job to oversee trials from start to finish. They deal closely with the litigants and counsel and thus the appellate court should be wary of overturning decisions. Question: What is the result of striking Robin’s Wood’s answer? Answer: Flanzraich wins. Question: Is it fair that Robin’s Wood does not get a chance to defend itself based on the actions of one employee? Answer: Robin’s Wood’s loss was the result of more than just the actions of Monforte. Robin’s Wood should have produced Monforte for deposition while he still worked for them. In Monforte’s absence, Robin’s Wood could have produced another representative from the company for the deposition, but failed to do so. By failing to produce anyone for the depositions, Robin’s Wood denied Flanzraich an opportunity to enforce her rights against the company. Moreover, Robin’s Wood consistently ignored the trial court’s orders to comply with the deposition requests. The trial judge gave Robin’s Wood many “last chances” but the company continued to be uncooperative. Question: This is still a harsh result. Why didn’t the trial judge order Robin’s Wood to pay for the costs of delay, or something else less drastic than striking its answer? Answer: While the court might have opted for such a remedy, it did not. As noted above, it is not the job of the appellate court to substitute its judgment unless the trial judge abused his discretion. Moreover, the delay in this case caused by Robin’s Wood was particularly egregious given Flanzraich’s age.

5-2c Summary Judgment Summary judgment: A ruling by the court that no trial is necessary because there are no essential facts in dispute. When discovery is completed, both sides may consider seeking summary judgment. Summary judgment is a ruling by the court that no trial is necessary because some essential facts are not in dispute. The purpose of a trial is to determine the facts of the case; that is, to decide who did what to whom, why, when, and with what consequences. If relevant facts are not in dispute, then there is no need for a trial. Summary judgment can be difficult for students to grasp. It is important because many cases in the text are appellate rulings on summary judgments entered by trial courts. Summary judgment makes the court focus on legal questions, not factual disputes. If there are essential facts in dispute summary judgment is not appropriate, and there must be a trial. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

To illustrate, suppose that Bob and Susan meet at a church pancake breakfast, chat about Bob’s Ferrari, and end up signing an agreement that Susan can buy it at the extraordinarily low price of $30,000. Bob refuses to honor the agreement, claiming he was intoxicated when he signed. Susan has 35 witnesses who swear that Bob was sober; Bob has only himself testifying that he was drunk. Question: Susan moves for summary judgment. The ruling? Answer: Summary judgment denied. The parties have a key factual dispute: whether Bob was drunk. It makes no difference how many witnesses are on each side. If there is some evidence on both sides of an essential fact question, a trial court must deny summary judgment. Question: Suppose Bob and Susan orally agree that she can buy the car for $30,000. Bob refuses to honor the deal and she sues. Discovery indicates that Susan has 30 witnesses who will testify that the parties orally agreed to the deal. Bob has five witnesses who will testify that the parties never even orally agreed. Bob moves for summary judgment, based on the statute of frauds provision of the Uniform Commercial Code: this kind of contract (for the sale of goods over $500) must be in writing to be enforceable. The ruling? Answer: Summary judgment granted. There is no need to decide which of the witnesses is telling the truth. Even if Susan’s witnesses are convincing, she still loses. As a matter of law, the contract is unenforceable. In the following case, the defendant won summary judgment, meaning that the case never went to trial. That was good news for the defendant, who happened to be the president of the United State at the time. And yet, this was only the beginning of trouble for that defendant, Bill Clinton.

Case: Jones v. Clinton24 Facts: In 1991, Bill Clinton was Governor of Arkansas. Paula Jones worked for a state agency, the Arkansas Industrial Development Commission (AIDC). When Clinton became President, Jones sued him, claiming that he had sexually harassed her. She alleged that, in May 1991, the Governor arranged for her to meet him in a hotel room in Little Rock, Arkansas. When they were alone, he put his hand on her leg and slid it toward her pelvis. She escaped from his grasp, exclaimed, “What are you doing?” and said she was “not that kind of girl.” Upset and confused she sat on a sofa near the door. She claimed that Clinton approached her, “lowered his trousers and underwear, exposed his penis, and told her to kiss it.” Jones was horrified, jumped up, and said she had to leave. Clinton responded by saying, “Well, I don’t want to make you do anything you don’t want to do,” and pulled his pants up. He added that if she got in trouble for leaving work, Jones should “have Dave call me immediately and I’ll take care of it.” He also said, “You are smart. Let’s keep this between ourselves.” Jones remained at AIDC until February 1993, when she moved to California because of her husband’s job transfer. President Clinton denied all of the allegations. He also filed for summary judgment, claiming that Jones had not alleged facts that justified a trial. Jones opposed the motion for summary judgment. Issue: Was Clinton entitled to summary judgment, or was Jones entitled to a trial?

990 F. Supp. 657, 1998 U.S. Dist. LEXIS 3902 United States District Court East. Dist Ark. 1998 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Chapter 1 Introduction to Law

Decision: Jones failed to make out a claim of sexual harassment. Summary judgment was granted for the President. Reasoning: To establish this type of sexual harassment case, a plaintiff must show that her refusal to submit to unwelcome sexual advances resulted in specific harm to her job. Jones received every merit increase and cost-of-living allowance for which she was eligible. Her only job transfer involved a minor change in working conditions, with no reduction in pay or benefits. Jones claims that she was obligated to sit in a less private area, often with no work to do, and was the only female employee not to receive flowers on Secretary’s Day. However, even if these allegations are true, all are trivial and none is sufficient to create a sexual harassment suit. Jones has demonstrated no specific harm to her job. Holding: Summary judgment for Clinton. Jones had failed to demonstrate any tangible job detriment. She had never been downgraded in her job, and in fact had been reclassified upward. She received every merit increase for which she was eligible. A mere change in job responsibilities, with no loss of status or pay, is not a job detriment. The facts that her work station was changed, that she sometimes had nothing to do, and that she did not receive flowers on Secretary’s Day do not add up to a federal claim of sexual harassment. Question: The court seems to regard Jones’s allegations as trivial. In fact, hasn’t she alleged disgusting behavior by her employer? How can the court regard her claims so lightly? Answer: This gets to the essence of summary judgment. The judge does indicate that the alleged behavior, if it occurred, was crude and revolting. That is not the issue. The judge is saying that it is not her job to decide whether this behavior–assuming it occurred–was offensive. It is the judge’s job to decide something else. Question: What is the judge obligated to decide? Answer: Whether the alleged behavior constituted sexual harassment. Nothing more. Question: Doesn’t summary judgment mean that there will be no trial? Answer: Yes, that is exactly what it means. Question: How can a judge decide whether there was sexual harassment without holding a trial? We do not know whether Clinton did these things or not. Answer: Summary judgment means that it does not matter whether he did them, because even if did, plaintiff loses. The purpose of a trial is to find the facts. The judge is telling us there is no need to do that, because even if Jones proved everything she alleged, she still would fail to make out a case of sexual harassment. Question: What is missing from Jones’s allegations? Answer: A claim of a significant job loss. If she had claimed that following the alleged encounter with Clinton she had been fired, demoted, or denied normal benefits, she would have made out a claim of harassment and could have proceeded to trial. Without such an allegation, she has no case.

5-3 Trial 5-3a The Trial Adversary system: A system based on the assumption that if two sides present their best case before a neutral party, the truth will be established. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Unit 1 The Legal Environment

Our system of justice assumes that the best way to bring out the truth is for both sides to “go at” the various witnesses, enabling a neutral factfinder (judge or jury) to detect the truth. A full demonstration of examination and cross-examination in the classroom may take up too much class time. The following exercise permits an interesting glimpse at one vital part of the process.

Role Play: Who Is Telling the Truth? Have a dozen students (the jury) leave the room. Then ask two students to read this dialogue: Jack: So, Kate, I understand you’re thinking of hiring a computer consultant for your travel business? Kate: Yeah, we probably need somebody. It’s beyond us. We want someone to come in, give some advice on systems, software, all that stuff. Jack: I did a project two months ago for another travel agency. Just about your size. They love it. Kate: Really? Jack: Here’s what I can do. I’ll come in, interview everybody, figure out what you need, recommend the hardware, set it up, install all software, and teach you how to use it. Flat fee: $20,000. Kate: Sounds good, but it’s too high for us. We couldn’t go higher than $15,000. Jack: I’ll tell you what: $17,500. Kate: I like it. I think we might do it. I’ll call you for sure tomorrow. Jack has now sued Kate, claiming that they had a deal for $17,500. Kate claims she never agreed to hire him. Prepare six students to “testify” to the jury (without any lawyers). They will simply make ad-libbed statements, but some will be lies. Jack will start by explaining the conversation; he will accurately describe the beginning but will conclude with a lie, saying that they made a firm deal for $17,500. Kate will accurately relate the conversation, and mention that the following day she decided not to hire Jack. Then four other students will briefly speak, two on behalf of Jack, and two on behalf of Kate. The two who speak for Jack will be supporting his claim that the parties had a firm deal. The two speaking for Kate will tell the truth, accurately describing what Kate and Jack said. Permit everyone a few minutes to prepare his or her statements. Then ask the “jury” to return, and hear the “evidence.” See if they can tell who is speaking the truth.

5-3a Right to Jury Trial Not all cases are tried by a jury. Both plaintiff and defendant have a right to demand a jury trial when the lawsuit is one for money damages, but the parties may waive their right to a jury, and have the case tried by a judge.

5-3b Opening Statements Each attorney makes an opening statement to the jury, summarizing the proof they expect to offer, with plaintiff going first.

Chapter 1 Introduction to Law

5-3c Burden of Proof Burden of proof: The obligation to convince the jury that a party’s version of the case is correct. Preponderance of the evidence: The plaintiff’s burden of proof in a civil lawsuit. Beyond a reasonable doubt: The government’s burden of proof in a criminal prosecution. In civil cases, the plaintiff has the burden of proof. That means that the plaintiff must convince the jury that its version of the case is correct; the defendant is not obligated to disprove the allegations. See Exhibit 5.2 for a diagram of the burden of proof. By contrast, in a criminal case, the prosecution must demonstrate beyond a reasonable doubt that the defendant is guilty. The burden of proof in a criminal case is much tougher because the likely consequences are, too.

5-3d Plaintiff’s Case Direct examination: A lawyer asks questions of his or her own witness. Cross-examine: A lawyer asks questions of an opposing witness. Plaintiff’s attorney asks questions of her own witness on direct examination. The defendant’s attorney will then cross-examine each witness, trying to create doubt in the jury’s mind.

5-3e Defendant’s Case Defendant’s attorney presents its evidence and witnesses. He does not call the witnesses who are not helpful to his case. In essence, he is trying to prove that plaintiff’s evidence is not true. But because he declined to depose Craig Bergson, he does not know that his evidence might have been helpful.

5-3f Closing Arguments Both lawyers sum up their cases explaining how they hope the jury will interpret what they have seen and heard, and emphasize the evidence on their side. The judge explains the law and instructs the jury as to its duty, telling them they are to evaluate the case based only on the evidence they heard at trial, relying on their own experience and common sense.

5-3g Verdict The jury deliberates informally, with all jurors entitled to voice their opinions. Some deliberations take two hours, some two weeks, some longer. Many states require a unanimous verdict, others may require only a 10-2 vote in a civil case.

Unit 1 The Legal Environment

5-4 Appeals Precedent: Earlier decisions by a court on similar or identical issues, on which subsequent court decisions can be based. Rich files an appeal to the court of appeal, and on the same day, increases his settlement offer, which is declined. Rich files his appeal on the two issues. In her brief, Janet cites many cases that she claims are precedent, earlier decisions by the state or appellate court on similar or identical issues.

5-4a Appeals Court Options Affirm: To allow the decision to stand. Modify: To affirm the outcome but with changes. Reverse and remand: To nullify the lower decision and return the case for reconsideration or retrial. Reverse: To rule that the loser in a previous case wins, with no new trial. While the case is on appeal, the parties settle. .

5-5 Alternative Dispute Resolution 5-4a Mediation Mediation: A form of ADR in which a neutral third party guides the disputing parties toward a voluntary settlement. A mediator does not render a decision in the dispute but uses a variety of skills to move the parties toward agreement.

5-4b Arbitration Arbitration: A form of ADR in which a neutral third party has the power to impose a binding decision. Arbitration agreements: Contracts in which the parties agree to arbitrate their claims instead of filing a lawsuit. A neutral third party guides the disputing parties to discuss their cases, then renders a decision which is binding on both parties. The use of arbitration may be court-ordered or voluntary. Example: Mandatory Arbitration This exercise examines the risks and benefits of mandatory alternative dispute resolution (ADR) in an employment contract for a hypothetical company, FacTree. Students should consider these facts and discuss the benefits and risks for the company and for employees. FacTree manufactures artificial trees and flowers. There are about 100 workers who do the routine assembly work for pay ranging from $8 per hour to $15 per hour. They work in two shifts. There are about a dozen supervisors who oversee their work. In the past few years there have been five employment lawsuits: three concerned sexual harassment and two concerned discrimination in promotion. All five settled before trial. For three of the suits the company’s attorney fees were over $50,000 per suit. For one of the claims, the company paid $250,000 in damages to the employee. The © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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company is considering mandatory ADR for all employment disputes. What are the benefits for each side? From the Company’s Perspective:  Quicker decisions. Managers will spend less time in discovery and trial preparation. Employees may have less ability to sustain vexatious litigation (though they may be able to file such claims even more easily).  Reduced attorney fees.  Reduced discovery. Unhappy employees will be allowed to see very few company documents concerning internal investigations of supervisors; other related claims of harassment or discrimination; employment statistics concerning gender, race, age, etc., and intra-company memoranda.  No class actions. The stakes may rise dramatically in a class action because the defendant faces with much greater exposure. This in turn may give the plaintiff class greater bargaining leverage. From the Employees’ Perspective:  Reduced cost of bringing claims. In a lawsuit, the plaintiff must first convince an attorney to accept the case on a contingent-fee basis, or else pay a large hourly rate. With ADR, the employee can either perform the work herself, or hire a lawyer whose hours will be greatly reduced.  Quicker decisions. A lawsuit may drag on for several years, including discovery, trial, and appeal. Before the decision is final, the employee may abandon the case and the job. With ADR, management will have less opportunity to “club” an employee into settlement by dragging out a lawsuit.  Amicable settlement. ADR may increase the chance of an informal, amicable decision. The parties may stop thinking in terms of “win-lose,” and strive for a rational compromise.  Less bargaining power. The inability to bring class actions, engage in pre-trial discovery, or obtain orders enforceable by a court decreases the ability of employees to change the employment relationship.

Chapter Conclusion No one will ever know for sure whether Tony Caruso took his own life. Craig Bergson’s evidence might have tipped the scales in favor of Coastal. But even that is uncertain, since the jury could have found him unpersuasive. After two years, the case ends with a settlement and uncertainty - both typical lawsuit results. The vaguely unsatisfying feeling about it all is only too common and indicates why litigation is best avoided – by reasonable negotiation.

Matching Questions Match the following terms with their definitions: © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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_____A. Arbitration oath _____B. Diversity jurisdiction _____C. Mediation _____D. Interrogatories _____E. Deposition

1. Pre-trial procedure involving written questions to be signed under 2. A form of ADR in which the parties themselves craft the settlement. 3. A pre-trial procedure involving oral questions answered under oath. 4. The power of a federal court to hear certain cases between citizens of different states. 5. A form of ADR that leads to a binding decision.

Answers: U. 4 V. 1 W. 5 X. 3 Y. 2

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 22. T F One advantage of arbitration is that it provides the parties with greater opportunities for discovery than litigation does. 23. T F In the U.S., there are many separate courts, but only one court system, organized as a pyramid. 24. T F If we are listening to witnesses testify, we must be in a trial court. 25. T F About one-half of all lawsuits settle before trial. 26. T F To survive a motion to dismiss, a plaintiff need only present enough facts to show that the wrongdoing was possible.

Multiple Choice Questions 1. A federal court has the power to hear: A. Any case. B. Any case between citizens of different states. C. Any criminal case. D. Appeals of any cases from lower courts. E. Any lawsuit based on a federal statute. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: E 2. Before trial begins, a defendant in a civil lawsuit believes that, even if the plaintiff proves everything he has alleged, the law requires the defendant to win. The defendant should: A. Request arbitration B. Request a mandatory verdict C. Move for recusal D. Move for summary judgment E. Demand mediation Answer: D 3. In a civil lawsuit, the: A. Defendant is presumed innocent until proven guilty B. Defendant is presumed guilty until proven innocent C. Plaintiff must prove her case by a preponderance of the evidence D. Plaintiff must prove her case beyond a reasonable doubt E. Defendant must establish his defenses to the satisfaction of the court Answer: C 4.

Mack sues Jasmine, claiming that she caused an automobile accident. At trial, Jasmine’s lawyer is asking her questions about the accident. This is: A. An interrogatory B. A deposition C. Direct examination D. Cross examination E. Opening statement Answer: C

5. Jurisdiction refers to: A. The jury’s decision B. The judge’s instructions to the jury C. Pre-trial questions posed by one attorney to the opposing party D. The power of a court to hear a particular case E. A decision by an appellate court to send the case back to the trial court Answer: D

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Case Questions 1. Which court(s) have jurisdiction as to each of these lawsuits—state or federal? Explain your reasoning with each. (a) Pat wants to sue his next-door neighbor, Dorothy, claiming that Dorothy promised to sell him the house next door. (b) Paula, who lives in New York City, wants to sue Dizzy Movie Theatres, whose principal place of business is Dallas. She claims that while she was in Texas on holiday, she was injured by their negligent maintenance of a stairway. She claims damages of $30,000. (c) Phil lives in Tennessee. He wants to sue Dick, who lives in Ohio. Phil claims that Dick agreed to sell him 3,000 acres of farmland in Ohio, worth more than $2 million. (d) Pete, incarcerated in a federal prison in Kansas, wants to sue the United States government. He claims that his treatment by prison authorities violates three federal statutes. Answer: (a) The state trial court of general jurisdiction may hear the case. There is no federal court jurisdiction. (b) The general trial court of Texas, only. There is no federal court diversity jurisdiction because the money sought is less than $50,000. (c) Ohio’s general trial court has jurisdiction. United States District Court has concurrent jurisdiction, based on diversity. The parties live in different states and the amount in question is over $50,000. (d) United States District Court has federal question jurisdiction, based on the federal statutes at issue. The general trial court of Kansas has concurrent jurisdiction. 2. When Giant, Inc., hired Kelly, it gave her an entire binder of papers to sign. Buried in the fine print was a clause requiring any future dispute between the parties to go to arbitration, and the arbitrators would be chosen by Giant. Years later, Kelly filed a sexual harassment suit claiming that her boss fondled her. She demanded her day in court, but Giants’ attorneys claim she was barred due to the arbitration clause. Will Kelly prevail? Answer: Likely, yes Because the arbitrator is not neutral, since the arbitrator was to be chosen by Giant, the court will be likely to hold the arbitration clause invalid, and Kelly will proceed with her lawsuit. 3. Douglas Corp. fired Sam five days after he got a tattoo. Sam sued Douglas for discriminating against people with tattoos. There is no law prohibiting employment discrimination on this basis. And the Douglas employee handbook clearly stated that employees should have no visible tattoos. What will likely happen in court after Sam’s attorney files the complaint? Answer: Douglas Corp will likely file a Motion to Dismiss, which will be granted. 4. Annie and Bart are coworkers. In fact, they shave a cubicle wall. Recently, they were involved in a fender-bender in the company parking lot. Each blames the other for the accident, and the two have

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stopped speaking. Would you advise them to try to settle their dispute through arbitration, mediation, or with a traditional lawsuit. Answer: Answers will vary, but mediation might be the best option. 5. Raul lives in Georgia. He creates custom paintings and sells them at a weekly art fair near Atlanta. Sarah lives in Vermont. While on vacation in Georgia, she buys one of Raul’s paintings for $500. Soon after she returns home, she decides the painting is ugly, calls Raul, and demands a refund. Raul refuses. Sarah wants to sue him in Vermont. Raul has never been to Vermont, and has never sold a painting to anyone else from Vermont. Do Vermont courts have personal jurisdiction over Raul? Why or why not? Answer: No, Vermont courts do not have personal jurisdiction over Raul. He does not have the minimum contacts with the state which are necessary for the court to impose jurisdiction.

Discussion Questions 1. In the Tony Caruso case described throughout this chapter, the defendant offers to settle the case as several stages. Knowing what you do now about litigation, would you have accepted any of the offers? If so, which ones? If not, why not? Answer: Answers will vary. 2. ETHICS Trial practice is dramatically different in Britain. The lawyers for the two sides, called solicitors, do not go into court. Courtroom work is done by different lawyers, called barristers. The barristers are not permitted to interview any witnesses before trial. They know the substance of what each witness intends to say but do not rehearse questions and answers, as in the United States. Which approach do you consider more effective? More ethical? What is the purpose of a trial? Of pre-trial preparation? Answer: Answers will vary. 3. The burden of proof in civil cases is fairly low. A plaintiff wins a lawsuit if he is 51% convincing, and then he collects 100% of his damages. Is this result reasonable? Should a plaintiff in a civil case be required to prove his case beyond a reasonable doubt? Or, if a plaintiff is only 51% convincing, should he get only 51% of his damages? Answer: Answers will vary. 4. Usually, both a plaintiff and a defendant can demand a jury trial in cases asking for cash damages. If you were involved in a trial with $50,000 at stake, would you want a jury trial? Would you trust a group of strangers to arrive at a fair verdict, or would you prefer a judge to decide the case? Would your answer depend upon whether you were the plaintiff or defendant? Answer: Answers will vary. 5. The Supreme Court has held that businesses can force consumers to arbitrate rather than bring class actions. But at least one study found that individuals rarely sue on their own because it is too

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expensive. Various consumer groups have proposed rules to block banks and credit card companies from this practice. Should the law ban consumer arbitration agreements? Answer: Answers will vary.

Suggested Additional Assignments Research: Class Actions Students should find a current article on a pending class action against a large pharmaceutical, tobacco, automobile, or other company. Students should answer these questions: 1. What is a class action? 2. How long has this class action been going? 3. How does a class action change the stakes for the parties? 4. What are the plaintiffs’ claims? 5. Have developments in the class action favored the plaintiffs or defendants? 6. What are the long-term business, legal, and social consequences of class actions such as this one? Do those consequences support class actions as a valid form of litigation?

Chapter 6 – Crime* Chapter Overview Chapter Theme Criminal behavior extends far beyond the street crime that is fodder for television dramas—white collar crime has a greater economic impact than street crime. Criminal law differs in important ways from civil law, the subject of most of the text: the state prosecutes the wrongdoer, the wrongdoer can face lengthy imprisonment or death, and rights embedded in the Constitution protect individuals accused by the state of criminal behavior.

Approaching Criminal Law Criminal law is a popular topic. Students have been exposed to it, primarily through media, for most of their lives. Their knowledge and interest tend to focus on street crime. The text introduces a balanced view, spending a number of pages on crimes that harm business and crimes committed by businesses.

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When we think of crime, we imagine drug dealers and ban robbers; we do not think of corporate executives sitting at polished desks. While “street crimes” are serious threats, they take second place to white-collar crime, which costs society tens of billions of dollars annually. Just the fear of crime is expensive. Criminal law is a balancing act between making society safe and protecting us all from false accusations and unfair punishment.

6-1 Criminal Procedure 6-1 a Civil versus a Criminal Case Criminal Procedure: The process by which criminals are investigated, accused, tried, and sentenced.

Prosecution Although a crime may give the victim a right to sue in civil court, only the government can prosecute a crime and punish the perpetrator by sending him to prison. The government may also impose a fine, but it keeps the fine and does not share it with the victim. Restitution: When a guilty defendant must reimburse the victim for the harm suffered.

Burden of Proof Beyond a reasonable doubt: The very high burden of proof in a criminal trial, demanding much more certainty than required in a civil trial. In a civil case, the plaintiff must prove her case only by a preponderance of the evidence. But because the penalties for conviction in a criminal case are so serious, the government must prove its case beyond a reasonable doubt.

Right to a Jury Bench trial: There is no jury; the judge decides the case. A judge or jury decides the facts of a case. A criminal defendant has a right to a trial by jury for any charge that could result in a sentence of six months or longer. The defendant may demand a jury trial or may waive that right, in which case the judge will be the fact finder.

Felonies and Misdemeanors Felony: A serious crime, for which a defendant can be sentenced to one year or more in prison. Misdemeanor: A less serious crime, often punishable by less than a year in a county jail. A felony is a serious crime, for which a defendant can be sentenced to one year or more in prison. Murder, robbery, rape, drug dealing, money laundering, wire fraud, and embezzlement are felonies. A misdemeanor is a less serious crime, often punishable by a year or less in a county jail. Public drunkenness, driving without a license, and simple possession of one marijuana cigarette are considered misdemeanors in most states.

6-1b State of Mind Guilty: A judge or jury’s finding that a defendant has committed a crime.

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Voluntary Act A defendant is not guilty of a crime if she was forced to commit it. In other words, she is not guilty if she acted under duress. However, the defendant bears the burden of proving by a preponderance of the evidence that she acted under duress.

Entrapment When the government induces the defendant to break the law, the prosecution must prove beyond a reasonable doubt that the defendant was predisposed to commit the crime.

Conspiracy If the police discover a plot to commit a crime, they can arrest the defendants before any harm has been done. A defendant can be convicted of taking part in a conspiracy if:  a conspiracy existed,  the defendants knew about it, and  some members of the conspiracy voluntarily took a step toward implementing it.

6-1c Gathering Evidence: The Fourth Amendment Warrant: Written permission from a neutral officer to conduct a search. Probable cause: It is likely that evidence of crime will be found in the place to be searched. The Fourth Amendment to the Constitution prohibits the government from making illegal searches and seizures of individuals, corporations, partnerships, and other organizations. The goal of the Fourth Amendment is to protect the individual from the powerful state.

Warrant As a general rule, the police must obtain a warrant before conducting a search. The warrant must specify with reasonable certainty the place to be searched and the items to be seized. If the police search without a warranty, they have, in most cases violated the Fourth Amendment.

Searches without a Warrant There are seven circumstances under which police may search without a warrant: • Plain View. • Emergencies. • Automobiles. • Lawful Arrest. • Consent. • Stop and Frisk. • No Expectation of Privacy. Technology and social media have created new challenges for the courts in determining what is a reasonable expectation of privacy. For example:  DNA Tests.  Heat Seeking Devices.  Digital Cameras.  Cellphones.  Computers.  Email.  Websites.  Chats. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 

Social Media. GPS Tracking.

Case: Rodriguez v. United States Facts: Driving along the Nebraska State Highway just after midnight, Dennys Rodriguez briefly swerved onto the highway shoulder, which is a violation of Nebraska law. At 12:06 a.m., Officer Morgan Struble pulled Rodriguez over for erratic driving. Struble questioned both Rodriguez and his passenger and ran a records check on the car registration and their drivers’ licenses. Struble gave Rodriguez a warning ticket. At 12:27 a.m., Struble finished explaining the warning to Rodriguez and returned the documents to the two men. He then asked permission to walk his police dog around Rodriguez’s vehicle, but Rodriguez said no. On the officer’s instructions, Rodriguez exited the vehicle. At 12:33 a.m., Struble led the dog twice around the SUV. During the second circuit, the dog signaled the presence of drugs. After searching the car, Struble found methamphetamine, an illegal drug. At trial, Rodriguez argued that the dog sniff was illegal because Struble had effectively conducted a stop and frisk after the traffic stop was over. But Struble did not have a clear and specific reason to suspect criminal activity for a legal stop and frisk. Both the trial court and the appellate court disagreed with Rodriguez. The Supreme Court granted certiorari. Issue: Was the dog sniff legal? Excerpts from Justice Ginsburg’s Decision: A seizure for a traffic violation justifies a police investigation of that violation. The seizure remains lawful only so long as unrelated inquiries do not measurably extend the duration of the stop. An officer, in other words, may conduct certain unrelated checks during an otherwise lawful traffic stop. But he may not do so in a way that prolongs the stop, absent the reasonable suspicion ordinarily demanded to justify detaining an individual. Beyond determining whether to issue a traffic ticket, an officer’s mission includes ordinary inquiries incident to the traffic stop. Typically, such inquiries involve checking the driver’s license, determining whether there are outstanding warrants against the driver, and inspecting the automobile’s registration and proof of insurance. These checks serve the same objective as enforcement of the traffic code: ensuring that vehicles on the road are operated safely and responsibly. A dog sniff, by contrast, is a measure aimed at detecting evidence of criminal wrongdoing. Traffic stops are especially fraught with danger to police officers, so an officer may need to take certain negligibly burdensome precautions in order to complete his mission safely [such as asking the driver to exit the car. [But] the dog sniff could not be justified on the same basis. Highway and officer safety are interests different in kind from the Government’s endeavor to detect crime in general or drug trafficking in particular. For the reasons stated the case is remanded for further proceedings consistent with this opinion. Question: What are some ordinary inquiries incident to a traffic stop? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: checking driver’s licenses, determining whether there are any outstanding warrants against the driver, and inspecting the automobile’s registration and proof of insurance. Question: Is it legally permissible for an officer to make unrelated inquiries pursuant to a traffic stop? Answer: Yes, as long as they do not extend the duration of the stop. Question: Was the officer in reasonable fear for his safety? Answer: No, no threat was apparent. Question: Do you agree with the Supreme Court’s decision in this case? Answer: Answers will vary.

Bonus Case: United States v. Jones25 Facts: The Washington, D.C. police suspected Antoine Jones of being a drug dealer. Without a valid search warrant, they attached a GPS tracking device to his car. For 28 days, they used the GPS to determine his whereabouts. Based on this evidence, Jones was convicted of a conspiracy to deal cocaine and was sentenced to life in prison. The appellate court reversed his conviction on the grounds that the police should have obtained a warrant before attaching the GPS. The Supreme Court granted certiorari. Issue: Was the warrantless use of a GPS an illegal search under the Fourth Amendment? Excerpts from Justice Scalia’s Decision: The Fourth Amendment provides in relevant part that “*t+he right of the people to be secure in their persons, houses, papers, and effects, against unreasonable searches and seizures, shall not be violated.” It is beyond dispute that a vehicle is an “effect” as that term is used in the Amendment. The Government physically occupied private property for the purpose of obtaining information. We have no doubt that such a physical intrusion would have been considered a “search” within the meaning of the Fourth Amendment when it was adopted. [F]or most of our history the Fourth Amendment was understood to embody a particular concern for government trespass upon the areas (“persons, houses, papers, and effects”) it enumerates. The judgment of the Court of Appeals for the D.C. Circuit is affirmed. Question: What language does a car fall under within the text of the Fourth Amendment? Answer: An “effect.” Question: For what purpose did the Government physically occupy private property in this case? Answer: The purpose of obtaining information.

Exclusionary Rule Under the exclusionary rule, evidence obtained illegally (or any information obtained as a result of this illegal behavior) may not be used at trial.

Discussion: Exclusionary Rule

Chapter 1 Introduction to Law

Many people have a fundamental conceptual problem with understanding the exclusionary rule: it only applies to incriminating evidence. They would, presumably, support a (non-sensical) rule that excluded non-incriminating evidence seized during an illegal search, but they believe that if incriminating evidence is found, how can a search be illegal? It would, of course, serve no constitutional purpose to exclude from trial evidence that has no bearing on a defendant’s guilt. The issue is to help those who stumble over this fact understand why courts created the exclusionary rule. One can start by not calling an illegal search a “technical violation” or “technical mistake.” We do not consider government’s seizure of a private residence without compensation to be a technical violation of the due process clause, or banning of peaceful political speech to be a technical violation of the First Amendment. Question: How can it possibly make sense to exclude legitimate evidence because a police officer made a mistake in getting a warrant? Aren’t we letting the criminal go free because the constable blundered? Answer: The Supreme Court has created the exclusionary rule as a judicial remedy to protect all citizens from potential police abuse. The theory is that if the police know in advance that illegally seized evidence cannot be used at trial, they will have no motive to obtain such evidence, and will go about their investigations lawfully. Question: Does the Supreme Court think that all police want to abuse the average citizen? Answer: No. What the court has said, by crafting the rule, is that one of the most valuable things there is about living in a democratic society is the ability to live without fearing the police. We should be able to sleep at night without worrying that our doors will be smashed in. Question: I haven’t done anything wrong and am not worried about the police “smashing in my doors in the middle of the night.” Why should I care about the exclusionary rule? Answer: There’s a saying—”A liberal is a conservative who has just been arrested; a conservative is a liberal who has just been mugged”—that, while obviously painting with overbroad strokes, contains an important kernel of truth. Our relationship to the criminal justice system and our rights as citizens tend to be grounded on personal experiences. Citizens of the United States, who live under the protection of a Constitution that guarantees certain individual liberties from governmental intrusion, should not pickand-choose which Constitutional guarantees they will support. Question: The difference between a lawful search or arrest and an unlawful one is often a warrant. What is so special about a warrant? Answer. The warrant requirement means that the police must obtain the permission of a neutral person before conducting most searches or making most arrests. Because the police are charged with responsibility to investigate crimes, they may have a vested interest in conducting investigations as aggressively as possible. The warrant requirement means that someone who has no personal interest in the investigation must first be convinced that there is probable cause to search some premises or make an arrest. Question: What might happen if there was no requirement for probable cause? Answer: For example, police might reason that a certain percentage of students at a large university use illegal drugs, and that therefore it would be profitable to stake out the campus and search everyone who enters it. Even if only a tiny percentage of students are carrying drugs, it might prove a good way to catch criminals. The problem is that all of the innocent people would be forced to endure periodic searches. Question: What is wrong with being searched if you don’t have anything to hide? Answer: Being searched is—by definition—invasive. Some people might not mind it, but there are many who do not want to feel that they live in a police state. Also, to allow police to search without a warrant is to give them tremendous power, which some officers might abuse. For example, a particular policeman might choose to search only minorities, or women, or students, or those living in a particular neighborhood. Ours is supposed to be a society regulated by law, not by personal, police power. Question: How many people go free because of the exclusionary rule? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Very few. As the text reports, most studies have shown that less than 1 percent of those prosecuted go free because evidence is excluded. Courts deny the great majority of motions to suppress, and in those few cases where they are allowed, the prosecution generally has additional evidence sufficient to convict. Bonus Notes: There are three exceptions to the exclusionary rule:  Inevitable Discovery  Independent Source  Good Faith Exception

6-1d After Arrest Right to a Lawyer: The Sixth Amendment The Sixth Amendment guarantees the right to a lawyer at all important stages of the criminal process. Because of this right, the government must appoint a lawyer to represent, free of charge, any defendant who cannot afford one.

Double Jeopardy Double jeopardy: A criminal defendant may be prosecuted only once for a particular criminal offense. The prohibition against double jeopardy means that a defendant may be prosecuted only once for a particular criminal offense. The purpose is to prevent the government from destroying the lives of innocent citizens with repetitive prosecutions.

Discussion: Double Jeopardy Question: What does double jeopardy mean? Answer: A criminal defendant may be prosecuted only once for a criminal offense. Question: I recall reading about cases where people were prosecuted by a state and by the federal government for the same offense. Why doesn’t that violate double jeopardy? Answer: To qualify as double jeopardy a second prosecution must be done by the same sovereign that prosecuted the first. There is no prohibition against a different sovereign prosecuting the same defendant, based on the same incident. In the Rodney King trials in Los Angeles, the police officers were first charged by the state of California. Their acquittal led to the 1992 Los Angeles riots. The United States then prosecuted the officers for civil rights violations and obtained convictions against two. Because the United States is a different sovereign from California, there was no double jeopardy problem. Question: Is that fair? Answer: Some argue that it is not fair; it is, however, legal. Question: O. J. Simpson was acquitted after the most highly publicized trial in history, yet he was then sued by the families of the victims. Didn’t that violate double jeopardy? Answer: No. The families filed a civil lawsuit. That is not a criminal prosecution and there is no double jeopardy issue.

Indictment Grand jury: A group of ordinary citizens who decide whether there is probable cause the defendant committed the crime with which she is charged. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Indictment: The government’s formal charge that the defendant has committed a crime and must stand trial. If the grand jury determines that there is probable cause, an indictment issues. Because the grand jury never hears the defendant’s evidence, it is relatively easy for prosecutors to obtain an indictment.

Arraignment At an arraignment, a clerk reads the formal charges of the indictment. The defendant must enter a plea to the charges. At this stage, most defendants plead not guilty.

Plea Bargaining Plea Bargain: An agreement in which the defendant pleads guilty to a reduced charge, and the prosecution recommends to the judge a relatively lenient sentence. In the federal court system, about 97% of all prosecutions end in a plea bargain. Such a high percentage has led to some concern that innocent people may be pleading guilty to avoid the risk of tough mandatory sentences. A judge need not accept the bargain, but usually does.

Self-Incrimination: The Fifth Amendment The Fifth amendment bars the government from forcing any person to provide evidence against himself. In other words, the police may not use mental or physical coercion to force a confession or any other information out of someone. In the following landmark case, the Supreme Court established the requirement that police remind suspects of their rights – the very same ones that we have all heard so many times on television shows.

Landmark Case: Miranda v. Arizona26 Facts: Ernesto Miranda was a mentally ill, penniless Mexican immigrant. At a Phoenix police station, a rape victim identified him as her assailant. The police did not tell him that he had a right to have a lawyer present during questioning. After two hours of interrogation, Miranda signed a confession that said that it had been made voluntarily. At Miranda’s trial, the judge admitted this written confession into evidence. The officers testified that Miranda had also made an oral confession during the interrogation. The jury found Miranda guilty of kidnapping and rape. After the Supreme Court of Arizona affirmed the conviction, the U.S. Supreme Court agreed to hear his case. Issues: Was Miranda’s confession admissible at trial? Should his conviction be upheld?

384 U.S. 436; 1966 U.S. LEXIS 2817 SUPREME COURT OF THE UNITED STATES, 1966 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Decision: Neither his written nor his oral confession was admissible. His conviction was overturned. Reasoning: The Supreme Court had had a series of cases in which the police had not only engaged in lengthy secret interrogations, but had also beaten, hanged, and whipped suspects. The court’s goals in this case were to prevent police wrongdoing, fairly balance state power and individual rights, and respect human dignity. Justice requires that the government, when seeking to punish an individual, must find the evidence itself rather than force him to reveal it from his own mouth. Therefore, once the police deprive a suspect of his freedom, they are required to protect his constitutional right to avoid selfincrimination. To do so, they must warn him 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 hired by him or provided by the government. If the police do not inform the accused of these rights, then nothing he says or writes can be admitted in court. The defendant may waive these rights, provided the waiver is made voluntarily, knowingly, and intelligently. If, however, he indicates in any manner and at any stage of the process that he does not want to be interrogated or wishes to talk with an attorney, then the police cannot question him. The mere fact that he may have volunteered some statements on his own does not deprive him of the right to refrain from answering any further questions until he has consulted with an attorney. Question: The Miranda warnings are based on what part of the Constitution? Answer: Miranda warnings are based on the defendant’s right against self-incrimination, contained in the 5th Amendment. Question: What was or were the problems the Supreme Court was trying to address, after seeing a series of cases with these problems? Answer: At the hands of the police in that day, suspects were often subjected to lengthy secret interrogations, beaten, hanged, and whipped.

Trial and Appeal When there is no plea bargain, the case must go to trial. The mechanics of a criminal trial and appeal are similar to those for a civil trial, described in Chapter 6, on dispute resolution.

Punishment The Eighth Amendment prohibits cruel and unusual punishment. Courts are generally unsympathetic to claims under this provision. For example, the Supreme Court has ruled that the death penalty is not cruel and unusual as long as it is not imposed in an arbitrary or capricious manner.27 Bonus Notes: Another important case under the Eighth Amendment involved California’s “three strikes” law, which dramatically increases sentences for repeat offenders. Gary Ewing, on parole from a nine27

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year prison term, was prosecuted for stealing three golf clubs worth $399 each. Because he had prior convictions, his crime, normally a misdemeanor, was treated as a felony. Ewing was convicted and sentenced to 25 years to life. The Supreme Court ruled that this sentence was not cruel and unusual and that the three strikes law was a rational response to a legitimate concern about crime.28 The Eighth Amendment also outlaws excessive fines. Forfeiture is the most controversial topic under this clause. Forfeiture is a civil law proceeding that is permitted by many different criminal statutes. Once a court has convicted a defendant under certain criminal statutes—such as a controlled substance law— the government may seek forfeiture of property associated with the criminal act. To determine if forfeiture is fair, courts look at three factors:  Whether the property was used in committing the crime  Whether it was purchased with proceeds from illegal acts, and  Whether the punishment is disproportionate to the defendant’s wrongdoing

6-2 Crimes That Harm Businesses (And Their Customers) Businesses must deal with five major crimes: larceny, embezzlement, fraud, arson, and hacking.

6-2a Larceny Larceny: the trespassory taking of personal property with the intent to steal it.

6-2b Embezzlement Embezzlement: The fraudulent conversion of property already in the defendant’s possession.

6-2c Fraud Fraud: Deception for the purpose of obtaining money or property. Fraud refers to a variety of crimes, all of which involve the deception of another person for the purpose of obtaining money or property. Types of fraud include wire and mail fraud, insurance fraud, Internet fraud, auctions, identity theft, and phishing.

Wire Fraud and Mail Fraud These are additional federal crimes involving the use of interstate mail, telegram, telephone, radio or television to obtain property by deceit.

Internet Fraud Online scams are common. The Internet’s anonymity and speed facilitate fraud. Common scams include advance fee scams, the sale of merchandise that is either defective or nonexistent, the so-called Nigerian letter scam, billing for services touted as “free,” and so on. Other common forms are: Auctions – Shilling is an increasingly popular online auction fraud. Shilling means that a seller either bids on his own goods or agrees to cross-bid with a group of other sellers. It is prohibited because the owner drives up the price of his own item by bidding on it. Identity Theft – This is one of the scariest crimes against property. Thieves steal the victim’s social security number and other personal information such as bank account numbers and mother’s maiden 28

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name, which they use to obtain loans and credit cards. Victims have the difficult task of proving that they were not responsible for the debts and they may even find themselves unable to obtain a credit card, loan, or job. Phishing Phishing: A fraudster sends a message directing the recipient to enter personal information on a website that is an illegal imitation of a legitimate site.

6-2d Arson Arson: The malicious use of fire or explosives to damage or destroy real estate or personal property.

6-3e Hacking Hacking: Gaining of unauthorized access to a computer system. Hacking is a crime under the federal Computer Fraud and Abuse Act of 1986 (CFAA).29 The CFAA prohibits:  Accessing a computer without authorization and obtaining information from it,  Intentional, reckless, and negligent damage to a computer,  Trafficking in computer passwords, and Courts are now in the process of figuring out how to interpret the CFAA. In the following case, a former employee clearly violated his company’s policies, but did he commit a crime? You be the judge.

Bonus You Be the Judge: United States v, Nosal30 Facts: David Nosal worked for an executive search firm, Korn/Ferry (K/F). Shortly after he left the company to start a competing business, he convinced some of his former colleagues to log into the company’s confidential database and give him customer names and contact information. K/F had authorized the employees to access the database, but not to disclose confidential client information to outsiders. The government charged Nosal with aiding and abetting his former colleagues in violating a provision of the CFAA that prohibits employees from exceeding their authorized access to a computer with intent to defraud. The trial court granted Nosal’s motion to dismiss. The government appealed. You Be the Judge: Did Nosal commit a crime when he aided and abetted others in violating a workplace policy on computer use? Argument for the Defendant: This provision of the CFAA can mean one of two things: (1) either it is a crime to access unauthorized data or, (2) in a more expansive view, it can apply to anyone who is legally entitled to access data, but who then uses this data in an unauthorized manner. That is what happened here. The K/F employees were authorized to access the confidential database, but they were not permitted to send it to Nosal.

18 U.S.C. Section 1030.

676 F.3d 854 United States Court of Appeals for the Ninth Circuit, 2012. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Congress enacted the CFAA primarily to address the growing problem of computer hacking, i.e., “intentionally trespassing into someone else’s computer files.” But, under the government’s view, everyone who uses a computer in violation of company policy, which may well include everyone who uses a computer, would be a criminal. According to the government, if an employer keeps certain information in a separate database that can be viewed on a computer screen, but not copied or downloaded and an employee copies the information to a thumb drive, he could be charged with a crime. The computer gives employees new ways to procrastinate, by g-chatting with friends, playing games, shopping or watching sports highlights. Such activities are routinely prohibited by many computer-use policies. Under the broad interpretation of the CFAA, such minor violations would become federal crimes. While it is unlikely that you will be prosecuted for watching cat videos on your work computer, you could be. How will an employee know the difference between a minor personal use and a criminal act? Employees who call family members from their work phones will become criminals if they send an email instead. They can read the sports section of USA Today at work, but they’d better not visit ESPN.com. And Sudoku enthusiasts should stick to printed puzzles, because visiting www.dailysudoku.com from their work computers might give them more than enough time to hone their Sudoku skills behind bars. Facebook prohibits its users from sharing login information. Are we going to cart every violator off to prison? The terms of service on dating websites prohibit inaccurate or misleading information. If you describe yourself as “tall, dark and handsome,” when you are actually short and homely, could you end up wearing a handsome orange prison jumpsuit? Argument for the Government: This statute explicitly requires an intent to commit fraud. Therefore, it has nothing to do with reading ESPN.com, playing Sudoku, checking email, or fibbing on dating sites. Instead, the K/F employees knowingly exceeded their access to a protected company computer and they did so with an intent to defraud. This distinction is not complicated. A bank teller is entitled to access money for legitimate banking purposes, but not to take the bank’s money for himself. A new car buyer may be entitled to take a vehicle around the block on a test drive but not to drive it to Mexico on a drug run.

Holding: Judgment for Nosal. Question: What does CFAA stand for? Answer: The Computer Fraud and Abuse Act. Question: What is hacking? Answer: The gaining of unauthorized access to a computer system.

6-3 Crimes Committed by Business A corporation can be found guilty of a crime based on the conduct of any of its agents, who include anyone undertaking work on behalf of the corporation. An agent can be a corporate officer, an

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accountant hired to audit a statement, a sales clerk, or almost any other person performing a job at the company’s request. If an agent commits a criminal act within the scope of his employment and with the intent to benefit the corporation, the company is liable. This means that the agent himself must first be guilty.

6-3a Making False Statements It is illegal to make false statements or engage in a cover up during any dealings with the United States government.

6-3b RICO Racketeer Influenced and Corrupt Organizations Act (RICO): A powerful federal statute, originally aimed at organized crime, now used in many criminal prosecutions and civil lawsuits. Racketeering acts: Any of a long list of special crimes, such as embezzlement, arson, mail fraud, wire fraud, and so forth. RICO is one of the most controversial statutes ever written. Congress passed the law primarily to prevent gangsters from taking money they earned illegally and investing it in legitimate businesses. RICO prohibits using two or more racketeering acts to accomplish any of these goals: (1) investing in or acquiring legitimate businesses with criminal money; (2) maintaining or acquiring businesses through criminal activity; or (3) operating businesses through criminal activity. It is a two-step process to prove that a person or an organization has violated RICO. • The prosecutor must show that the defendant committed two or more racketeering acts, which are any of a long list of specified crimes: embezzlement, arson, mail fraud, wire fraud, and so forth. Thus, if a gangster ordered a building torched in January and then burned a second building in October, that would be two racketeering acts. If a stockbroker told two customers that Bronx Gold Mines was a promising stock, when she knew that it was worthless, that would be two racketeering acts. • The prosecutor must then show that the defendant used these racketeering acts to accomplish one of the three purposes listed above. If the gangster committed two arsons and then used the insurance payments to buy a dry-cleaning business, that would violate RICO. If the stockbroker gave fraudulent advice and used the commissions to buy advertising for her firm, that would violate RICO. Treble damages: A judgment for three times the harm actually suffered.

6-3d Money Laundering Money laundering: Using the proceeds of criminal acts either to promote crime or conceal the source of the money.

Discussion: Money Laundering Cases and Prosecutorial Ethics Federal prosecutors have sharply increased the number of people they charge with money laundering. Because more people are funneling drug money out of the country? Not necessarily, argue defense lawyers. They say that prosecutors are now routinely adding on money laundering charges to cases that used to be routine fraud cases. For example, a medical supply company bills the federal government for prosthetic devices that it never delivered. Formerly, that would have been a simple © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Medicare fraud case. Today, though, it is likely to be a Medicare fraud and money laundering case. Prosecutors in such a case argue that the money obtained illegally from the federal government is used to invest in and maintain a legitimate business, and that is money laundering. If the medical supply company uses money obtained from fraudulent bills to pay the rent on its company headquarters, it has laundered the money. What is the big deal? Time in prison. A simple fraud conviction typically results in a sentence of five years or less; a money laundering conviction can increase the penalty to 20 years in prison. In addition, a prosecutor who tacks on a money laundering charge puts extra pressure on the defendant to plea bargain, because the penalty for a conviction could be so high. Defense lawyers claim that this practice is unethical, in that Congress intended stiff money laundering penalties for big-time drug dealers who gravely damage our country by importing harmful substances. A small business dealer who cheats once or twice should not be treated like a drug kingpin. Prosecutors respond that they are ethically required to charge the most serious provable crime, and that Congress wrote the money laundering statute broadly in order to discourage all fraud, not just drugrelated offenses.

Bonus Case: United States v. Kennard31 Facts: The reverend Abraham Kennard bilked hundreds of churches out of millions of dollars through a phony grant scheme. Abraham created the Network International Investment Corporation and then approached churches and other nonprofits with an offer: for every $3,000 in membership fees that an organization paid to the Network, the Network would award $500,000 in grants. Abraham told investors that the grants were possible because he had secured wealthy investors who would provide financing, and that the Network expected to earn a profit from its Christian resorts. More than 1,600 churches and other nonprofits paid Abraham over $8.7 million. Abraham deposited the money into an escrow account in the name of his lawyer, and then transferred the money into another account in the name of Promotional Times International, Ltd., which was controlled by Abraham’s brother Laboyce Kennard. The investors never received their money and Abraham was found guilty of various crimes. Laboyce was found guilty of money laundering. He appealed, arguing there was insufficient proof that he knowingly laundered money. Issue: Was there sufficient evidence that Laboyce knowingly laundered money? Holding: Yes, conviction affirmed. Laboyce claims that there was not enough evidence for a jury to find beyond a reasonable doubt either the existence of a criminal agreement or his knowing participation in it. To convict Laboyce on the money laundering conspiracy charge, the prosecution had to prove that some agreement existed to launder the proceeds of Abraham’s fraud scheme, and that Laboyce knowingly participated in that agreement. The extent of Laboyce’s knowledge of the details in the conspiracy does not matter if the prosecution can show that he knew the essential objectives of the conspiracy.

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There was sufficient evidence to prove that Laboyce knowingly participated in the agreement to launder the proceeds from Abraham’s fraud. Laboyce set up the Promotional account and made large deposits to that account of cashier’s checks from Abraham and checks drawn on the escrow account. Laboyce made most of the withdrawals from the Promotional account including cashier’s checks made payable to Abraham. Laboyce was also involved in Network events. For example: Laboyce went with Abraham to a Network meeting in Charlotte, North Caroline at which Abraham gave Network members fake checks instead of the promised grant money; Laboyce videotaped Abraham at a fake groundbreaking ceremony for a Network resort which was used to hold off member complaints; Laboyce “worked security” at a Network meeting where Abraham told the members their grants would be delayed again; and Laboyce was present at a meeting where Abraham told him that an FBI investigation of the Network led to a seizure of the escrow account. This evidence, according to the court, was enough for a jury to find beyond a reasonable doubt that Laboyce knowingly participated in the conspiracy to launder the proceeds of the fraud. Question: What is money laundering? Answer: Money laundering is taking the profits of certain crimes and either (1) using the money to promote crime or (2) attempting to conceal the source of the money. Question: How did the money laundering occur here? Answer: Payments received from members based on a fraudulent investment scheme was passed through two accounts to hide their source and relationship to Abraham. Question: If Laboyce did not commit the fraud, what crime did he commit? Answer: Laboyce was charged with conspiring to commit money laundering. Question: How is that different than money laundering? Answer: Conspiracy to launder money involves an agreement to launder money, and Laboyce’s knowing and voluntary participation in that agreement.

6-3d Hiring Illegal Workers It is illegal to knowingly employ unauthorized workers.

6-3e Foreign Corrupt Practices Act The Foreign Corrupt Practices Act (FCPA) prohibits American companies from paying bribes overseas.

6-3f Punishing a Corporation Fines The most common punishment for a corporation is a fine. This makes sense in that the purpose of a business is to earn a profit, and a fine, theoretically, hurts. But most fines are modest by the present standards of corporate wealth.

Compliance Programs Federal Sentencing Guidelines: The detailed rules that judges must follow when sentencing defendants convicted of federal crimes. Compliance program: A plan to prevent and detect improper conduct at all levels of the company. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The Federal Sentencing Guidelines are the detailed rules that judges must follow when sentencing defendants convicted of crimes in federal court. The guidelines instruct judges to determine whether, at the time of the crime, the corporation had in place a serious compliance program, that is, a plan to prevent and detect criminal conduct at all levels of the company.

Chapter Conclusion Crime has an enormous impact on society. Companies are victims of crimes, and sometimes they commit criminal actions. Successful business leaders are ever-vigilant to protect their company from those who wish to harm it, whether from the inside or out.

Matching Questions Match the following terms with their definitions: _____A. Larceny 1. A statute designed to prevent the use of criminal proceeds in legitimate businesses. _____B. RICO 2. Fraudulently keeping property already in the defendant’s possession _____C. Money Laundering 3. Using the proceeds of criminal acts to promote crime. _____D. Phishing 4. Directing someone to enter personal information on a website that is an illegal imitation of a legitimate site. _____E. Embezzlement 5. The trespassory taking of personal property. Answers: Z. 5 AA. 1 BB. 3 CC. 4 DD. 2

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 27. T F Both the government and the victim are entitled to prosecute a crime. 28. T F If police are interrogating a criminal suspect in custody and he says that he does not want to talk, the police must stop questioning him. 29. T F A misdemeanor is a less serious crime, punishable by less than a year in jail. 30. T F Corporate officers can be convicted of crimes; corporations themselves cannot be. 31. T F An affidavit is the government’s formal charge of criminal wrongdoing. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Multiple Choice Questions 1. Cheryl is a bank teller. She figures out a way to steal $99.99 per day in cash without getting caught. She takes the money daily for eight months and invests it in a catering business she is starting with Floyd, another teller. When Floyd learns what she is doing, he tries it, but is caught in his first attempt. He and Cheryl are both prosecuted. A. Both are guilty only of larceny. B. Both are guilty only of larceny and violating RICO. C. Both are guilty only of embezzlement. D. Both are guilty only of embezzlement and violating RICO. E. Both are guilty only of embezzlement. Answer: C. 2. In a criminal case, which statement is true? A. The prosecution must prove the government’s case by a preponderance of the evidence. B. The criminal defendant is entitled to a lawyer even if she cannot afford to pay for it herself. C. The police are never allowed to question the accused without a lawyer present. D. All federal crimes are felonies. Answer: B. 3. Henry asks his girlfriend, Alina, to drive his car to the repair shop. She drives his car all right—to Las Vegas, where she hits the slots. Alina has committed: A. fraud B. embezzlement C. larceny D. a RICO violation Answer: C. 4. Which of the following elements is required for a RICO conviction? A. Investment in a legitimate business B. Two or more criminal acts C. Maintaining or acquiring businesses through criminal activity D. Operating a business through criminal activity Answer: B. 5. The police are not required to obtain a warrant before conducting a search if: A. a reliable informant has told them they will find evidence of a crime in a particular location. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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B. they have a warrant for part of a property and another section of the property is in plain view. C. they see someone on the street who could possibly have committed a criminal act. D. someone living on the property has consented to the search. Answer: D.

Case Questions 1. The police arrested James and Will for murder. Will’s trial was first. He was acquitted because his minister testified that they had spent the evening of the murder playing Scrabble together. Later, at James’s trial Will admitted to having committed the murder, so James was acquitted. Why would Will confess: Answer: Will was free to confess because he could not be tried again fir the same crime. Having gone to trial and been found not guilty, he could not be tried again for that crime, no matter what he said.

You Be the Judge: WRITING PROBLEM. An undercover drug informant learned from a mutual friend that Philip Friedman “knew where to get marijuana.” The informant asked Friedman three times to get him some marijuana, and Friedman agreed after the third request. Shortly thereafter Friedman sold the informant a small amount of the drug. The informant later offered to sell Friedman three pounds of marijuana. They negotiated the price and then made the sale. Friedman was tried for trafficking in drugs. He argued entrapment. Was Friedman entrapped? Argument for Friedman: The undercover agent had to ask three times before Friedman sold him a small amount of drugs. A real drug dealer, predisposed to commit the crime, leaps at an opportunity to sell. If the government spends time and money luring innocent people into the commission of crimes, all of us are the losers. Argument for the Government: Government officials suspected Friedman of being a sophisticated drug dealer, and they were right. When he had a chance to buy three pounds, a quantity only a dealer would purchase, he not only did so, but bargained with skill, showing a working knowledge of the business. Friedman was not entrapped—he was caught. Answer: Friedman argued entrapment, claiming that there was no evidence of his predisposition to traffic in drugs. The Alabama Supreme Court ruled against him. The court noted that Friedman admitted to occasional use of marijuana, that he had been able quickly to locate marijuana to resell to the agent, and that he showed a sophisticated knowledge of the drug when bargaining over the price of three pounds. The court held that there was no evidence of entrapment. Friedman v. State, 654 So.2d 50, 1994 Ala. Crim. App. LEXIS 179 (1994).

3. Conley owned video poker machines. Although they are outlawed in Pennsylvania, he placed them in bars and clubs. He used profits from the machines to buy more machines. Is he guilty of money laundering? Answer: Yes. It is money laundering to take the proceeds of illegal acts and either conceal them or, as he did, use them to promote additional crimes. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. Shawn was caught stealing letters from mailboxes. After pleading guilty, he was sentenced to two months’ in prison and three years’ supervised release. One of the supervised release conditions required him to stand outside a post office for eight hours wearing a signboard stating, “I stole mail. This is my punishment.” He appealed this requirement on the grounds that it constituted cruel and unusual punishment. Do you agree? Answer: The appeals court affirmed the sentence on the grounds that it did not violate standards of decency. United States v. Gementera, 379 F.3d 596 (2004). 5. While driving his SUV, George Xinos struck and killed a pedestrian. He then fled the scene of the crime. A year later, the police downloaded information from his car’s onboard computer which they were able to use to convict him of the crime. Should this information have been admissible at trial? Answer: A California court ruled that Xinos did have a reasonable expectation of privacy and the data was not admissible in court. because the computer had simply been recording his movements on a public road. People v. Xinos, 192 Cal. App. 4th 637 (Cal. App. 6th Dist. 2011).

Discussion Questions 1. Under British law, a police officer must now say the following to a suspect placed under arrest: “You do not have to say anything. But if you do not mention now something which you later use in your defense, the court may decide that your failure to mention it now strengthens the case against you. A record will be made of anything you say and it may be given in evidence if you are brought to trial.” What is the goal of this British law? What does a police officer in the United States have to say, and what difference does it make at the time of an arrest? Which approach is better? Answer: Answers will vary. 2. In some countries, bribery is common and widely accepted. What is wrong with bribery, anyway? Why should it be illegal for American companies to pay bribes in countries where everyone else is? Answer: Answers will vary.

3. ETHICS You are a prosecutor who think it is possible that Naonka, in her role as CEO of a brokerage firm, has stolen money from her customers, many of whom are not well-off. If you charge her and her company with RICO violations, you know that she is likely to plea bargain because otherwise her assets and those of the company may be frozen by the court. As part of the plea bargain, you might be able to get her to disclose evidence about other people who might have taken part in this criminal activity. But you do not have any hard evidence at this point. Would such an indictment be ethical? Do the ends justify the means? Is it worth it to harm Naonka for the chance of protecting thousands of innocent investors? Answer: Answers will vary.

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4. California passed a “three strikes” law, dramatically increasing sentence for repeat offenders. If defendants with two or more serious convictions were convicted of a third felony, the court had to sentence them to life imprisonment. Such a sentence required the defendant to actually serve a minimum of 25 years, and in some cases much more. Gary Ewing, on parole from a nine-year prison term, was prosecuted for stealing three golf clubs worth $399 each. Because he had prior convictions, the crime, normally, a misdemeanor, was treated as a felony. Ewing was convicted and sentenced to 25 years to life. Did Ewing’s sentence violate the Eighth Amendment’s prohibition against cruel and unusual punishment? Answer: The Supreme Court ruled that this sentence was not cruel and unusual and that the three strikes law was a rational response to a legitimate concern about crime. Ewing v. California, 538 U.S. 11 (S. Ct. 2003).

5. Ramona Fricosu was indicted on charges of real estate fraud. During a legal search of her home, the police found a computer with encrypted files. Would it be a violation of her Fifth Amendment right against self-incrimination to force her to unencrypt these files? Answer: The courts are divided on this topic. This court did order Fricosu to unencrypt the files on the theory that she was already incriminated because the police knew the laptop was hers. United States v. Fricosu, 841 F. Supp. 2d 1232 (D. Colo. 2012). But a different court ruled that a man suspected of having child pornography on his computer did not have to unencrypt the files. United States v. Doe, 670 F.3d 1335 (11th Cir. Fla. 2012)

6. Suppose two people are living together: the suspect and a tenant. If the tenant consents to a police search of the premises, then the police are not required to first obtain a warrant. What if the suspect and the tenant disagree, with the tenant granting permission while the suspect forbids the police to enter? Should the police be required to obtain a warrant before searching? Or what if the suspect denies permission to enter but the police go back later and the tenant consents? Answer: In the first situation, the S. Ct. ruled that if the suspect is standing there and denies consent, the police may not conduct a search. Georgia v. Randolph, 547 U.S. 103 (U.S. 2006). As for the 2nd situation, in 2014, the S. Ct. refused to extend Georgia v. Randolph’s requirement of a cooccupant consent to a situation where the objecting occupant is absent from the property. The decision has implications for people who live with others. Co-occupants should be aware that their fellow co-occupants may consent to a police search if they are not there, even if they previously objected to the consent search. Fernandez v. California, 34 S.Ct. 1126 (2014).

Hiring relatives of foreign officials for no-show jobs is a violation of the FCPA. But what about hiring children of government officials into real jobs? Is that also a violation? The U.S. government is investigating JPMorgan Chase & Co.’s practice of hiring the children of top Chinese officials in Hong Kong. What are the rules in this situation? What should they be? Answer: According to the WSJ, “Factors that would help a company fend off bribery inquiries would include proof that there was a vacant position to start with (as opposed to the company having created a new position for the official's relative); that the relative was qualified to fill it; and that the

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relative performed the duties of the position satisfactorily, legal experts said.” Of concern would be any evidence of a quid pro quo around the time of hiring. 8. A police officer in North Carolina stopped Nick’s car because it had a broken brake light. Nick allowed the officer to search the car and, during the search, the officer found cocaine. It turns out that the original stop was invalid because drivers in North Carolina are allowed to drive with only one brake light. The cop did not know the law. Does the exclusionary rule prevent the cocaine from being admissible in court? Answer: If the original stop was illegal, then the search following from it, even though Nick gave permission, cannot stand. The exclusionary rule will apply.

Suggested Additional Assignments Research: Corporate Crime Students should find a newspaper or magazine article involving crime committed by a business or corporate executive. What are the economic costs of the (alleged) crime? What penalties can the state impose for the crimes? Are they penalties too harsh or too weak when compared to penalties for street crime? How should the law deal with the defendants’ conduct? Research: Computer Crime Students should find a newspaper or magazine article involving a computer crime, such as online fraud, online identity theft, or use of sites such as Craigslist and MySpace to perpetrate crimes. What new issues and/or obstacles are raised when crime is committed online? What new problems might the computer raise for law enforcement? Research: Revolving Door? Students should research recidivism rates for U.S. prisons. What percentage of prisoners return to prison for committing new crimes? Do recidivism rates differ by the type of crime a person committed? By age of the prisoner when committed to prison? By race? By education? By sex? By the type of penal environment in which the prisoner served time? Field Work: Criminal Court Students should visit a criminal session of a local trial court and observe court proceedings for a minimum of two hours. (It is likely easier for students in an urban environment to complete this assignment, but students near county seats should also have access to criminal court sessions.) Students should attempt to find a criminal trial, sentencing, or pre-trial motions. They should sit, observe, and compare what they see with the images they’ve formed of criminal court from the media.

Chapter 7 – Intentional Torts and Business Torts* Chapter Overview Chapter Theme A wide variety of intended acts can have unintended consequences. With intentional torts, the defendant may not have intended to harm the plaintiff, but her deliberate actions have resulted in © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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alleged injury. Anticipating the harm that can result enables us to consider carefully the actions themselves.

Torts Tort: A violation of a duty imposed by the civil law. Intentional Torts: Harm caused by a deliberate action. “Tort” means “wrong.” A tort is a violation of a duty imposed by the civil law. Torts differ from crimes in that crimes are prosecuted by the government. Tort cases are filed by the wronged party. A particular action may be both a tort and a crime. A tort also differs from a contract dispute in that in a tort, there is usually no prior agreement between the parties. The law itself creates the duty breached by the defendant in a tort case.

7-1 Intentional Torts 7-1a Defamation Libel: Written defamation. Slander: Oral defamation. Element: A fact that a plaintiff must prove to win a lawsuit. There are four elements to a defamation case: Defamatory statement. This is a factual statement that is likely to harm another person’s reputation. Falsity. The statement must be false. Communicated. The statement must be communicated to at least one person other than the plaintiff. Injury. The plaintiff most show some injury, unless the case involves false statements about sexual behavior, crimes, contagious diseases, and professional abilities. In these cases, the law is willing to assume injury. Mere statement of opinion does not constitute defamation. Defamation involves four elements: Defamatory statement, that is false, communicated to someone other than the plaintiff, that somehow injures the plaintiff. Bonus notes: In cases involving false statements about sexual behavior, crimes, contagious diseases, and professional abilities, the law is willing to assume injury without requiring the plaintiff to prove it. Lies in these four categories amount to slander per se when they are spoken and libel per se when they are published The following landmark case involves libel per se, The New York Times, and alleged police brutality. Set in Alabama during the racially charged 1960s, this landmark Supreme Court decision changed the rules of the defamation game for all public personalities.

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Landmark Case: New York Times Co. v. Sullivan32

Facts: In 1960, The New York Times ran a full-page advertisement paid for by civil rights activists. The ad described an a series of abuses by the police of Montgomery, Alabama, against civil rights activists. The ad also accused the Montgomery police of bombing the home of Dr. Martin Luther King, Jr., and unjustly arresting him seven times. Most of the ad’s statements were true, but a few were not. The NYT did not check the ad’s accuracy before publishing it. Montgomery’s police commissioner (L.B. Sullivan) sued The New York Times under Alabama’s law on libel per se. An Alabama court agreed with Sullivan, awarding him damages of $500,000. The Supreme Court of Alabama affirmed. The New York Times appealed to the U.S. Supreme Court, arguing that the ad was protected by the First Amendment’s freedom of speech. Issue: Does the First Amendment protect defamatory criticism of public officials? Decision: Yes. To win a defamation case, a public official must prove that the harmful statement was made with malice. Reasoning: First Amendment protection does not depend on the truth, popularity, or social utility of the ideas expressed. Debate on public issues should be uninhibited, robust, and wideopen. Sometimes it will include unpleasantly sharp attacks on government and public officials. Sometimes it may even include inaccurate and defamatory statements. The NYT advertisement was protected by the First Amendment, even though it contained falsehoods. To preserve free debate about the official conduct of public officials, it is necessary to limit their ability to recover damages in defamation suits. To recover for defamation, a public official must prove that the defamatory statement was made with “actual malice,” that is, with knowledge that it was false or with reckless disregard for the truth. There is no evidence that the NYT acted with malice. The evidence suggests that the NYT was at most negligent in failing to catch the inaccuracies. The judgment of the Supreme Court of Alabama is reversed. Question: What does a public official have to prove in order to recover damages for a defamatory falsehood relating to his official conduct? Answer: Actual malice. Question: What is actual malice? Answer: Knowledge that a statement was false or with reckless disregard of whether it was false or not. Bonus Question: What is libel per se? 32

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Bonus Answer: Written defamation involving false statements about sexual behavior, crimes, contagious diseases, and professional abilities. Bonus Case: Yeagle v. Collegiate Times33 Facts: Sharon Yeagle was the Assistant to the Vice President of Students Affairs and Virginia Polytechnic Institute and State University. One of Yeagle’s duties was to help students apply to the Governor’s Fellows Program. The school newspaper published an article describing the university’s success in placing students and included a quote from Yeagle. Under Yeagle’s name in the article was the phrase “Director of Butt Licking.”

Yeagle sued the Collegiate Times for defamation and the trial court dismissed the case ruling that no reasonable person would take the words literally. Yeagle appealed.

Issue: Was the phrase defamatory, or was it deliberate exaggeration that no reasonable person would take literally?

Holding: Judgment for Collegiate Times affirmed. The court held that the phrase was no more than rhetorical hyperbole. Although the phrase was disgusting, offensive, and in bad taste, it could not reasonably be understood as stating an actual fact about Yeagle's job title or her conduct, or that she committed a crime of moral turpitude. Yeagle's assertion that the phrase demonstrated a lack of integrity in the performance of her duties also failed. The phrase could not reasonably be considered as conveying factual information about Yeagle, thus it did not support a cause of action for defamation.

Question: Why didn’t the district court allow Yeagle to present her case at trial? Wasn’t she entitled to his day in court? Answer: Yeagle had her day in court—before the judge who dismissed her case. A plaintiff only gets a trial if there are facts in dispute or if the law could be interpreted in more than one way. Neither was true in this case. Question: Why does the court look at phrase in the context in which it appeared, from the standpoint of the average reader? Answer: The phrase could not be read in a vacuum. The same phrase appearing on the front page of a national newspaper would lead to a very different interpretation of their meaning. Question: What was the context in which they appeared? Answer: They were in a student newspaper, readers of which appreciate humor and lively language In this context, a reader viewing the phrase would not interpret it as literal statements of fact. Question: Why is that important? The photo and caption offended Yeagle. Answer: It is important because without an untrue statement of fact, Yeagle cannot prove a prima facie case of defamation. 7-1b False Imprisonment False imprisonment: The intentional restraint of another person without reasonable cause or consent. 33

255 Va. 293, 497 S.E.2d 136, 1998 Va. LEXIS 32, Virginia Supreme Court, 1998 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Generally, a store may detain a customer or worker for alleged shoplifting if there is a reasonable basis for the suspicion and the detention is done reasonably. Most states have regulations that govern how long and under what circumstances a customer or employee may be held for suspicion of shoplifting or theft. 7-1c Battery and Assault Battery: A harmful or offensive bodily contact. Assault: An action that causes another person to fear an imminent battery. Assault and battery are related, but not identical. Battery is an intentional touching of another person in a way that is harmful or offensive. Assault occurs when a defendant does some act that makes a plaintiff fear an imminent battery. 7-1d Fraud Fraud: Injuring another person by deliberate deception.

7-1e Intentional Infliction of Emotional Distress Intentional Infliction of emotional distress: Extreme and outrageous conduct that causes serious emotional harm.

Case: Turley v. ISG Lackawanna, Inc. 774 F.3d 140, U.S. Ct. App., 2d Cir. (2014) Facts: Elijah Turley was a steelworker, he was the only African-American in his department. For years, Lackawanna employees tormented Turley with racist epithets and degrading retreatment. Thirty percent of the workers referred to him as “that f****** n*****.” Coworkers broadcast monkey sounds over the plant’s intercom system and vandalized his car and his workstation. On several occasions, Lackawanna employees threatened to kill Turley. Lackawanna managers witnessed the abuse and often participated in it. When Turley reported death threats, they laughed. They seldom punished the offenders and even blocked the police from investigating Turley’s complaints. This persecution caused him serious psychiatric problems. Turley sued the managers for intentional infliction of emotional distress (“IIED”). A jury agreed with him, but the defendants appealed, arguing that the behavior was not outrageous enough to be IIED. Issue: Did Turley make a valid claim for intentional infliction of emotional distress? Decision: Yes, Turley’s claim was valid. Reasoning: A defendant is liable for the intentional infliction of emotional distress only when his conduct is outrageous in character, extreme in degree, and utterly intolerable in a civilized community. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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A good test is whether the average member of the community would respond to the defendants’ conduct by exclaiming, “Outrageous!” Over a period of years, the managers witnessed, allowed, and even encouraged Turley’s abuse. Tasteless, rude, inappropriate, or vulgar conduct alone is not enough to establish an IIED claim. Here, the defendants’ shocking actions met the tort’s high standard of outrageous conduct. Question: What was the conduct that led to Turley’s claim of intentional infliction of emotional distress? Answer: There were many, such as death threats, degrading treatment, racial epithets and other conduct which tormented Turley over a period of three years. Question: What was the defense of Lackawanna’s managers? Answer: That their conduct was not outrageous enough. Question: Did the court agree? Answer: No. The court found the conduct deplorable, and noted the managers’ allowing the conduct, and sometimes even active participation.

Bonus Case: Jane Doe and Nancy Roe v. Lynn Mills34 Facts: Late one night, an anti-abortion protestor named Robert Thomas climbed into a dumpster located behind the Women's Advisory Center, an abortion clinic. He found documents indicating that the plaintiffs were soon to have abortions at the clinic. Thomas gave the information to Lynn Mills. The next day, Mills and Sister Lois Mitoraj created signs, using the women's names, indicating that they were about to undergo abortions, and urging them not to “kill their babies.” Doe and Roe (not their real names) sued, claiming intentional infliction of emotional distress (as well as breach of privacy). The trial court dismissed the lawsuit, ruling that the defendants' conduct was not extreme and outrageous. The plaintiffs appealed. Issue: Have the plaintiffs made a valid claim of intentional infliction of emotional distress? Holding: Dismissal reversed, and remanded for trial. “The objectionable aspect of defendants' conduct does not relate to their views on abortion or their right to express those views, but, rather, to the fact that defendants gave unreasonable or unnecessary publicity to purely private matters involving plaintiffs. . . . We believe this is the type of case that might cause an average member of the community, upon learning of defendants' conduct, to exclaim, ‘Outrageous!’ “ Question: What are the elements of intentional infliction of emotional distress? Answer: A plaintiff must prove extreme and outrageous conduct that caused her serious emotional harm. Question: According to the appeals court, how does the law determine whether a defendant’s conduct is sufficiently extreme to constitute this tort? Answer: The court said that the elements have probably been established if the average member of the community would exclaim, “outrageous!” 34

212 Mich. App. 73, 536 N.W.2d 824, 1995 Mich. App. LEXIS 313 Michigan Court of Appeals, 1995 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Don’t the defendants have a First Amendment right to express their opinions? Answer: Absolutely. Question: Then how can the appeals court reverse the trial court’s dismissal? Isn’t the court diminishing the defendants’ First Amendment rights? Answer: The court acknowledges that the defendants have a right to express their views on abortion. What they do not have a right to do is publicize the names of these women and the fact that they were about to undergo abortions. That is purely private information of no interest to the general public, and that in turn means that the defendants had no right to divulge it. Question: Does the appeals court ruling mean that the plaintiffs have proven their case of intentional infliction of emotional distress? Answer: No. The ruling simply means that the plaintiffs are entitled to a jury trial. The court is ruling that the trial court should not have dismissed the case. A jury could legitimately consider this conduct extreme and outrageous. Now it will be up to a jury to decide whether the conduct really does meet that standard.

7-2 Damages 7-21 Compensatory Damages Compensatory damages: Are intended to restore the plaintiff to the position he was in before the defendant’s conduct caused injury. Single recovery principle: Requires a court to settle a legal case once and for all, by awarding a lump sum for past and future expenses.

7-2b Punitive Damages Punitive damages: Punishment of the defendant for conduct that is extreme and outrageous. The U.S. Supreme Court has ruled that a verdict must be reasonable. In awarding punitive damages, a court must consider three “guideposts”   

The reprehensibility of the defendant’s conduct The ratio between the harm suffered and the award, and The difference between the punitive award and any civil penalties used in similar cases.

You Be the Judge: Boeken v Philip Morris Incorporated35 Facts: In the mid-1950s, Richard Boeken began smoking Marlboro cigarettes at the age of 10. Countless advertisements, targeted at boys aged 10 to 18, convinced him and his friends that the “Marlboro man” was powerful, healthy and manly. At the time, scientists uniformly believed that cigarette smoking caused lung cancer, but Philip Morris and other tobacco companies waged a long-term campaign to convince the public otherwise. Philip Morris also added ingredients to its cigarettes to increase their addictive power.

127 Cal. App.4th 1640, 26 CalRptr.3d 638, California Court of Appeals, 2005. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Boeken saw the Surgeon General’s warnings about the risk of smoking, but he trusted the company’s statements that cigarettes were safe. Beginning in the 1970s, he tried many times to stop but always failed. Finally, in the 1990s, he quit after he was diagnosed with lung cancer but resumed smoking again once he had recovered from the surgery. Boeken filed suit against Philip Morris for fraud and other torts. He died of cancer before the case was concluded. The jury found Philip Morris liable for fraudulently concealing that cigarettes were addictive and carcinogenic. It awarded Boeken $5.5 million in compensatory damages and also assed punitive damages – of $3 billion. The trial judge reduced the punitive award to $100 million. Philip Morris appealed. You Be the Judge: Was the punitive damage award too high, too low or just right? Argument for Philip Morris: The court should substantially reduce the $100 million punitive award because it is totally arbitrary. The Supreme Court has indicated that punitive awards should not exceed compensatory damages by more than a factor of nine. The jury awarded Mr. Boeken $5.5 million in compensatory damages, which means that punitive damages should absolutely not exceed $49.5 million. We argue that they should be even lower. Cigarettes are a legal product, and our packages have displayed the Surgeon General's health warnings for decades. Mr. Boeken's death is tragic, but his cancer was not necessarily caused by Marlboro cigarettes. And even if cigarettes did contribute to his failing health, Mr. Boeken chose to smoke throughout his life, even after major surgery on one of his lungs. Argument for Boeken: The Supreme Court says that "few" cases may exceed the 9-to-1 ratio if the defendant’s behavior is particularly bad. Philip Morris created ads that targeted children, challenged clear scientific data that its products caused cancer, and added substances to its cigarettes to make them more addictive. Does it get worse than that? The behavior of Phillip Morris has caused terrible harm. The plaintiff died a terrible death from cancer. The company’s cigarettes kill 200,000 American customers each year, while its weekly profit is roughly $100 million dollars. At a minimum, the court should keep the punitive award at that figure. But we ask that the court reinstate the jury's original $3 billion award. Holding: Boeken’s punitive damage award was reduced to $50 million. Question: On what theory did Boeken sue Philip Morris? Answer: Boeken sued for fraud. Question: How did he claim Philip Morris committed fraud? Answer: He claimed that Philip Morris advertised its product in a misleading way knowing that the product was dangerous, and that it added chemicals to the product to increase its addictiveness. Question: Boeken testified that he read the Surgeon General’s warning about smoking in the 1960’s, so how can he argue fraud? Answer: The court held that although Boeken read the warning, he relied on the statements made by Philip Morris that the connection between smoking and cancer was not clear. The court also © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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stated that Philip Morris marketing “Light” cigarettes, which Boeken smoked, knowing that they were more harmful than Boeken or other ordinary consumers would expect. Question: Why did the court hold that these facts justified such a large award of punitive damages? Answer: Because it held that Philip Morris would not have achieved the same level of economic success without misrepresenting the harmful and addictive qualities of its cigarettes.

Bonus Landmark Case: State Farm v. Campbell36 Facts: While attempting to pass several cars on a two-lane road, Campbell drove into oncoming traffic. An innocent driver swerved to avoid Campbell and died in a collision with a third driver. The family of the deceased driver and the surviving third driver both sued Campbell. As Campbell’s insurer, State Farm represented him in the lawsuit. It turned down an offer to settle the case for $50,000, the limit of Campbell's policy. The company had nothing to gain by settling because even if Campbell lost big at trial State Farm’s liability was capped at $50,000. A jury returned a judgment against Campbell for $185,000. He was responsible for the $135,000 that exceeded his policy limit. He argued with State Farm, claiming that it should have settled the case. Eventually, State Farm paid the entire $185,000, but Campbell still sued the company, alleging fraud and intentional infliction of emotional distress. His lawyers presented evidence that State Farm had deliberately acted in its own best interests rather than his. The jury was convinced, and in the end, Campbell won an award of $1 million in compensatory damages, and $145 million in punitive damages. State Farm appealed. Issue: What is the limit on punitive damages? Excerpts from Justice Kennedy's Opinion: We address whether an award of $145 million in punitive damages, where full compensatory damages are $1 million, is excessive and in violation of the Due Process Clause. The Utah Supreme Court relied upon testimony indicating that State Farm's actions, because of their clandestine nature, will be punished at most in one out of every 50,000 cases as a matter of statistical probability, and concluded that the ratio between punitive and compensatory damages was not unwarranted. Compensatory damages are intended to redress the concrete loss that the plaintiff has suffered by reason of the defendant's wrongful conduct. By contrast, punitive damages serve a broader function; they are aimed at deterrence and retribution. The Due Process Clause prohibits the imposition of grossly excessive or arbitrary punishments. The reason is that elementary notions of fairness dictate that a person receive fair notice not only of the conduct that will subject him to punishment, but also of the severity of the penalty that a State may impose. To the extent an award is grossly excessive, it furthers no legitimate purpose and constitutes an arbitrary deprivation of property. A defendant should be punished for the conduct that harmed the plaintiff, not for being an unsavory. We decline to impose a bright-line ratio which a punitive damages award cannot exceed. Our jurisprudence and the principles it has now established demonstrate, however, that, in practice, few 36

538 U.S. 408

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awards exceeding a single-digit ratio between punitive and compensatory damages, to a significant degree, will satisfy due process. Single-digit multipliers are more likely to comport with due process, while still achieving the State's goals of deterrence and retribution, than awards with ratios in range of 145 to 1. Nonetheless, because there are no rigid benchmarks that a punitive damages award may not surpass, ratios greater than those we have previously upheld may comport with due process where a particularly egregious act has resulted in only a small amount of economic damages. The precise award in any case must be based upon the facts and circumstances of the defendant's conduct and the harm to the plaintiff. In sum, courts must ensure that the measure of punishment is both reasonable and proportionate to the amount of harm to the plaintiff and to the general damages recovered. In the context of this case, we have no doubt that there is a presumption against an award that has a 145-to-1 ratio. The compensatory award in this case was substantial; the Campbells were awarded $ 1 million for a year and a half of emotional distress. This was complete compensation. The harm arose from a transaction in the economic realm, not from some physical assault or trauma; there were no physical injuries; and State Farm paid the excess verdict before the complaint was filed, so the Campbells suffered only minor economic injuries. The judgment of the Utah Supreme Court is reversed, and the case is remanded for proceedings not inconsistent with this opinion. Question: Did State Farm show any evil intent in turning down the offer to settle? Answer: No; State Farm’s conduct was not reprehensible nor evil. State Farm was making a business decision. Question: What would have been an appropriate punitive damage award? Answer: Arguably, punitive damages should not have been awarded as State Farm’s conduct was not extreme and the $1 million compensatory award was sufficient.

7-2c Tort Reform and the Exxon Valdez Some people believe that jury awards are excessive and need statutory reform; others say that excessive awards are rare and modest in size. About half of the states have passed limits on jury awards. Laws vary, but many distinguish between economic and noneconomic damage. Under this kind of law, a jury may award any amount for economic damages (lost wages, medical expense, other measurable losses), but pain and suffering and other losses difficult to measure are capped at some level, such as $500,000. Bonus Notes: In the Exxon Valdez case, Captain Hazelwood’s negligence caused the Exxon Valdez to run aground off the coast of Alaska. The ship dumped 11 million gallons of oil into the sea, damaging 3,000 square miles of vulnerable ecosystem. The oil spill forced fishermen into bankruptcy, disrupted entire communit8ies, and killed hundreds of thousands of birds and animals, many of which have still not recovered. At trial, the jury decided that Exxon had been reckless by permitting the captain, a known alcoholic, to pilot the ship. They awarded compensatory damages of $507 million, and punitive damages of $5 billion. Exxon appealed. Nearly two decades later, the Supreme Court ruled, noting that much of the criticism of punitive damage awards appeared to be overstated, but also noting that the problem appeared to be the unpredictability © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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of punitive damages. They ruled that in maritime cases such as this one, the ratio should be no higher than 1:1, punitive damages to compensatory damages. They approved the jury’s compensatory award of $507 million, and reduced the punitive award from $5 billion to $507 million. Supporters of the court’s decision said it would allow businesses to make plans based on predictable outcomes. Opponents said the justices ignored the jury’s finding of reckless behavior and calamitous environmental harm.

7-2d Business Torts Tortious Interference with a Contract Tortious interference with a contract: An intentional tort in which the defendant improperly induced a third party to breach a contract with the plaintiff. Tortious interference with a contract exists only if the plaintiff can establish the following four elements: • There was a contract between the plaintiff and a third party; • The defendant knew of the contract; • The defendant improperly induced the third party to breach the contract or made performance of the contract impossible; and • There was injury to the plaintiff. Because companies routinely compete, it is not always easy to identify tortious interference. The three most commonly disputed issues concern elements one and three. A defendant may also rely on the defense of justification:  It was acting to protect an existing economic interest  It was acting in the public interest  The existing contract could be terminated at will by either party.

Bonus Notes: Cases of contract interference can result in enormous verdicts. Pennzoil made an unsolicited bid to buy 20% of Getty Oil at $100 per share. This offer was too low to satisfy the Getty board of directors, but it go the parties talking. Negotiations continued, the price moved up to $112.50 a share, and finally the Getty board voted to approve the deal. A press release announced an agreement in principle between Pennzoil and Getty. Before the ink on the press release was dry, Texaco appeared and offered Getty stock holders $128 per share for the entire company. Getty turned its attention to Texaco, leaving Pennzoil the jilted lover. So it sued. In Texas state court, Pennzoil claimed that Texaco had maliciously interfered with a Pennzoil-Getty contract, costing Pennzoil vast amounts of money. Texaco argued that it had acted in good faith, and that there was no binding contract between the other two. But the jury bought Pennzoil’s argument, and awarded $7.53 billion in actual damages, plus $3 billion more in punitive damages. After an appeal, the companies settled: Texaco agreed to pay Pennzoil $3 billion, and then filed for bankruptcy. The case illustrates two key issues: Did a contract exist, and was the defendant’s behavior improper?

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Commercial Exploitation Commercial exploitation: Prohibits the unauthorized use of another person’s likeness or voice for business purposes.

Chapter Conclusion This chapter has been a potpourri of misdeeds, a bubbling cauldron of conduct best avoided. Although tortious acts and their consequences are diverse, two generalities apply:  First, the boundaries of intentional torts are imprecise, and depend on the factfinder who analyzes it.  Second, thoughtful executives and careful citizens, aware of the shifting standards and potentially vast liability, will strive to ensure that their conduct never provides the factfinder an opportunity to give judgment.

Matching Questions Match the following terms with their definitions: _____A. Interference with a contract _____B. Fraud _____C. False imprisonment _____D. Defamation _____E. Punitive damages _____F. Intentional infliction of Emotional distress _____G. Commercial exploitation

1. Money awarded to punish a wrongdoer. 2. Intentionally restraining another person without reasonable cause. 3. Intentional deception, frequently used to obtain a contract with another party. 4. Deliberately stealing a client who has a contract with another. 5. Violation of the exclusive right to use one’s own name, likeness, or voice. 6. Using a false statement to damage someone’s reputation. 7. An act so extreme that an average person would say, “Outrageous!”

Answers: A. 4 B. 3 C. 2 D. 6 E. 1 F. 7 G. 5

True/False Questions Circle T for true or F for false: (Correct answers are bolded) © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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32. T F A store manager who believes a customer has stolen something may question him but not restrain him. 33. T F Becky punches Kelly in the nose. Becky has committed the tort of assault. 34. T F A defendant cannot be liable for defamation if the statement, no matter how harmful, is true. 35. T F In most cases, a winning plaintiff receives compensatory and punitive damages. 36. T F A company that wishes to include a celebrity’s picture in its magazine ads must first obtain the celebrity’s permission.

Multiple Choice Questions 1. A valid defense in a defamation suit is: A. falsity B. honest error C. improbability D. opinion E. third-party reliance Answer: D. 2. Joe Student, irate that he received a B- on an exam rather than a B, stands up in class and throws his laptop at the professor. The professor sees it coming and ducks just in time; the laptop smashes against the chalkboard. Joe has committed: A. assault B. battery C. negligence D. slander E. No tort, because the laptop missed the professor. Answer: A. 3.

Marsha, a supervisor, furiously berates Ted in front of 14 other employees, calling him "a loser, an incompetent, a failure as an employee and as a person.” She hands around copies of Ted’s work and mocks his efforts for 20 minutes. If Ted sues Marsha, his best claim will be: A. Assault B. Battery C. Intentional infliction of emotional distress D. Negligence E. Interference with a contract Answer: C.

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4. Rodney is a star player on the Los Angeles Lakers basketball team. He has two years remaining on his four-year contract. The Wildcats, a new team in the league, try to lure Rodney away from the Lakers by offering him more money, and Rodney agrees to leave Los Angeles. The Lakers sue. The Lakers will: A. Win a case of defamation B. Win a case of commercial exploitation C. Win a case of intentional interference with a contract D. Win a case of negligence E. lose Answer: C. 5. Hank and Antonio, drinking in a bar, get into an argument that turns nasty. Hank punches Antonio several times, knocking him down and breaking his nose and collarbone. Which statement is true? A. Antonio could sue Hank, who might be found guilty. B. Antonio and the state could start separate criminal cases against Hank. C. Antonino could sue Hank, and the state could prosecute Hank. D. The state could prosecute Hank, but only with Antonio’s permission. E. If the state prosecutes Hank, he will be found liable or not liable, depending on the evidence. Answer: C.

Case Questions 1

NOW 4. You are a vice-president in charge of personnel at a large manufacturing company. In-house detectives inform you that Gates, an employee, was seen stealing valuable computer equipment. Gates denies the theft, but you believe the detectives and fire him. The detectives suggest that you post notices around the company, informing all employees what happened to Gates and why. This will discourage others from stealing. While you think that over, a phone call from another company’s personnel officer asks for a recommendation for Gates. Should you post the notices? What should you say to the other officer? Answer: These are difficult problems, which a manager must think through carefully. Negative statements can lead to a defamation lawsuit. If you have irrefutable proof that Gates did steal, you are probably on safe ground. But if you doubt your ability to prove his theft, you must be very careful. If you state to the personnel officer precisely what you know about the theft, and nothing more, you are probably on safe ground. Even if you are incorrect, most courts will hold that you have qualified privilege to speak to someone who needs to know the truth. As long as you display no malice, you are not committing slander. Some managers, though, are extra careful and simply refuse to say anything in such a situation. As to posting the notices, you should not do it. The other employees have no need to know your allegations about Gates, and thus you have no qualified privilege to inform them. If you are wrong, it is libel, and juries are often very sympathetic to injured employees.

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2. Tata Consultancy of Bombay, India, is an international computer consulting firm. It spends considerable time and effort recruiting the best personnel from India’s leading technical schools. Tata employees sign an initial three-year employment commitment, often work overseas, and agree to work for a specified additional time when they return to India. Desai worked for Tata, but then quit and formed a competing company, which he called Syntel. His new company contacted Tata employees by phone, offering more money to come work for Syntel, bonuses, and assistance in obtaining permanent resident visas in the United States. At least 16 former Tata employees left their work without completing their contractual obligations and went to work for Syntel. Tata sued. What did it claim, and what should be the result? Answer: Tata sued for interference with contractual rights. The United States District Court granted summary judgment for Syntel, but on appeal the Court of Appeals reversed. The court stated that Syntel had “sought to reap where it had not sown by actively and systematically soliciting Tata employees . . . before they were legally free to do so. . . “ It remanded the case for trial. 3. For many years, Johnny Carson was the star of a well-known television show, The Tonight Show. For about 20 years, he was introduced nightly on the show with the phrase, “Here’s Johnny!” A large segment of the television-watching public associated the phrase with Carson. A Michigan corporation was in the business of renting and selling portable toilets. The company chose the name “Here’s Johnny Portable Toilets,” and coupled the company name with the marketing phrase, “The World’s Foremost Commodian.” Carson sued, claiming that the company’s name and slogan violated his right to commercial exploitation. Carson sued. What claim is he making? Who should win, and why? Argument for Carson: The toilet company is deliberately taking advantage of Johnny Carson’s good name. No company has the right to use his name, his picture, or anything else closely identified with him, such as the phrase “Here’s Johnny.” The pun is personally offensive and commercially unfair. Argument for Here’s Johnny Portable Toilets: Johnny Carson doesn’t own his first name. It is available for anyone to use for any purpose. Further, the popular term “john,” meaning toilet, has been around much longer than Carson or even television. We are entitled to make any use of it we want. Our corporate name is amusing to customers who have never heard of Carson, and we are entitled to profit from our brand recognition. Answer: Carson sued for commercial exploitation, and should win. Because the phrase, ‘Here’s Johnny!” was associated with Johnny Carson, the company illegally appropriated the phrase for commercial gain. He worked hard for decades to build a brilliant career and earn a reputation as a creative, funny, likable performer. Decision for Defendant overturned on appeal. A celebrity’s right of publicity is invaded whenever the celebrity’s identity is intentionally appropriated for commercial purposes. And Identity is not limited to the celebrity’s name or likeness. It includes any characteristic that is clearly associated with the celebrity. Carson’s claim of the invasion of his right of publicity clearly has. The theory of the right is that a celebrity’s identity can be valuable in the promotion of products, and the celebrity has an interest that may be protected from the unauthorized commercial exploitation of that identity. Carson v. Here’s Johnny Portable Toilets, Inc., 698 F.2d 831 U.S.Ct.App, 6th Cir. (1983) 4. You are a vice-president in charge of personnel at a large manufacturing company. In-house detectives inform you that Gates, an employee, was seen stealing valuable computer equipment. Gates denies the theft, but you believe the detectives and fire him. The detectives suggest that you post notices around the company, informing all employees what happened to Gates and why. This will discourage others from stealing. While you think that over, a phone call from another © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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company’s personnel officer asks for a recommendation for Gates. Should you post the notices? What should you say to the other officer? Answer: These are difficult problems, which a manager must think through carefully. Negative statements can lead to a defamation lawsuit. If you have irrefutable proof that Gates did steal, you are probably on safe ground. But if you doubt your ability to prove his theft, you must be very careful. If you state to the personnel officer precisely what you know about the theft, and nothing more, you are probably on safe ground. Even if you are incorrect, most courts will hold that you have qualified privilege to speak to someone who needs to know the truth. As long as you display no malice, you are not committing slander. Some managers, though, are extra careful and simply refuse to say anything in such a situation. As to posting the notices, you should not do it. The other employees have no need to know your allegations about Gates, and thus you have no qualified privilege to inform them. If you are wrong, it is libel, and juries are often very sympathetic to injured employees. 5. Andrew Greene sued Paramount Pictures for defamation arising out of the film “The Wolf of Wall Street.” Although the film did not use his name, Greene alleged that the fictitious toupee=wearing character Nicky “Rugrat” Kosksoff was based on him The film portrayed Rugrat as a “criminal, drug user, degenerate, depraved, and devoid of any morality or ethics.” What would Greene need to prove to be successful in his claim? Answer: To prove defamation, a plaintiff must prove a defamatory statement that was false and communicated to others. He must also prove that the statement caused injury. The District Judge denied Paramount’s motion to dismiss the lawsuit as to defamation. Even though the movie did not use Greene’s name or image, the court found that making the connection to the plaintiff was reasonable and the likeness “unmistakable.” Greene v. Paramount Pictures corp., 138 F.Supp.3d 226 (2015)

Discussion Questions 1. In the Exxon Valdez case, the Supreme Court limited punitive damages in maritime cases to no more than the compensatory damages awarded in the same case. In cases that do not involve maritime law, the ratio is usually limited to 9-to-1. Which is the better guideline? Why? Answer: Answers will vary. 2. You have most likely heard of the Liebeck v. McDonald’s case. Liebeck spilled hot McDonald's coffee in her lap, and suffered third degree burns. At trial, evidence showed that her cup of coffee was brewed at 190 degrees, and that, more typically, a restaurant's "hot coffee" is in the range of 140 to 160 degrees. A jury awarded Liebeck $160,000 in compensatory damages and $2.7 million in punitive damages. The judge reduced the punitive award to $480,000, or three times the compensatory award. Comment on the case, and whether the result was reasonable. Answer: Answers will vary.

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3. The Supreme Court has defined public figures as those who have “voluntarily exposed themselves to increased risk of injury by assuming an influential role in ordering society.” When deciding whether someone is a public figure, courts look at whether this person has received press coverage, sought the public spotlight, and has the opportunity to publicly rebut the accusations. Some have argued that social media makes anyone with a public Facebook profile or a certain number of Twitter followers a public figure. Do you agree? Should courts revisit the definition of “public figure” in light of social media? Answer: Answers will vary. 4. This chapter described two lawsuits in which juries initially gave awards of $100 million or more. Is there any point at which the raw number of dollars is just too large? Was the original jury award excessive in Boeken v. Philip Morris or the Exxon Valdez case? Answer: Answers will vary.

5. Many retailers have policies that instruct employees not to attempt to stop shoplifters. Some store owners fear false imprisonment lawsuits and possible injuries to workers more than the losses related to stolen merchandise. Are these “don’t be a hero” policies reasonable? Would you put one in place if you owned a retail store? Answer: Answers will vary.

Suggested Additional Assignments Research: Criticism by the Press Ask students to find a newspaper article, editorial, or column that harshly criticizes someone. Has the author or publisher made efforts to avoid a claim of libel? How? Research: On Line Defamation Ask students to find an on-line posting either on a social networking site or celebrity gossip site that harshly criticizes someone. Has the author made efforts to avoid a claim of defamation? What unique features of the Internet make pursuing a defamation claim difficult? Should the Internet Service Provider be responsible too?

Research: Tortious Interference In the financial pages of a newspaper, students should find an article about two corporations negotiating a major contract, such as for the sale of a subsidiary. Ask them to outline a hypothetical in which a third corporation enters the negotiations. When is it lawful for a third party to force its way into the bargaining, and when is it tortious interference with a prospective advantage? What preventive law steps should that company's CEO take?

Chapter 8 - Negligence, Strict Liability, and Product Liability* Chapter Overview © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Chapter Theme When someone's person or property is hurt, how far should society extend liability? The law has struggled for centuries to find compensation for the injured without making every citizen the insurer of all others.

8-1 Negligence We might call negligence the “unintentional” tort because it concerns harm that arises by accident. Should a court impose liability? Bonus Discussion: The McDonald’s Hot-Coffee Case A majority of students are likely to have heard of the lawsuit in which Stella Liebeck sued McDonalds for burns she suffered after spilling a cup of its take-out coffee in her lap. It is also likely that whatever these students know about the case is either wrong or, incomplete. Students may also have seen a chain email about the “Stella” awards, named after Liebeck. Its message is that the tort system is out of control. Whatever problems exist with the tort system are not revealed by the stories in the Stella awards email, because none of the stories is true. All are urban legends.37 They have been circulating online for years As for Liebeck’s suit against McDonald's, what most people do not realize is that the coffee that burned Liebeck was 180 degrees, 15-20 degrees hotter than coffee typically served in restaurants. The jury considered whether McDonald's acted improperly in selling 180-degree (or hotter) coffee that was significantly hotter than a consumer would expect from common experience. Stella Liebeck incurred third-degree burns, received skin grafts, and spent seven days in the hospital. Testimony at trial showed that before the lawsuit, McDonalds had received over 700 complaints about burns, some of them thirddegree, suffered by customers who spilled coffee on themselves. A McDonalds' executive testified that McDonalds knew of the risk of burns caused by its hotter-than-average coffee and knew that most customers didn't realize the specific risk posed by coffee at those temperatures, but nevertheless didn't intend to warn customers of the risk. The suit was not about a mere failure to warn that coffee is hot; it was about failure to warn of the danger created by serving materially hotter-than-normal coffee to customers who knew they were buying something hot, but not THAT hot. These facts, of course, cannot be construed only to support a finding that McDonald’s was negligent. Discussing this case enables students to explore the concept of duty of due care and the cost/benefit calculus involved in any business decision, and reinforces the important lesson that we should take time to learn the facts before passing judgment—on anything. 38

Landmark Case: Palsgraf v. Long Island Railroad, 248 N.Y. 339; 162 N.E. 99 Court of Appeals of New York, (1928)

See http://www.snopes.com/autos/techno/cruise.asp; http://www.overlawyered.com/archives/000479.html; http://www.snopes.com/legal/lawsuits.asp 38

To learn more about the facts of this case (e.g. —Liebeck was not driving when she spilled the coffee), see http://www.vanfirm.com/mcdonalds-coffee-lawsuit.htm © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Facts: Helen Palsgraf was waiting on a railroad platform. As a train began to leave the station, a man carrying a package ran to catch it. He jumped aboard but looked unsteady, so a guard on the car reached out to help him as another guard, on the platform, pushed from behind. The man dropped the package, which struck the tracks and exploded—since it was packed with fireworks. The shock knocked over some heavy scales at the far end of the platform, and one of them struck Palsgraf. She sued the railroad. Issue: Was the railroad liable for Palsgraf's injuries? Decision: No, the railroad was not liable. Reasoning: No one could foresee that what the guards did would harm someone standing at the far end of the platform. Therefore, it does not matter whether or not the guards were careless. For the railroad to be liable, Palsgraf had to show not just that a wrong took place, but that the wrong was to her. Negligence in the air is not enough. For example, if a driver speeds through city streets, it is easy to see that someone may be hurt. But, in this case, even the most cautious mind would not imagine that a package wrapped in a newspaper would spread wreckage throughout the station. The railroad employees owed Palsgraf a duty to be reasonably cautious and vigilant. They did not owe a duty to prevent all harm, no matter how unlikely. Question: Was the railroad liable? Answer: No; even though the defendant’s act caused the harm, the defendant could not have foreseen injuring Palsgraf. Question: Should an individual be held responsible for all injuries of his conduct? Answer: No; there are times when people act negligently but could not have seen all of the consequences. To win a negligence case, a plaintiff must prove five elements. Much of the remainder of the chapter will examine them in detail. They are:  Duty of Due Care. The defendant had a legal responsibility to the plaintiff. This is the point from the Palsgraf case.  Breach. The defendant breached her duty of care, or failed to meet her legal obligations.  Factual Cause. The defendant’s conduct actually caused the injury.  Proximate Cause. It was foreseeable that conduct like the defendant’s might cause this type of harm.  Damages. The plaintiff has actually been hurt, or has actually suffered a measureable loss.

8-1a Duty of Due Care Each of us has a duty to behave as a reasonable person would under the circumstances. Most courts accept Cardozo’s viewpoint in the Palsgraf case. Judges draw an imaginary line around the defendant and say that she owes a duty to the people within the circle, but not to those outside it. The test is generally “foreseeability.” If the defendant could have foreseen injury to a particular person, she has a duty to him.

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Case: Hernandez v. Arizona Board of Regents, 177 Ariz. 244, 866 P.2d 1330, 1994 Ariz. LEXIS 6 Arizona Supreme Court, 1994 Facts: At the University of Arizona, the Epsilon Epsilon chapter of Delta Tau Delta fraternity gave a welcoming party for new members. The fraternity’s officers knew that the majority of its members were under the legal drinking age, but they permitted everyone to consume alcohol. John Rayner, who was under 21 years of age, left the party. He drove negligently and caused a collision with an auto driven by Ruben Hernandez. At the time of the accident, Rayner’s blood alcohol level was .15, exceeding the legal limit. The crash left Hernandez blind and paralyzed. Hernandez sued Rayner, who settled the case based on the amount of his insurance coverage. The victim also sued the fraternity, its officers and national organization, all fraternity members who contributed money to buy alcohol, the university, and others. The trial court granted summary judgment for all defendants and the court of appeals affirmed. Hernandez appealed to the Arizona Supreme Court. Issue: Did the fraternity and the other defendants have a duty of due care to Hernandez? Decision: Yes, the defendants did have a duty of due care to Hernandez. Reasoning: Historically, Arizona and most states have considered that consuming alcohol led to liability, but not furnishing it. However, the common law also has had a long-standing rule that a defendant could be liable for supplying some object to a person who is likely to endanger others. Giving a car to an intoxicated youth is an example of such behavior. The youth might easily use the object (the car) to injure other people. There is no difference between giving a car to an intoxicated youth and giving alcohol to a young person with a car. Both acts involve minors who, because of their age and inexperience, are likely to endanger third parties. Furthermore, furnishing alcohol to a minor violates several state statutes. The defendants did have a duty of due care to Hernandez and to the public in general. Reversed and remanded. Question: What duty did the defendants owe to Hernandez? Answer: They were liable for supplying a youth with alcohol, which caused him to injure Hernandez when the youth left in his car. Question: Did the defendants do anything else wrong? Answer: Yes. Although they knew that several members of the fraternity were not of legal age for purposes of drinking, they allowed everyone at the event to drink alcohol, including underrated drinkers. Question: Was it foreseeable that supplying alcohol to a driver might result in injury? Answer: Yes, it was foreseeable, especially if the driver became too impaired to drive safely.

8-1b Special Duty: Landowners Trespasser: A person on another’s property without consent. Licensee: A person on another’s land for her own purposes, but with the owner’s permission. Invitee: A person who has a right to enter another’s property because it is a public place or a business open to the public. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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In several circumstances, people have special duties to others. Three of them are outlined here:    

Lowest Liability: Trespassing Adults – A landowner is liable to a trespasser only for intentionally injuring him or for some other gross misconduct. The landowner has no liability to a trespasser for mere negligence. Mid-level Liability: Trespassing Children – The law makes exceptions when the trespassers are children. If there is some human-made thing on the land that may be reasonably expected to attract children, the landowner is probably liable for any harm. Higher Liability: Licensee – A social guest is a typical licensee. A licensee is entitled to a warning of hidden angers that the owner knows about. But only hidden dangers; the owner has no duty to warn guests of obvious dangers. Highest Liability: Invitee – the owner has a duty of reasonable care to an invitee. With social guests, you must have actual knowledge of some specific hidden danger to be liable, but not with invitees. You are liable even if you had no idea that something on your property posed a hidden danger.

8-1c Special Duty: Professionals A person at work has a heightened duty of care. While on the job, she must act as a reasonable person in her profession.

8-1d Breach of Duty Breach of duty: A defendant breaches his duty of due care by failing to behave the way a reasonable person would under similar circumstances.

8-1e Causation Factual Cause: The defendant’s breach led to the ultimate harm. Proximate Cause: Proximate Cause: Refers to a party who contributes to a loss in a way that a reasonable person could anticipate. For the defendant to be liable, the type of harm must have been reasonably foreseeable.

You Be The Judge: Resnick v. AvMed, Inc. 693 F.3d 1317, U.S. Ct.App. 11th Cir. (2012). Facts: Juana Curry and William Moore, customers of AvMed Insurance, took care to protect their private information. They destroyed mail that contained sensitive data and avoided uploading any such information online. Despite their care, they both became victims of identity theft. Unknown identity © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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thieves opened bank accounts in Curry’s name and changed her home address with the U.S. Postal Service. Someone opened an E*Trade account in Moore’s name. Curry and Moore blamed AvMed. About a year earlier, two unencrypted laptops containing the health information, Social Security numbers, names, addresses, and phone numbers of 1.2 million AvMed customers had been stolen from the company’s offices. The plaintiffs sued AvMed for negligence, claiming the company breached it duty to keep customer information secure and this breach caused their identity theft. Curry and Moore argued that if it had not been for AvMed’s carelessness, they would not have been victims of identity theft. AvMed filed a motion to dismiss, arguing that the plaintiffs could not prove that the breach caused their injuries a year later. You Be the Judge: Was Avmed’s data breach the proximate cause of the identity theft? Argument for Plaintiffs: Your honors, my clients are prudent people who guard their personal information. They are careful when sharing and buying online. Sometimes they even shred their mail. My clients shared their information with AvMed to secure insurance, and lo and behold, someone used that same information to open unauthorized bank accounts. The only way the thieves could have accessed the sensitive data was through AvMed’s breach. Had it not been for AvMed’s negligence, my clients would not have suffered identity theft. Argument for AvMed: Your honors, with all due respect, welcome to the twenty-first century. Identity theft is a reality in all of our lives. The Federal Trade Commission estimates that each year this crime affects nine million people – more than the population of New York City. And we are all at risk: Even the most careful person shares potentially sensitive information every day when she gives her credit card to a waiter, files her taxes online, or registers for a coupon. In this case, the only thing that the plaintiffs can show is that their information was on a stolen laptop and that they were victims of identity theft a year later. Was AvMed the only company that had the plaintiff’s information? Seems unlikely. There is simply no way to prove a causal connection between the AvMed breach and the subsequent identity thefts. Holding: The court denied AvMed’s motion to dismiss, noting that plaintiffs alleged they had never experienced identity theft prior to the data breach, that they had taken “substantial precautions” to safeguard their personally identifiable information, and that the sensitive information on the stolen laptop was the same sensitive information used to steal plaintiff’s identity. Question: Does this ruling mean that all hacked businesses will be held potentially liable for identity theft? Answer: No. Here, the court noted that the plaintiffs’ facts beyond mere allegations of time and sequence. Question: What are some of the ways you can protect yourself from identity theft? Answer: Take the same precautions that plaintiffs did, being cautious about sharing such information, avoiding posting it online, and shredding mail that potentially could reveal such information to identity thieves.

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Res ipsa loquitur: The facts imply that the defendant’s negligence caused the accident. Because res ipsa loquitur dramatically shifts the burden of proof from plaintiff to defendant, it applies only when: 1) The defendant had exclusive control of the thing that caused the harm 2) The harm normally would not have occurred without negligence, and 3) The plaintiff had no role in causing the harm

Case: Brumberg v. Cipriani USA, Inc. 2013 NY Slip Op 06759 Supreme Court of New York, 2013. Facts: Cornell professor Joan Jacobs Brumberg attended a university fundraiser catered by Cipriani. During the event, she feasted on fancy appetizers. About 30 minutes later, she felt intense abdominal pain, which did not go away. Weeks later, her doctors removed a 1 1/2-inch piece of wood from her digestive tract. The shard caused internal injuries, which took two surgeries to repair. Brumberg’s physician believed that her injuries were the result of eating wood at Cornell’s cocktail party. On that day, she had eaten little else and had experienced no pain until the event, where she ate many appetizers, including shrimp on wood skewers. The doctor supposed that the wood moved through her digestive system for 30 minutes before becoming caught and causing the pain. But when experts compared Brumberg’s shard with the wood in Cipriani’s toothpicks and skewers, they found that the two were not the same material, eliminating direct evidence of causation. Brumberg sued Cipriani USA, Inc. for negligence. A lower court dismissed her case on a motion for summary judgment, concluding there was not enough proof that Cipriani caused Brumberg’s injury. The professor appealed, relying on the doctrine of res ipsa loquitur. Issue: Does re ipsa loquitur apply here? Decision: Yes, res ipsa loquitur applies. Reasoning: For res ipsa loquitur to apply, (1) the event must be of a kind that would not have occurred in the absence of someone’s negligence, (2) it must be caused by something in the defendant’s exclusive control, and (3) it must not be the plaintiff’s fault. Without negligence on someone’s part, wood does not just end up in food at parties. Someone had to have put the shard there. Cipriani had exclusive control at the party, which took place at a banquet hall that the company operated. Since its employees were the only ones who prepared and served the good, it was highly unlikely that another guest could have slipped the shared in the food without being seen. Professor Brumberg did nothing wrong. The injury was caused by the wood, not by her failure to notice it in her good. Reversed. Question: What are the criteria for res ipsa loquitor to apply?

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Answer: (1) the event must be of a kind which ordinarily does not occur in the absence of someone’s negligence; (2) it must be caused by an agency or instrumentality within the exclusive control of the defendant; and (3) it must not have been due to any voluntary action or contribution on the part of the plaintiff. Question: Which element do the parties dispute in this case? Answer: The second one, exclusive control.

Bonus You Be the Judge: Griffith v. Valley of Sun Recovery, Inc., 126 Ariz. 227, 613 P.2d 1283 Arizona Court of Appeals, 1980 Facts: Don Gorney was a “repo man”—someone authorized to find and take cars whose owners are behind on payments. A repossessor is allowed to drive away in such a car, provided he can do it peacefully. Gorney worked for Valley of Sun Recovery. He sought a car belonging to Linda Marsalek and Bob Williams. Gorney knew that there had been other, failed efforts to repossess the Marsalek car, including a violent confrontation involving attack dogs. He thought he could do better. Gorney went to the car at 4:00 in the morning. He unscrewed the bulb in an overhead street lamp. He unlocked the car, setting off its alarm, and quickly hid. The alarm aroused the neighborhood. Williams and a neighbor, Griffith, investigated and concluded it was an attempted theft. They called the police. Gorney watched all of this from his hiding place. When everyone had gone, Gorney entered the car, again setting off the alarm and arousing the neighborhood. Williams and Griffith again emerged, as did another neighbor, dressed in his underwear and carrying a shotgun. They all believed they had caught a thief. Williams shouted for the gun and the neighbor passed it to him, but it went off accidentally and severely injured Griffith. Griffith sued Valley of Sun. The trial court granted summary judgment for Valley of Sun, and Griffith appealed. You Be the Judge: • Did Valley of Sun have a duty to Griffith? • If so, did the company breach its duty? • If so, was the breach the factual cause of the injury? • If so, was this type of injury foreseeable? Argument for Griffith: Your honors, Mr. Griffith should be allowed to make his case to a jury and let it decide whether Valley of Sun’s repossession led to his injury. Mr. Griffith has demonstrated every element of negligence. Valley of Sun had a duty to everyone in the area when it attempted to repossess a car. It could easily have foreseen injury. Car repossessions always involve antagonism between the car owner and the repo company. Obviously, Gorney breached his duty. He was caught up in some fantasy, dreaming that he was Harrison Ford in an adventure film. He knew from previous repossession attempts that trouble was certain. But rather than minimizing the danger, he exacerbated it. He unscrewed a lightbulb, guaranteeing poor visibility and confusion. He set off the car alarm twice, making the whole neighborhood jittery.

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Factual causation is indisputable. Had it not been for his preposterous game playing, no neighbors would have been outside, no guns present—and no accidental shooting. And this type of harm is easily foreseeable. We should have a chance to take our case to a jury. Argument for Valley of Sun Recovery: Your honors, there are three good reasons to end this case today: no duty, no breach, no causation. It is preposterous to suggest that Valley of Sun has a legal duty to an entire neighborhood. Car owners who are behind on their payments live in all parts of all communities. Is a repossession company to become an insurer of the entire city? Yes, some danger is involved because delinquent owners are irresponsible and sometimes dangerous. Should we therefore allow them to keep their cars? Of course not. We must act, and that is what Valley of Sun does. They do it safely, your honors. Even if there had been a duty, there was no breach. Mr. Gorney attempted to repossess when it was least likely anyone would see him. What should Mr. Gorney have done, asked for permission to take the car? That is a recipe for violence. If the owner were reasonable, there would be no repossession in the first place. Factual causation? Valley of Sun did not create this situation. The car owners did. They bought the car and failed to pay for it. Even if there were factual causation, Valley of Sun is not liable because there is a superseding cause: the negligent use of a firearm by one of Mr. Griffith’s neighbors. No jury should hear this case, your honors, because there is no case. Holding: Summary judgment for defendants is reversed, and the case is remanded for trial. Valley of the Sun did owe a duty to Griffith, which it breached. Discussion The case of Griffith v Valley of Sun Recovery often provokes animated discussion and strong reactions. One effective way to present the case and make a lasting impression about the relationship between duty of due care and foreseeability is to select one student—preferably one who disagrees vehemently that Valley of Sun could be liable—and take him or her through the facts step-by-step, asking whether each step is a reasonably foreseeable result of the previous step. For example: “Was it reasonably foreseeable that Gorney might encounter violence when repossessing this care?” “Yes.” “Was it reasonably foreseeable that such violence might be heightened if Gorney was discovered repossessing the car at 4:00 AM?” “Yes.” “Was it reasonably foreseeable that the car’s owner and neighbors might be anxious to hear a car alarm at 4:00 AM?” (The instructor may need to point out that car alarms were relatively new and not routinely ignored in the late 1970s, when these events occurred.) “Yes.” “Was it reasonably foreseeable that their anxiety would be heightened when they came outside to discover a streetlight had been broken?” “Yes.” Proceed to build the chain of foreseeability in this fashion. Students often balk at the point when they are asked “Was it reasonably foreseeable that someone would introduce a gun into this situation?” and “Was it reasonably foreseeable, once a gun is introduced into the situation, that someone might be shot?” In a country where there are about as many (or more) guns than people, responding “no” to this question may say more about the student’s socio-economic background than their understanding of what is reasonably foreseeable. The point of this exercise is to demonstrate both how a jury could find in favor of Griffith, and how the concept of reasonable foreseeability can lead from one event to another seemingly distant, which is both the strength—and danger of negligence analysis.

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Finally, a plaintiff must persuade the court that he has suffered harm that is genuine, not speculative. Among the most vexing questions are suits involving future harm, involving injuries that may lead to serious medical problems down the road. Under the single recovery rule, a court must decide today the full extent of present and future damages.

8-1g Defenses Assumption of the Risk Assumption of the risk: A person who voluntarily enters a situation of obvious danger cannot complain if she is injured. Wherever there is an obvious hazard, a special rule applies. Assumption of the risk: a person who voluntarily enters a situation that has an obvious danger cannot complain if she is injured. However, the doctrine does not apply if someone is injured in a way that is not an inherent part of the dangerous activity. NFL players assume substantial risks when they take the field, but some injuries fall outside the rule.

Bonus Case: Truong v. Nguyen, 67 Cal. Rptr.3d 675, 156 Cal.App.4th 865. California Court of Appeals, 2007. Facts: On a warm California day, there were about 30 personal watercraft (jet skis) operating on Coyote Lake. The weather was fair and visibility good. Anthony Nguyen and Rachael Truong went for a ride on Anthony’s Polaris watercraft. Cu Van Nguyen and Chuong Nguyen (neither of whom were related to Anthony) were both riding a Yamaha Waverunner. Both jet skis permitted a driver and passenger, each seated. The two watercraft collided near the middle of the lake. Rachael was killed, and the others all injured. Rachael’s parents sued Anthony, Cu Van, and Chuong, alleging that negligent operation of their watercraft caused their daughter’s death. The defendants moved for summary judgment, claiming that assumption of the risk applies to jet skiing. The parents appealed, arguing that jet skiing was not a sport and Rachael never assumed any risk. Issue: Does assumption of the risk apply to jet skiing? Excerpts from Judge McAdams’s Decision: In a sports context, [assumption of the risk] bars liability because the plaintiff is said to have assumed the particular risks inherent in a sport by choosing to participate. Thus, a court need not ask what risks a particular plaintiff subjectively knew of and chose to encounter, but instead must evaluate the fundamental nature of the sport and the defendant’s role in or relationship to that sport. In baseball, a batter is not supposed to carelessly throw the bat after getting a hit and starting to run to first base. However, assumption of risk recognizes that vigorous bat deployment is an integral part of the sport and a risk players assume when they choose to participate. A batter does not have a duty to another player to avoid carelessly throwing the bat after getting a hit. Even when a participant’s conduct violates a rule of the game and may subject the violator to internal sanctions prescribed by the sport itself, imposition of legal liability for such conduct might well alter fundamentally the nature of the sport by deterring participants from vigorously engaging in activity. Coparticipants’ limited duty of care is to refrain from intentionally injuring one another or engaging in © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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conduct that is so reckless as to be totally outside the range of the ordinary activity involved in the sport. It appears that an activity falls within the meaning of ‘sport’ if the activity is done for enjoyment or thrill, requires physical exertion as well as elements of skill, and involves a challenge containing a potential risk of injury. As a matter of common knowledge, jet skiing is an active sport involving physical skill and challenges that pose a significant risk of injury, particularly when it is done—as it often is—together with other jet skiers in order to add to the exhilaration of the sport by racing, jumping the wakes of the other jet skis or nearby boats, or in other respects making the sporting activity more challenging and entertaining. In response to the plaintiff’s complaint that the trial court erroneously assumed that the litigants were contestants in some sort of consensual competition event and/or spectator sport, [we conclude] that the doctrine applies equally to competitive and noncompetitive but active sports. Plaintiffs urge [that] Rachel was merely a passenger on the Polaris and was not actively involved in the sport. The record supports the conclusion that riding as a passenger on a personal watercraft [is participating in a sport], because it is done for enjoyment or thrill, requires physical exertion as well as elements of skill, and involves a challenge containing a potential risk of injury. The vessel is open to the elements, with no hull or cabin. It is designed for high performance, speed, and quick turning maneuvers. The thrill of riding the vessel is shared by both the operator and the passenger. Obstacles in the environment such as spraying water, wakes to be crossed, and other watercraft are part of the thrill of the sport, both for the operator and the passenger. The summary judgment is affirmed. Question: What is assumption of the risk? Answer: Assumption of the risk is a defense to a negligence claim, whereby a person who voluntarily enters a situation that has an obvious danger, cannot complain if they are injured as a result of that danger. Question: Is the court saying that death is an obvious danger when jet skiing? Answer: Not necessarily. What the court is saying is that Rachel voluntarily participated in a sport that had risks. Based on assumption of the risk, Rachel’s parent cannot claim that they should be compensated for injury as a result of those risks that Rachel voluntarily assumed. Question: But Rachel was a passenger on a jet ski out for fun on a warm afternoon, how is that engaging in a sport? Answer: The court made it clear that jet skiing is a sport, regardless of whether it is competitive or non-competitive. Jet skiing is a sport because it requires skill, physical exertion, and challenge containing a potential risk of injury. This particularly so when it is done with more than one person, and with other jet skiers.

Contributory and Comparative Negligence Contributory negligence: A plaintiff who is even slightly negligent recovers nothing. Comparative negligence: A plaintiff may generally recover even if she is partially responsible.

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8-2 Strict Liability and Product Liability 8-2a Strict Liability Strict liability: A high level of liability assumed by people or corporations who engage in activities that are very dangerous. Some activities are so naturally dangerous that the law places an especially high burden on anyone who engages in them. A corporation that produces toxic waste can foresee dire consequences from its business that a stationery store cannot. This higher burden is strict liability. There are two main areas of business that incur strict liability: ultrahazardous activity and defective products. Defective products are discussed below, in the section on product liability. Ultrahazardous Activity Ultrahazardous activity: A defendant engaging in such acts is virtually always liable for resulting harm.

Bonus Case: New Jersey Dept. of Environmental Protection v. Alden Leeds, Inc., 153 N.J. 272; 708 A.2d 1161; 1998 N.J. LEXIS 212; 46 ERC(BNA) 1447 (Supreme Court of New Jersey 1998) Facts: The Alden Leeds company packages, stores, and ships swimming pool chemicals. The firm does most of its work at its facility in Kearns, New Jersey. At any given time, about 21 different hazardous chemicals are present. The day before Easter, a fire of unknown origin broke out in “Building One” of the company’s site, releasing chlorine gas and other potentially dangerous by-products into the air. There were no guards or other personnel on duty. The fire caused $9 million in damage to company property. Because of the potentially dangerous gas, the Department of Environmental Protection (DEP) closed the New Jersey Turnpike along with half a dozen other major highways, halted all commuter rail and train service in the area, and urged residents to stay indoors with windows closed. An unspecified number of residents went to local hospitals with respiratory problems. Based on New Jersey’s Air Pollution Control Act (APCA), the DEP imposed a civil fine on Alden Leeds for releasing the toxic chemicals. The appellate court reversed, finding that there was no evidence the company had caused the fire or the harm, and the case reached the state’s high court. Issue: Did the company cause the harm? Excerpts from Justice Coleman’s Decision: The court affirmed that the APCA is a strict liability statute and that there must be a causal nexus between the defendant and the harm. It reversed the appellate court’s holding that the storing of hazardous chemicals by Alden Leeds does not satisfy that nexus. The DEP does not have to prove that the chemical operator started the fire. In 1962, this Court adopted the proposition that "an ultrahazardous activity which introduces an unusual danger into the community should pay its own way in the event it actually causes damage to others." An actor who chooses to store dangerous chemicals should be responsible for the release of those chemicals into the air. That Alden Leeds lawfully and properly stored chemicals does not alter that conclusion. The risks attendant to the storage of dangerous substances counsel in favor of precautions to prevent their release. Alden Leeds took no such precautions. On the day of the fire, there was no one stationed at the plant to alert the authorities as soon as a fire or other unforeseen calamity erupted. There was no response to the alarm that sounded. The law imposes a duty upon those who store hazardous substances to ensure that the © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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substances on their property do not escape in a manner harmful to the public. Regardless of what started the fire, it was the knowing storage of chemicals by Alden Leeds that caused the release of air contaminants once the fire reached the chemicals. Question: Who won? Answer: The state won. Question: Did Alden Leeds start the fire that led to the release of toxic fumes? Answer: No. Question: Why? Answer: There was no evidence as to what caused the fire. Question: They why is Alden Leeds liable? Answer: This is an example of strict liability. Strict liability is liability without fault; it arises when a defendant engages in some activity for which a law imposes strict liability. Question: What did Alden Leeds do that subjected it to strict liability? Answer: It stored various hazardous chemicals on its property. The court stated “the law imposes a duty upon those who store hazardous substances to ensure that the substances on their property do not escape in a manner harmful to the public. Alden Leeds failed to meet that burden.” Question: Alden Leeds is in the business of selling chemicals and it stored them lawfully! Does this mean it is liable for any harm those chemicals cause while they are on its property? Answer: Precisely. Question: How is that fair? Answer: The law only applies strict liability to certain ultrahazardous activities. Those who engage in such activities know—or the law says they should know—that they will be strictly liable for any harm that results from them. Question: How does a person who engages in such activities protect itself from liability? Answer: First, it goes without saying that it must follow all laws regulating such activities. Second, it must exercise a high duty of due care to prevent harm—these activities are ultra-hazardous, after all. Third, it should obtain insurance to cover its liability when harm does occur. Question: Wouldn’t such insurance be expensive? Answer: Probably, and the company would likely pass on its cost to customers. Question: Is that fair? Answer: Consider the alternative. If the company does not obtain insurance and cannot compensate those harmed by its ultra-hazardous activities, is it fair that the victims bear 100% of the cost? It is more fair to allocate the cost between those companies that engage in the ultrahazardous activities and the consumers of such companies’ goods or services. Question: How far should strict liability go? Suppose a tornado struck Alden Leeds, released poisonous gas into the atmosphere, and killed twenty people. Should the company be liable? Answer: It appears that the majority here would answer “yes.” In their view, it is the storage that leads to liability. It is irrelevant what precipitates the harm. A dissenting justice disagrees, and argues that the prevailing view is that there should be no liability when the harm is started by nature or third parties.

8-2b Product Liability Negligence In negligence cases concerning goods, plaintiffs typically raise one or more of these claims:  Negligent design: the buyer claims that the product injured her because the manufacturer designed it poorly. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Negligent manufacture: The buyer claims that some careless conduct caused a dangerous product to leave the plant. Failure to warn: A manufacturer is liable for failing to warn the purchaser or users about the dangerous of normal use and foreseeable misuse. But there is no duty to warn about obvious dangers.

Bonus You Be The Judge: Boumelhem v. Bic Corp., 211 Mich. App. 175 Michigan Court of Appeals, 1995. Facts: Ibrahim Boumelhem, aged four, began playing with a Bic disposable lighter that his parents had purchased. He started a fire that burned his legs and severely burned his six-month-old brother over 85 percent of his body. Ibrahim’s father sued Bic, claiming that the lighter was negligently designed because it could have been childproof. He also claimed failure to warn because the lighter did not clearly warn of the danger to children. The Boumelhem court considered evidence and analyses from several other cases against Bic. The court noted that consumers use over 500 million disposable lighters annually in the United States. Each lighter provides 1,000 to 2,000 lights. During one three-year period, children playing with disposable lighters started 8,100 fires annually, causing an average of 180 people to die every year, of whom 140 were children under five. Another 990 people were injured. The average annual cost of deaths, injuries, and property damage from child-play fires was estimated at $310 to $375 million, or 60 to 75 cents per lighter sold. Bic had acknowledged in earlier litigation that it was foreseeable lighters would get into children’s hands and injure them. Bic had also agreed that it was feasible to make a more child-resistant lighter. The trial court relied on a Michigan case. In Adams v. Perry Furniture Co.,39 four minor children had died in a fire started when one of them was playing with a Bic lighter. The Adams court had found no negligent design and no failure to warn, and it dismissed all claims. The trial court in the present case followed Adams and dismissed Boumelhem’s claims. He appealed. You Be the Judge: Did Bic negligently design its disposable lighter? Did Bic negligently fail to warn of the lighter’s dangers? Argument for Boumelhem: Your honors, the Adams court decided the issues wrongly. There is a reason that new plaintiffs are back in this court, the year after Adams, raising related issues against Bic: the company is killing hundreds of children every year. In its efforts to maximize corporate profits, it is literally burning these children to death and injuring hundreds more. That’s wrong. Bic has acknowledged that its disposable lighters can and will get into the hands of children. Bic knows full well that its product will injure or kill a certain percentage of these children—very young children. Bic has admitted that it could design a childproof lighter, and it knows perfectly well how to include effective warnings on its lighters. But rather than improve product design and give effective warnings, Bic prefers to do business as usual and litigate liability for injured children. We ask this court to rule that Bic breached its duty to design and manufacture a lighter that will keep our kids safe, and breached its duty to warn.

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Argument for Bic: Your honors, the Bic Corp. is as horrified as anyone over the injuries to these children and the deaths of other kids. But Bic is not responsible. The children’s parents are responsible. We sympathize with their grief, but not with their attempt to pass parental responsibility onto the shoulders of a corporation. There are several reasons Bic is not liable in this case. First, the Adams court decided the matter, and that precedent is binding. Second, Bic has no duty to design a different lighter. The test in design defect cases is whether the risks are unreasonable in light of the foreseeable injuries. Young children can hurt themselves in countless ways, from falls to poisonings to automobile injuries. There is one answer to these dangers, and it is called good parenting. The parents who bought this lighter purchased it because it could start a fire. The moment they purchased it, they assumed the obligation to keep it away from their children. These are useful products, which is why Bic sells hundreds of millions per year. Other consumers should not be forced to pay an outrageously high price for a simple tool, just because some parents fail to do their job. The failure to warn argument is even weaker. The law imposes no failure to warn when the danger is obvious. Every adult knows that lighters are potentially dangerous, if misused, or if passed on to children. No one would be helped by a warning that said, “This lighter starts fires. Don’t give it to children.” Holding: Judgment for Bic on both issues. Question: In negligence cases concerning goods, plaintiffs typically raise what 3 issues? Answer: Negligent design, negligent manufacture, and failure to warn. Question: What is the test in design defect cases? Answer: Whether the risks are unreasonable in light of the foreseeable injuries.

Strict Liability for Defective Products In strict liability, the injured person need not prove that the defendant’s conduct was unreasonable. The injured person must show only that the defendant manufactured or sold a product that was defective, and that the defect caused harm. Most states have adopted the following model: 1. One who sells any product in a defective condition unreasonably dangerous to the user or consumer to his property is subject to liability for physical harm thereby caused to the ultimate user or his 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 user or consumer without substantial change on the condition in which it is sold 2. The rule stated in subsection (a) 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 contractual relation with the seller. These are the key terms in subsection (1):  Defective condition unreasonably dangerous to the user  In the business of selling © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Reaches the user without substantial change Has exercised all possible care No contractual relation

Case: Daniell v. Ford, 581 F. Supp. 728 U.S. District Court, New Mexico 1984. Facts: See the chapter opener. Connie Daniell argued that Ford was both (1) negligent because it did not warn her that there was no opening mechanism in the trunk and (2) strictly liable for this design defect. Ford sought summary judgment. Issue: Was Ford negligent in failing to warn Connie of the missing latch? Was Ford strictly liable for a design defect? Decision: No. Ford was neither negligent nor strictly liable. Reasoning: A manufacturer only has a duty to address foreseeable risks. When a consumer’s unforeseeable use of a product causes injury, the manufacturer is not liable in negligence or strict liability. An automobile trunk is used to stow goods. Its design makes it nearly impossible for an adult to enter it and close the lid. The plaintiff’s use of the trunk in an attempt to kill herself was unforeseeable. Therefore, Ford had no duty to design an internal release or opening mechanism to prevent suicide. Ford also did not have a duty to warn plaintiff of the danger of her conduct. The risk of locking oneself in a trunk is obvious. Neither negligence nor strict liability imposes a duty to warn of known dangers. Ford’s motion for summary judgment is granted. Question: Why didn’t the manufacturer have a duty to warn the plaintiff of the danger of her conduct? Answer: Because of the plaintiff's unforeseeable use of the product. Question: When is a risk not foreseeable by a manufacturer? Answer: Where a product is used in a manner which could not reasonably be anticipated by the manufacturer and that use is the cause of the plaintiff's injury.

8-2c Contemporary Trends The most contentious cases are generally defective design cases, which often involve failure to warn. Most courts have adopted one of two tests for design and warning cases:  Consumer expectation: A court finds the manufacturer liable for defective design if the product is less safe than a reasonable consumer would expect.  Risk-utility test: a court weighs the benefits for society against the dangers the product poses, using these factors:  The value of the product  The gravity or seriousness of the danger  The likelihood that such danger will occur  The mechanical feasibility of a safer alternative design, and  The adverse consequences of an alternative design © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Chapter Conclusion Negligence issues necessarily remain in flux, based on changing social values and concerns. A working knowledge of these issues and pitfalls can help everyone – business executive and ordinary citizen alike.

Matching Questions Match the following terms with their definitions: _____A. Breach 1. Money awarded to an injured plaintiff _____B. Strict liability 2. Someone who has a legal right to enter upon land _____C. Compensatory damages 3. A defendant’s failure to perform a legal duty _____D. Negligence 4. A tort in which an injury or loss is caused accidentally _____E. Invitee 5. Legal responsibility that comes from performing ultrahazardous acts Answers: H. 3 I. 5 J. 1 K. 4 L. 2

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 37. T F There are five elements in a negligence case, and a plaintiff wins who proves at least three of them. 38. T F Max, a 19-year-old sophomore, gets drunk at a fraternity party and then causes a serious car accident. Max can be found liable and so can the fraternity. 39. T F Some states are comparative negligence states, but the majority are contributory negligence states. 40. T F A landowner might be liable if a dinner guest fell on a broken porch step, but not liable if a trespasser fell on the same place. 41. T F A defendant can be liable for negligence even if he never intended to cause harm. 42. T F When Mrs. Palsgraf sued the railroad, the court found that the railroad should have foreseen what might go wrong. 43. T F Under strict liability, an injured consumer could potentially recover damages from the product’s manufacturer and the retailer who sold the goods.

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Multiple Choice Questions 1. In which case is a plaintiff most likely to sue based on strict liability? A. defamation B. injury caused on the job C. injury caused by a tiger that escapes from a zoo D. injury caused partially by the plaintiff and partially by the defendant E. injury caused by the defendant’s careless driving. Answer: B. 2. Martha signs up for a dinner cruise on a large commercial yacht. While the customers are eating dinner, the yacht bangs into another boat. Martha is thrown to the deck, breaking her wrist. She sues. At trial, which of these issues is likely to be the most important? A. Whether the yacht company had permission to take Martha on the cruise B. Whether the yacht company improperly restrained Martha C. Whether Martha feared an imminent injury D. Whether the yacht’s captain did a reasonable job of driving the yacht E. Whether Martha has filed similar suits in the past Answer: D. 3. Dolly, an architect, lives in Pennsylvania, which is a comparative negligence state. While she is inspecting a construction site for a large building she designed, she is injured when a worker drops a hammer from two stories up. Dolly was not wearing a safety helmet at the time. Dolly sues the construction company. The jury concludes that Dolly has suffered $100,000 in damages. The jury also believes that Dolly was 30% liable for the accident, and the construction company was 7o percent liable. Outcome? A. Dolly wins nothing B. Dolly wins $30,000 C. Dolly wins $50,000 D. Dolly wins $70,000 E. Dolly wins $100,000 Answer: D. 4. A taxi driver, hurrying to pick up a customer at the airport, races through a 20 mph hospital zone at 45 mph and strikes May, who is crossing the street in a pedestrian crosswalk. May sues the driver and the taxi company. What kind of suit is this? A. Contract B. Remedy C. Negligence D. Assault E. Battery Answer: C.

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5. For this question, assume the same facts as in question 4. Now determine which of the following can be considered a proximate cause of Carl's injuries? A. Randy B. Mark C. Both Randy and Mark D. None of the above Answer: B. 6. CPA Question: To establish a cause of action based on strict liability in tort for personal injuries resulting from using a defective product, one of the elements that the plaintiff must prove is that the seller (defendant): A. Failed to exercise due care B. Was in privity of contract with the plaintiff C. Defectively designed the product D. Was engaged in the business of selling the product Answer: D

Case Questions 1. Randy works for a vending machine company. One morning, he fills up a vending machine that is on the third floor of an office building. Later that day, Mark buys a can of Pepsi from that machine. He takes the full can to a nearby balcony and drops it three floors onto Carl, a coworker who recently started dating Mark’s ex=girlfriend. Carl falls unconscious. Is Randy a cause in fact or Carl’s injury? Is he a proximate cause? What about Mark? Answer: Randy is not a cause in fact nor a proximate cause of Carl’s injuries, but Mark certainly is. 2. ETHICS Koby, age 16, works after school at FastFood from 4 p.m. until 11 p.m. On Friday night, the restaurant manager sees that Koby is exhausted, but insists that he remain until 4:30 a.m., cleaning up, then demands that he work Saturday morning from 8 a.m. until 4 p.m. On Saturday afternoon, as Koby drives home, he falls asleep at the wheel and causes a fatal car accident. Should FastFood be liable? What important values are involved this issue? Answer: Ethically, Koby’s manager does bear responsibility for the accident. He has a moral obligation to keep his stakeholders (here his employee and members of the community in which his business operates) safe. He also violates the Golden Rule. The manager does not want to drive alongside exhausted drivers, and he should not make decisions that require exhausted workers to drive. 3. Ryder leased a truck to Florida Food Service; Powers, an employee, drove it to make deliveries. He noticed that the door strap used to close the rear door was frayed, and he asked Ryder to fix it. Ryder failed to do so in spite of numerous requests. The strap broke, and Powers replaced it with a nylon rope. Later, when Powers was attempting to close the rear door, the nylon rope broke and he fell, sustaining severe injuries to his neck and back. He sued Ryder. The trial court found that Powers’ attachment of the replacement rope was a superseding cause, relieving Ryder of any liability, and granted summary judgment for Ryder. Powers appealed. How should the appellate court rule? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: The case was reversed and remanded for trial. Powers v. Ryder Truck, 625 So. 2d 979, 1993 Fla. App. LEXIS 10729 (Fla. Dist. Ct. App. 1993). Whether an event is a superseding cause is a jury question, unless it is so bizarre as to be entirely unforeseeable by the defendant. Here, even if Powers was negligent in attaching a nylon rope, that negligence was not so bizarre as to be unforeseeable by Ryder. 4. Jane Doe, an aspiring model, created a profile on ModelMayhem.com, a networking website for models. Two men used the site to lure her to a fake audition, where they drugged and sexually assaulted her and recorded a video of the act for sale as internet porn. The website had reason to know that some men posed as fake talent scouts. Doe sued ModelMayhem, alleging that the site knew of her assailants’ criminal histories and failed to warn her. What result? Answer: California law imposes a duty to warn a potential victim of third-party harm when a person has a “special relationship to either the person whose conduct needs to be controlled or ... to the foreseeable victim of that conduct.” On a motion to dismiss, the court allowed the model’s failure to warn claim. Students should assess whether and to what extent the website had a duty to the user. Jane Doe v. Internet Brands, Inc. ___Fd.___ (2016). 5.

At the end of a skateboard exhibition, one of the performers tossed a skateboard into the rowdy crowd. David rushed to catch the prize but was injured when his fellow spectator trampled him to snatch it away. What is the likely outcome if David sues the promoter of the skateboarding show for negligence? Answer: The promoter of the skateboarding show will argue that David assumed the risk, especially when he tried to catch the skateboard thrown to the crowd, knowing he could be injured.

Discussion Questions 1. NOW 1 Imagine an undefeated high school football team on which the average lineman weighs 300 pounds. Also, imagine a 0-10 team on which the average lineman weighs 170 pounds. The undefeated team sets out to hit as hard as they can on every play, and to run up the score as much as possible. Before the game is over, 11 players from the lesser team have been carried off the field with significant injuries. All injuries were the result of "clean hits" – none of the plays resulted in a penalty. Even late in the game, when the score is 70-0, the undefeated team continues to deliver devastating hits that are far beyond what would be required to tackle and block. The assumption of the risk doctrine exempts the undefeated team from liability. Is this reasonable? Answer: Answers will vary. 2. NOW 2 Self-driving cars are no longer science fiction. These vehicles are programmed to use lasers, sensors, software, and maps to drive themselves. A handful of states have passed laws allowing driverless technology on the road. But what happens when a driverless-car harms someone? Who should be at fault? The passenger? The programmer? The manufacturer? Answer: Answers will vary.

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3. Imagine you are eating at a fast-food restaurant when your tooth suddenly and painfully cracks as a result of a piece of bone in your hamburger. Would you sue the restaurant? Why or why not? Would society be better off it lawsuits over such injuries were difficult to win? Answer: Answers will vary. 4. People who serve alcohol to others take a risk. In some circumstances, they can be held legally responsible for the actions of the people they serve. Is this fair? Should an intoxicated person be the only one liable if harm results? If not, in what specific circumstances is it fair to stretch liability to other people? Answer: Answers will vary. 5. Congress passed the Protection for Lawful Commerce in Arms Act which provides that gun manufacturers and retailers cannot be sued for injuries arising from the criminal misuse of a weapon. Critics argue that when gun makers market and sell military-style assault rifles to civilians, they should be held liable because these highly dangerous weapons are designed for specially trained soldiers, not the general public. Should makers of assault rifles be liable for these tragedies? Answer: Answers will vary.

Suggested Additional Assignments Field Work: An Accident Waiting to Happen Ask students to find a negligence suit waiting to happen and report their findings during class. They should try to spot some careless maintenance, unsafe condition, or other unreasonable behavior that invites a problem. Are the school stairs in satisfactory condition? Are the doors in their apartment secured with a lock and is visitor access controlled with an intercom system? Are sidewalks shoveled free of snow on their walk to school? Does their employer maintain a safe workplace? At a construction site, are pedestrians exposed to any dangers? They should be able to find several instances of unreasonable behavior. Field Work: How Hot is Hot? Ask a small group of students—preferably coffee-drinkers—to borrow an instant-read thermometer (available in home-goods stores for under $10) and visit at least three or four local restaurants that serve take-out coffee. They should purchase a cup of coffee in a take-out cup, check its temperature, and record their findings. They should also taste it to determine how comfortable and satisfying it is to drink, and save the cup. Ask them to compute the average temperature and report to the class the high, low, and average temperature of the coffee purchased. Was any of the coffee uncomfortably hot? What was its temperature? Which coffee was most satisfying? Did the cups bear warnings about drinking hot coffee? If a cup did not bear a warning, what restaurant served it? Research: Cost of the Tort System In March 2006 Tillinghast, a consulting unit of Towers, Perrin, issued a report that put the annual cost of the American tort system at $260 billion—almost equal to the annual sales at Wal-Mart. Critics said the report’s conclusions are deeply flawed.40 Have students research this report and the resulting controversy, prepare a brief summary of the positions on both sides, and present them to the class.

“Match Divides Critics As Startling Toll of Torts Is Added Up” by Liam Pleven, The Wall Street Journal, March 13, 2006 p. A2 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Chapter Overview* Chapter Theme Soon after the invention of the telephone, police realized that secretly recording phone calls could help catch criminals. But this innovation created a new legal issue: Did the police need a warrant before installing wiretaps? In 1928, the Supreme Court answered that question when it ruled that the Fourth Amendment did not require the government to obtain a warrant before listening to, or recording, private telephone conversations. The Court reasoned that wiretaps were not an invasion of privacy because they did not involve physical intrusion. Justice Louis Brandeis strongly disagreed. In one of the most important dissents in Supreme Court history, eh foresaw the challenges of modern privacy – and argued that any interpretation of the Constitution had to adapt to changing technologies. He wrote: Discovery and invention have made it possible for the Government, by means far more effective than stretching upon the rack, to obtain disclosure of what is whispered in the closet. In the application of a constitution, our contemplation cannot be only of what has been but of what may be. The progress of science in furnishing the Government with means of espionage is not likely to stop with wire-tapping. Ways may someday be developed by which the Government, without removing papers from secret drawers, can reproduce them in court, and by which it will be enabled to expose to a jury the most intimate occurrences of the home. Advances in the psychic and related sciences may bring means of exploring unexpressed beliefs, thoughts and emotions. Can it be that the Constitution affords no protection against such invasions of individual security? … *E+very unjustifiable intrusion by the Government upon the privacy of the individual, whatever the means employed, must be deemed a violation of the Fourth Amendment.

9-1 Privacy in a Digital World 9-1a How We Lose Our Privacy Online Sometimes we voluntarily give up our privacy without considering the consequences; in other cases, it is taken from us without our knowledge. Some of the ways our privacy may be violated or taken advantage of include Social Media sites, Data mining and behavioral marketing, and Lack of workplace privacy.

Data Breaches Most people store important data about themselves electronically: their photos, emails, music, contacts, documents, and of course, their passwords. In addition, businesses, employers, and others keep digital records, often including sensitive data such as Social Security numbers and medical or financial records. Thieves eagerly seek access to this treasure trove.

Ethics Some companies have launched marketplaces for personal data. One firm offers users $8 a month in return for unrestricted access to their social media accounts and credit card transactions. Critics argue that privacy is an important component of human dignity and that it is wrong to cheapen it © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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by turning it into a commodity – like a car or a cheeseburger. They also contend that these companies are exploiting people, who can never really know how their information may be used against them. Is it ethical to buy people’s privacy? Under what conditions? What personal data would you be willing to sell? To whom? For how much?

Surveillance and Discrimination The ability to share our opinions, relationship status, and location on social media sites like Facebook, Twitter, and Instagram has revolutionized the way we communicate and socialize. It has also affected workplace relationships as technology allows employers to monitor what their employees and job applicants do and say on the job and in their spare time. Employer intrusion into an employee’s personal life may lead to discriminatory practices. One study found that 45% of employers snooped around in candidates’ social media profiles before hiring. More than a third of those reported having found content that caused them not to hire the applicants. When the content points to illegality or fraud, employer are within their rights to reject a candidate. But what if the employer refuses to hire the candidate because her Facebook page reveals she is religious, married, or planning to have children?

Big Data 80% of Americans shop online -0 and most online retailers collect customers’ personal data. This information may provide a better shopping experience, but merchants have another motive, too. Consumer information is very valuable. U.S. firms spend $2 billion a year on personal data collection. Companies can use data-mining tools to find out a lot of information about you. And data leads to surprising insights. Credit card firms discovered that people who buy anti-scuff pads for their furniture are less likely to default on debts. Data mining also leads to behavioral marketing, a widespread practice that involves inferring needs and preferences from a consumer’s online behavior and then targeting related advertisements to them. Target has found that shoppers who buy cocoa-butter lotion are likely to be pregnant. In one such case, Target sent coupons for baby items to the shopper, who was a teenager whose family did not know she was pregnant; she had not yet told them. The Internet of Things More and more, everyday devices, vehicles and buildings are now connected to the internet, further endangering privacy. The connected gadgets gather, send and receive data. When the police suspected a man had murdered his houseguest, they ordered Amazon to turn over all the records from his Amazon Echo, the voice-activated digital assistant on his kitchen counter. Do people give up their privacy when they allow a microphone into their home or share the sleeping habits with the interconnected mattress? Many legal and ethical questions remain unanswered, as the technology moves faster than regulation.

9-2 The Law of Privacy There is no single source of privacy law. It is important to remember that the term “privacy” encompasses many topics. Here, we focus on data privacy, or people’s right to control information about themselves.

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9-2a Constitutional Law: The Fourth Amendment Reasonable expectation of privacy: The test to analyze whether privacy should be protected. The Fourth Amendment to the Constitution prohibits unreasonable searches and seizures by the government. In enforcing this provision, courts ask whether a person had a reasonable expectation of privacy, which requires two elements: 1. The person had an actual, subjective expectation of privacy. 2. Society accepts the person’s expectation of privacy as reasonable. Courts have held that employees do not have a reasonable expectation of privacy in the workplace, especially if using hardware provided by the employer, or if the employee handbook says they may be monitored.

Case: Chaney v. Fayette County Public School District, 2013 U.S. Dist. LEXIS 143030; 2013 WL 5486829 U.S. District Court for the Northern District of Georgia, 2013. Facts: At a countrywide internet safety seminar, Curtis Cearley, the public school district’s technology director, presented a Power Point slideshow about social media privacy to hundreds of students and parents. To illustrate embarrassing and irresponsible social media posts, Cearley used a picture he found on local high schooler Chelsea Chaney’s Facebook page. Because Chaney’s profile allowed access to “friends” and “friends of friends,” Cearley had obtained legitimate access to it. The image showed Chaney in a bikini posing with a life-size cutout of rapper Snoop Dogg. Cearley’s slides, which included Chaney’s full name, were also distributed in hard copy to everyone in attendance. Chaney, who had not authorized use of the picture, was surprised and humiliated. In her view, Cearley had publicly implied that she was reckless with her posings and inappropriate in her social life. Chaney sued Cearley and the district under the Fourth Amendment, alleging that he had violated her privacy. The district filed a motion to dismiss. Issue: Did Chaney have a reasonable expectation of privacy in her bikini Facebook picture? Decision: No, Chaney did not have a reasonable expectation of privacy. Reasoning: To establish a reasonable expectation of privacy, a person must show: (1) that she had a subjective expectation of privacy and *2) that society is willing to recognize her expectation as legitimate. Chaney clearly had a subjective expectation of privacy in her Facebook photos – she actually thought they were private. But she cannot show that her expectation was reasonable or legitimate.

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A person has no legitimate expectation of privacy in information she voluntarily shares. Chaney argued that, by limiting access to “friends and friends of friends” she had intended to keep her page private. But that setting does not ensure privacy because she had no control over her Facebook friends’ friends, who may be total strangers and number in the hundreds, if not thousands. Indeed, Cearley obtained rightful access to her Facebook postings. Whatever Chaney may have expected when she posted the picture, she in fact surrendered her privacy because society would not recognize an expectation of privacy as legitimate. Question: What does a person need to show to establish a reasonable expectation of privacy? Answer: A person must show that she had a subjective expectation of privacy and must show a willingness of society to recognize that expectation as legitimate. Question: Was Chaney able to prove these elements? Answer: She proved that she had a subjective expectation of privacy, but not one that society would recognize. Question: What should Chaney have done differently? Answer: She could have limited access to her photos to “friends” only.

9-2b Common Law: Privacy Torts Public disclosure of private facts: A tort providing redress to victims of unauthorized and embarrassing disclosures. The public disclosure tort requires the plaintiff to show all of the following:  The defendant made public disclosure  The disclosed facts had been private  The facts were not of legitimate concern to the public  The disclosure is highly offensive to a reasonable person

Intrusion Intrusion into someone’s private life is a tort if a reasonable person would find it offensive. The tort of intrusion requires the plaintiff to show that the defendant: 1. Intentionally intruded, physically or otherwise, 2. upon the solitude or seclusion of another or on his private affairs or concerns, 3. in a manner highly offensive to a reasonable person.

Case: Ehling v. Monmouth-Ocean Hosp. Serv. Corp., 872 F. Supp. 2d 369 United States District Court for the District of New Jersey, 2012. Facts: Deborah Ehling, a registered nurse and paramedic who worked at the Monmouth-Ocean Hospital Service Corporation (MONOC) reacted on her Facebook page to a shooting. Her Facebook privacy settings limited access to just “friends.” An 88 yr old sociopath white supremacist opened fire in the Wash D.C. Holocaust Museum this morning and killed an innocent guard (leaving children). Other guards opened fire. The 88 yr old was shot. He survived. I blame the DC paramedics. I want to say 2 things to the DC medics. 1. WHAT WERE YOU THINKING? and 2. This was your opportunity to really make a difference! WTF!!!! And to the other guards go to target practice. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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A hospital supervisor summoned one of Ehling’s coworkers, who was her Facebook friend, into an office where she forced him to access his account so that she could view Ehling’s post. The supervisor sent a copy of the posting to the boards that regulate nursing and paramedics in New Jersey with a letter saying that the hospital was concerned that this statement showed a disregard for patient safety. She filed suit against MONOC, alleging intrusion. In her view, these letters were a malicious attempt to damage her reputation and possibly cause her to lose her license. She claimed that she had a reasonable expectation of privacy in her Facebook posting because her comment was disclosed to a limited number of people whom she had individually invited to view a restricted access webpage. The hospital filed a motion to dismiss, arguing that Ehling did not have a reasonable expectation of privacy in her Facebook posting because the comment was disclosed to dozens of people, including coworkers. Issue: Did Ehling have a reasonable expectation of privacy in her Facebook posting? Decision: Yes, a jury could find that Ehling’s expectation was reasonable. Reasoning: To state a claim for intrusion, a plaintiff must allege sufficient facts to demonstrate that the defendant intentionally invaded in a highly offensive way. Expectations of privacy are established by general social norms and must be objectively reasonable 0- a plaintiff’s subjective belief that something is private is irrelevant. There are few hard-and-fast rules for what constitutes a reasonable expectation of privacy. Some courts have held that it is reasonable to share a secret with a limited number of people if the recipients are unlikely to divulge it. Other courts have determined that sharing with just two coworkers invalidates any expectation of privacy. Privacy determinations are made on a case-by-case basis, in light of the specific circumstances in each case. Here, Ehling stated a plausible claim for invasion of privacy. She actively took steps to protect her Facebook page from public viewing. Whether her expectation was reasonable is a question for the jury to decide. Question: What are the elements for a claim of intrusion in this case? Answer: Plaintiff must allege sufficient facts to demonstrate that (1) her solitude, seclusion, or private affairs were intentionally infringed upon, and that (2) this infringement would highly offend a reasonable person. Question: Are expectations of privacy governed by subjective or objective standards? Answer: Objective. Question: What is the concept of “limited privacy?” Answer: The idea that when an individual reveals private information about herself to one or more persons, she may retain a reasonable expectation that the recipients of the information will not disseminate it further.

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Electronic Communications Privacy Act: A federal statute prohibiting unauthorized interception of access to, or disclosure of wire and electronic communications. Wiretap Act: The section of the ECPA that prohibits the interception of face-to-face oral communications and telephone calls. Stored Communications Act: The section of the ECPA that prohibits the unlawful access to stored communications, such as email. Today, instead of having a single comprehensive data privacy law, the United States has a collection of federal privacy laws that apply to particular types of personal data. Different federal laws apply to your consumer credit information, your medical data, and even the movies you rent.

Wiretapping and Electronic Surveillance The Wiretap Act does not protect every conversation:  If one party to the conversation consents, secret recording is legal under federal law. However, many states have their own laws requiring the consent of all parties  Businesses may monitor conversations with their customers in the ordinary course of business provided they give notice. This rule explains why we often hear “this call may be monitored for training purposes” when we call companies  Finally, wiretap laws only protect speakers with a reasonable expectation of privacy in the conversation.

You Be the Judge: Huff v. Spaw, 794 F.3d 543, U.S. Ct. App, Sixth Cir. (2015) Facts: James Huff was the chairman of the Kenton County Airport Board, which manages the Cincinnati/Northern Kentucky International Airport (CVG). While at a conference in Italy with his wife Bertha and a colleague named Larry Savage, Huff used his iPhone to call Carol Spaw for help with dinner reservations. Spaw, who was the executive assistant to CVG’s CEO, did not answer, so Huff hung up and put his iPhone in his jacket pocket. Later, Huff and Savage retreated to an outdoor hotel balcony to discuss CVG personnel matters, including the possible firing of the CEO. During this conversation, Huff’s iPhone inadvertently placed a call to (“pocket-dialed”) Spaw’s office phone. When Spaw answered she quickly realized that the call was unintentional but continued to listen in anyway. Concerned that the men were plotting against her boss, Spaw put her office phone on speaker mode and used an iPhone to record Huff’s call. For one hour and thirty-one minutes, Spaw listened, recorded, and transcribed. Her iPhone first captured Huff’s discussion with Savage and, later, his personal conversations with Bertha in their hotel room. Spaw typed up her notes, hired a company to improve the quality of the iPhone reco0rding, and shared the resulting information with other Board members. Huff sued Spaw under the federal Wiretap Act, alleging that she violated his privacy when she intentionally intercepted and disclosed his confidential communications. The district court entered summary judgment for Shaw, reasoning that Huff did not have a reasonable expectation of privacy in his pocket-dialed call, and therefore the Wiretap Act did not apply. Huff appealed. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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You Be the Judge: Did Huff have a reasonable expectation of privacy in his pocket-dialed conversation? Argument for Huff: To demonstrate a reasonable expectation of privacy, Huff must first show that he had an actual expectation of privacy and, second, he must prove that his expectation was reasonable. Huff and Savage retreated to an outdoor balcony to make sure their conversation was not overheard. Seeing no one within earshot, they had an actual expectation that their conversation was private. the defendant suggests that, because Huff knew his iPhone was capable of pocket-dialing, his expectation was not reasonable. If this view were true, no one in modern society could ever expect privacy. Argument for Spaw: James Huff’s statements do not qualify for Wiretap Act protection because he did not have a reasonable expectation of privacy. The question is not what Huff thought, assumed, or wanted – it is whether it was reasonable for him to believe he was entitled to complete privacy under the circumstances. Huff knew his phone was capable of pocket-dialing and transmitting his conversation, but he took no precautions to safeguard against this foreseeable event. He could have locked his phone or powered it down. His carelessness exposed his conversation to Spaw. If a person inadvertently undresses in front of an uncovered window, he cannot claim that he deserved privacy when a passerby takes his picture. The same concept applies here. Holding: James Huff’s statements do not quality as oral communications for purposes of Title III of the Wiretap Act because he exposed them to Spaw when he pocket-dialed her. Therefore, he had no reasonable expectation of privacy in those statements. Question: Do you think Spaw’s interception of the call was intentional? Answer: Yes. She not only listened, but she also recorded and transcribed the 90 minute call. Question: Do you agree with the court’s reasoning as to Huff’s expectation of privacy? Answer: Answers will vary. Question: Have you ever pocket-dialed someone? Were the results harmful in any way? Answer: Answers will vary. Accessing Email Under the ECPA:  Any intended recipient of an electronic communication has the right to disclose it  ISPs are generally prohibited from disclosing electronic messages to anyone other than the addressee.  An employer has the right to monitor workers’ electronic communications if: 1. the employee consents 2. the monitoring occurs in the ordinary course of business, ort 3. in the case of email, if the employer provides the computer system Thus, an employer has the right to monitor electronic communication even if it does not relate to work activities. But one thing employers cannot do is access an employee’s social media profile by trickery or coercion. You should consider anything you publish on the Internet to be public.

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Foreign Intelligence Surveillance Act (FISA): Federal Statute governing the government’s collection of foreign intelligence in the U.S. The Foreign Intelligence Surveillance Act (FISA) sets out the rules for the use of electronic surveillance to collect foreign intelligence (otherwise known as spying) within the United States. In the aftermath of the 9/11 terrorist attacks, FISA’s provisions were weakened. Now, the FISA provides that:   

To spy on people located in the United States who are communicating abroad, the government does not need a warrant but it must obtain permission from a secret Foreign Intelligence Surveillance Court (FISC). Government agencies must delete irrelevant and personally identifying data before providing it to other agencies. The government must notify defendants if the evidence being used against them in court was gathered in FISA surveillance.

State Statutes Many states have passed their own privacy laws. Examples of some of these are:  Reader Privacy: prohibits libraries from disclosing their patrons’ reading habits  Online Privacy Policies: California requires any website that collects personal information to post a privacy policy conspicuously, and abide by it

9-3 Regulation in the Digital World The “internet,” a term derived from “interconnected network,” began in the 1960s as a project to link military contractors and universities. Today, it is a giant network connecting smaller groups of linked computer networks. The World Wide Web, a subnetwork of the internet, is a decentralized collection of documents containing text, pictures, and sound; users can move from document to document using links that form a “web” of information.

9-3a Regulation of User-Generated Content User-generated content: Any content created and made publicly available by end users.

Sir Tim Berners-Lee, creator of the world Wide Web, described his vision as a place where all meet and read and write. But he acknowledged that bad things can happen online.

9-3b Online Speech The First Amendment to the Constitution protects free speech, even when it is dreadful, and that includes Internet postings, no matter how bad, that have appeared on Internet message boards and blogs. As upsetting as they may be, they are protected as free speech under the First Amendment so long as the poster is not violating some other law. However, there are some exceptions: Defamation  Opinions are not defamatory  Statements must be verifiably false  Anonymity: anonymous speech is protected, if it is lawful

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In the bonus case below, the plaintiffs argued that the statements were defamatory but the courts disagreed, ruling that they were simply opinions.

Bonus Case: You Be the Judge: Juzwiak v. John/Jane Doe, 415 N.J. Super. 442; 2 A.3d 428; 2010 N.J. Super. LEXIS 154, SUPERIOR COURT OF NEW JERSEY, APPELLATE DIVISION, 2010. Facts: Juzwiak was a tenured teacher at Hightstown High School in New Jersey. He received three emails from someone who signed himself “Josh,” with the address, “Josh Hartnett <jharthat@yahoo.com >“. The teacher did not know anyone of that name. These emails said: 1. Subject line: “Hopefully you will be gone permanently” Text: “We are all praying for that. Josh” 2. Subject line: “I hear Friday is ‘D’ day for you” Text: “I certainly hope so. You don’t deserve to be allowed to teach anymore. Not just in Hightstown but anywhere. If Hightstown bids you farewell I will make it my lifes (sic) work to ensure that wherever you look for work they know what you have done.” 3. Subject line: “Mr. Juzwiak in the Hightstown/East Windsor School System.” Text: It has been brought to my attention and I am sure many of you know that Mr. J is reapplying for his position as a teacher in this town. It has further been pointed out that certain people are soliciting supporters for him. This is tantamount to supporting the devil himself. I am not asking anyone to speak out against Mr. J but I urge you to then be silent as we cannot continue to allow the children of this school system nor the parents to be subjected to his evil ways. Thank you. Josh It seems that this third email was sent to other people, but it was not clear to whom. Because Juzwiak did not know who “Josh” was, he filed a complaint against John/Jane Doe, seeking damages for intentional infliction of emotional distress. As part of the lawsuit, he served a subpoena on Yahoo!, asking it to reveal “Josh’s” identity. When Yahoo! notified “Josh” of the lawsuit, he asked the court to quash the subpoena. In a court hearing, Juzwiak testified that the threatening emails had severely disrupted his life, causing deep anger and depression as well as insomnia that had impaired his ability to concentrate and function effectively. In addition, this emotional stress had exacerbated his back problems and caused him to lose twenty pounds. Although he had already been taking anti-depressants, a psychiatrist prescribed four additional drugs for depression, anxiety and insomnia, which were not effective in reducing his symptoms. Juzwiak also stated that he had thoughts of hurting himself and the entire episode had consumed his life for several months. When the trial court refused to issue the subpoena against Yahoo!, Juzwiak appealed. You Be the Judge: Should the trial court have issued the subpoena? Which interest is more important: “Josh’s” first amendment right to free speech or Juzwiak’s protection from harassing emails? Argument for “Josh”: Free speech is the first, and most important, right in the Bill of Rights. To ensure a vibrant marketplace of ideas, the First Amendment protects not only open but also anonymous speech. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Sometimes speakers must be allowed to withhold their identities to protect themselves from harassment and persecution. Nothing in these messages was a realistic threat to the teacher’s safety. “Hopefully you will be gone permanently” could easily mean “Hope you will move out of town.” Juzwiak reported these emails to the police, but they took no action. Presumably they would have done so if there had been any real threat. Nor did these emails constitute an intentional infliction of emotional distress. They were not so extreme and outrageous as to be utterly intolerable in a civilized community. “Josh” did not accuse Juzwiak of vile or criminal acts. The language was not obscene or profane. In short, if Juzwiak is going to teach high school, he needs to develop a thicker skin and a better sense of humor. Argument for Juzwiak: The right to speak anonymously is not absolute. “Josh” requires protection from harassment? That is an absurd argument. These emails contained death threats: “Hopefully you will be gone permanently” and “I hear Friday is ‘D’ day for you.” Juzwiak was frightened enough to go to the police. He suffered serious physical and emotional harm. These emails are not entitled to the protection of the First Amendment. Furthermore, the emails constituted intentional infliction of emotional distress. They were extreme and outrageous conduct designed to cause harm. They achieved their goal. In balancing the rights in this case, why would the court protect “Josh”, who has set out to cause harm, over the innocent teacher? Holding: The New Jersey appellate court held that a plaintiff who fails to make out a claim of intentional infliction of emotional distress based on anonymous, offensive e-mails can’t compel the sender’s Internet service provider to reveal his or her identity. Question: Did Juzwiak prove his claim for intentional infliction of emotional distress? Answer: No; Juzwiak did not prove that the defendant’s conduct was so extreme and outrageous nor that the conduct caused distress so severe that no reasonable man could be expected to endure it.

SLAPP: A SLAPP, or strategic lawsuit, against public participation, is a defamation lawsuit whose main objective is to silence speech through intimidation, rather than win a defamation case on the merits. Violence While the 1st Amendment may protect offensive or outrageous speech, it does not protect threats of violence against individuals. In the following case, the Supreme Court addressed the limits of free speech on social media.

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Case: Elonis v. United States., 135 S.Ct. 2001, United States Supreme Court 2001 Facts: On Facebook, Anthony Elonis often posted violent rap lyrics targeted at his ex-wife and others. He wrote that his lyrics were fictitious, an art form, and part of his First Amendment rights. Despite the disclaimers, many who knew him found his posts troubling – and threatening. Elonis posted: Did you know that it’s illegal for me to say I want to kill my wife?... It’s one of the only sentences that I’m not allowed to say… Now it was okay for me to say to right then because I was just telling you that it’s illegal for me to say I want to kill my wife… Um, but what’s interesting is that it’s very illegal to say I really, really think someone out there should kill my wife…But not illegal to say with a with a mortar launcher. Accompanying the post was a diagram of his ex-wife’s house with instructions on how to make the best getaway. In another instance, Elonis wrote he would make “a name for himself” by initiating “the most heinous school shooting every imagined.” This post prompted two FBI agents to visit Elonis’s home. When they left, Elonis immediately took to Facebook, writing that he would “leave *the female FBI agent+ bleedin’ from her jugular.” Elonis was arrested for the federal crime of transmitting “any communication containing any threat … to injure the person of another” across state lines. That statute did not define a threat but the trial judge instructed the jury that the First Amendment does not protect a “true threat.” The test of a true threat, according to the judge, was whether a reasonable person would perceive the statement as threatening. Elonis appealed, arguing that the test for a true threat should include the speaker’s intent to threaten, not the listener’s perception. The appeals court affirmed Elonis’s conviction which was appealed to the Supreme Court. Issue: Should a threat be defined by the speaker’s intent or by the listener’s reasonable perception? Decision: To be a crime, a threat must have been made with an intent to harm. Reasoning: Under tort law, a defendant may be liable simply based on his behavior, that is, if he has failed to act like a reasonable person. But to be found guilty under criminal law, the defendant must have intended to cause harm. Elonis’s conviction was based solely on how others interpreted his posts, rather than on evidence of his own mental state or intent. Without evidence that Elonis means his posts to be a threat, his conviction cannot stand. Wrong-doing must be conscious to be criminal. Question: What is the difference between the legal standard for guilt based on the complainant’s reasonable perception of danger, and the standard which requires mens rea, or some other description of conscious criminal action? Answer: A criminal conviction based on the complainant’s reasonable perception of danger would be based on the standard for an action in negligence, not a criminal action. Our system is based on the requirement for a criminal conviction that the defendant know he did something illegal. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Do you think Elonis’s Facebook posts were threatening? Answer: Yes, (though answers may vary). His repeated posts regarding killing his ex-wife, and especially his posting of a diagram of her house with instructions on how to make the best getaway were chilling. Question: Do you agree with the Court’s decision? Answer: Answers will vary, but this case demonstrates a basic foundational requirement for criminal conviction.

9-3c Liability of Internet Service Providers Communications Decency Act of 1996 (CDA): Provides ISPs immunity from liability when information was provided by an end user. Under the CDA, end users and anyone who simply provides a neutral forum for information (such as ISPs and website operators) are not liable for content that is provided by someone else. Only content providers are liable. Note that the CDA does not protect web hosts or ISPs that engage in crimes or infringe intellectual property rights. Website operators are also liable for their broken contracts and promises.

Case: Jones v. Dirty World Entertainment Recordings, LLC., 755 F.3d 398; United States Court of Appeals for the Sixth Circuit, 2015 Facts: Sarah Jones, a high school teacher and Cincinnati Bengals cheerleader, was the subject of several posts on TheDirty.com, a gossip website run by Nik Richie. Anonymous submissions accused Jones, among other things, of being promiscuous with many football players and suggested that she had a sexually transmitted disease. Richie then posted some of his own comments to the effect that Jones was a sex addict and unfit to be a teacher. Jones sent over 27 emails to Richie asking him to remove the posts, but he refused. Jones sued The Dirty for defamation and intentional infliction of emotional distress. A jury awarded her $38,000 in compensatory damages and $300,000 in punitive damages. The Dirty appealed, arguing that the CDA made it immune from liability because it did not create or develop the defamatory content. Issue: Is The Dirty immune from liability under Section 230 of the Communications Decency Act? Decision: Yes, The Dirty is not liable. Reasoning: Under the CDA, websites are not liable for content created or posted by third parties. Web hosts also have the right to exercise traditional editorial functions, such as deciding whether to publish, display, or alter content. So long as the website does not create or develop the harmful content at issue, it is free from responsibility. An anonymous third party – not The Dirty or Richie – was responsible for Jones’s defamation. The Dirty cannot be liable simply because it published the posts. As to Richie’s own commentary, the website is © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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also immune. Richie did not create or develop the defamatory content. Although he commented on it, eh did not materially add to the defamation. Question: What role did Richie play in developing the content that was posted as a profile of Jones? Answer: According to the court, Richie did not materially develop the content that was originally posted by a third party. Question: Was Richie content provider? Answer: No, Richie did not create the particular content that caused the trouble, although he did comment on the content, arguably making it worse. Question: Is Richie liable? Answer: No. Question: Why did Congress make ISPs immune from liability for material posted online by others under the Communications Decency Act? Answer: To promote the free exchange of information and ideas over the Internet and because it would be impossible for service providers to screen each of millions of postings for possible problems. Question: Can Jones recover damages from anyone? Answer: Only if she learns who posted the offensive material. Question: A great deal of harm can be done very quickly on the Internet. Did Congress make the right policy decision when it passed the CDA? Answer: Answers will vary.

Bonus Case: Carafano v. Metrosplash.com, Inc., 339 F.3d 1119; 2003 U.S. App. LEXIS 16548 United States Court of Appeals for the Ninth Circuit, 2003 Facts: Christianne Carafano is a film actor under the stage name Chase Masterson. Someone posted a profile of her on the Matchmaker.com Internet dating service. This phony profile stated that Carafano was “*l+ooking for a one-night stand” and for a “hard and dominant” man with “a strong sexual appetite,” and that she “liked sort of being controlled by a man, in and out of bed.” The profile also provided her home address and an email address, which, when contacted, produced an automatic email reply stating, “You think you are the right one? Proof it!!” *sic+, and providing Carafano’s home address and telephone number. Unaware of this posting, Carafano began receiving sexually explicit and harassing phone calls, faxes, and email messages. Feeling unsafe, Carafano and her son moved out of their Los Angeles home. When Carafano’s assistant learned of the false posting she contacted Matchmaker.com, demanding its removal. It took Matchmaker.com two days to remove the phony profile. Carafano sued Matchmaker for invasion of privacy, misappropriation of the right of publicity, defamation, and negligence. The district court rejected Matchmaker’s argument for immunity under the CDA on the grounds that the company provided part of the profile content. Issue: Does the CDA protect Matchmaker from liability? Excerpts from Judge Thomas’s Decision: Through [the CDA], Congress granted most Internet services immunity from liability for publishing false or defamatory material so long as the information was © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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provided by another party. As a result, Internet publishers are treated differently from corresponding publishers in print, television, and radio. Congress enacted this provision for two basic policy reasons: to promote the free exchange of information and ideas over the Internet and to encourage voluntary monitoring for offensive or obscene material. Interactive computer services have millions of users. It would be impossible for service providers to screen each of their millions of postings for possible problems. Faced with potential liability for each message republished by their services, interactive computer service providers might choose to severely restrict the number and type of messages posted. Congress considered the weight of the speech interests implicated and chose to immunize service providers to avoid any such restrictive effect. Under [the CDA], therefore, so long as a third party willingly provides the essential published content, the interactive service provider receives full immunity regardless of the specific editing or selection process. The fact that some of the content [in Carafano’s fake profile+ was formulated in response to Matchmaker’s questionnaire does not *make Matchmaker liable+. Doubtless, the questionnaire facilitated the expression of information by individual users. However, the selection of the content was left exclusively to the user. Matchmaker cannot be considered an “information content provider” under the statute because no profile has any content until a user actively creates it. Further, even assuming Matchmaker could be considered an information content provider, the statute would still bar Carafano’s claims unless Matchmaker created or developed the particular information at issue. In this case, critical information about Carafano’s home address and the e-mail address that revealed her phone number were transmitted unaltered to profile viewers. Thus Matchmaker did not play a significant role in creating, developing, or “transforming” the relevant information. Thus, despite the serious and utterly deplorable consequences that occurred in this case, we conclude that Congress intended that service providers such as Matchmaker be afforded immunity from suit. Question: What role did Matchmaker play in developing the content that was posted as a profile of Carafano? Answer: Matchmaker provided the questionnaire that the perpetrator filled out. Question: Was Matchmaker a content provider? Answer: No, Matchmaker did not create the particular content that caused the trouble (home address, sexual content, etc.). Question: Is Matchmaker liable? Answer: No. Question: Why did Congress make ISPs immune from liability for material posted online by others under the Communications Decency Act? Answer: To promote the free exchange of information and ideas over the Internet and because it would be impossible for service providers to screen each of millions of postings for possible problems. Question: Can Carafano recover damages from anyone? Answer: Only if she learns who posted the offensive material. Question: A great deal of harm can be done very quickly on the Internet. Did Congress make the right policy decision when it passed the CDA? Answer: Answers will vary.

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Ethics: JuicyCampus.com was a website where college students could anonymously gossip about their schools. To encourage users to “dish dirt,” the site promised total anonymity: It did not require a login or username; its slogan was “Always anonymous…Always juicy;” and it assured its users that it was impossible “for anyone to find out who you are and where you are located.” The site also instructed users on how to download IP-cloaking software to further ensure anonymity. As a result, most of the Juicy Campus posts were more than just juicy: They ranged from shocking accusations to harassment and revenge. These rumors tarnished reputations, hurt feelings, and tore apart college communities. Women, minorities, and gay students were disproportionately affected. Whether or not it is legally liable, does JuiciyCampus.com have an ethical duty to its users? What Life Principles are at stake?

9-3d Consumer Protection The FTC Commission Act authorizes the Federal Trade Commission (FTC) to protect consumers and prevent unfair competition. Unfair or Deceptive Advertising Section 5 of the FTC Act prohibits unfair and deceptive acts of practices. Spam Spam: Unsolicited commercial email. Spam is officially known as unsolicited commercial email (UCE) or unsolicited bulk email (UBE). The Controlling the Assault of Non-Solicited Pornography and Marketing Act (CAN-SPAM) is a federal statute that regulates spam, but does not prohibit it. Under the statute, commercial email:     

May not have deceptive headings (From, To, Reply to, Subject) Must offer an opt-out system permitting the recipient to unsubscribe Must clearly indicate that the email is an advertisement Must provide a valid physical return address (not just a P.O. box), and Must clearly indicate the nature of pornographic messages

Bonus Case: You Be the Judge: United States of America v. Cyberheat, Inc., 2007 U.S. Dist. LEXIS 15448, United States District Court for the District of Arizona, 2007. Facts: Cyberheat, Inc., ran sexually explicit websites for consenting adults. It hired other companies, called affiliates, to drive potential subscribers to its sites. The affiliates were paid a fee for each subscriber they generated. The contract that Cyberheat signed with its affiliates explicitly prohibited them from violating the CAN-SPAM Act. It also discouraged email promotions. However, Cyberheat did not investigate its affiliates, nor did it actively monitor their compliance. Cyberheat provided affiliates with a hyperlink to use in emails that would link them directly to the sexually explicit site being advertised.

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The FTC alleged that ten Cyberheat affiliates violated CAN-SPAM by sending 642 unwelcome, sexually explicit spam emails for which they were paid $209,120 in commissions. In some cases the pornographic emails had fake subject lines, when in fact the email contained pornographic images. Cyberheat received about 400 complaints, which it ignored or handled belatedly. Oftentimes the affiliate was allowed to continue for more than one year or was never terminated. The Justice Department filed suit seeking civil penalties of up to $11,000 for each violation and an injunction to prohibit further violations. Both the FTC and Cyberheat filed motions for summary judgment. You be the Judge: Did Cyberheat violate the CAN-SPAM Act? Holding: Possibly, the case must go to trial. According to the court, the CAN-SPAM Act was not enacted in a vacuum. The purpose of the Act is to protect those who do not want to view sexually explicit material. Anyone who supplies this pornographic material should be held to a high standard – they must be responsible for ensuring that it is not sent to innocent and unwilling recipients. Cyberheat could have foreseen that when it supplied pornographic materials to its affiliates, violations of the Act would result. It might not be fair to hold Cyberheat responsible for an accidental or mistaken violation, immediately attended to and corrected. But that is not what happened here – Cyberheat kept paying any number of violators. It cannot insulate itself from any liability for the actions of the affiliates on its ultimate behalf and for its financial benefit purely by putting on blinders. It has a duty that it can only delegate at its own peril. Question: Did Cyberheat know its affiliates were sending sexually explicit emails? Answer: There was no evidence that Cyberheat actually knew that its affiliates were sending sexually explicit emails. However, according to the court, Cyberheat should have known that its affiliates would violate the Act because Cyberheat supplied the affiliates with a hyperlink that when clicked went directly to the sexually explicit material. Question: But, Cyberheat told its affiliates specifically not to violate the Act and discouraged them from using email. How can Cyberheat, then, be responsible for its affiliates violations? Answer: According to the court, the purpose of the Act is to protect those who do not want to view sexually explicit material. As a supplier of sexually explicit material, Cyberheat has a duty to ensure the material is not sent to unwilling recipients. In this case, Cyberheat could have foreseen that its affiliates would have violated the Act. Moreover, the facts indicate that Cyberheat knew of violations and continued to pay those affiliates that violated the Act. Cyberheat cannot use the actions of its affiliates as a shield from liability when Cyberheat knew its affiliates were violating the Act. Field Work: Spam (See end of this document) Students who completed this assignment should report their findings now. Chart the answers to these questions on the board:   

What is the average amount of spam students receive in one week? Who received the most spam in one week? Who received the least? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Did the person who received the least take special measures to cut down on spam? Have they noticed any decrease in the amount of spam they receive since passage of the CANSPAM Act in 2003? Have they noticed any change in the nature of the spam messages they receive?

Cybersecurity Almost every state now has data breach laws, and some have enacted data disposal laws.

Chapter Conclusion The digital world has brought great social benefit and innovation, but also presents challenges. In a race between the law and technology, it is usually technology that wins. Many of the laws that apply to the digital world were written in the time before the internet was part of our daily lives. Courts can apply some of these old laws in new ways, but new laws and novel problemsolving approaches are required.

Multiple Choice Questions 1. The following agency is charged with the regulation of electronic communications: A. National Security Agency B. Federal Trade Commission C. Federal Communications Commission D. None of the above Answer: C. 2. Because Blaine Blogger reviews movies on his blog, cinemas allow him in for free. Nellie Newspaper Reporter also gets free admission to movies. Blaine ________ disclose on his blog that he receives free tickets. Nellie _________ disclose in her articles that she receives free tickets. A. must/must B. need not/need not C. must/need not D. need not/must Answer: C. 3. Which of the following is not protected by the First Amendment? A. True threats B. All threats C. Offensive language D. Insults Answer: A. 4. An employer has the right to monitor workers’ electronic communications if A. The employee consents B. The monitoring occurs in the ordinary course of business C. The employer provides the computer system D. All of the above © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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E. None of the above Answer: D. 5. Spiro Spammer sends millions of emails a day asking people to donate to his college tuition fund. Oddly enough, many people do. Everything in the emails is accurate (including his 1.9 GPA). Which of the following statements is true? A. Spiro has violated the Can-Spam Act because he has sent unsolicited commercial emails. B. Spiro has violated the Can-Spam Act if he has not offered recipients an opportunity to unsubscribe. C. Spiro has violated the Can-Spam Act because he is asking for money. D. Spiro has violated the Can-Spam Act unless the recipients have granted permission to him to send these emails. E. Spiro has not violated any laws. Answer: B. 6. Sushila suspects that her boyfriend is being unfaithful. While he is asleep, she takes his iPod out from under his pillow and goes through all his playlists. Then she finds what she has been looking for: Plum’s Playlist. It is full of romantic songs. Sushila sends Plum an email that says, “You are the most evil person in the universe!” Which law has Sushila violated? A. The First Amendment B. The Communications Decency Act C. The Stored Communications Act D. The Wiretap Act E. None of these Answer: E

Case Questions 1.

ETHICS Chitika, Inc. provided online tracking tools on websites. When consumers clicked the “optout” button, indicating that they did not want to be tracked, they were not – for ten days. After that, the software would resume tracking. Is there a legal problem with Chitika’s system? An ethical problem? What Life Principles were operating here? Answer: The FTC found that this system was unfair and deceptive under Section 5 of the FTC Act. Chitika entered into a consent order under which opt-out provision would last five years

You Be the Judge: WRITING PROBLEM Jerome Schneider wrote several books on how to avoid taxes. These books were sold on Amazon.com. Amazon permits visitors to post comments about items for sale. Amazon’s policy suggests that these comments should be civil (e.g., no profanity or spiteful remarks). The comments about Schneider’s books were not so kind. One person alleged Schneider was a felon. When Schneider complained, an Amazon representative agreed that some of the postings violated its guidelines and promised that they would be removed within one to two business days. Two days later, the posting had not been removed. Schneider filed suit. Argument for Schneider: Amazon has editorial discretion over the posted comments: It both establishes guidelines and then monitors the comments to ensure that they comply with the © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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guidelines. These activities make Amazon an information content provider, not protected by the Communications Decency Act. Also, Amazon violated its promise to take down the content. Argument for Amazon: The right to edit material is not the same thing as creating the material in the first place. Answer: The court held for Amazon. Editing material does not create liability under the CDA. The court also ruled that Amazon was not liable for failing to remove the offending comments – that failure to act is also protected under the CDA. Note that the court in the Yahoo! case would have held Amazon liable, under promissory estoppel, for not taking down the material after promising to do so. 3. Barrow was a government employee. Because he shared his office computer with another worker, he brought in his personal computer from home to use for office work. No other employee accessed it, but it was connected to the office network. The computer was not password protected, nor was it regularly turned off. When another networked computer was reported to be running slowly, an employee looked at Barrow’s machine to see if it was the source of the problem. He found material that led to Barrow’s termination. Had Barrow’s Fourth Amendment rights been violated? Answer: No. First, the person who accessed Barrow’s computer was not a representative of any government, but a private person, another employee of his employer. The Fourth Amendment prohibits only government activity. Second, Barrow did not demonstrate an expectation of privacy in his computer. He did not password-protect it, he left it on for long periods of time, and he left it unattended. 4. Someone posted a fake profile of actor Christianne Carafano on a dating website, Matchmaker.com. The profile, which included Carafano’s photo, telephone number, and home address, invited men with” a strong sexual appetite” to join her in a one-night stand. Carafano received many sexually explicit and threatening messages and was forced to move out of her home. She sued Matchmaker, arguing that the company was liable for invasion of privacy, defamation, and negligence. What result? Answer: The Ninth Circuit Court of Appeals ruled that the website was not liable because it did not create the content that was posted. This case represents the purpose of the CDA, to protect internet service providers from liability for material posted by third parties. Carafano vs. Metrosplash.com, Inc., 339 F.3d 1119; 2003 U.S. App. LEXIS 16548 United States Court of Appeals for the Ninth Circuit, 2003 5. Suspecting his wife was unfaithful, Simpson attached a recording device to the telephone lines in their home. Through the secret recordings, he was able to prove that she was indeed having an affair. Simpson’s wife sued her husband under the Federal Wiretap Act. Who wins and why? Answer: Simpson’s wife wins, because she, and other parties to whom she spoke, had a reasonable expectation of privacy.

Discussion Questions 1. Marina Stengart used her company laptop to communicate with her lawyer via her personal, password-protected, web-based e-mail account. The company’s policy stated: E-mail and voice mail messages, internet use and communication and computer files are considered part of the company’s business and client records. Such communications are not to be considered © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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private or personal to any individual employee. Occasional personal use is permitted; however, the system should not be used to solicit for outside business ventures, charitable organizations, or for any political or religious purpose, unless authorized by the Director of Human Resources. After she filed an employment lawsuit against her employer, the company hired an expert to access her emails that had been automatically stored on the laptop. Are these emails protected by the attorney client privilege? How does this case compare with Scott v. Beth Israel earlier in the chapter? Answer: The court ruled the attorney client privilege protected these emails. Stengart had a reasonable expectation of privacy because she had taken steps to protect the privacy of those emails and shield them from her employer. She used a personal, password-protected e-mail account instead of her company e-mail address and did not save the account’s password on her computer. Also the company policy did not clearly reveal that it had the right to read emails stored on a company computer. Stengart v. Loving Care Agency, Inc., 201 N.J. 300. 2.

Eric Schmidt, former CEO of Google, has written: The communication technologies we use today are invasive by design, collecting our photos, comments and friends into giant databases that are searchable and, in the absence of outside regulation, fair game for employers, university admissions personnel and town gossips. We are what we tweet. Do you consider this a problem? If so, can the law fix it? Answer: Answers will vary.

3. Imagine that you are the judge in the Elonis case. Would you have excused Elonis’s conduct under the First Amendment? When is a threat a true threat and when is it just social media banter? Answer: Answers will vary. 4. The European Union has created a “right to be forgotten” online. This right allows Europeans to request that websites take down their personal information, as long as it is not in the public interest. For example, a person would be able to request that Facebook delete her unflattering photograph, if it is outdated and is not newsworthy. Is this law a good idea? Would U.S. lawmakers ever consider a law like this? Why or why not? Answer: Answers will vary 5.

ETHICS JuicyCampus.com was a website where college students could anonymously gossip about their schools. To encourage users to “dish dirt,” the site promised total anonymity: It did not require a login or username; its slogan was “Always anonymous…Always juicy”; and it assured its users that it was impossible “for anyone to find out who you are and where you are located.” The site also instructed users on how to download IP-cloaking software to further ensure anonymity. As a result, most of the Juicy Campus posts were more than just juicy: They ranged from shocking accusations to harassment and revenge. These rumors tarnished reputations, hurt feelings, and tore apart college communities. Women, minorities, and gay students were disproportionately affected. Whether or not It is legally liable, does JuicyCampus.com have an ethical duty to its users? What Life Principles are at stake? Answer: Answers will vary.

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Suggested Additional Assignments Field Work: Cookies and Internet Functionality Have students block their web browsers from accepting cookies and record how it changes their online experience. (Since people usually find that blocking cookies substantially diminishes the quality of their Internet time, tell them to write down their cookie settings before changing them and the steps they took to block cookies, so they can reverse the instructions when they have had enough of this experiment.) Firefox users can change their cookie settings via these menu choices: Select Tools/Options/Privacy, uncheck the box labeled “Allow sites to set cookies,” then exit by clicking “OK.” Internet Explorer users should select these menu choices: Tools/Internet Options/Privacy; click on the “Advanced” button; on the following screen check the box labeled “Override automatic cookie handling,” choose “Block” under both First-party cookies and Third-party cookies, then exit by clicking “OK.” Research: Online Safety Ask students what steps they take to protect both their privacy online and the security of their computer. They should consider options such as: providing incorrect personal information; softwarebased protections (e.g., the Windows Security Center or Zone Alarm); hardware-based protections (e.g., cable modems or routers utilizing Network Address Translation and firewalls); and Internet-based protections (e.g., anonymous remailers). Research: Electronic Privacy Shortly before the class on cyberlaw, visit the Websites http://www.privacy.org or http://www.epic.org and assign one or two of the articles for class discussion. Field Work: Spam Ask students to count how many spam messages they receive in a week. If students have more than one email account, ask them to track which account receives more spam. Are some ISPs better than others at blocking spam? Have students noticed any decrease in the amount of spam they receive since passage of the CAN-SPAM Act in 2003? Have they noticed any change in the nature of the spam they receive? Field Work: Phishing Phishing is a fast-growing crime that involves sending fraudulent emails directing the recipient to enter personal information on a Website that is an illegal imitation of a legitimate site. Ask students to print out a phishing email they have received. (Many such messages purportedly come from eBay, PayPal and Chase.) How obvious is it that the message is illegitimate?

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Chapter Overview* Chapter Theme Contracts make business matters more predictable and are integral to the day-to-day business and personal life. Understanding how contracts are formed, the rules of contract law, and remedies the law has created to address harm that can result when formal contract rules don’t apply enables greater control over one’s life.

Approaching Contract Law People make promises every day. The law will enforce some but not others. Why? What distinguishes a promise the law will enforce—a contract—from a promise the law will not enforce? One way for students to begin to understand the differences between unenforceable promises and contracts is to pose common examples of the former and ask why the law would not enforce them. For example, suppose one student asks another out on a date, say to attend a party on the coming Saturday night. The invited student makes preparations for the date, buying clothes, getting a haircut, whatever fits the situation. The student who issued the invitation doesn’t show up at the appointed time. Can the student who was stood up sue the other for breach of contract? Experience tells students the answer is “of course not,” but why is that so? This promise involves offer and acceptance (“would you like to go to this party with me on Saturday night? I’ll meet you at your apartment at 10:30.” “Sure! That would be great!”), consideration (each party promises to do something he or she is not otherwise obligated to do, and each gives his or her promise in exchange for the other’s promise), contractual capacity (make the parties over the age of 18 to dispense with this issue), and a legal purpose. Why can’t the disappointed student file a breach of contract lawsuit as soon as the courts open on Monday? Certainly one reason the law would not enforce this promise is that while there is offer and acceptance; there was no intent to form a contract. These parties thought they were agreeing to go on a date, which does not create contractual expectations, whatever emotional expectations it may raise. However, if one changes the facts somewhat—a businesswoman at an out-of-town conference arranges for a male escort from a legitimate companionship service to attend a business/social engagement, then fails to show up at the appointed time—the parties’ expectations take on the aspect of contract. One purpose of contract law, then, is to distinguish unenforceable day-to-day promises from legallyenforceable promises.

10-1 Contracts 10-1a Elements of a Contract A contract is a legally enforceable agreement. For a contract to be enforceable, seven key characteristics must be present. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Offer: Someone proposes a deal. Acceptance: To accept, the party must respond in a certain way. Consideration: There must be an exchange between them. Legality: The contract must be for a lawful purpose. Capacity: The parties must be adults of sound mind. Consent: Certain kinds of trickery and force can prevent the formation of a contract. Writing: Some kinds of contracts must be in writing.

Other Important issues:  Third-Party Interests: Can a third party sue?  Performance and Discharge: What is a party performs poorly?  Remedies: A court will award money or other relief. Applying these principles to the opening scenario, is the “contract” between Chris and Chez Luc legally binding?  A valid offer and acceptance: Chez Luc’s website set the terms; Chris accepted when he clicked the box.  Consideration: Chez Luc gave Chris a reservation in exchange for Chris’s promise not to use his phone.  Capacity and Legality: Both parties are adults of sound mind.  Consent: There was no fraud or trickery.  Writing: The terms were in writing (tho they did not have to be). Contract: A legally enforceable agreement. A contract is a promise that the law will enforce. Usually, we seek to answer three basic questions:  Is it certain that the defendant promised to do something?  If she did promise, is it fair to make her honor her word?  If she did not promise, are there unusual reasons to hold her liable anyway?

10-1b Types of Contracts Bilateral and Unilateral Contracts Bilateral contract: A contract where both parties make a promise. Unilateral contract: A contract where one party makes a promise that the other party can accept only by doing something. In a bilateral contract, both parties make a promise. When the bargain is a promise for a promise, it is a bilateral agreement. The vast majority of contracts are bilateral. In a unilateral contract, one party makes a promise that the other party can accept only by actually doing something. These are less common. Executory and Executed Contracts Executory contract: An agreement in which one or more parties has not yet fulfilled its obligations. Executed Contract: An agreement in which all parties have fulfilled their obligations.

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A contract is executory when it has been made, but one or more parties has not yet fulfilled its obligations. The moment the parties strike their bargain, they have an executory bilateral express contract. A contract is executed when all parties have fulfilled their obligations.

Valid, Unenforceable, Voidable, and Void Agreements Valid contract: A contract that satisfies all legal requirements. Unenforceable agreement: A contract where the parties intend to form a contract, but a court declares that some rule of law prevents enforcing it. Voidable contract: An agreement that, because of some defect, may be terminated by one party, such as a minor, but not by both parties. Void agreement: An agreement that neither party may legally enforce. A valid contract is one that satisfies all of the law’s requirements. It has no problems in any of the seven areas listed at the beginning of this chapter, and a court will enforce it. An unenforceable agreement occurs when the parties intend to form a valid bargain but a court declares that some rule of law prevents enforcing it. A voidable contract occurs when the law permits one party to terminate the agreement. This happens, for example, when the other party has committed fraud, or when an agreement has been signed under duress. A void agreement is one that neither party can enforce, usually because the purpose of the deal is illegal or because one of the parties had no legal authority to make a contract.

Bonus Case: Mr. W. Fireworks, Inc. v. Ozuna, No. 04-08-00820-CVCourt of Appeals of Texas, San Antonio, 2009. Facts: Mr. W sells fireworks. Under Texas law, retailers may only sell fireworks to the public during the two weeks immediately before the Fourth of July and during two weeks immediately before New Year’s Day. And so, fireworks sellers like Mr. W tend to lease property. Mr. W leased a portion of Ozuna’s land. The lease contract contained two key terms:  

“In the event the sale of fireworks on the aforementioned property is or shall become unlawful during the period of this lease and the term granted, this lease shall become void.” “Lessor(s) agree not to sell or lease any part of said property including any adjoining, adjacent, or contiguous property to any person(s) or corporation for the purpose of selling fire-works in competition to the Lessee during the term of this lease, and for a period of ten years after lease is terminated.” (Emphasis added.)

 A longstanding San Antonio city ordinance bans the sale of fireworks inside city limits, and also within 5,000 feet of city limits. Like all growing cities, San Antonio sometimes annexes new land, and its city limits change. One annexation caused the Ozuna property to fall within 5,000 feet of the new city limit, and it became illegal to sell fireworks from the property. Mr. W stopped selling fireworks and paying rent on Ozuna’s land. Two years later, San Antonio’s border shifted again. This time, the city disannexed some property and shrank. The new city limit placed Ozuna’s property just beyond the 5,000 foot no-fireworks zone. Ozuna then leased a part of his land to Alamo Fireworks, a competitor of Mr. W. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Mr. W sued for breach of contract, arguing that Ozuna had no right to lease to a competitor for a period of ten years. The trial court granted Ozuna’s motion for summary judgment. Mr. W appealed. Issue: Did Ozuna breach his contract with Mr. W by leasing his land to a competitor? Holding: The property owners [argue] that when the city ordinance made the sale of fireworks illegal on the subject properties, the leases became void, resulting in the property owners and Mr. W no longer having an enforceable agreement. Mr. W’s argues that the provision restricting the property owners from leasing to competitors survived the agreement. This is inconsistent with the meaning of “voidable” contracts. For example, when a minor enters into a contract, that contract is not void, but is voidable at the election of the minor. This means that the minor may set aside the entire contract at his option, but he is not entitled to enforce portions that are favorable to him and at the same time disaffirm other provisions that he finds burdensome. He is not permitted to retain the benefits of a contract while repudiating its obligations. Here, while Mr. W is arguing that the illegalization of the sale of fireworks made the contract “voidable,” it is still seeking to enforce the provision of the contract prohibiting the property owners from leasing to competitors. We decline to adopt such an interpretation. Further, contracts requiring an illegal act are void. We therefore hold that the illegalization of the sale of the fireworks on the respective properties did not trigger the provision in the leases prohibiting the property owners from leasing to competitors of Mr. W. We affirm the judgment of the trial court. Question: When did the lease become void? Answer: as soon as San Antonio’s city limited changed and Ozuna’s land fell within 5,000 feet of the city. Question: What is the effect of the lease becoming void? Answer: Neither party can enforce the lease.

Express and Implied Contracts Express contract: An agreement with all the important terms explicitly stated. Implied contract: A contract where the words and conduct of the parties indicate that they intended an agreement. In an express contract, the two parties explicitly state all important terms of their agreement. The vast majority of contracts are express contracts. Some express contracts are oral, and some are written. In an implied contract, the words and conduct of the parties indicate that they intended an agreement. Today, the hottest disputes about implied contracts arise in the employment setting. Many corporate employees have at-will relationships with their firms, which means they are free to quit at any time, or the firm can fire them at any time for any reason. But this can be changed by a personnel manual which grants certain rights. Students often find implied contracts difficult to understand, perhaps because the other paired terms introduced in this section present two faces of some aspect of contract: bilateral and unilateral, executory and executed. People do not enter negotiations with intent to form an implied contract. Implied contract is not another method of forming a contract, but a remedy a court may apply after the © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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fact if there was no valid contract between the parties but their words and conduct manifest implied intent that certain promises would be legally enforceable.

CASE: DeMasse v ITT Corporation, 194 Ariz.500, 984 P.2d 1138 Supreme Court of Arizona, 1999 Facts: Roger DeMasse and five others were employees-at-will at ITT Corporation where they started working at various times between 1960 and 1979. Each was paid an hourly wage. ITT issued an employee handbook, which it revised four times over two decades. The first four editions of the handbook stated that within each job classification, any layoffs would be made in reverse order of seniority. The fifth handbook made two important changes. First, the document stated that “nothing contained herein shall be construed as a guarantee of continued employment. ITT does not guarantee continued employment to employees and retains the right to terminate or lay off employees.” Second, the handbook stated that “ITT reserves the right to amend, modify or cancel this handbook, as well as any or all of the various policies [or rules] outlined in it.” Four years later, ITT notified its hourly employees that layoff guidelines for hourly employees would not be based on seniority but on ability and performance. About ten days later, the six employees were laid off, though less senior employees kept their jobs. The six employees sued. ITT argued that because the workers were employees at will, the company had the right to lay them off at any time, for any reason. The case reached the Arizona Supreme Court. You Be The Judge: Did ITT have the right unilaterally to change the layoff policy? Decision: No, ITT did not have the right unilaterally to change the layoff policy because a valid implied contract prevented the company from doing so. Reasoning: An employer has the right to lay off an at-=will employee for virtually any reason. That means that the employer also has the right unilaterally to change the layoff policy. However, when the words or conduct of the parties establish an implied contract, the employee is no longer at-will. In deciding whether there is an implied contract concerning job security, the key issue is whether a reasonable person would conclude that the parties intended to limit the employer’s right to terminate the employee. A company makes a contract offer when it puts in the handbook a statement about job security that a reasonable employee would consider a commitment. The worker can then accept that offer by beginning or continuing employment. At that point, the parties have created a binding implied contract. Here, the first handbook declared that layoffs would be based on seniority. The employees accepted that offer by working, and from that time on, an implied contract governed the employment relationship. ITT had no right to change the layoff policy unilaterally. Question: The employee handbook was a written document. Why was it considered implied, as opposed to express? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: ITT included in the handbook a sentence stating that it reserved the right to change or cancel any terms or policies outlined in the handbook. Thus, it was not outlining an express contract. Nevertheless, the court held that the handbook did constitute an implied contract because any reasonable employee would consider the layoff policy a committed intention to limit the employer’s right to terminate an employee. Question: Does this decision mean that employers cannot hire employees “at will”? Answer: No. Courts routinely enforce at will contracts. The issue here was that the employee handbook implied that the employees had certain rights. Specifically, because the handbook created expectations about the layoff policy, the employer did not have the right to change the policy without consulting employees. Question: Does the outcome of this case suggest that employers cannot alter employee handbooks once the document has been written? Answer: No, the case merely demonstrates that if an employee handbook creates an implied contract between employer and employee, then the employer cannot unilaterally change the content of the handbook. If ITT had included DeMasse and the other employees in the decision to alter the handbook, and they had agreed with the change, then the employees would not have had a strong case.

Bonus Case: Britt v. Chestnut Hill College, 429 Pa.Super. 263, 632 A.2d 557, 1993 Pa.Super.LEXIS 3356 Pennsylvania Superior Court, 1993 Facts: Joseph Britt, a detective, enrolled in a Master’s Degree program at Chestnut Hill College in Pennsylvania. Chestnut Hill promised students credit for life experience. The college promised Britt important credits for his life experience if he enrolled, and after he did enroll, the school awarded the promised credits. Britt took a one-week required course entitled “Gender Stereotyping,” taught by Professor Klee. As part of a classroom exercise, Klee directed another student, who Britt claimed was a “known” homosexual, to make physical advances toward Britt. The student complied by telling Britt that he was attracted to him and by touching Britt above the knee. Britt rejected the student’s advances. The next day, Klee assigned that same student to serve as a “facilitator” to “deal with Britt’s anger.” Klee became openly critical of Britt’s attitude and performance in the class and awarded him a “C” grade for the course. Britt claimed that Klee thereafter did everything within his power to sabotage Britt’s reputation and academic career. Klee arranged to have himself assigned as Britt’s academic advisor and, after doing so, personally revoked, and successfully persuaded other instructors to revoke, the life experience credits that had been granted to Britt upon admission to the college. The revocation of those credits caused Britt not to graduate as scheduled. Britt sued. The trial court dismissed his contract claim, essentially ruling that a college had an absolute right to award and revoke credits as it saw fit. Britt appealed. Issue: Did Britt have an implied contractual right to receive credits from the college for life experience? Holding: Judgment for the college reversed. The court reinstated Britt’s contract claim. In the words of the court: © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The economic reality is that colleges and universities are competing to attract non-traditional age students and many of those institutions have designed programs to cater to them. Through advertising and recruitment campaigns, an increasing number of colleges and universities are inducing students who wish to return to school with flexible schedules, evening and weekend classes, and academic credit for life experience. Students, in turn, attracted by these options, may seek to apply to a particular institution and inquire as to the requirements they will have to meet in order to achieve their degree. Where an individual is induced to enroll in a university or college based upon an award of certain life experience credits, the institution cannot then, after the student’s enrollment, revoke those credits. We point out that, by reaching this conclusion, we are in no way attempting to interfere with an academic institution’s rights to develop its curriculum and set requirements for a given degree. However, where a college or university promises a student, upon enrollment, a certain amount of life experience credits, the purpose of which is to enable that student to graduate at an accelerated rate, provided that he or she successfully completes the course chosen, the institution cannot breach its promise. Where a student can prove that such an agreement was made, the university or college cannot revoke the life experience credits. Question: What should Britt argue to convince the court of his implied contract claim? Answer: The college made a deal and should be forced to stick to it. This college, like many, is using the idea of “life experience credits” as a lure to attract older students. If a college chooses to advertise such credits to attract students, and promises to award them when a student applies or enrolls, it should be held to its promise. Question: What should the college argue to refute Britt’s claim? Answer: This is not a business deal. All we have here is an unhappy college student. If Britt wins on the contract issue, can he also sue to have his grade of “C” raised to an “A”? Can all students file suit just because they are unhappy with grades, credits, or class schedule? Is a student entitled to a refund because she does not like her dorm roommate, or had an unhappy date on Friday, or thought that last night’s chicken pot pie was overcooked? A college is a collegial place of learning, and both professors and the administration must have wide latitude in assigning grades and credits. Britt’s aggressive reaction to an innocuous in-class exercise demonstrated that he was desperately in need of some sensitivity training–the precise purpose of the course! Should students like Britt decide a course’s content? A college’s curriculum? Must we reward Britt’s immature conduct by appointing him provost? General Question: Has your college, or that of a friend, made any promises that it has failed to keep? In your view, did the promises create a contract? Was the contract express or implied?

10-1c Sources of Contract Law Common Law We have seen the evolution of contract law from the twelfth century to the present. Express and implied contracts, promissory estoppel, and quasi-contract were all crafted, over centuries, by appellate courts deciding one contract lawsuit at a time. Many contract lawsuits continue to be decided using common law principles developed by courts.

Uniform Commercial Code Business methods changed quickly during the industrial revolution. Corporations now regularly conducted business across state lines and around the world. These developments presented a problem, since common-law principles varied from state to state. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Businesses became frustrated, and sought a body of law for business transactions that reflected modern commercial methods and provided uniformity. The Uniform Commercial Code (UCC) was developed in 1952, and governs many aspects of commerce. The Code governs the sale and leasing of goods, negotiable instruments, bank deposits, letters of credit, investment securities, secured transactions and other commercial matters. Every state has adopted at least part of the UCC. Goods: Are things that are movable, other than money and investment securities. Regarding contracts, the most important part of the Code is Article 2, governing goods: anything movable, except for money, securities, and certain legal rights. If a contract involves both goods and services is a mixed contract. In a mixed contract, Article 3 governs only if the primary purpose was the sale of goods. In the following bonus case, the court had to decide the primary purpose.

Case: Fallsview Glatt Kosher Caterers, Inc. v. Rosenfeld, 2005 WL 53623 Civil Court, City of New York, 2005 Facts: During the Jewish holidays, Fallsview Glatt Kosher Caterers organized programs at Kutcher’s Country Club, where it provided all accommodations, food and entertainment. Fallsview sued Willie Rosenfeld, alleging that he had requested accommodations for 15 members of his family, agreeing to pay $24,050, and then failed to appear or pay. Rosenfeld moved to dismiss, claiming that even if there had been an agreement, it was never put in writing. Under UCC section 2-201, any contract for the sale of goods worth $500 or more can only be enforced if it is in writing and signed. Fallsview argued that the agreement was not for the sale of goods, but for services. The company claimed that because the contract was not governed by the UCC, it should be enforced even with no writing. Issue: Was the agreement one for the sale of goods, requiring a writing, or for services, enforceable with no writing? Holding: Rosenfeld’s motion to dismiss to denied. Mr. Rosenfeld contends that the “predominant purpose” and “main objective” of the agreement alleged by Fallsview was the “service of Kosher food,” while the hotel accommodations and entertainment were merely “incidental or collateral” services. Defendant argues that “the essential religious obligation during this eight day period *Passover+ and the principal reason why people attend events similar to the Program sponsored by plaintiff is in order to facilitate their fulfillment of the requirement to eat only food which is ‘Kosher for Passover’. It is the desire to obtain these ‘goods’ and not the urge for ‘entertainment’ or ‘accommodations’ that motivates customers to subscribe to such ‘Programs’.” However, a review of the characteristics of Fallsview’s daily activities program leads the Court to conclude that the “essence” of the family and communal “experience” is defined primarily by “services” and not by “goods” Question: What was the basis for the Caterer’s claim? Answer: Breach of contract because Rosenfeld failed to pay $24,500 for Passover accommodations. Question: On what law was the Caterer’s claim based? Answer: Common law. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Then why does this court’s opinion discuss the UCC? Answer: Because Rosenfeld argued that the contract is governed by the UCC. Question: Why does he argue that? Answer: Because his agreement with the plaintiff was oral, the UCC requires contracts for more than $500 be in writing, and thus this contract is unenforceable and the court should dismiss the lawsuit. Question: When a contract involves both goods and services, how does a court typically determine whether the UCC applies? Answer: Most courts use the predominant purpose test: that is, if the predominant purpose of the contract was the sale of goods, then the UCC governs. If the predominant purpose of the agreement was provision of services, then the common law governs. Question: On what basis does Rosenfeld claim that this contract is governed by the UCC? Answer: He argues the contract was primarily for the plaintiff to provide Kosher food in connection with observance of the Passover holiday, and that the hotel accommodations and entertainment were incidental. Question: What did the court decide here—was the predominant purpose of the contract for goods or services? Answer: Services. Question: Why? Answer: The court looks at the totality of what the contract would have provided Rosenfeld, pointing to a lengthy list of activities and entertainment available as part of the accommodations. Question: Does it rely on anything else? Answer: The court also notes that under the UCC “quantity is even more important than price” but that a contract of the type in this case would rarely specify the quantity of goods to be provided; it would not, for instance, state how many briskets or noodle kugels Rosenfeld would be served during his stay. Question: What is the result of this decision? Answer: As an oral contract governed by common law, the statute of frauds does not apply and the contract is enforceable. The plaintiff’s claim can thus proceed to trial.

10-2 Enforcing Non-Contracts 10-2a Promissory Estoppel Promissory estoppel: A possible remedy for an injured plaintiff in a case with no valid contract, when the plaintiff can show justifiable reliance on a promise made by defendant. Even when there is no contract, a plaintiff may use promissory estoppel to enforce the defendant’s promise if he can show that: • The defendant made a promise knowing that the plaintiff would likely rely on it • The plaintiff did rely on the promise • The only way to avoid injustice is to enforce the promise. Aetna made a promise to the Andreasons – namely, its assurance that all of the damage was covered by insurance. The company knew that the Andreasons would rely on that promise, which they did by ripping up a floor that might have been salvaged, throwing out some furniture, and buying materials to

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repair the house. Is enforcing the promise the only way to avoid injustice? Yes, ruled the Utah Court of Appeals.41 Many promissory estoppel cases involve employment law - bosses make promises that they fail to keep. The following case illustrates what can happen when you bet on the wrong promise:

Case: Harmon v. Delaware Harness Racing Commission, 62 A.3d. 1198 Supreme Court of Delaware, 2013. Facts: The Delaware Harness Racing Commission (Commission) hired Donald Harmon to be the Presiding Judge of harness racing (charged with enforcing racetrack rules). After years on the job, Harmon was arrested for improperly changing a judging sheet to favor a horse. The Commission suspended him without pay pending the outcome of the criminal case. John Wayne (yes, his name was John Wayne) was the executive officer of the Commission. During his suspension, Harmon asked Wayne if the Commission would reinstate him upon being acquitted. When Wayne asked the commissioners they looked at each other and then said “Yes.” The commissioners told Wayne he could relay that message to Harmon. Based on this promise, Harmon decided not to look for other jobs. Immediately after his acquittal, Harmon asked for his job back. After some time, the Commission refused to reinstate him as promised. Harmon sued the Commission, claiming promissory estoppel. A trial court sided with Harmon and awarded him $102,273, representing the wages he would have earned if the Commission had kept its promise. But the Superior Court reversed the decision, so Harmon appealed to the Supreme Court of Delaware. Issue: Was the commissioners’ promise to Harmon enforceable? Decision: Yes, the commissioners’ promise to Harmon was enforceable under promissory estoppel. Reasoning: To prevail on a promissory estoppel claim, Harmon had to prove that: (1) the Commission made a promise to him; (2) which it reasonably expected him to rely on; (3) he did rely on it, to his detriment; and (4) to avoid injustice, the Commission’s promise must be enforced. All four of these requirements were met: 1. When Wayne asked if Harmon would be reinstated, the commissioners all looked at each other before saying “Yes.” This informal vote was clear evidence that a promise was made. 2. The commissioners told Wayne to relay their decision to Harmon. They must have known Harmon would rely on Wayne’s word. 3. Harmon did not look for other work. Thus, he suffered a substantial detriment. 4. It would be unfair for Harmon to lose income because he relied on a promise from the commissioners. 41

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Question: What are the elements of promissory estoppel in this case? Answer: A plaintiff must establish that: (i) a promise was made; (ii) it was the reasonable expectation of the promisor to induce action or forbearance on the part of the promisee; (iii) the promisee reasonably relied on the promise and took action to his detriment; and (iv) such promise is binding because injustice can be avoided only by enforcement of the promise. Question: How did Harmon reasonably rely on the Commission’s promise and take action to his detriment? Answer: He was offered several horse training opportunities, but he could not pursue them because, if he did, he would not be allowed to return to his position as a judge. Question: Who is the promise in this case? Answer: Harmon

10-2b Quasi-Contract Quasi-contract: A possible remedy for an injured plaintiff in a case with no valid contract, when the plaintiff can show benefit to the defendant, reasonable expectation of payment, and unjust enrichment. Quantum meruit: “As much as he deserves.” The damages awarded in a quasi-contract case. Even when there is no contract, a court may use quasi-contract to compensate a plaintiff who can show that: • The plaintiff gave some benefit to the defendant • The plaintiff reasonably expected to be paid for the benefit and the defendant knew this; and • The defendant would be unjustly enriched if he did not pay.

You Be the Judge: Lund v. Lund 848 N.W.2d 266, Supreme Court of North Dakota (2014). Facts: Wendell Lund was a dutiful son to his parents, Orville and Betty. Like his siblings, he helped around the house and tended to the land for most of his adult life. He did not pay room and board. When Orville and Betty divorced, they split the farm. But Wendell thought he deserved a cut. He sued both his parents under a theory of quasi-contract. He argued that he went above and beyond his duties as a son: He paid half of the farm’s real estate taxes and worked the land as if it was his own. As such, it would be unfair for his parents to retain the benefits of his work. You Be the Judge: Was it unfair for Wendell’s parents to reap the benefits his work on the family farm? Argument for Wendell: For years of his adult life, Wendell worked the family farm as if it was his own. Why, you ask? Because he expected that the land would one day indeed be his – and his parents knew it. Wendell did not just tend to the property; he went so far as to pay half of its real estate taxes some years. Many adults may help their parents, but few pay their real estate taxes unless they expect something in return. Orville and Betty are unfairly benefiting from Wendell’s labor. Argument for Parents: Your honors, life on a family farm involves community living. Each family member contributes for the sake of the group, not for the sake of ownership. Wendell and his siblings each had their share of chores and responsibilities, but they also enjoyed benefits, including a house, meals, and © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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assistance with work. It would not be unfair for Orville and Betty to retain the fruits of their family’s labor. Decision: There is no unjust enrichment in this case which would justify finding a quasi-contract. Reasoning: Here, the benefit received by Wendell’s parents were similar in nature to the benefits provided by his siblings when they returned home. In addition, Wendell Lund received reciprocal benefits, including a house, meals, and assistance with work.

Question: Why did Wendell believe he deserved money from his parents? Answer: He believed he had contributed to the care and upkeep of the farm beyond what a son might typically do. Question: Did the court find any unjust enrichment on the part of Orville and Betty? Answer: No, the court found no inequity, holding that the benefits provided by Wendell were similar in nature to the benefits provided by his siblings when they returned home. Question: What do you think of a son who sues his parents? Answer: Answers will vary.

Bonus Case: Novak v. Credit Bureau Collection Service, 877 N.E.2d 1253, Ind.App., 2007. Facts: David Novak suffered a brain aneurysm and was unconscious. An ambulance took him to Saint Regional Medical Center, where doctors successfully operated. Novak remained in the hospital for two months and then was discharged. Novak did not pay the Medical Center’s bill, and the claim was assigned to a collection agency which sued Novak for the debt. The trial court found that Novak owed the debt under quasi-contract because Novak was unconscious and could not consent to the treatment, and the medical services were necessary to avoid serious bodily injury or death Issue: Was the credit bureau entitled to damages based on quasi-contract? Holding: Yes, judgment for the credit bureau affirmed. According to the court, Novak relies on earlier cases which state the person must impliedly or expressly request the benefits. The court disagrees and relies on Galloway v. Methodist Hospital where the court held: To recover on the basis of quasi-contract, the party seeking recovery must demonstrate that a benefit was rendered to the other party, under circumstances which equity demands compensation in order to prevent unjust enrichment. Novak argued that unlike him, the Galloway’s went to the hospital voluntarily when Mrs. Galloway experienced toxemia and needed an emergency caesarian section, whereas he was taken to the hospital without his knowledge or consent. Therefore, he neither expressly nor impliedly requested care. In response, the trial court correctly held: © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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A person who has supplied things or services to another, although acting without the other’s knowledge or consent, is entitled to restitution therefore from the other if: a. he acted [in an official capacity] and with intent to charge therefore, and b. the things or services were necessary to prevent the other from suffering serious bodily harm or pain, and c. the person supplying them had no reason to know that the other would not consent to receiving them, if mentally competent, and d. it was impossible for the other to give consent or, because of extreme youth or mental impairment, the other’s consent would have been immaterial. Here, a benefit was rendered to Novak to prevent serious bodily injury, thus in fairness the credit bureau must be compensated to prevent unjust enrichment. Question: In this case, Novak never agreed to the services. Isn’t one element of a contract that there must be an agreement; an offer and acceptance? Answer: Yes, those are elements of a contract; however, quasi-contract is a theory of recovery when there is no contract. In this case, there is no contract, but that does not necessarily mean the credit bureau should not get paid. Question: The court laid out some specific reasons why people like the Medical Center should be paid under these circumstances. Can you think of any non-legal reason why the decision makes sense? Answer: There are several public policy reasons why this decision makes sense. First, it is fair: this is the Medical Center’s work, they routinely provide these services, and they reasonably expect to get paid for these services. If a court denied them compensation for services that are the heart of what they do, it would seriously undermine the Medical Center’s, and facilities like it, ability to stay in business. Also, if the medical center did not get compensated for rendering lifesaving assistance in these circumstances, they would stop rendering lifesaving help (or any other kind) to patients who enter the emergency room unconscious. On a larger level, how would out system of emergency care be different if hospitals and medical centers refused such treatment?

10-3 Agreement 10-3a Making an Offer Offer: In contract law, an act or statement that proposes definite terms and permits the other party to create a contract by accepting those terms. Offeror: The person who makes an offer. Offeree: The person to whom an offer is made. Two questions determine whether the statement is an offer:  Do the offeror’s words and actions indicate an intention to make a bargain?  Are the terms of the offer reasonably definite?

Bonus Discussion Case: An offer is an act or statement that proposes definite terms and permits the other party to create a contract by accepting those terms. Sometimes we forget that by making a valid offer, we give that power to the other person. Sometimes corporate officers forget the point. Nationwide Mutual Insurance Company wanted to energize a regional meeting, so it announced a contest for the best company slogan, to be used at the convention. “Here’s what you could win: His © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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and Hers Mercedes. An all-expense-paid trip around the world. Additional prizes to be announced. (All prizes subject to availability.)” David Mears and 184 other employees entered. Mears’s slogan, “At the Top and Still Climbing,” was the winner. One company officer told Mears that he had won the two cars, while another one said that the cars were just a joke. Ultimately, Nationwide informed Mears that the prizes were never meant seriously. The company did, however, use his slogan for its convention, and banners, booklets, and balloons all echoed with his phrase. Mears failed to see the joke, and filed suit in federal court. The jury didn’t laugh, either. They awarded Mears $60,000, the value of two of the least expensive Mercedes. The trial judge gave a judgment n.o.v. for Nationwide, ruling that the terms of the agreement were too vague to enforce. On appeal, however, the Eighth Circuit Court of Appeals agreed with the jury, and reinstated the $60,000 damage award. Question: Was this a bilateral or unilateral contract? Answer: Unilateral. Question: How can you tell? Answer: Mears accepted the offer by tendering performance, not by making a promise in response to Nationwide’s offer. Question: Did Nationwide intend this offer to be taken seriously? Answer: Nationwide apparently wanted employees to suggest slogans but considered the prizes to be a joke. Question: If Nationwide didn’t intend it to be taken seriously then why did the jury find that Mears’ accepted it and created a contract?

Invitations to Bargain An invitation to bargain is not an offer. It amounts only to an invitation to negotiate.

Problems with Definiteness It is not enough that the offeror indicates that she intends to enter into an agreement. The terms of the offer must also be definite.

Case: Baer v Chase, 392 F.3d 609 Third Circuit Court of Appeals, 2004. Facts: David Chase was a television writer-producer with many credits, including a detective series called The Rockford Files. He became interested in a new program, set in New Jersey, about a “mob boss in therapy,” a concept he eventually developed into The Sopranos. Robert Baer was a prosecutor in New Jersey who wanted to write for television. He submitted a Rockford Files script to Chase, who agreed to meet with Baer. When they met, Baer pitched a different idea, concerning “a film or television series about the New Jersey Mafia.” He did not realize Chase was already working on such an idea. Later that year, Chase visited new Jersey. Baer arranged meetings for Chase with local detectives and prosecutors, who provided the producer with information, material, and personal stories about their experiences with organized crime. Detective Thomas Koczur drove Chase and Baer to various New Jersey locations and introduced Chase to Tony Spirito. Spirito shared stores about loan sharking, power struggles between © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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family members connected with the mob, and two colorful individuals known as Big Pussy and Little Pussy, both of whom later became characters on the show. Back in Los Angeles, Chase wrote and sent to Baer a draft of the first Sopranos teleplay. Baer called Chase and commented on the script. The two spoke at least four times that year, and Baer sent Chase a letter about the script. When The Sopranos became a hit television show, Baer sued Chase. He alleged that on three separate occasions, Chase had agreed that if the program succeeded, Chase would “take care of” Baer and would “remunerate Baer in a manner commensurate to the true value of his services.” This happened twice on the phone, Baer claimed, and once during Chase’s visit to New Jersey. The understanding was that if the show failed, Chase would owe nothing. Chase never paid Baer anything. The district court dismissed the case, holding that the alleged promises were too vague to be enforced. Baer appealed. Issue: Was Chase’s promise definite enough to be enforced? Decision: No, the promise was too indefinite to be enforced. Reasoning: To create a binding agreement, the offer and acceptance must be definite enough that a court can tell what the parties were obligated to do. The parties need to agree on all of the essential terms; if they do not, there is no enforceable contract. One of the essential terms is price. The agreement must either specify the compensation to be paid or describe a method by which the parties can calculate it. The duration of the contract is also basic: How long do the mutual obligations last? There is no evidence that the parties agreed on how much Chase would pay Baer, or when or for what period. The parties never defined what they mean by the “true value” of Baer’s services or how they would determine it. The two never discussed the meaning of “success” as applied to The Sopranos. They never agreed on how “profits” were to be calculated. The parties never discussed when the alleged agreement would begin or end. Baer argues that the courts should make an exception to the principle of definiteness when the agreement concerns an “idea submission.” The problem with his contention is that there is not the slightest support for it in the law. There is no precedent whatsoever for ignoring the definiteness requirement, in this type of contract or any other. Affirmed. Question: Chase said he would “take care of” Baer and pay him “in a manner commensurate with the true value of his services.” Don’t those statements show Chase’s intent to compensate Baer? Answer: Yes. Question: Then why does the court rule in favor of Chase and let him avoid payment? Answer: The issue in this case is not Chase’s intent but the definiteness of the offer. Question: There are methods to determine what fair compensation would be. The trial court could hear evidence about what others who’ve made similar creative contributions to television shows are © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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paid, or hear expert testimony from people in the business about the customary payment for services similar to Baer’s. Why doesn’t the court try to arrive at a method of fair compensation? Answer: It is not the court’s job in a breach of contract case to substitute its judgment for the parties’ judgment about what the contract’s terms should be. Question: Why? Answer: Because to separate enforceable promises from unenforceable promises, contract law imposes certain formal rules about how a contract is formed. And one of those rules is that the parties must have taken time and care to define their agreement so a third party can understand whether it has been performed. Question: How does the court arrive at its decision? Answer: It looks to New Jersey law, which says that the price or amount of compensation is an essential term in any contract. Question: Does that mean the parties must specify a dollar amount in the contract for its terms to be definite? Answer: Not necessarily, as long as the parties do specify a method by which compensation can be determined. If a contract fails to state the dollar amount of compensation or a practicable method to determine it, the contract is invalid. Question: So Chase and Baer could have agreed, say, that Baer would be compensated in an amount equal to the average paid for screenwriting services for the pilots of the three most popular HBO television serials within the previous two years? Answer: If it is practicable to ascertain the facts necessary to calculate this average, then the answer is yes.

10-3b Termination of Offers Revocation Revocation: Cancellation of the offer. An offer is revoked when the offeror “takes it back” before the offeree accepts.

Case: Nadel v. Tom Cat Bakery 2009 N.Y. Slip Op 32661, Supreme Court of New York, New York County, 2008 Facts: A Tom Cat Bakery delivery van struck Elizabeth Nadel as she crossed a street. Having suffered significant injuries, Nadel filed suit. Before the trial began, the attorney representing the baker’s owner offered a $100,000 settlement, which Nadel refused. While the jury was deliberating, the bakery’s lawyer again offered Nadel the $100,000 settlement. She decided to think about it during lunch. Later that day, the jury sent a note to the judge. The bakery owner told her lawyer that, if the note indicated the jury had reached a verdict, he should revoke the settlement offer. Back in the courtroom, the bakery’s lawyer said, “My understanding is that there’s a note … I was given an instruction that if the note is a verdict, my client wants to take the verdict.” Nadel’s lawyer then said, “My client will take the settlement. My client will take the settlement”

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The trial court judge allowed the forewoman to read the verdict, which awarded Nadel – nothing. She appealed, claiming that a $100,000 settlement had been reached. Issue: Did Nadel’s lawyer accept the settlement offer in time? Decision: No, the bakery owner’s lawyer revoked the offer before acceptance. Reasoning: An offer definitely existed. And the twice-repeated statement, “My client will take the settlement,” indicates a clear desire to accept the proposal. The problem is that the acceptance came too late. Analyzing the timeline, the bakery owner’s attorney indicated that if a verdict had been returned, eh revoked the offer. This notice was given before the attempted acceptance. And so, since a verdict had in fact been returned, the offer was no longer open. The parties did not reach a binding settlement agreement. Question: What did the jury award Nadel? Answer: Nothing. They found in favor of the defendant? Question: Did the defendant make a settlement offer to plaintiff? Answer: Yes, while the jury was deliberating, the de3fendant offered $100,000 in settlement. Question: What was Nadel’s response? Answer: She wanted to think about it over lunch. Question: Was the offer still open at that time? Answer: Yes. She had not accepted or rejected it, and she had not made a counteroffer. Question: What happened next? Answer: The jury sent a note to the judge. As soon as that happened, defendant said that if the note indicated the jury had come to a verdict, she wanted to revoke the settlement offer. Question: Was the offer still open at this time? Answer: No one knew. If the note said the jury had come to a verdict, the offer was revoked. If the note said something else, it was still open. Question: Did Nadel’s attorney attempt to accept the offer at this time? Answer: Yes, he said his client accepted the offer. Question: What happened next? Answer: The contents of the jury’s note was revealed. Question: Did the note say the jury had come to a verdict? Answer: Yes. Question: Was the offer still open at this time? Answer: No. Once the judge determined the content of the note, it revealed they had reached a verdict, and so the offer was withdrawn. Question: Did Nadel’s attorney accept the offer while it was open? Answer: No.

Rejection If an offeree rejects an offer, the rejection immediately terminates the offer. Counteroffer Counteroffer: A party makes a counteroffer when it responds to an offer with a new and different proposal. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Expiration When an offer specifies a time limit for acceptance, that period is binding. If the offer specifies no time limit, the offeree has a reasonable period in which to accept.

Destruction of the Subject Matter If the subject matter of the contract is destroyed, the offer terminates.

10-3c Acceptance The offeree must say or do something to accept. Marge cannot leave a voice-mail message making an offer, and saying, “I’ll assume you agree unless I hear from you.” That will not constitute an acceptance.

Mirror Image Rule Mirror image rule: A contract doctrine that requires acceptance to be on exactly the same terms as the offer.

UCC and the Battle of the Forms The UCC dramatically modifies the mirror image rule. An acceptance that adds additional or different terms will often create a contract. For the sale of goods:    

For the sale of goods, the most important factor is whether the parties believe they have a binding agreement. If their conduct indicate that they have a deal, they probably do. If the offeree adds new terms to the offer, acceptance by the offeror generally creates a binding agreement. If the offeree changes the terms of the offer, a court will probably rely on general principles of the UCC to create a fair contract. If a party wants a contract on its terms only, with no changes, it must clearly indicate that.

10-3d Communication of Acceptance Method and Manner of Acceptance If an offer demands acceptance in a particular method of manner, the offeree must follow those requirements. If the offer does not specify a type of acceptance, the offeree may accept in any reasonable manner and method.

Time of Acceptance: The Mailbox Rule An acceptance is generally effective upon dispatch, meaning the moment it is out of the offeror’s control. Terminations, on the other hand, are effective when received.

Chapter Conclusion Contracts govern countless areas of our lives, from intimate family issues to multibillion-dollar corporate deals. Understanding contract principles is essential for a successful business or professional career and is invaluable in private life. This knowledge is especially important because courts no longer rubber-stamp any agreement that two parties have made. If we know the issues that courts scrutinize, the agreement we draft is likelier to be enforced. We thus achieve greater control over our affairs – the very purpose of a contract.

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Matching Questions Match the following terms with their definitions: _____A. Implied contract 1. A party that makes an offer _____B. Mirror image rule 2. An agreement based on one promise in exchange for another _____C. Offeree 3. A party that receives an offer. _____D. Offeror 4. An agreement based on the words and actions of the parties _____E. Bilateral contract 5. A common law principle requiring the acceptance to be on exactly the terms of the offer. Answers: M. 4 N. 5 O. 3 P. 1 Q. 2

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 44. T F To be enforceable, all contracts must be in writing. 45. T F Abdul hires Sean to work in his store and agrees to pay him $9 per hour. This agreement is governed by the Uniform Commercial Code. 46. T F If an offer demands a reply within a stated period, the offeree’s silence indicate acceptance. 47. T F Without a meeting of the minds there cannot be a contract. 48. T F An agreement to sell cocaine is a voidable contract.

Multiple Choice Questions 1. Mark, a newspaper editor, walks into the newsroom and announces to a group of five reporters: “I’ll pay a $2,000 bonus to the first reporter who finds definitive evidence that Senator Blue smoked marijuana at the celebrity party last Friday.” Anna, the first reporter to produce the evidence, claims her bonus based on: A. Unilateral contract B. Promissory estoppel C. Quasi-contract D. Implied contract E. Express contract Answer: A. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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2. Raul has finished the computer installation he promised to perform for Tanya, and she has paid him in full. This is: A. An express contract B. An implied contract C. An executed contract D. A bilateral contract E. No contract Answer: C. 3. Consider the following: I. Madison says to a group of students, “I’ll pay $35 to the first one of you who shows up at my house and mows my lawn.” II. Lea posts a flyer around town that reads, “Reward: $500 for information about the person who keyed my truck last Saturday night in the Wag-a-Bag parking lot. Call Lea at 555-53098. Which of these proposes a unilateral contract? A. I only B. II only C. Both I and II D. None of these Answer: C. 4. On Monday night, Louise is talking on her cell phone with bill. “I’m desperate for a manager in my store,” says Louise. “I’ll pay you $45,000 per year, if you can start tomorrow morning. What do you say?” “It’s a deal, “ says Bill. “I can start tomorrow at 8 a.m.. I’ll take $45,000, and I also want 10 percent of any profits you make above last year’s.” Just then Bill loses his cell phone signal. The next morning he shows up at the store, but Louise refuses to hire him. Bill sues. Bill will: A. Win, because there was a valid offer and acceptance B. Win, based on promissory estoppel C. Lose, because he rejected the offer D. Lose, because the agreement was not put in writing E. Lose, because Louis revoked the offer Answer: C. 5. Which of the following amounts to an offer? A. Ed says to Carmen, “I offer to sell you my pen for $1.” B. Ed says to Carmen, “I’ll sell you my pen for $1.” C. Ed writes, “I’ll sell you my pen for $1.” D. Ed writes, “I’ll sell you my pen for $1,” and gives the note to Carmen. E. All of these © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: D.

Case Questions 1. ETHICS John Stevens owned a dilapidated apartment that he rented to James and Cora Chesney for a low rent. The Chesneys began to remodel and rehabilitate the unit. Over a four-year period, they installed two new bathrooms, carpeted the floors, installed new septic and heating systems, and rewired, replumbed, and painted the apartment. Stevens periodically stopped by and saw the work in progress. The Chesneys transformed the unit into a respectable apartment. Three years after their work was done, Stevens served the Chesneys with an eviction notice. The Chesneys counterclaimed, seeking the value of the work they had done. Are they entitled to it? Answer: Yes, they are entitled to the value of their work, said the court in Chesney v. Stevens, 435 Pa. Super. 71, 644 A.2d 124.0, 1994 Pa. Super. LEXIS 2388 (Pa. Super. Ct. 1994). They have neither an express nor an implied contract for the work. Stevens did nothing to create either. But he was aware of the work they were doing, and he should know that they would reasonably expect compensation. It would be unjust, said the court, to permit him to keep the benefit without paying anything, and so the Chesneys won their case of quasi-contract, receiving quantum meruit damages for the value of their work.

2. Tindall operated a general contracting business in Montana. He and Konitz entered into negotiations for Konitz to buy the business. The parties realized that Konitz could succeed with the business only if Tindall gave support and assistance for a year or so after the purchase, especially by helping with the process of bidding for jobs and obtaining bonds to guarantee performance. Konitz bought the business, and Tindall helped with the bidding and bonding. Two years later, Tindall presented Konitz with a contract for his services up to that point. Konitz did not want to sign, but Tindall insisted. Konitz signed the agreement, which said: “Whereas Tindall sold his contracting business to Konitz and thereafter assisted Konitz in bidding and bonding, without which Konitz would have been unable to operate, NOW THEREFORE Konitz agrees to pay Tindall $138,629.” Konitz later refused to pay. Comment. Answer: Konitz need not pay. Tindall's work had already been performed, without any expectation of payment, when the parties signed the contract. Past consideration is no consideration, and the contract is void. Tindall v. Konitz Contracting, Inc., 249 Mont. 345, 783 P.2d 1376, 1989 Mont. LEXIS 348 (1989).

3. Sal says to Jennifer, “I’ll trim all of your trees if you pay me $300.” Jennifer replies, “It’s a deal, if you’ll also feed my dog next week when I go on vacation.” Does the common law or the UCC apply to Sal’s proposal? Is Jennifer’s reply an acceptance? Why or why not? Answer: The common law applies. Jennifer’s reply is not an acceptance because the mirror image rule requires that acceptance be on precisely the same terms as the offer.

4. Raul makes an offer to Tina. He says, “I’ll sell you this briefcase for $100.” Describe four ways in which this offer might be terminated. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: An offer may be terminated by revocation, rejection, expiration, or operation of law. Answers as to specifics will vary. 5. West purchased a horse from Strauss. When West discovered that the horse had a leg injury, he got a driver to return the horse to Strauss, but Strauss refused to accept delivery. Not knowing what to do with the injured animal, the driver took it to Bailey. Five months later, Bailey sent bills for the horse’s care to West, who returned them with a note saying he did not own the horse. Bailey sued West for the expenses incurred in boarding the horse. West argued that, when Bailey accepted the horse, he was aware of the controversy regarding the horse’s ownership, so he could not reasonably expect to be compensated. Who wins, and why? Answer: Bailey loses. There was no mutual agreement between Bailey and West to form a contract, so there could be no quasi-contract, no contract implied in fact. Bailey v. West, 249 A.2d 414, Supreme Court of Rhode Island (1969).

Discussion Questions 1. Someone offers to sell you a concert ticket for $50, and you reply, “I’ll give you $40,” The seller refuses to sell at the lower price, and you say, “OK, OK, I’ll pay you $50.” Clearly, no contract has been formed, because you made a counteroffer. If the seller has changed her mind and no longer wants to sell for $50, she doesn’t have to. But is this fair? If it is all part of the same conversation, should you be able to accept the $50 offer and get the ticket? Answer: Answers will vary. 2. Have you ever made an agreement that mattered to you, only to have the other person refuse to follow through on the deal? Looking at the list of elements in the chapter, did your agreement amount to a contract? If not, which element did it lack? Answer: Answers will vary. 3. The day after Thanksgiving, known as Black Friday, is the biggest shopping day of the year. One major retailer advertised a “Black Friday only” laptop for $150. On Thanksgiving night, hundreds of people waited for the store to open to take advantage of the laptop deal—only to learn that the store only had two units for sale at the discounted price. Did the retailer breach its contract with the hundreds of consumers who sought the deal? What obligation, if any, does the retailer have to its consumers? Answer: These cases resulted in numerous complaints to the FTC. Students might note that after these incidents, retailers began listing how many products of each they would have in stock. Regardless of these consumer protection issues, an advertisement is not a valid offer to contract. It is merely an invitation to offer. 4. Consider promissory estoppel and quasi-contracts. Do you like the fact that these doctrines exist? Should courts have “wiggle room” to enforce deals that fail to meet formal contract requirements. Or, should the rule be, “If it’s not an actual contract, too bad. No deal.” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Answers will vary. 5. Each time employees at BizCorp enter their work computers, the following alert appears: “You are attempting to access the BizCorp network. By logging in, you agree to BizCorp’s Computer Usage Policy and certify that your use of this computer is strictly for business purposes. Any activities conducted on this system may be monitored for any reason at the discretion of BizCorp” Once an employee has logged in, have the parties formed a valid contract? Discuss. Answer: U.S. courts uphold these notices as valid consent for employee monitoring. Students might be engaged in a discussion on the use of technology in the office and whether these “contracts” should be enforceable. Are they coercive?

Suggested Additional Assignments Research: The Contracts around Us Students should locate and read one or more of the contracts they have entered into in the past year— an apartment lease, a university-housing residency agreement, a mobile phone service agreement, terms of use for a fee-based website, or a retail sales agreement for a personal computer. How long is it? How much of it do they understand? Are any of the terms particularly surprising or unfair? If students do this assignment at the start of the unit on contracts they can measure what they’ve learned by reading the contract again after they’ve completed the unit.

Chapter Overview* Chapter Theme The law does not hold us accountable for every promise we make. The doctrine of consideration determines which promises a court must enforce, and what the key requirements are to create a legally binding contract.

11-1 What is Consideration? Consideration: The inducement, price, or promise that causes a person to enter into a contract and forms the basis for the parties’ exchange. There are two basic elements of consideration: 1. Value: Consideration requires legal benefit to the promisor or legal detriment to the promisee. Legal benefit means receiving something of measurable value. That thing can be money, groceries, insurance, a promise not to sue, or anything else or value to the promisee. 2. Bargained-for Exchange: According to Justice Holmes, “the essence of consideration is that “the promise must induce the detriment and the detriment must induce the promise.”42 The two parties must have bargained for whatever was exchanged and struck a deal: “If you do this, I’ll do that.”

11-1a What is Value? 42

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Act: Any action that a party was not legally required to take in the first place. Forbearance: Refraining from doing something that one has a legal right to do. Promise to Act or Forbear: A promise to do (or not do) something in the future counts as consideration. The promise to mow someone’s lawn next week is the equivalent of actually doing the yardwork. As we have seen, an essential part of consideration is that both parties must get something of value. That item of value can be an “act” (doing something not required by law), a “forbearance” (an agreement to NOT do something that is otherwise allowed by law), or a “promise to act or forebear” (a promise to do, or not to do, something in the future). In the following case, did the promise of forbearance have value? Did a contract signed in blood count? You Be the Judge!

You Be the Judge: Kim v. Son, 2009 Cal. App. LEXIS 2011, 2009 WL 597232, Court of Appeal of California, 2009 Facts: Stephen Son was a part owner and operator of two corporations. Because the businesses were corporations, Son was not personally liable for the debts of either one. Jinsoo Kim invested a total of about $170,000 in the companies. Eventually, both of them failed, and Kim lost his investment. Son felt guilty over Kim’s losses. Later, Son and Kim met in a sushi restaurant and drank heroic quantities of alcohol. At one point, Son pricked his finger with a safety pin and wrote the following in his own blood: “Sir, please forgive me. Because of my deeds you have suffered financially. I will repay you to the best of my ability.” In return, Kim agreed not to sue him for the money owed. Son later refused to honor the bloody document, and pay Kim the money. Kim filed suit to enforce their contract. The judge determined that the promise did not create a contract because there had been no consideration. You Be The Judge: Was there consideration? Argument for Kim: As a part of the deal made at the sushi restaurant, Kim agreed not to sue Son. What could be more of a forbearance than that? Kim had a right to sue at any time, and he gave the right up. Even if Kim was unlikely to win, Son would still prefer not to be sued. Besides, the fact that Son signed the agreement in blood indicates how seriously he took the obligation to repay his loyal investor. At a minimum, Son eased his guilty conscience by making the agreement, and surely that is worth something. Argument for Son: Who among you has not at one point or another become intoxicated, experienced emotions more powerful than usual, and regretted them the next morning? Whether calling an exgirlfriend and professing endless love while crying or writing out an agreement in your own blood, it is all the same. A promise not to file a meritless law suit has no value at all. It did not matter to Son whether or not Kim filed suit because Kim could not possibly win. If this promise counts as value then © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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the concept of consideration is meaningless because anyone can promise not to sue any time. Son had no obligation to pay Kim. And the bloody napkin does not change that fact, because it was made without consideration of any kind. It is an ordinary promise, and not a contract that creates any legal obligation. Holding: The trial court’s statement of decision sufficiently delineated the factual and legal basis of the court’s ultimate decision Kim failed to show the blood agreement was an enforceable contract or that Son defrauded him. Question: What did the court determine? Answer: Son, while extremely intoxicated, made a gratuitous unenforceable promise to repay what the corporations owed “to the best of *his+ ability.” The court also made the specific finding there was no evidence Son had personally guaranteed the debt or showing Son received any of the money. Given this lack of evidence, there was no basis upon which to consider the issue of forbearance as a substitute form of consideration. If a claim is invalid, forbearance is immaterial. The court’s failure to specifically discuss and reject the forbearance claim did not render the statement of decision inadequate.

Bonus Landmark Case: Hamer v. Sidway, 124 N.Y. 538, New York Ct. of Appeals, 1891 Facts: William Story wanted his nephew to grow up healthy and prosperous. In 1869, he promised the 15-year-old boy $5,000 if the lad would refrain from drinking liquor, using tobacco, swearing and playing cards or billiards for money, until his twenty-first birthday. The nephew had a legal right to do those things. The nephew agreed and kept his word. When he reached his twenty-first birthday, the nephew notified his uncle that he had honored the agreement. The uncle congratulated the young man and promised to give him the money, but said he would wait a few more years before handing over the cash, until the nephew was more mature. The uncle died and his estate refused to pay. Hamer, to whom the nephew had transferred his rights, sued. The estate argued that the nephew had given no consideration for the uncle’s promise. The trial court found for the plaintiff and the uncle’s estate appealed. Issue: Did the nephew give consideration for the uncle’s promise? Holding: Judgment for plaintiff affirmed. The nephew gave valid consideration by refraining from doing things he was legally entitled to do. The estate argued that there was no consideration because the nephew benefited from avoiding the proscribed actions, but the court was unpersuaded: “Courts will not ask whether the thing which forms the consideration does in fact benefit the promisee or a third party, or is of any substantial value to anyone. It is enough that something is promised, done, forborne, or suffered by the party to whom the promise is made as consideration for the promise made to him.” Question: Before we discuss the contracts issue, can you explain how Hamer wound up as the plaintiff? Answer: The nephew assigned—transferred—to Hamer his right to receive payment from the uncle. Assignment is discussed in Chapter 17, Third Parties. Question: Why did the uncle’s estate deny payment to Hamer? Answer: The estate argued that the nephew gave nothing to the uncle in exchange for the uncle’s promise; therefore there was no consideration and no contract. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: How did the estate characterize this transaction? Answer: As a promise to make a gift, not enforceable as a contract. Question: What was Hamer’s argument? Answer: Hamer argued that the nephew did give something to the uncle in exchange for the uncle’s promise: the nephew’s promise to refrain from alcohol, tobacco, swearing, and cards until he turned 21. Question: The uncle received no benefit from the nephew’s promise. Why does the court hold that the nephew gave consideration? Answer: Because the nephew promised to suffer a detriment. Question: The nephew gave up activities that were bad for his health. What detriment did he suffer? Answer: “Detriment” here does not mean that the nephew experienced adverse consequences. One suffers a detriment for purposes of consideration by promising to refrain from something one has a legal right to do, or promising to do something one is not obligated to do. Question: Which of these concepts applies here? Answer: The nephew promised to refrain from alcohol, tobacco, etc., all things that, when these promises were exchanged in 1875, the nephew had the legal right to enjoy. Question: Still, how is the nephew’s detriment a benefit to the uncle? Answer: It is not a benefit in any economic sense, but that does not matter. What matters is that the uncle’s promise to pay $5,000 if the nephew refrained from these activities—money the uncle was not otherwise obligated to pay the nephew—induced the nephew to promise in return to refrain from these activities, which he otherwise had the legal right to enjoy. These promises thus involved the bargained-for exchange of legal value. Question: Would a similar exchange of promises today between an adult and 15-year-old also result in a contract? Answer: No. In the U.S. persons under the age of 18 cannot purchase tobacco products and persons under the age of 21 cannot drink or gamble legally. Therefore a promise to refrain from these activities is not a detriment for purposes of contract law.

11-1b What Constitutes Exchange? Bargained for: When something is sought by the promisor and given by the promisee in exchange for their promises. The parties must bargain for the consideration. Something is bargained for if it is sought by the promisor and given by the promisee in exchange for their respective promises. Eliza hires Joe to be her public relations manager for $15,000 a year. Both Eliza and Joe have made promises to induce the other’s action. But what if the going rate for a PR manager with Joe’s experience is $65,000? Joe made a bad deal, but that does not mean it lacked consideration. Courts do not analyze the economic terms of an exchange to determine whether consideration was adequate. For consideration to be adequate in the eyes of the law, it must provide some benefit to the promisor or some detriment to the promisee, but these need not amount to much. Law professors often call this the “peppercorn rule,” a reference to a Civil War–era case in which a judge mused, “What is a valuable consideration? A peppercorn.”43 Here, both Eliza and Joe are promisor and promisee; each receives a benefit and incurs a detriment. 43

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Bonus Discussion: A Bargain and an Exchange Consideration does not require counteroffers. Students may equate “bargained-for” with “haggledover.” A simple example can demonstrate the meaning of “bargained-for” in this context: Curt offers to mow Pedro’s lawn once a week for $50 beginning May 1 and ending November 1. Pedro accepts. Where is the bargained-for exchange? Curt promised to mow Pedro’s lawn to induce Pedro to promise in return to pay Curt $50 a week. Pedro responded to Curt’s inducement by promising to pay Curt $50 per week if Curt mows Pedro’s lawn. To determine whether there was a bargained-for exchange, students should ask “did the offeree make its promise or tender its performance in response to the offer?” One St. Patrick’s Day, Mark Trieste was walking on the beach when he saw a body in the sand. Trieste reported the body to police. Police identified the body as that of 21-year-old Brian Wilson, who had been missing since New Year’s Eve. Distraught over his disappearance Wilson’s family had offered a $25,000 reward for information leading to his whereabouts. When Trieste found the body and notified police he did not know about Wilson’s disappearance or the offer of reward money. Looking at these facts strictly as a matter of contract law, is Wilson’s family obligated to pay Trieste the reward? Question: What kind of contract did the reward offer seek to form—bilateral or unilateral? Answer: Unilateral. Wilson’s family offered to pay the reward in exchange for performance: information about Wilson’s whereabouts. Question: Trieste’s information led to discovery of Wilson’s body. What is the family’s argument that it has no obligation to pay the reward? Answer: Trieste’s call to police was not induced by the reward offer. Trieste may have been a good citizen, but he was not tendering performance in response to an offer to form a unilateral contract. Question: What is Trieste’s response to this consideration argument? Answer: He doesn’t have one based on contract law—if he never knew of the offer, how can he claim that it induced his performance?

11-2 Legality 11-2a Non-compete Agreements: Sale of a Business When a non-compete agreement is ancillary to the sale of a business, it is enforceable if reasonable in time, geographic area, and scope of activity.

11-2b Non-compete Agreements: Employment Contracts A noncompete agreement is an agreement in which an employee promises not to work for a competitor for some time after leaving the company. It used to be that these covenants were rare and reserved for top officers but they have now become commonplace throughout many organizations. Non-competes limit an individual’s right to make a living and choose their work. Sometimes an employer proposes this agreement after the employee is already on board. What consideration does the employee receive for signing a covenant not to compete? What additional value does the employee receive? The law varies by state, but the current majority view is that an implied promise to continue employment is enough consideration to validate a non-compete. The following bonus case reflects the current majority view. Sometimes consideration issues can drive you nuts.

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Bonus Case: Snider Bolt & Screw v. Quality Screw & Nut, 2009 U.S. Dist. LEXIS 50797, 2009 WL 1657549, U.S. Dist. Ct. for the Western Dist. Of Kentucky, 2009 Facts: James Scott signed a covenant not to compete when he went to work for Snider Bolt & Screw. The agreement prohibited him from taking a job with a competitor for one year after leaving Snider. Three years later, Mr. Scott quit his job at Snider and immediately went to work for Quality Screw & Nut (QSN). Snider obtained a temporary restraining order that banned Scott from working at his new job. QSN argued that the covenant not to compete was void for lack of consideration. It asked the court to lift the temporary restraining order. Issue: Did the covenant not to compete lack consideration? Excerpt from Judge Heyburn’s Decision: Snider says that when Scott signed his covenant not to compete, he did so based upon an implied promise that Snider would continue his employment. Indeed, Snider did maintain Scott’s employment until Scott himself left his job in October, 2005. Kentucky courts have found quite specifically that “where an employer has fulfilled an implied promise to continue the employee’s employment, that promise is sufficient consideration *to] support enforcement of the employee’s promise not to compete.” The Kentucky Supreme Court subsequently held that even continued at-will employment would be sufficient consideration. Here, Scott worked for another three years and left on his own accord to join QSN. These circumstances fit within the rule and the Court finds that the Covenant is supported by adequate consideration. Consequently, the Court has no basis for sustaining QSN’s motion. In the absence of specific state statutes, non-compete agreements are enforceable only if they meet all of the following standards: 1. 2. 3. 4. 5.

They are reasonably necessary for the protection of the employer. They provide a reasonable time limit. They have a reasonable geographic limit. They are not harsh or oppressive to the employee. They are not contrary to public policy.

The legality of a non-compete depends on the facts of each case: the type of work, industry, and restrictions imposed. Many firms ask employees to sign non-competes that are unenforceable. Was the non-compete in the following case styled fairly, or was the employee clipped?

Case: King v. Head Start Family Hair Salons, Inc., 885 So.2d 769, Supreme Court of Alabama, 2004 Facts: Kathy King was a single mother supporting a college-age daughter. For 25 years, she had worked as a hair stylist. For the most recent 16 years, she had worked at Head Start, which provided haircuts, coloring, and styling for men and women. King was primarily a stylist, though she had also managed one of the Head Start facilities.

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King quit Head Start and began working as manager of a Sports Clips shop, located in the same mall as the store she just left. Head Start sued King, claiming that she was violating the noncompetition agreement that she had signed. The agreement prohibited King from working at a competing business within a two-mile radius of any Head Start facility for 12 months after leaving the company. The trial court issued an injunction enforcing the noncompete and King appealed. Issue: Was the noncompetition agreement valid? Decision: The agreement was only partly valid. Reasoning: Head Start does business in 30 locations throughout Jefferson and Shelby counties. Virtually every hair-care facility in those counties is located within two miles of a Head Start business and is thus covered by the non-competition agreement. The contract is essentially a blanket restriction, entirely barring King from this business. King must work to support herself and her daughter. She is 40 years old and has worked in the hair-care industry for 25 years. She cannot be expected at this stage in life to learn new job skills. Enforcing the noncompetition agreement would create a grave hardship for her. The contract cannot be permitted to impoverish King and her daughter. On the other hand, Head Start is entitled to some of the protection it sought in this agreement. The company has a valid concern that if King is permitted to work anywhere she wants, she could take away many customers from Head Start. The trial court should fashion a more reasonable geographic restriction, one that will permit King to ply her trade while ensuring that Head Start does not unfairly lose customers. For example, the lower court could prohibit King from working within two miles of the Head Start facility where she previously worked, or some variation on that idea. Reversed and remanded. Question: How does the court analyze the reasonableness of this noncompetition agreement? Answer: It looks at the impact of the noncompetition provisions in light of King’s ability to earn a living given her age, job experience, and prospects. Question: Why does it rule that the noncompetition is invalid? Answer: It would bar King from working within a two-mile radius of any Head Start facility. Head Start has 30 facilities in two counties and the effect of the noncompetition clause would be to make it extremely difficult for King to find employment in the only field she knows. Question: Since it ruled the clause to be invalid, is King free to take a job anywhere? Answer: No. The court recognized that it would be unfair to Head Start to throw out the entire agreement. It instructs the trial court to enforce a more reasonable restriction, suggesting that King be limited from working within a two-mile radius of the Head Start facility where she worked formerly. Question: What effect would that have on King? Answer: Ironically, it would result in King losing the job to which she moved from Head Start, because it is located in the same mall as her old job. Question: Courts tend to be antagonistic to noncompetition agreements. Why is that? Answer: They restrain trade and injure the public. The primary goal is to protect the public, though the secondary aim is to protect a worker’s right to use his skills and energy to his best advantage. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Suppose an employer could request any restrictions it wanted on future employment. What problems could that create? Answer: An employer might demand that the employee not work anywhere in the particular field after leaving. That would mean that, the more experienced the worker, the more difficult it would be for him to leave, since he would be forfeiting his skill and his chance to earn a living. The employer, aware of the employee’s inability to leave, could impose increasingly arduous and unfair work requirements. Question: But if an employee agrees to certain conditions, why shouldn’t they be enforced? If a worker knowingly agrees he will never work for another employer, anywhere, in the same field, why not require him to live up to his word? Answer: Contemporary courts will not do so, because they consider such agreements harmful to the general public. Giving an employer the power to prohibit future employment would diminish competition and job mobility, both considered essential for a healthy economy. Question: If a court is free to ignore a contract provision, such as a noncompete agreement, doesn’t that render the contract worthless? Answer: It does not make a contract worthless, but it does diminish the ability of the parties to predict the future, and to use a contract to control the future. The more flexibility a court shows, enforcing some contracts while rejecting others, the less predictable the law, and business, become.

11-2c Exculpatory Clauses Exculpatory clause: A contract provision that attempts to release one party from liability in the event the other is injured. An exculpatory clause is generally unenforceable when it attempts to exclude an intentional tort or gross negligence. An exculpatory clause is usually unenforceable when the affected activity is in the public interest, such as medical care, public transportation, or some essential service. An exculpatory clause is generally unenforceable when the parties have greatly unequal bargaining power. An exculpatory clause is generally unenforceable unless the clause is clearly written and readily visible.

Bonus Case: You Be the Judge: Ransburg v Richards, 770 N.E.2d 393 Indiana Court of Appeals, 2002 Facts: Barbara Richards leased an apartment at Twin Lakes, a complex owned by Lenna Ransburg. The written lease declared that: • Twin Lakes would “gratuitously” maintain the common areas. • Richards’ use of the facilities would be “at her own risk.” • Twin Lakes was not responsible for any harm to the tenant or her guests, anywhere on the property (including the parking lot), even if the damage was caused by Twin Lakes’ negligence. It snowed. As Richards walked across the parking lot to her car, she slipped and fell on snow-covered ice. Richards sued Ransburg, who moved for summary judgment based on the exculpatory clause. The trial court denied Ransburg’s motion and she appealed. Issue: Was the exculpatory clause valid? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Argument for Tenant: An exculpatory clause in a contract for an essential service violates public policy. When an ill person seeks medical care, his doctor cannot require him to sign an exculpatory clause. In the same way, a person has to live somewhere. Her landlord cannot force her to sign a waiver. Landlords tend to be wealthy and powerful. There is generally no equality of bargaining power between them. The tenants are not freely agreeing to the exculpatory language. Moreover, if a landlord fails to maintain property, not just the tenant is at risk. Visitors, the mail carrier, the general public, could all walk through the Twin Lakes parking lot. The public’s interest is served when landlords maintain their properties. They must be held liable when they negligently fail to maintain common areas and injuries result. Argument for Landlord: Ms. Richards does indeed have to live somewhere, but she does not have to live on the plaintiff’s property. Surely there are many dozens of properties nearby. If Richards had been dissatisfied with any part of the proposed lease – excessive rent, strict rules, or an exculpatory clause she was free to take her business to another landlord. Landlords may generally be wealthier than their tenants, but that fact alone does not mean that a landlord is so powerful that leases are offered on a “take it or leave it” basis. Here, the landlord stated the exculpatory clause plainly. This is a clear contract between adults, and it should stand in its entirety. Holding: Judgment affirmed. Excerpts from the court’s opinion: Resolving the question of whether this lease provision is void as against public policy turns on fairly balancing the parties’ freedom to contract against the policy of promoting responsibility for damages caused by one’s own negligent acts. A tenant’s choices may be limited; he can accept one landlord or go to another who charges the same rent and asks the tenant to sign the same standard form lease. We conclude that five factors weigh in favor of not enforcing this type of clause in residential leases: (i) the nature of the subject matter of the contract; (ii) the strength of the public policy underlying the statute; (iii) the likelihood that refusal to enforce the bargain or term will further that policy; (iv) how serious or deserved would be the forfeiture suffered by the party attempting to enforce the bargain; and (v) the parties relative bargaining power and freedom to contract. Given the vast number of people clauses like these affect, the inequality of bargaining power caused by the need for housing, the fact that people who are not parties to the contracts could suffer as a result of such clauses, and the desire to promote responsible maintenance by landlords to avoid personal injuries by tenants and third parties, we find that the factors weigh in favor of public policy. Dissent: The majority ignores the plain meaning of the exculpatory clause and violates the well-settled common law right of the parties to make such a provision and to have it enforced according to its terms. Question: What is an exculpatory clause? Answer: A contract provision that one party uses to avoid liability, generally for negligence or other torts. Question: Why did the court hold this exculpatory clause to be unenforceable? Answer: It relied on the disparity in bargaining power between landlords and tenants, stating that the latter’s choices may be limited, and thus tenants have little leverage to bargain for better terms. Question: Is that always true? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No. The relative leverage between landlords and tenants will depend on many factors including vacancy rates, tenants’ economic status, and the strength of local landlord/tenant laws Question: Many of the examples in the text show exculpatory clauses to be unenforceable. Is that the general rule? Answer: Note that the text distinguishes between exculpatory clauses in consumer contracts, or those between individuals and businesses such as here, and exculpatory clauses in business-tobusiness contracts. Question: Why is that distinction important? Answer: Courts may, as in this case, be more willing to take an active role in determining the fairness of consumer or other contracts between individuals and businesses. However courts will generally not look beyond the terms of a contract between businesses, particularly in sophisticated contracts or those in which the parties were represented by counsel. Question: Why? Answer: Courts should rarely second-guess the fairness of decisions made by businesspeople in the pursuit of business interests. Business contracts frequently allocate risk, or expose one party willingly to risk, in ways that reflect careful assessment of business opportunities. Question: Can you explain further? Answer: A valid exculpatory clause may enable a business to offer products or services at a lower cost than it would charge if it had to cover the cost of potential liability. A customer may choose to enter into a contract with that business because of the cost advantage provided by the exculpatory clause. If the customer wants to protect itself against the risk of the business’s negligence it may be able to do so through insurance, self-insurance, risk-mitigation practices, or other means. Courts should, as a general rule, not inject themselves into the midst of these calculations.

Bonus: Role Play: Exculpatory Clauses An exculpatory clause is one that attempts to release one party from liability in the event of injury to the other party. These clauses have an obvious attraction to many companies, but they carry one major risk: a court may ignore them. Courts frequently reject exculpatory clauses that they consider overbroad. In this exercise students will hear the facts of a case and then formulate and respond to various arguments about an exculpatory clause. Divide the classroom into three sections. One section will represent the injured plaintiffs in this automobile accident case, the second will represent the defendant, Hertz, and the third will judge the arguments and ask questions. The case is Hertz Corp v. Garrott.44. The standard Hertz lease, used in Illinois, included a provision stating that the rented vehicle would be driven only by the customer and certain authorized persons who had the customer’s permission. One such authorized person was an immediate family member who was a licensed driver over the age of 25. Angelique Garrott rented a Hertz car. The next day Angelique’s husband, Rodney, was driving the vehicle when it struck a Chicago taxicab, injuring the cab’s passengers and damaging both cars. Regrettably, Rodney was under age 25, intoxicated, and driving without a license, which had been suspended several months earlier. All of the injured parties sued Hertz. The standard lease, which Ms. Garrott signed, contained a provision for Hertz to provide liability insurance for the car. But Hertz argued that its coverage did not apply in this case. On the back of the lease form, in small print, an exculpatory clause stated that if the customer permitted an unauthorized or prohibited use of the vehicle, the insurance would be voided and the customer would be responsible for all losses. Hertz claimed that since Rodney, unlicensed, underage, and drunk, was obviously an 44

238 Ill. App. 3d 231, 606 KEW 219, 1992 Ill. App. LEXIS 1751 Michigan Court of Appeals, 1992 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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unauthorized driver, the insurance was void, and the company was off the hook. The taxi company and the injured passengers argued that Hertz’s insurance still applied. Question for Hertz Lawyers: Make an argument for Hertz that its insurance coverage did not apply to this accident. Possible Answer: This argument is simple and straightforward. The lease agreement explicitly stated that the car could be driven only by an authorized driver, meaning a sober, licensed driver over age 25. Rodney was unlicensed, drunk, and underage. Consequently this was unauthorized use. As the back of the form stated, unauthorized use voided the insurance coverage. That was the agreement Angelique Garrott made, and that is the contract the court should enforce. Question for Injured Parties’ Lawyers: Make an argument for the taxi company and its passengers that Hertz’s insurance coverage did apply. Answer: The policy should be void as against public policy. The primary purpose of this liability insurance is to protect innocent third parties. Hertz should not be entitled to void a policy, causing innocent people to suffer. Rodney’s use was foreseeable, even if it was illegal and in violation of the contract. Hertz should pay. Suggested Additional Questions: For Hertz: If Hertz can avoid paying damages because of this violation of the law (driving without a license and drunk driving), couldn’t Hertz rewrite the contract so that its insurance is voided by any improper driving, such as speeding, an illegal turn, and so forth? Couldn’t Hertz in fact make the policy useless if it chose to? Answer: It would be unfair and unjust to write insurance that became void whenever there was an accident. What Hertz is trying to do here is perfectly reasonable: to limit the people who drive its cars. For Injured Parties: The Garrotts knew perfectly well that Rodney should not be driving. Even without reading the contract, they could have guessed that a drunk, unlicensed driver did not have permission to use the car. Further, both driving without a license and drunk driving are serious violations of the law. Why should a court help people who violate the contract and break the law? Answer: A court probably should not help such people, but it must protect innocent parties such as the taxi company and the passengers who could easily be injured by the car–and injured again by the exculpatory clause. For Judges: Who should win and why? Answer: The trial court ruled in favor of Hertz on the insurance issue, declaring the exculpatory clause valid and the insurance void. But the Illinois court of appeal reversed, holding that Hertz’s exculpatory clause was void for two reasons. First, the exculpatory clause was on the back of the form. A customer would not be likely to know that certain acts invalidated the insurance coverage. Second, and more importantly, Hertz had no right as a private entity to impose sanctions on an unlicensed, intoxicated driver, when the effect of the action would be to harm the general public and to benefit the company. In other words, Hertz is not free to include an exculpatory clause, nullifying insurance coverage, when the result is to penalize and harm the general public. The exculpatory clause has no effect, and this vehicle is covered by Hertz’s liability insurance.

11-3 Capacity Capacity: The legal ability to enter into a contract.

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11-3a Minors A minor is someone under the age of 18. Because a minor lacks legal capacity, she normally can create only a voidable contract. A voidable contract may be cancelled by the party who lacks capacity.

Disaffirmance A minor who wishes to escape from a contract generally may disaffirm it Disaffirm: To give notice of refusal to be bound by an agreement.

Restitution A minor who disaffirms a contract must return the consideration he has received, to the extent he is able. A minor who wishes to escape from a contract generally my disaffirm it. He may notify the other party that he refuses to be bound by the agreement. In the following bonus case, Kevin Green did just that.

Bonus Case: Star Chevrolet Co. v. Green45 Facts: Kevin Green paid $4,600 cash for a used Camaro from Star Chevrolet. When the car blew a gasket, the dealer refused to give Kevin his money back. Kevin repaired the car himself and drove it on the highway, where it was wrecked. Kevin sued Star, and the trial court awarded him the full price of the car, because he was a minor when he bought it. Star appealed. Issue: Is Kevin Green entitled to disaffirm the contract even though the Camaro has been destroyed? Holding: The appeals court affirmed judgment for Green but reduced the award to $3,100, based on the car’s salvage value. A minor may disaffirm a contract. He is required to return the consideration only if it is still in his possession. If the minor has wasted, squandered, or otherwise destroyed the consideration, he need not return it and is still entitled to his money back. Question: Star Chevrolet either did not know that Green was entitled to his money back, or knew but refused to honor it. Why was that a particularly costly mistake by Star? Answer: If Star had returned Green’s money when he first asked, it would have received a basically sound car with a blown gasket. Because it failed to do so, it ended up with a car of only salvage value. Question: Why was Kevin Green permitted to keep the insurance proceeds and his purchase price? Answer: Because of the collateral source rule, which states that a defendant that is found to owe a plaintiff money cannot reduce its liability by an amount the plaintiff will be compensated by another source. See fn. 1, p. 320. Question: Kevin Green knew that he was a minor. Why should he be allowed to make an agreement, wreck a car, and then get his money back? Answer: The policy behind the court’s ruling was to discourage businesses from entering into agreements with minors. If a minor were barred from rescinding whenever a business could prove he was sophisticated, that would encourage companies to make deals with minors in the

473 So. 2d 157, 1985 Miss. LEXIS 2141 Supreme Court of Mississippi, 1985 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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expectation that many or most could be enforced. It is that temptation that the court wishes to remove.

11-3b Mentally Impaired Persons A person suffers from a mental impairment if, by reason of mental illness or defect, he is unable to understand the nature and consequences of the transaction. A party suffering mental impairment generally creates only a voidable contract. Exception: If the person has been adjudicated incompetent, then all of his future agreements are void.

11-3c Intoxication Similar rules apply in cases of drug or alcohol intoxication. When one party is so intoxicated that he cannot understand the nature and consequences of the transaction, the contract is voidable. But courts are highly skeptical of intoxication arguments. See the bonus landmark case which follows.

Bonus Landmark Case: Babcock v. Engel, 58 Mont. 597, Supreme Ct. of Montana, 1920 Facts: While Charles Engel’s wife was out of town, he sat home alone, drinking mightily. During this period, he made an agreement with G. M. Babcock to trade a 320 acre farm and $2000 worth of personal property for a hotel. Engel’s property was worth approximately twice the value of the hotel. Engel later refused to honor the deal on the grounds that he had been intoxicated when he made the agreement. Babcock sued, but the jury sided with Engel and dismissed the complaint. Babcock appealed. Issue: Was Engel so intoxicated that his agreement with Babcock became voidable? Excerpts from Justice Holloway’s Decision: If, as a matter of fact, Engel was so far under the influence of intoxicating liquor when he signed the contract that he was incapable of giving his assent it would be voidable at the election of Engel when he became sober. [T]he jury answered that on November 22, Engel was “so under the influence of intoxicating liquors as to deprive him of his powers of reasoning and render him unable to comprehend the consequences of his act in executing said agreement.” Engel himself testified to the effect that, availing himself of his wife’s absence from home, he had been indulging greatly to excess and had been drunk on November 21; that he drank heavily of whisky which he had at his home on the morning of November 22; that immediately upon his arrival in the town he had four or five drinks of whisky and blackberry before he entered upon the negotiations with Babcock. Upon the question of his intoxication he was corroborated abundantly. Four other witnesses, each apparently disinterested, testified that at the time in question Engel was intoxicated, could not comprehend the nature of his acts, in other words, that he was not qualified to transact business. The jury determined upon the credibility of the witnesses. Intoxication is not made a defense by the Codes, and there was a time in the history of our jurisprudence when courts refused to lend their aid to relieve one from the consequences of his own voluntary intemperance, but the doctrine has long since been abandoned. The courts do not now © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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concern themselves so much with the question of intoxication as with the question of contractual capacity, and if in fact either party is not mentally capable of giving his free consent to the terms disclosed by the writing, it is altogether immaterial by what cause his incapacity was produced. The courts have simply recognized the fact that intoxication, among other things, may render a person incapable of making a binding contract. The test approved by the great majority of the decisions is the same which is applied in other forms of mental derangement, namely, that the deed or contract will be voidable if the person, at the time of its execution, was so far under the influence of intoxicants as to be unable to understand the nature and consequences of his act, and unable to bring to bear upon the business in hand any degree of intelligent choice and purpose. Affirmed. Question: What was the court’s holding? Answer: The court held that the contract was voidable due to Engel’s intoxication. Question: What did the court use as a comparison? Answer: The court said the test approved is the same as those suffering a mental impairment

11-4 Reality of Consent Rescind: To cancel a contract

11-4a Fraud Fraud: Intending to induce the other party to contract, knowing the words are false or uncertain that they are true. Fraud begins when a party to a contract represents something that is factually wrong. An injured person must show the following: 1. The defendant knew that the statement was false, or that he made the statement recklessly and without knowledge of whether it was false; 2. The false statement was material; and 3. The injured party justifiably relied on the statement.

Element One: Intentional or Reckless Misrepresentation of Fact The injured party must show a false statement of fact. Notice that this does not mean the statement was necessarily a “lie.” If the speaker makes the statement with the reasonable belief that it is true, it is an innocent misrepresentation, not fraud. Opinions and “puffery” do not amount to fraud. Common “puffery” phrases include “high-quality,” “expert workmanship” and “you’re in good hands with us.”

Element Two: Materiality The injured party must demonstrate that the statement was material or important. A minor misstatement does not meet this second element. Was the misstatement likely to influence the decision of the misled party significantly? If so, it was material.

Element Three: Justifiable Reliance The injured party must show that she actually did rely on the false statement, and that her reliance was reasonable.

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In the case of fraud, the injured party generally has a choice of rescinding the contract or suing for damages or, in some cases, doing both. The choice of doing both is available in all states when a contract is for the sale of goods under the UCC.

Innocent Misrepresentation Misrepresentation: A statement that is factually wrong. If all elements of fraud are present except the misrepresentation of fact was not made intentionally or recklessly, then innocent misrepresentation has occurred. So, if a person misstates a material fact but with good reason to believe the statement true, most states allow rescission of a contract, but not damages.

11-4b Mistake Not all mistakes are created equal: Some mistakes lead to voidable contracts; others create enforceable (if unfortunate) deals. How can we know the difference? First, we must ask who was mistaken because different rules apply to unilateral and mutual mistakes. We must also examine the character of the mistake to see if its circumstances warrant rescission.

Unilateral Mistake Unilateral Mistake: Occurs when only one party negotiates based on a factual error. To rescind for unilateral mistake, Sometimes one party enters a contract under a mistaken assumption; the other is not mistaken. In these cases it is not easy for the mistaken party to rescind a contract. To rescind for unilateral mistake, the mistaken party must demonstrate that he entered into the contract because of a basic factual error and that the nonmistaken party knew or had reason to know of the error.

Mutual Mistake Mutual mistake: Occurs when both parties negotiate based on the same fundamental factual error. A mutual mistake occurs when both contracting parties share the same mistake. If the contract is based on a fundamental factual error by both parties, the contract is voidable by either one. But courts will not rescind contracts on the basis of:  Prediction error  Mistake of value  Conscious uncertainty

The following bonus landmark case demonstrates these concepts.

BONUS Landmark Case: Sherwood v. Walker, 66 Mich. 568, Supreme Court of Michigan, 1887 Facts: Rose 2d of Aberlone was a gentle, 1,420 lb. cow that lived in Michigan in 1886. Rose’s owner, Hiram Walker & Sons, was a cattle breeder who bought her for $850. After a few years, Walker concluded that Rose could have no calves. As a barren cow, she was worth much less than $850, so Walker agreed to sell her for beef to T. C. Sherwood. Walker told Sherwood that Rose was “probably © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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barren, and would not breed.” After some negotiation, Walker agreed to sell Rose for “five and one-half cents per pound, live weight, fifty pounds shrinkage,” or $80. But when Sherwood came to collect Rose, the parties realized that (surprise!) she was pregnant. As a confirmed breeder, Rose was now worth about $1,000. Walker refused to part with the happy mother, and Sherwood sued for breach of contract. Walker defended, claiming that both parties had made a mistake and that the contract was voidable. After the lower court ruled the contract was enforceable, Walker appealed. Issue: Does a bilateral mistake render a contract voidable? Excerpts from Justice Morse’s Decision: A party who has given an apparent consent to a contract of sale may refuse to execute it, or he may avoid it after it has been completed, if the assent was founded, or the contract made, upon the mistake of a material fact—such as the subject matter of the sale, the price, or some collateral fact materially inducing the agreement; and this can be done when the mistake is mutual. If there is a difference as to the substance of the thing bargained for, then there is no contract; but if it be only a difference in some quality or accident, the contract remains binding. The mistake of the parties went to the whole substance of the agreement. The parties would not have made the contract of sale except upon the understanding and belief that she was incapable of breeding, and of no use as a cow. A barren cow is substantially a different creature than a breeding one. There is as much difference between them for all purposes of use as there is between an ox and a cow that is capable of breeding and giving milk. The mistake affected the character of the animal for all time, and for its present and ultimate use. She was not in fact the animal, or the kind of animal, the defendants intended to sell or the plaintiff to buy. The mistake affected the substance of the whole consideration, and it must be considered that there was no contract to sell or sale of the cow as she actually was. The thing sold and bought had in fact no existence. Defendants had a right to rescind, and to refuse to deliver, and the verdict should be in their favor. Question: What type of mistake is present in this case? Answer: A bilateral mistake. Question: Would the Defendant have been able to rescind the contract if they made a unilateral mistake? Answer: Probably not. To rescind for a unilateral mistake, the Defendant would have to show that they entered the contact because of a basic factual error and that either (1) enforcing the contract would be unconscionable, or 2) the nonmistaken party knew of the error. Question: Why is a court decision from 1887 still relevant today? Answer: Because of our common law system based upon precedent and the doctrine of stare decision.

11-5 Contracts in Writing The Statute of Frauds: A plaintiff may not enforce any of the following agreements, unless the agreement, or some memorandum of it, is in writing and signed by the defendant. The agreements that must be in writing are those: © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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For any interest in land That cannot be performed within one year To pay the debt of another Made by an executor of an estate to pay the debt of the estate; Made in consideration of marriage; and For the sale of goods worth $500 or more.

But, once a contract is fully executed, it makes no difference that it was unwritten.

11-5a Contracts that Must Be in Writing Agreements for an Interest in Land Exception: Full Performance by the Seller: If seller has completely performed, a court is likely to enforce the agreement, even if it was oral. Exception: Part Performance by the Buyer: if Buyer paid part of the purchase price and either entered onto the land or made improvements to it, she may be able to enforce the contract.

Agreements that Cannot Be Performed within One Year The one-year period begins on the date the parties make the agreement. The critical phrase here is “cannot be performed within one year.” But if a contract could possibly be completed within one year, it need not be in writing. Example: Betty gets a job at Burger Brain, throwing fries in oil. Her boss tells her she can have Fridays of for as long as she works there. That oral contract is enforceable whether Betty stays one week or 57 years. I could have been performed within one year if, say, Betty quit the job after six months. Therefore, it need not be in writing. The following case picks up the story of Lynn and Howard and their war over a winning lottery ticket. Who will win? Only one of them.

Case: Browning v. Poirier 165 So.3d 663, Supreme Court of Florida (2015) Facts: Howard Browning and Lynn Poirier were a couple. Early on, they promised to share any lottery winnings equally. Fourteen years after that oral promise, they purchased a million-dollar winning ticket. But after Poirier collected the prize, she refused to give Browning half. Browning sued Poirier for breach of oral contract. Poirier claimed that the oral agreement was unenforceable because the Statute of Frauds requires promises that are not performable within a year to be in writing. Issue: Will the court enforce this open-ended promise to share future lottery winnings? Decision: Yes. This promise does not have to be in writing because it can be performed within one year. Reasoning: This promise could have been completed within a year of its making. If either Browning or Poirier had won the lottery that first year after their vow to share, the agreement would have been fully © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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performed. Likewise, if either Browning or Poirier had ended the deal during its first year, it would also have been completed. Nothing in the contract terms demonstrates that it could not be fulfilled within one year, so it is enforceable. Poirier must share the winnings with Browning. Question: Who won this case? Answer: Browning did. Poirier must share the lottery winnings with him. Question: Why did the court rule in favor of Browning? Answer: Because the oral contract was certainly capable of being performed within one year. It all depended upon when either of them bought a winning lottery ticket. Question: The statute of frauds requires that contracts that cannot be completed within one year must be in writing. When does the time begin to accrue? Answer: On the date of the oral agreement. Question: How long was it from the date of the agreement until Poirier purchased a winning lottery ticket? Answer: About fourteen years. Question: How could Poirier have kept all the winnings for herself? Answer: If at the time the oral contract was made, they had agreed that it would end in, say, two years, the contract would have expired long before Browning won the money.

Promise to Pay the Debt of Another When one person agrees to pay the debt of another as a favor, it must be in writing to be enforceable.

Promise Made by an Executor of an Estate An executor’s promise to use her own funds to pay a debt of the estate must be in writing to be enforceable.

Promise Made in Consideration of Marriage A promise made in consideration of marriage must be in writing to be enforceable.

11-5a What the Writing Must Contain The writing may be formal or informal but must:  Be signed by the defendant, and  State with reasonable certainty the name of each party, the subject matter of the agreement, and all of the essential terms and promises.

Signature Any mark or logo placed on a document to indicate acceptance – even an “x” – will do. In addition, ecommerce creates new methods of signing.

Reasonable Certainty The writing must be certain and complete.

11-5c Sale of Goods A contract for the sale of goods worth $500 or more is not enforceable unless there is some writing, signed by the defendant, indicating that the parties reached an agreement. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Chapter Conclusion It is not enough to bargain effectively and obtain a contract that gives you exactly what you want. The deal must have consideration or it will not amount to a contract. Bargaining a contract with a noncompete or exculpatory clause that is too one-sided may lead a court to ignore it. Both parties must be adults of sound mind and must give genuine consent. Misrepresentation and mistakes indicate that at least one party did not truly consent. Some contracts must be in writing to be enforceable, and the writing must be clear and unambiguous.

Matching Questions Match the following terms with their definitions: _____A. Fraud 1. A contract clause intended to relieve one party from potential tort liability _____B. Restitution 2. The idea that contracts must be a two-way street _____C. Part Performance 3. The intention to deceive the other party _____D. Exculpatory clause 4. Restoring the other party to its original position _____E. Consideration 5. Entry onto land, or improvements made to it, by a buyer who has no written contract Answers: R. 3 S. 4 T. 5 U. 1 V. 2

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 49. T F A contract may not be rescinded based on puffery. 50. T F An agreement for the sale of a house does not need to be in writing if the deal will be completed within one year. 51. T F Non-compete clauses are suspect because they tend to restrain free trade. 52. T F A seller of property must generally disclose latent defects that he knows about. 53. T F A court is unlikely to enforce an exculpatory clause included in a contract for surgery. 54. T F An agreement for the sale of 600 plastic cups, worth $0.50 each, must be in writing to be enforceable.

Multiple Choice Questions 1. In which case is a court most likely to enforce an exculpatory clause? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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A. Dentistry B. Hang gliding C. Parking lot D. Public transportation E. Accounting Answer: B. 2. Sarah, age 17, uses $850 of her hard-earned, summer-job money to pay cash for a diamond pendant for the senior prom. She has a wonderful time at the dance, but decides the pendant was an extravagance, returns it, and demands a refund. The store has a “no refund” policy that is clearly stated on a sign on the wall. There was no defect in the pendant. The store refuses the refund. When Sarah sues, she will: A. Win $850 B. Win $425 C. Win, but only if she did not notice the “no refund” policy D. Win, but only if she did not think the “no refund” policy applied to her E. Lose Answer: A. 3. Tobias is selling a surrealist painting. He tells Maud that the picture is by the famous French artist Magritte, although in fact Tobias has no idea whether that is true or not. Tobias’ statement is: A. A bilateral mistake B. A unilateral mistake C. A fraud D. An innocent misrepresentation E. Legal, so long as he acted in good faith Answer: C. 4. Louise emails Sonya, “I will sell you my house at 129 Brittle Blvd. for $88,000, payable in one month. Best, Louise.” Sonya emails back, “Louise, I accept the offer to buy your house at that price. Sonya.” Neither party prints a copy of the two emails. A. The parties have a binding contract for the sale of Louise’s house. B. Louise is bound by the agreement, but Sonya is not. C. Sonya is bound by the agreement, but Louise is not. D. Neither party is bound because the agreement was never put in writing. E. Neither party is bound because the agreement was never signed. Answer: A. 5. In February, Chuck orally agrees to sell his hunting cabin, with 15 acres, to Kyle for $35,000, with the deal to be completed in July, when Kyle will have the money. In March, while Chuck is vacationing © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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on his land, he permits Kyle to enter the land and dig the foundation for a new cottage. In July, Kyle arrives with the money, but Chuck refuses to sell. Kyle sues. A. Chuck wins because the contract was never put in writing. B. Chuck wins because the contract terms were unclear. C. Kyle wins because a contract for vacation property does not need to be written. D. Kyle wins because Chuck allowed him to dig the foundation. E. Kyle wins because Chuck has committed fraud. Answer: A. 6. Ted’s wallet is as empty as his bank account, and he needs $3,500 immediately. Fortunately, he has three gold coins that he inherited from his grandfather. Each is worth $2,500, but it is Sunday, and the local rare coins store is closed. When approached, Ted’s neighbor Andrea agrees to buy the first coin for $2,300. Another neighbor, Cami, agrees to buy the second for $1,100. A final neighbor, Lorne, offers “all the money I have on me” - $100 – for the last coin. Desperate, Ted agrees to the proposal. Which of the deals is supported by consideration? A. Ted’s agreement with Andrea, only B. Ted’s agreements with Andrea and Cami, only C. All three of the agreements D. None of the agreements Answer: C.

Case Questions 1. American Bakeries had a fleet of over 3,000 delivery trucks. Because of the increasing cost of gasoline, the company was interested in converting the trucks to propane fuel. It signed a requirements contract with Empire Gas, in which Empire would convert “approximately 3,000” trucks to propane fuel, as American Bakeries requested, and would then sell all required propane fuel to run the trucks. But American Bakeries changed its mind and never requested a single conversion. Empire sued for lost profits. Who won? Answer: Empire won over $3.2 million dollars, and the appeals court affirmed. Empire Gas Corp. v. American Bakeries Co., 840 F.2d 1333, 1988 U.S. App. LEXIS 2482 (7th Cir. 1988). Since this was a requirements contract for the sale of goods (the conversion units and the propane gas were the goods), it was governed by UCC §2-306. American Bakeries did have the right to reduce the number of conversions from the estimated 3,000. It could potentially reduce them even to zero, but any reduction had to be done in good faith, meaning that changed circumstances made a reduction important. Here, American Bakeries never offered any reason at all, and the jury verdict was reasonable.

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2. Guyan Machinery, a West Virginia manufacturing corporation, hired Albert Voorhees as a salesman and required him to sign a contract stating that if he left Guyan he would not work for a competing corporation anywhere within 250 miles of West Virginia for a two-year period. Later, Voorhees left Guyan and began working at Polydeck Corp., another West Virginia manufacturer. The only product Polydeck made was urethane screens, which comprised half of 1 percent of Guyan’s business. Is Guyan entitled to enforce its noncompete clause? Answer: No. The noncompete clause is unenforceable here because the two companies are not really in competition and Guyan therefore has no confidential information or customer lists to protect. Voorhees v. Guyan Machinery Co., 191 W. Va. 450, 446 S.E.2d 672, 1994 W.Va. LEXIS 27 (1994). 3. ETHICS: Richard and Michelle Kommit traveled to New Jersey to have fun in the casinos. While in Atlantic City, they used their MasterCard to withdraw cash from an ATM conveniently located in the “pit” - the gambling area of a casino. They ran up debts of $5,500 on the credit card and did not pay. The Connecticut National Bank sued for the money. Law aside, who has the moral high ground? Is it acceptable for the casino to offer ATM services in the gambling pit? If a credit card company allows customers to withdraw cash in a casino, is it encouraging them to lose money? Do the Kommits have any ethical right to use the ATM, attempt to win money by gambling, and then seek to avoid liability? Answer: They should and did claim that they borrowed the money to gamble. They argued correctly that a gambling debt is unenforceable in Connecticut. The appellate court remanded the case so that the trial court could determine whether the bank knew that the money was borrowed for gambling. If the bank knew the intended use of the money (which a court could but need not infer from the location of the ATM), the debt is void. Connecticut National Bank of Hartford v. Kommit, 31 Mass. App. Ct. 348, 577 N.E.2d 639, 1991 Mass. App. LEXIS 660 (Mass. Ct. App. 1991). As to which party has the high ground, of course, the answer is that it is a tie for last place. Clearly the credit card company is encouraging people to gamble, by placing its ATM in the gambling pit. Just as certainly, the Kommits are trying to have it both ways, gambling in the hopes of a quick gain, then attempting to avoid liability by invoking this legal principle. Generally, when faced with two parties who are both less than saintly, courts attempt to make rulings that will be in the best interests of society, in the long term. 4. While on a cruise, DePrince inquired about the price of a 20-carat diamond in the ship’s gift shop. After confirming with the cruise line’s corporate office, the sales person told DePrince that the price was $235,000. DePrince’s traveling companions, who both happened to be gemologists, told him that the price was too good to be true: A diamond that large should cost at least $2 million. DePrince ignored their advice and purchased the diamond. Soon after the sale was completed, the cruise line realized that the $235,000 price quote was per carat, not the total price. What kind of mistake did the cruise line make? Can the cruise line void the transaction? Answer: They did void the transaction, based on unilateral mistake, saying that DePrince well knew the true value of the diamond. DePrince v. Starboard Cruise Services, Inc., 163 So.3d 586, Ct. of App. of Fla. (2015) 5. When they were dating, Kris promised his wife Wendellyn that, if she moved to Wyoming and married him, he would take care of her for the rest of her life. Three years later, the couple filed for © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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divorce and Wendellyn claimed that Kris’s oral promise entitled her to care for life. Kris argued that his promise was unenforceable because it should have been in writing. Who is right? Answer: The court held for the husband. The husband’s alleged promises relating to support should have been in writing, since it was a promise in consideration of marriage. Wendellyn Kay Dane v. Kris Alan Dane, 2016 WY 38; 368 P.3d 914, 2016 Wyo LEXIS 40

Discussion Questions 1. During the Gold Rush, John Tuppela bought an Alaskan mine. Sadly, he only found problems there. A court declared him insane and institutionalized him. Four years later, Tuppela emerged to learn that gold had been discovered in his mind, but a court-appointed guardian had already sold it. Tuppela called on his life-long friend, Embola:” If you will give me $50 so I can go to Alaska, I will pay you $10,000 when I win my property back.” Embola accepted the offer, advancing the $50. Tuppela won back his mind, but when he asked his guardian to pay Embola the promised $10,000, the guardian refused. The guardian argued there was insufficient consideration. Embola sued. Was $50 adequate consideration to support Tuppela’s promise of $10,000? Answer: Although the difference between Embola’s $50 and Tuppela’s $10,000 was staggering, it was not for the court to judge whether it was an intelligent bargain. Both parties knew what they were doing, Embola undertook a risk, and his $50 was valid consideration. The question of adequacy is for the parties as they bargain, not for the courts.

2. Does the coverage of the Statute of frauds make sense as it currently stands? Would it be better to expand the law and require that all contracts be in writing? Or should the law be done away with altogether? Answer: Answers will vary. 3. Imagine that you are starting y8ouor own company in your hyper=competitive industry: You are putting your life savings, your professional contacts, and your innovative ideas on the line. As you begin to hire a sales force, you consider binding new employees to non-compete agreements. Outline the ideal terms of your employees’ non-competes. What is its duration? What is its geographical radius? Are those terms appropriate for your industry? When you are done, pass your proposed terms to classmates and discuss its enforceability. Answer: Answers will vary. 4. The Justice Department shut down three of the most popular online poker websites. State agencies take countless actions each year to stop illegal gaming operations. Do you believe that gambling by adults should be regulated? If so, which types? Rate the following types of gambling from most acceptable to least acceptable:

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Answer: Answers will vary. 5. Ball-Mart, a baseball card store, had a 1968 Nolan Ryan rookie card in almost perfect condition for sale. Any baseball collector would have known that the card was worth at least $1,000; the published monthly price guide listed its market value at $1,200. Bryan was a 12-year-old boy with a collection of over 40,000 baseball cards. When Bryan went to Ball-Mart, Kathleen, who knew nothing about cards, was filling in for the owner. The Ryan card was marked “1200”, so Bryan asked Kathleen if this meant 12 dollars. She said yes, and sold it to him for that amount. When Ball-Mart’s owner realized the mix-up, he sued to rescind the contract. Who wins? Answer: Ball-Mart will win. This was a cause of unilateral mistake on the part of Kathleen, which Bryan knew about and took advantage of, to add to his collection. Bryan knew the true value of the card.

Suggested Additional Assignments Research: Binding Promise Using the library or the Internet, students should find a current article that raises a dispute about a promise. Typically, someone made a statement that another person or company relied on, but the speaker now declares the “promise” was never meant to be binding. These issues are common in political disputes, entertainment industry contracts, commercial sales negotiations, labor negotiations, employment arguments, and many other cases. Students should be prepared to summarize the dispute and analyze it, declaring whether the promise is binding.

Chapter 12 – Performance of a Contract* Chapter Overview Chapter Theme A moment's caution should enable contracting parties to anticipate and realistically appraise any rights and responsibilities of third parties. Parties to a contract generally have the power to assign their contract rights and delegate their contract duties, with some limitations.

12-1 Third Party Beneficiaries Third party beneficiary: Someone who is not a party to a contract but stands to benefit from it. The two parties who make a contract always intend to gain some benefit for themselves. Often, though, their bargain will also benefit someone else. A third-party beneficiary is someone who was not a party to the contract but stands to benefit from it. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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12-1a Types of Beneficiaries Promisor: Makes the promise that a third party seeks to enforce. Promisee: The contract party to whom a promise is made. Creditor beneficiary: When the contracting party intended the benefit in fulfillment of some duty or debt, the beneficiary is a creditor beneficiary. Donee-beneficiary: When the contracting party intended the benefit as a gift, the beneficiary is a donee beneficiary. Incidental beneficiary: A party who benefits from the contract, although the contract was not designed for their benefit. In the following case, an unlikely plaintiff sues for breach of a state contract. Was the prison inmate an intended beneficiary or was his argument just smoke and mirrors? Who was entitled to sue?

Rathke v. Corrections Corporation of America, Inc., 153 P.3d 303, Supreme Court of Alaska, 2007

Facts: The state of Alaska entered into a contract with Corrections Corporation of America (CCA), a private company, to house Alaska’s inmates in CCA prisons located in Arizona. The contract required CCA to abide by Alaska’s standards and disciplinary procedures.

Gus Rathke was an Alaska inmate at a CCA prison located in Arizona. A routine drug test revealed marijuana in his system. Rathke’s level of marijuana was within the limit allowed by the Alaska’s law, but exceeded Arizona’s limit. CCA applied the more stringent Arizona standard. As a result, Rathke spent thirty days in punitive segregation and lost his prison job. Rathke sued CCA, claiming that he was an intended third party beneficiary of the contract between Alaska and CCA. The trial court disagreed. Rathke appealed to Alaska’s Supreme Court. Issue: Was Rathke an intended beneficiary of the contract between the state of Alaska and CCA?] Decision: Yes, the prisoner was the intended beneficiary of the prison contract. Reasoning: To determine if Rathke was an intended beneficiary, we must look to the state of Alaska’s intention in entering the prison contract: Did the state intend to give its prisoners the benefit of CCA’s performance? The answer is yes. Alaska owes legal duties to its prisoners. When it contracted with CCA, it was acquiring services that it otherwise would have performed itself: housing inmates. The contract required CCA to step into the state’s role, keeping prisons and safeguarding prisoners’ rights according to Alaska standards. The services were rendered directly to the prisoners, so it is clear that the contract was for their benefit. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The Alaska/CCA contract is explicit: CCA must apply the standards of Alaska law to Alaska prisoners. When CCA applied Arizona law to discipline Rathke, it breached the contract. Since Rathke is an intended third party beneficiary, he has the right to sue CCA for breach. Question: Who is the intended beneficiary in this case? Answer: Rathke. Question: What is the definition of a third-party beneficiary? Answer: Someone who was not a party to the contract but stands to benefit from it.

12-2 Assignment and Delegation Assignment: Transferring contract rights. Delegation: Transferring contract duties. After a contract is made, one or both parties may wish to substitute someone else for themselves. A contracting party may transfer his rights under a contract, which is called an assignment of rights. Or a party may transfer her obligations under the contract, which is a delegation of duties.

12-2a Assignment Assignor: The person making an assignment. Assignee: The person receiving an assignment. Obligor: The party obligated to do something.

What rights are assignable? Any contractual right may be assigned unless the assignment:  Would substantially change the obligor’s rights or duties under the contract;  Is forbidden by law or public policy; or  Is validly precluded by the contract itself.

Substantial Change Personal services: Any service that must be performed by the promisor. An assignment is prohibited if it would substantially change the obligor’s situation. An assignment is also prohibited when the obligor is agreeing to perform personal services; the close working relationship in such agreements makes it unfair to expect the obligor to work with a stranger.

Public Policy Some assignments are prohibited by public policy.

Contract Prohibition One of the contracting parties may try to prohibit assignment in the agreement itself. One example is the typical apartment lease, which prohibits subletting without the landlord’s approval.

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Bonus Case: Tenet Healthsystem Surgical, LLC v. Jefferson Parish Hospital Service District No. 146 Facts: MSC owned a shopping center and leased space to Tenet for use as an outpatient surgery and general medical practice. According to the lease, Tenet could assign with the consent of the lessor, and said consent would not be unreasonably withheld. MSC sold the shopping center to West Jefferson, and a few months later Tenet went out of business. Tenet requested permission from West Jefferson to assign the lease to Pelican medical, which intended to use the space for an occupational medical clinic. West Jefferson denied permission claiming Pelican would be performing work not permitted under the original lease and that Pelican’s proposed uses would compete with West Jefferson’s adjacent hospital. Tenet sued claiming West Jefferson unreasonably withheld consent to assign the lease. The trial court gave summary judgment to West Jefferson and Tenet appealed. Issue: Did West Jefferson unreasonably withhold permission to assign the lease? Holding: Yes, reversed and remanded. According to the court, Tenet used the facility for an outpatient surgery center. Pelican planned to use the facility for an occupational medical clinic, including services such as physical exams, drug screenings, low acuity emergencies, and also treat patients for depression, lacerations, broken bones and pneumonia. These uses fit within the limits of a “general medical and physicians offices, including related uses” as permitted under the lease. West Jefferson also opposed the assignment because it claimed Pelican’s proposed uses would compete with West Jefferson’s adjacent hospital. According to the court, only factors that relate to the landlord’s interest in preserving the leased property or in having the terms of the lease performed should be considered, such as the financial responsibility of the proposed subtenant, or the suitability of the proposed use of the property by the subtenant. “A landlord’s personal taste or convenience is not properly considered.” Any objection to the assignment must relate to ownership and operation of the premises, not the landlord’s general economic interest. Here, West Jefferson’s refusal to consent to the assignment based on Pelican’s increased competition relates to West Jefferson’s general economic interest rather than the ownership or operation of the facility. Thus, West Jefferson’s refusal to consent is wholly personal and does not relate to an objective evaluation of Pelican as a tenant. Moreover, if West Jefferson were allowed to deny consent in this manner, it would expand West Jefferson’s rights under the lease in such a way never agreed to by the parties to the lease. Thus West Jefferson’s’ refusal to grant Tenet consent to assign the lease based on increased competition from Pelican was unreasonable. Question: Why did Tenet want to assign their lease to pelican? Answer: Because the Tenet facility went out of business and they could presumably no longer make their rent payments. Question: If that is the case, why would West Jefferson deny the assignment to Pelican?

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Answer: West Jefferson thought Pelican would use the space for more than that allowed in the lease, and because the proposed use of the space by Pelican would compete with West Jefferson’s adjacent hospital. Question: Isn’t it reasonable for West Jefferson to not want to increase competition with its hospital? Answer: Probably, but that is not the standard for evaluating whether withholding consent to assign a lease is reasonable. According to the court, West Jefferson can only consider whether Pelican would be a financially responsible subtenant and the nature of the proposed use by Pelican. Question: Isn’t that what West Jefferson did? The proposed use of the facility by Pelican would compete with its adjacent hospital? Answer: Potentially, but according to the court the problem with that argument is that the proposed use of the facility by Pelican fits within the permitted uses in the existing lease, which West Jefferson agreed to honor when it bought the property from MSC.

How Rights are Assigned An assignment may be written or oral, and no particular formalities are required. However, when someone wants to assign rights governed by the Statute of Frauds, she must do it in writing.

Rights of the Parties After Assignment Once the assignment is made and the obligor notified, the assignee may enforce her contractual rights against the obligor. The obligor may generally raise all defenses against the assignee that she could have raised against the assignor.

12-2b Delegation of Duties Delegator: A person who gives his obligation under a contract to someone else. Delegatee: A person who receives an obligation under a contract from someone else. Obligee: The person who has an obligation coming to her. Most duties are delegable. But delegation does not by itself relieve the delegator of his own liability to perform the contract.

What Duties are Delegable? An obligor may delegate his duties unless: 1. delegation would violate public policy, or 2. the original contract prohibits delegation, or 3. the obligee has a substantial interest in personal performance by the obligor. Public Policy – Delegation may violate public policy. Contract Prohibition – It is very common for a contract to prohibit delegation. Substantial interest in Personal Performance – There is no single test that will perfectly define this group, but generally, when the work will test the character, skill, discretion, and good faith of the obligor, she may not delegate her job.

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Rescind: To terminate a contract by mutual agreement.

12-3a Performance Strict Performance and Substantial Performance Strict Performance. Courts dislike strict performance because it enables one party to benefit without paying and sends the other one home empty-handed. A party is generally not required to render strict performance unless the contract expressly demands it and such a demand is reasonable. Substantial Performance. Courts often rely on the substantial performance doctrine, especially in cases involving services as opposed to those concerning the sale of goods or land. In a contract for services, a party that substantially performs its obligations will generally receive the full contract price, minus the value of any defects. When is a performance substantial? There is no perfect test, but courts look at these issues:  How much benefit has the promisee received?  If it is a construction contract, can the owner use the thing for its intended purpose?  Can the promisee be compensated with money damages for any defects?  Did the promisor act in good faith?

12-3b Good Faith The parties to a contract must carry out their obligations in good faith. The difficulty, of course, is applying this general rule to a wide variety of problems that may arise when people or companies do business.

Rashard Mendenhall v. Hanesbrands,Inc. 856 F.Supp.2d 717, U.S.D.C., Middle Dist., North Carolina (2012) Facts: Football player, Rashard Mendenhall and Hanesbrands (HBI) entered into an endorsement agreement for the promotion of athletic wear. The contract said that HBI could terminate it if Mendenhall did anything to “shock, insult or offend the majority of the consuming public.” After the death of terrorist Osama bin Laden, Mendenhall made the following comments via Twitter: What kind of person celebrates death? It’s amazing how people can HATE a man they never even heard speak. We’ve only heard one side… For those of you who said we want to see Bin Laden burn in hell, I ask how would God feel about your heart? Mendenhall’s tweets got much attention. Some people reacted positively, but others were outraged. The next day, HBI ended Mendenhall’s contract, claiming his tweets offended the public. But HBI’s press release told another story: It announced that it split with Mendenhall because it disagreed with his views. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Mendenhall sued for breach of the implied covenant of good faith and fair dealing. HBI moved for a judgment on the pleadings. Issue: Did HBI violate the implied covenant of good faith and fair dealing? Decision: Because HBI may have acted unreasonably, the motion is denied. Reasoning: The covenant of good faith and fair dealing prohibits parties from acting arbitrarily, irrationally, or unreasonably. At this early stage of litigation, the facts suggest that HBI may have acted unreasonably. HBI told inconsistent stories. It informed Mendenhall it was ending the contract because his tweets offended the majority of the public. But it told the public the rupture was due to HBI’s disagreement with his views. Which one was it? If HBI terminated Mendenhall because he offended people, it would have to prove that a majority of the public did indeed take offense to the tweets - that is the termination standard the contract imposes. If, on the other hand, HBI ended the contract merely because it disagreed with the tweets, that would be an arbitrary or bad faith decision. Question: What is the covenant of good faith and fair dealing? Answer: It is a doctrine implied in all contracts that the parties act in good faith to carry out the terms of the contract fairly. Question: Did HBI breach that covenant? Answer: It’s too early to say. The Court found that a questions of fact existed as to whether or not they did act in good faith and deal fairly, so that the case could not be decided by means of a motion for judgment on the pleadings. Instead, a jury must decide the questions of fact. Question: In terminating its business relationship with Mendenhall, HBI relied on its termination rights pursuant to section 17(a) of its contract with him. Why didn’t that work? Answer: That clause authorized dismissal in the case in which Mendenhall was arrested or committed a crime, or which tended to bring him into public disrepute, contempt, scandal, or ridicule, or tending to shock, insult or offend the majority of the consuming public. Question: But isn’t that what happened? The public reaction to Mendenhall’s tweets was bad, wasn’t it? Answer: Some of it was, but other reactions, as the Court pointed out, supported his view. That’s why the Court found that this case involved questions of fact for the jury.

Bonus Case: Brunswick Hills Racquet Club Inc. v. Route 18 Shopping Ctr. Associates47 Facts: Brunswick Hills Racquet Club (Brunswick) owned a tennis club on property that it leased from Route 18 Shopping Center Associates (Route 18). The lease ran for 25 years, and Brunswick had spent about $1 million in capital improvements. The lease expired, and Brunswick had the option of either buying the property or purchasing a 99-year lease, both on very favorable terms. To exercise its option, Brunswick had to notify Route 18 no later than September 30, and had to pay the option price of

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$150,000. If Brunswick failed to exercise its options, the existing lease automatically renewed as of September 30, for 25 more years, but at more than triple the current rent. Nineteen months before the option deadline, Brunswick’s lawyer wrote to Rosen Associates, the company that managed Route 18, stating that Brunswick intended to exercise the option for a 99-year lease. He requested that the lease be sent well in advance so that he could review it. He did not make the required payment of $150,000. Rosen replied that it had forwarded Spector’s letter to its attorney, who would be in touch. In April, Spector again wrote, asking for a reply from Rosen or its lawyer. Over the next six months, the lawyer continually asked for a copy of the lease, or information, but neither Route 18’s lawyer nor anyone else provided any data. Eventually, the September deadline passed. Route 18’s lawyer notified Brunswick that it could not exercise its option to lease, because it had failed to pay the $150,000 by September 30. Brunswick sued, claiming that Route 18 had breached its duty of good faith and fair dealing. The trial court found that Route 18 had no duty to notify Brunswick of impending deadlines, and gave summary judgment for Route 18. The appellate court affirmed, and Brunswick appealed to the state supreme court. Issue: Did Route 18 breach its duty of good faith and fair dealing? Holding: Judgment for Route 18 reversed. Excerpts from Justice Albin’s Decision: Courts generally should not tinker with a finely drawn and precise contract entered into by experienced business people that regulates their financial affairs. [However,] every party to a contract is bound by a duty of good faith and fair dealing in both the performance and enforcement of the contract. Good faith is a concept that defies precise definition. Good faith conduct is conduct that does not violate community standards of decency, fairness, or reasonableness. The covenant of good faith and fair dealing calls for parties to a contract to refrain from doing anything which will have the effect of destroying or injuring the right of the other party to receive the benefits of the contract. Our review of the undisputed facts of this case leads us to the inescapable conclusion that defendant breached the covenant of good faith and fair dealing. Nineteen months in advance of the option deadline, plaintiff notified defendant in writing of its intent to exercise the option to purchase the 99year lease. Plaintiff mistakenly believed that the purchase price was not due until the time of closing. During a 19-month period, defendant, through its agents, engaged in a pattern of evasion, sidestepping every request by plaintiff to discuss the option and ignoring plaintiff’s repeated written and verbal entreaties to move forward on closing the 99-year lease despite the impending option deadline and obvious potential harm to plaintiff. Defendant never requested the purchase price of the lease. Indeed, as defendant’s attorney candidly admitted at oral argument, defendant did not want the purchase price because the successful exercise of the option was not in defendant’s economic interest.

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Ordinarily, we are content to let experienced commercial parties fend for themselves and do not seek to introduce intolerable uncertainty into a carefully structured contractual relationship by balancing equities. But there are ethical norms that apply even to the harsh and sometimes cutthroat world of commercial transactions. We do not expect a landlord or even an attorney to act as his brother’s keeper in a commercial transaction. We do expect, however, that they will act in good faith and deal fairly with an opposing party. Plaintiff’s repeated letters and telephone calls to defendant concerning the exercise of the option and the closing of the 99-year lease obliged defendant to respond, and to respond truthfully. [Plaintiff is entitled to exercise the 99-year lease.] Question: Brunswick failed to pay the option price of $150,000 when it notified Route 18 of its exercise of the 99-year lease option. Why doesn’t that end the case, in favor of Route 18? Answer: The court states that Brunswick’s failure to pay arose from a mistaken belief. Implicit in this statement is recognition that had Route 18 responded to any of Brunswick’s repeated entreaties for a copy of the lease the mistake would have been discovered and could have been corrected. Question: The definition of good faith is nebulous. What standard does the court apply? Answer: It looks at whether one party destroys or injures the other parties’ ability to receive the benefits of the contract. Question: What does that mean in practical terms? Answer: It means that courts must examine each claim of breach of the covenant of good faith and fair dealing case-by-case, analyzing the basis of the claim against the benefits flowing to the injured party under the contract. Question: It seems in these cases that courts could wind up interfering with legitimate competitive business practices. Answer: That is a valid concern, one that courts recognize. As the court states here, “courts generally should not tinker with a finely drawn and precise contract entered into by experienced business people that regulates their financial affairs.”

12-3c Breach When one party materially breaches a contract, the other party is discharged.

Statute of Limitations Statute of limitations: Limits the time within which an injured party may file suit.

12-3d Impossibility True impossibility means that something has happened making it utterly impossible to do what the promisor said he would do. True impossibility is generally limited to these three causes: 1. destruction of subject matter, 2. death of the promisor in a personal services contract, and 3. illegality. It is rare for contract performance to be truly impossible, but common for it to become a financial burden to one party.

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12-4 Remedies Interest: A legal right in something. There are four principal contract interests a court may seek to protect: • Expectation interest. This interest is what the injured party reasonably thought she would get from the contract. The goal is to put her in the position she would have been in if both parties had fully performed their obligations. • Reliance interest. Even if the injured party has not shown an expectation interest, he can still recover damages if he proves that he spent money in reliance on the agreement and that, in fairness, he should receive compensation. • Restitution interest. The injured party may be unable to show an expectation interest or reliance. But perhaps she has conferred a benefit on the other party. Here, the objective is to restore to the injured party the benefit she has provided. • Equitable interest. In some cases, money damages will not suffice to help the injured party. Something more is needed, such as an order to transfer property to the injured party (specific performance) or an order forcing one party to stop doing something (an injunction).

12-4a Expectation Interest This is the most common remedy. The expectation interest is designed to put the injured party in the position she would have been in had both sides fully performed their obligations. Law students have for generations studied the following landmark case, which students may find interesting.

Landmark Case: Hawkins v. McGee48 Facts: Hawkins suffered a severe electrical burn on the palm of his right hand. After years of living with disfiguring scars, he went to visit Dr. McGee, who was well-known for his early attempts at skin grafting surgery. The doctor told Hawkins “I will guarantee to make the hand a hundred per cent perfect.” Hawkins hired him to perform the operation. McGee cut a patch of healthy skin from Hawkins’ chest and grafted it over the scar tissue on Hawkins’ palm. Unfortunately, the chest hair on the skin graft was very thick, and it continued to grow after the surgery. The operation resulted in a hairy palm for Hawkins. Feeling rather…embarrassed…Hawkins sued Dr. McGee. The trial court judge instructed the jury to calculate damages in this way: “If you find the plaintiff entitled to anything, he is entitled to recover for what pain and suffering he has been made to endure and what injury he has sustained over and above the injury that he had before.” The jury awarded Hawkins $3000, but the court reduced the award to $500. Dissatisfied, Hawkins appealed. Issue: How should Hawkins’ damages be calculated? 48

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Decision: Hawkins should receive the difference between the benefit the contract promised and the benefit he actually received. Reasoning: The lower court’s jury instructions were improper. Damages in contract cases are designed to give the plaintiff the benefit he would have received if the contract had been properly performed. Pain and suffering are not relevant. Almost any surgery involves some pain and suffering, but the benefits conferred can outweigh such harm. McGee could have performed his obligations perfectly and still caused Hawkins pain. The correct determination of damages is related instead to the difference in value of the “100 percent perfect” hand Hawkins was promised and the hand as it was after the actual procedure. Remanded for a new trial to calculate what these damages are. Question: What does the holding by the New Hampshire Supreme Court mean? Answer: The New Hampshire Supreme Court restated the rule for damages in a contract breach action - the measure of damages is the difference between the value of the contract as carried out and the value of the contract as broken.

Side Note: this case is also known for its reference in the book and movie The Paper Chase. Due to the basic case facts, it is commonly called to as the “hairy hand” case.

Compensatory damages: Are those that flow directly from the contract. Incidental damages: Are the relatively minor costs that the injured party suffers when responding to the breach.

Direct Damages Direct damages are those that flow directly from the contract. They are the most common monetary award for the expectation interest.

Consequential Damages Consequential damages: Damages that result from the unique circumstances of the plaintiff. Also known as special damages. The injured party may recover consequential damages only if the breaching party should have foreseen them when the two sides formed the contract. In the following case, the plaintiff lost not only profits, but their entire business. Can they recover for harm that is so extensive? You decide:

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You Be the Judge: Bi-Economy Market, Inc. v. Harleysville Ins. Co. of New York.

Facts: Bi-Economy Market, a family-owned meat market, was insured by Harleysville Insurance. The “Deluxe Business Owner’s” policy provided replacement cost for damage to buildings and inventory. Coverage also included “business interruption insurance” for one year, meaning the loss of pre-tax profits plus normal operating expenses, including payroll. A fire destroyed the Market’s building and its inventory. The Market immediately filed a claim with Harleysville, but the insurer responded slowly. Harleysville eventually offered a settlement of $163,000, and a year later an arbitrator awarded the market $407,000. During that year, Harleysville paid for 7 months of lost income, but refused to pay more. The Market never recovered or re-opened. Bi-Economy sued claiming that Harleysville’s slow, inadequate payments destroyed the company and also sought consequential damages for the permanent destruction of its business. Harleysville claimed that it was only responsible for damages specified in the contract: the building, inventory, and payroll. The trial court gave summary judgment for Harleysville. The appellate court affirmed holding that when they entered into the contract, the parties did not contemplate damages for termination of the business. Bi-Economy appealed to the state’s highest court. You Be the Judge: business?

Is Bi-Economy entitled to consequential damages for the destruction of its

Argument for Bi-Economy: Bi-Economy is a small, family business. We paid for business interruption insurance for an obvious reason; In the event of a disaster, we lacked the resources to keep going while buildings were constructed and inventory purchased. We knew that in such a calamity, we would need prompt reimbursement – compensation covering the immediate damage and our ongoing lost income. Why else would we pay the premium? At the time we entered into the contract, Harleysville could easily foresee that if it responded slowly, with insufficient payments, we could not survive. They knew that is what we wanted to avoid – and it is just what happened. The insurer’s bad faith offer of a low figure, and its payment of only seven months’ lost income, ruined a fine family business. When the insurance company agreed to business interruption coverage, it was declaring that it would act fast and fairly to sustain a small firm in crisis. The insurer should now pay for the full harm it has wrought. Argument for Harleysville: We contracted to insure the Market for three losses: its building, inventory, an lost income. After the fire, we performed a reasonable, careful evaluation and made an offer we considered fair. An arbitrator later awarded Bi-Economy additional money, which we paid. However, it is absurd to suggest that in addition to that, we are liable for an open-ended commitment for permanent destruction of the business. Consequential damages are appropriate in cases where a plaintiff suffers a loss that was not covered in the contract. In this case, though, the parties bargained over exactly what Harleysville would pay in the event of a major fire. If the insurer has underpaid for lost income, let the court award a fair sum. 49

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However, the parties never contemplated an additional, enormous payment for cessation of the business. There is almost no limit as to what that obligation could be. If Bi-Economy was concerned that a fire might put the company permanently out of business, it should have said so at the time of negotiating for insurance. The premium would have been dramatically higher. Neither Bi-Economy nor Harleysville ever imagined such an open-ended insurance obligation, and the insurer should not pay an extra cent. Holding: Yes, judgment for Harleysville reversed. To determine whether consequential damages were reasonably contemplated by the parties, courts must look at the nature and purpose of the contract between the parties, and what liability the parties reasonable expected Harleysville to take on in the event of a loss. Here, according to the court, the purpose of business interruption coverage was to ensure that Bi-Economy had the financial support necessary to sustain its business in the event disaster occurred. Thus, the very purpose of business interruption coverage would have made Harleysville aware that if it breached its obligations under the contract to investigate in good faith and pay covered claims it would have to pay damages to Bi-Economy for the loss of its business as a result of the breach. Implicit in the insurance contract was an obligation on Harleysville to honestly and promptly evaluate the claim. Harleysville knew that failure to do this would defeat the very purpose of the insurance contract, and would cause more damage to Bi-Economy. When an insured, like Bi-Economy, suffers additional damages as a result of an insurer’s excessive delay or improper denial, the insurance company should be liable for these damages. This is not to punish the insurer, but to give the insured its bargained-for-benefit. Harleysville argued that consequential damages were only appropriate where an insured suffered a loss that was not in the contract. However, according to the court, consequential damages are not “losses” bargained for by the parties. Consequential damages are in addition to the losses caused by a calamitous event, and include those additional damages caused by an insurance company’s failure to timely investigate, adjust and pay the claim. Therefore, the court the court found that Bi-Economy’s claim for consequential damages including the demise of its business, was reasonably foreseeable and contemplated by the parties, and thus cannot be dismissed. Question: What are consequential damages? Answer: Consequential damages are damages that result from the unique circumstances of this particular party. Question: What were the unique circumstances of Bi-Economy? Answer: That it could not stay in business in the event of a disaster if there was a long delay in the investigation or a denial of its claim. Question: Wasn’t the unique circumstance that it went out of business? Answer: No, and that was what Harleysville tried to tell the court: Bi-Economy went out of business, that is not covered by business interruption insurance. What Bi-Economy was saying was that it went out of business because Harleysville unfairly delayed the investigation and unfairly failed to pay its entire claim. The court agreed with Bi-Economy. Question: What point was the court trying make by explaining the difference between a loss and damages? Answer: What the court was saying was a loss was something contemplated by the parties when they made the insurance contract, and thus was something both sides bargained for. Damages, on the other hand, result from a loss, and are in addition to a loss. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Why is Harleysville liable for Bi-Economy going out of business? Answer: Because, according to the court, it was reasonably foreseeable to Harleysville that if there was a delay in the investigation or if they did not fairly pay Bi-Economy’s claim, Bi-Economy would go out of business. This was foreseeable because the point of business interruption insurance is to pay business expenses during the time of a calamity. Thus Harleysville knew that Bi-Economy did not have the funds to pay the expenses, and therefore could go out of business if Harleysville did not pay the claim promptly.

Incidental Damages Incidental damages: Are the relatively minor costs that the injured party suffers when responding to the breach.

12-4b Reliance Interest The reliance interest is designed to put the injured party in the position he would have been in had the parties never entered into a contract.

12-4d Restitution Interest Rescission: The undoing of a contract, which puts both parties in the position they were in when they made the agreement.

12-4d Other Equitable Interests Specific Performance: Compels parties to perform the contract they agreed to when the contr4act concerns the sale of land or some other unique asset. A court will award specific performance, ordering the parties to perform the contract, only in cases involving the sale of land or some other asset that is unique.

Injunction Injunction: A court order to do something or to refrain from doing something.

12-4e Mitigation of Damages Mitigate: To keep damages as low as possible. A party injured by a breach of contract may not recover for damages that he could have avoided with reasonable efforts.

Chapter Conclusion A moment’s caution! Often that is the only thing needed to avoid years of litigation. Yes, the broad powers of a court may enable it to compensate an injured party, but problems of proof and the uncertainty of remedies demonstrate that the best solution is a carefully drafted contract and socially responsible behavior.

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Matching Questions Match the following terms with their definitions: _____A. Material 1. A type of breach that substantially harms the innocent party _____B. Intended beneficiary 2. When a party has no more obligations under a contract _____C. Discharged 3. Damages that can be recovered only if the breaching party should have foreseen them _____D. Consequential 4. A third party who should be able to enforce a contract between two others Answers: W. 1 X. 4 Y. 2 Z. 3

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 55. T F Contract dates and deadlines are strictly enforceable unless the parties agree otherwise. 56. T F Where one party has clearly breached, the injured party must mitigate damages. 57. T F Courts award the expectation interest more often than any other remedy. 58. T F A party who delegates duties remains liable for contract performance.

Multiple Choice Questions 1.

Bob, a mechanic, claims that Cathy owes him $1,500 on a repair job. Bob wants to assign his claim to Hardknuckle Bank. The likeliest reason that Bob wants to do this is A. Cathy also owes Hardknuckle Bank money. B. Hardknuckle Bank owes Bob money on a consumer claim. C. Hardknuckle Bank owes Bob money on a repair job. D. Bob owes Hardknuckle Bank money. E. Bob and Cathy are close friends. Answer: D.

The agreement between Bob and Cathy says nothing about assignment. May Bob assign his claim to Hardknuckle? A. Bob may assign his claim but only with Cathy’s agreement. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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B. Bob may assign his claim, but only if Cathy and Hardknuckle agree. C. Bob may assign his claim without Cathy’s agreement. D. Bob may assign his claim but Cathy may nullify the assignment. E. Bob may not assign his claim because it violates public policy. Answer: C. 3.

Jody is obligated under a contract to deliver 100,000 plastic bottles to a spring water company. Jody’s supplier has just gone bankrupt; any other suppliers will charge her more than she expected to pay. This is A. Consequential damages B. Impossibility C. Expectation interest D. Substantial performance E. Legally irrelevant Answer: E.

An example of true impossibility is A. Strict performance B. Failure of condition C. Illegality D. Material breach Answer: C.

Museum schedules a major fundraising dinner, devoted to a famous Botticelli picture, for September 15. Museum then hires Sue Ellen to restore the picture, her work to be done no later than September 14. Sue Ellen is late with the restoration, forcing the Museum to cancel the dinner and lose at least $500,000 in donations. Sue Ellen delivers the picture, in excellent condition, two weeks late. Museum sues. A. Museum will win. B. Museum will win if, when the parties made the deal, Sue Ellen knew the importance of the date. C. Museum will win provided that it was Sue Ellen’s fault she was late. D. Museum will win provided that it was not Sue Ellen’s fault she was late. E. Museum will lose.

Answer: B. 6.

Tara is building an artificial beach at her lakefront resort. She agrees in writing to buy 1,000 tons of sand from Frank for $20 per ton, with delivery on June 1, at her resort. Frank fails to deliver any sand, and Tara is forced to go elsewhere. She buys 1,000 tons from Maureen at $25 per ton, and © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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then is forced to pay Walter $5,000 to haul the sand to her resort. Tara sues Frank. Tara will recover A. Nothing B. $5,000 C. $10,000 D. $15,000 E. $30,000 Answer: C.

Case Questions 1. Nationwide Discount Furniture hired Rampart Security to install an alarm in its warehouse. A fire would set off an alarm in Rampart’s office, and the security company was then supposed to notify Nationwide immediately. A fire did break out, but Rampart allegedly failed to notify Nationwide, causing the fire to spread next door and damage a building owned by Gasket Materials Corp. Gasket sued Rampart for breach of contract, and Rampart moved for summary judgment. Comment. Answer: Rampart's motion was allowed. Gasket was merely an incidental beneficiary of the Rampart-Nationwide contract. Neither party intended to benefit Gasket, and Gasket thus had no right to enforce the contract. Orion Group v. Nationwide Discount Sleep Center, 1990 U.S. Dist. LEXIS 10197 (E.D. Pa. 1990). 2. In response to the subprime mortgage crisis, the federal government created the Home Affordable Modification Program (HAMP) to help struggling homeowners refinance their mortgage debt, thereby reducing the foreclosure rate. HAMP facilitates contracts between the U.S. Treasury and mortgage lenders, who modify eligible homeowners’ mortgage loans in return for incentive payments. The Mackenzies applied for a HAMP modification of their home. Although they were eligible, Flagstar bank foreclosed on their Massachusetts home. The Mackenzies sued Flagstar for breach of contract, claiming they were intended third-party beneficiaries of the lender’s contract with the government. Will the Mackenzies succeed on this theory? Answer: Answers will vary. 3. Evans built a house for Sandra Dyer, but the house had some problems. The garage ceiling was too low. Load-bearing beams in the “great room” cracked and appeared to be steadily weakening. The patio did not drain properly. Pipes froze. Evans wanted the money promised for the job, but Dyer refused to pay. Comment. Answer: This case creates an issue of substantial performance. The court held that the low garage ceiling was a minor problem and would not defeat substantial performance. But the cracked beams were very serious and might require major reconstruction. The water collecting in the patio could seep under the house and destroy the foundation. The freezing pipes posed a danger of bursting. The contractor had failed to substantially perform and was not entitled to his contract price. He was © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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owed only the value of work completed, if any. Evans & Associates v. Dyer, 246 Ill. App. 3d 231, 615 N.E.2d 770, 1993 Ill. App. LEXIS 826 (Ill. App. Ct. 1993). 4. Brunswick owned a tennis club on property that it leased from Route 18. Upon expiration of its 25year lease, Brunswick had the option of either buying the property or purchasing a 99-year lease, both on very favorable terms. To exercise its option, Brunswick had to notify Route 18 no later than September 30 and had to pay the option price of $150,000. If Brunswick failed to exercise its options, the existing lease automatically renewed for 25 more years at more than triple the current rent. Over a year before the deadline, Brunswick informed Route 18 that it intended to exercise the option for a 99-year lease and asked to review the new lease. Route 18 responded with delays and did not provide a new lease, despite repeated pleas. After the September deadline passed, Route 18 notified Brunswick that it was too late to exercise the option because it did not pay the $150,000 on time. Brunswick sued, claiming that Route 18 had breached its duty of good faith and fair dealing. What result? Answer: Judgment for Route 18 reversed. Every party to a contract is bound by a duty of good faith and fair dealing in both the performance and enforcement of the contract. Good faith conduct is conduct that does not violate community standards of decency, fairness, or reasonableness. The covenant of good faith and fair dealing calls for parties to a contract to refrain from doing anything which will have the effect of destroying or injuring the right of the other party to receive the benefits of the contract. Plaintiff’s repeated letters and telephone calls to defendant concerning the exercise of the option ant eh closing of the 99-year lease obliged defendant to respond, and to respond truthfully. Plaintiff is entitled to exercise the 99-year lease. Brunswick Hills Racquet Club, Inc. v. Route 18 Shopping Center Associates, 182 NJ 210, 864 A.2d 387, Supreme Court of new Jersey, 2005. 5. The Madariagas owned a restaurant where they served “Albert’s Famous Mexican Hot Sauce.” They entered into a contract to sell the restaurant and the formula for the secret sauce to Morris. Although Morris paid the agreed-upon price, the sellers refused to give him the recipe unless he also paid them lifetime royalties for the sales. Which of these remedies should Morris seek; expectation, restitution, specific performance or reformation? Why? Answer: Morris should seek specific performance, and compel the Madariagas to give him the recipe, as was set forth in their contract. Madariaga v. Morris, 639 S.W.2d 709 (1982).

Discussion Questions 1. A manufacturer delivers a new tractor to Farmer Ted on the first day of the harvest season. But the tractor will not start. It takes two weeks for the right parts to be delivered and installed. The repair bill comes to $1,000. During the two weeks, some acres of Farmer Ted’s crops die. He argues in court that his lost profit on those two acres is $60,000. The jury awards the full $1,000 for the tractor repairs, and $60,000 for the lost crops. Identify the two types of awards. Is it fair that Farmer Ted received 60 times the value of the repair bill for his lost crops? Answer: Farmer Ted received compensatory damages of $1,000 for the repair bill, and consequential damages of $60,000 for his lost profits. Because the tractor was ordered for harvest time, the defendant should certainly have foreseen the potential consequential damages. Although © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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answers may vary as to whether Farmer Ted’s recovery is “fair,” it is the only remedy that will make Farmer Ted whole again. 2. If a person promises to give you a gift, there is usually no consideration. The person can change his mind and decide not to give you the present, and there is nothing you can do about it. But if a person makes a contract with someone else and intends that you will receive a gift under the agreement, you are a donee beneficiary and you do have rights to enforce the deal. Are these rules unacceptably inconsistent? If so, which rule should change? Answer: Answers will vary. 3. The death of a promisor in a personal services contract discharges an agreement. But if a promisor dies, other kinds of contracts live on. Is this sensible? Would it be better to discharge all kinds of agreements if one of the parties passes away? Answer: Answers will vary. 4. PepsiCo entered into a contract to sell its corporate jet to Klein for $4.6 million. Before the deal closed, the plane was sent to pick up PepsiCo’s chairman of the board, who was stranded at Dulles airport. The chairman then decided that the company should not part with the plane. Klein sued PepsiCo for specific performance, arguing that he could not find a similar jet on the market for that price. Should a court force PepsiCo to sell its plane? Answer: Based on Klein v. PepsiCo 845 F.2d 76 (4th Cir. 1988). The court said that specific performance cannot be granted where damages are recoverable and adequate. The fact that there was no other plane on the market in that price range was not enough to say it was “unique” for purposes of equitable relief. 5. ETHICS: The National Football League (NFL) owns the copyright to the broadcasts of its games. It licenses local television stations to telecast certain games and maintains a “blackout rule,” which prohibits stations from broadcasting home games that are not sold-out 72 hours before the game starts. Certain home games of the Cleveland team were not sold out, and the NFL blocked local broadcast. But several bars in the Cleveland area were able to pick up the game’s signal by using special antennas. The NFL wanted the bars to stop showing the games. What did it do? Was it unethical of the bars to broadcast the games that they were able to pick up? Apart from the NFL’s legal rights, do you think it had the moral right to stop the bars from broadcasting the games? Answer: It sued and obtained an injunction, based on a violation of the NFL’s copyright in the broadcasts. The permanent injunction prohibited the bars from showing any blacked-out games without written permission. NFL v. Rondor, Inc., 840 F. Supp. 1160 (N.D. Ohio 1993).

Suggested Additional Assignments Drafting Exercise: Avoiding Third-Party Claims This hypothetical is based on a real suit between sports fans from the University of Wisconsin and the University of California at Los Angeles (UCLA). The students represent UCLA. This year's UCLA Bruins football team is on the verge of winning the PAC10 title, which will guarantee the team a trip to the Rose Bowl, one of the most prestigious of post-season contests. By coincidence, representatives of the © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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PAC10 are renegotiating a contract with the Big Ten, the other conference that sends a team to the Rose Bowl. The existing contract requires the school that represents the PAC10 in the game to supply to that year's Big Ten school 4,000 tickets to the game, for use by fans, alumni, and so on. Demand for this year's tickets is already huge. UCLA is not sure it can supply the 4,000 tickets and does not want to be sued by disappointed Wisconsin fans. The danger is that Badger supporters might book trips to California relying on the guaranteed 4,000 tickets, discover that they have no game tickets, and sue UCLA as third-party beneficiaries. UCLA has spoken to the PAC10 representative about a change in the contract, but she insists that it is only fair for the PAC10 to do its best to supply the 4,000 tickets to the Big Ten. Students should draft a proposed contract clause that obligates the PAC10 school to supply tickets to the Big Ten school but makes it clear that the contract is not intended to benefit anyone other than the two schools. In other words, the contract should prevent third-party beneficiary claims. Research: Contract Limits on Assignment Students who rent housing should review their leases for language limiting their ability to assign the lease. Do the leases bar assignment outright? Permit it with the landlord’s consent? Can the landlord withhold consent in its sole discretion or must the landlord have a reasonable basis for not consenting to an assignment? They should prepare a short summary of their findings to present to the class. Diagramming a Case Students should diagram the case of Wells Fargo Bank Minnesota v BrooksAmerica Mortgage Corporation on p. 371 of the text. The diagram should look roughly like the one on p. 372, and should identify the two contracting parties, the assignor and assignee; indicate what was assigned; and describe the legal issue that the assignment has caused. The issue is whether Wells Fargo is entitled to its monthly lease payments despite the fact that BrooksAmerica never received financing.

Chapter 13 – Practical Contracts* Chapter Overview Chapter Theme You have been studying the theory of contract law. This chapter is different – its purpose is to demonstrate how that theory operates in practice. We will look at the structure and content of a standard agreement and answer questions such as: Do you need a written agreement? What does all these legal terms mean? Are any important provisions missing? By the end of the chapter, you will have a roadmap for understanding a written contract.50(Note that we do not repeat here what you have learned in prior chapters about the substantive law of contracts.) This chapter has another goal, too: We will look at the relationship between lawyers and their clients and their different roles in creating a contract. First, ask whether you need a written contract. Some cases work out well without a written contract, but there are times when you should definitely sign an agreement: 1. The Statute of Frauds requires it. 2. The deal is crucial to your life or the life of your business. 3. The terms are complex. 50

For further reading on practical contracts, see Scott Burnham, DRAFTING AND ANALYZING CONTRACTS, LexisNexis; Charles M. Fox, WORKING WITH CONTRACTS, Practical Law Institute; George W. Kuney, THE ELEMENTS OF CONTRACT DRAFTING, Thomson/West. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. You do not have an ongoing relationship or trust with the other party.

13-1 Creating a Contract First ask whether you need a written agreement at all. Oral contracts can be successful, but there are time when an agreement should definitely be in writing: 1. The Statute of Frauds requires it. 2. The deal is critical to your life or the life of your business. 3. The terms are complex. 4. You do not have an ongoing r4elationship with the other party.

13-1a The Lawyer Businesspeople sometimes refer to their lawyers as the business prevention department. For this reason, they may be reluctant to ask an attorney to draft a contract for fear of the time and expense that lawyers can inject into the process. And they worry that a lawyer will kill the deal. Part of the problem is that lawyers and clients have very different views of the future. Lawyers and Clients: Business people are optimists; they believe they have negotiated a great deal and everything will go well. Lawyers are trained to be pessimists—they try to foresee and protect against everything that can possibly go wrong. Their primary goal is to protect their clients by avoiding litigation, now and in the future. Lawyers also prefer to negotiate touchy subjects at the beginning of a relationship when everyone is on friendly terms and eager to make a deal, rather than waiting until trouble strikes. One advantage of using lawyers is to conduct these negotiations is that they can serve as the bad guys. Hiring a Lawyer If you do hire a lawyer, be aware of certain warning signs. Although the lawyer’s goal is to protect you, a good attorney should be a dealmaker, not a deal-breaker. She should help you to achieve your goals, and hardly ever say, “You cannot do this.” Instead, she should say, “here are the risks to this approach,” or “Here is another way to accomplish your goal.” Your lawyer’s goal should NOT be to annihilate the other side. In the end, the contract will be more beneficial to all if the parties’ relationship is harmonious. The best deals are those in which success for one means success for all.

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13-1b Who Drafts the Contract? Generally, both sides would prefer to control the pen (prepare the first draft of the contract) because the drafter has the right to choose a structure and wording that best represents his interests. Typically, the party with the most bargaining power prepares the drafts. In the movie contract, Producer’s lawyer was in charge of the first draft. The contract then went to Artist’s lawyer, who added the provisions that mattered to his client.

13-1c Mistakes Remember that one purpose of a contract is to avoid litigation.

Vagueness Vagueness: When a provision in a contract is deliberately left unclear. The parties to a contract deliberately include a provision that is unclear. Why would they do that? It may be that they are not sure what they can get from the other side, or in some cases, even what they really want. So they try to form a contract that leaves their options open. They hope that they can decide later what the provision really meant. However, as the following case illustrates: Vagueness is your enemy.

You Be The Judge: Quake Construction v. American Airlines51 Facts: Jones Brothers Construction was the general contractor on a job to expand American Airlines facilities at O’Hare International Airport. Jones Brothers invited Quake Construction to bid on the employee facilities and automotive maintenance shop (“the project”). After Quake bid, Jones Brothers orally informed Quake that it was awarding Quake the project and would soon forward a contract. Jones Brothers wanted the license numbers of the subcontractors that Quake would be using, but Quake could not furnish those numbers until it had assured its subcontractors that they had the job. Quake did not want to give that assurance until it was certain of its own work. So Jones Brothers sent a letter of intent that stated, among other things: We have elected to award the contract for the subject project to your firm as we discussed on April 15. A contract agreement outlining the detailed terms and conditions is being prepared and will be available for your signature shortly. Your scope of work includes the complete installation of expanded lunchroom, restaurant and locker facilities for American Airlines employees as well as an expansion of American Airlines existing Automotive Maintenance Shop. A sixty (60) calendar day period shall be allowed for the construction of the locker room, lunchroom and restaurant area beginning the week of April 22. The entire project shall be completed by August 15. Subject to negotiated modifications for exterior hollow metal doors and interior ceramic floor tile material as discussed, this notice of award authorizes the work set forth in the [attached] documents at a lump sum price of $1,060,568.00. Jones Brothers Construction Corporation reserves the right to cancel this letter of intent if the parties cannot agree on a fully executed subcontract agreement.

141 Ill. 2d 281, 565 N.E.2d 990, 1990 lll. LEXIS 151 Supreme Court of Illinois, 1990 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The parties never signed a more detailed written contract, and ultimately Jones Brothers hired another company. Quake sued, seeking to recover the money it spent in preparation and its loss of anticipated profit. You Be The Judge: Was the letter of intent a valid contract? Argument for Quake: This letter was a valid contract. It explicitly stated that Jones awarded the contract to Quake. It also said, “This notice of award authorizes the work.” The letter included significant detail about the scope of the contract, including the specific facilities Quake would be working on. Furthermore, the work was to commence approximately 4 to 11 days after the letter was written. This short period of time indicates that the parties intended to be bound by the letter so that work could begin quickly. And, the letter contained a cancellation clause. If it was not a contract, why would anyone need to cancel it? Argument for Jones: This letter was not a contract. It referred several times to the execution of a formal contract by the parties, thus indicating that they did not intend to be bound by the letter. Look at the cancellation clause carefully: It could also be interpreted to mean that the parties did not intend to be bound by any agreement until they entered into a formal contract. Holding: The letter of intent was construed to be a contract to negotiate a formal agreement. The letter of intent was ambiguous as to the parties’ intent to be bound by it. Question: Was the letter of intent ambiguous? Answer: Yes. Although it details and authorizes the work and sets a time table, it also says that a formal contract with more detail was being prepared. Question: What language in the letter of intent suggests the parties have agreed to a contract? Answer: The letter gave detailed instructions about the work, and set deadlines for its beginning and its completion. Question: What language in the letter of intent suggests the parties have NOT agreed to a contract? Answer: The fact that the agreement refers to a future, formal contract with more detail. Question: Do you think the parties expected the work to begin BEFORE the final contract was issued? If so, why? Answer: Yes, since work was to begin only 4-11 days after they discussed the letter of intent.

The true test of whether a vague clause belongs in a contract is this: Would you sign the contract if you knew that the other side’s interpretation might win in court? Ambiguity Ambiguity: When a provision in a contract is unclear by accident. Ambiguity occurs in contracts when the parties think only about what they want a provision to mean, without considering the literal meaning or the other side’s perspective. Any ambiguity is interpreted against the drafter of the contract.

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What is the law of typos? First of all, the law has a fancier word than typo – it is scrivener’s error. (A scrivener is a clerk who copies documents.) In the case of a scrivener’s error, a court will reform a contract if there is clear and convincing evidence that the mistake does not reflect the true intent of the parties.

You Be the Judge: Heritage Technologies v. Phibro Tech52 Facts: Heritage wanted to buy a substance called TBCC from Phibro but, because of uncertainty in the industry, the two companies could not agree on a price for future years. It turned out, though, that the price of TBCC tended to rise and fall with that of copper sulfate, so Heritage proposed that the amount it paid for TBCC would increase an additional $15 per ton for each $0.01 increase in the cost of copper sulfate over $0.38 per pound. Two top officers of Heritage and Phibro met in the Delta Crown Room at LaGuardia Airport to negotiate the purchase contract. At the end of their meeting, the Phibro officer hand wrote a document stating the terms of their deal and agreeing to the Heritage pricing proposal. Negotiations between the two companies continued, leading to some changes and additions to their Crown Room agreement. In a draft prepared by Phibro, the $.01 number was changed to $0.1, that is, from 1¢ to 10¢. In other words, in the original draft, Heritage agreed to a first increase if copper sulfate went above 39¢ per pound, an additional price rise at 40¢, and so on. But in the Phibro draft, Heritage’s first increase would not occur until the price of copper sulfate went to 48¢ a pound, with a second rise at 58¢. In short, the Phibro draft was much more favorable to Heritage than the Heritage proposal had been. At some point during the negotiations, the lawyer for Heritage asked his client if the $ 0.1 figure was accurate. The Heritage officer said that the increase in this amount was meant to be payment for other provisions that favored Phibro. There is no evidence that this statement was true. The contract went through eight drafts and numerous changes but, after the Crown Room meeting, the two sides never again discussed the $0.1 figure. After the execution of the agreement, Heritage discovered a different mistake. When Heritage brought the error to Phibro’s attention, Phibro agreed to make the change even though it was to Phibro’s disadvantage to do so. All was peaceful until the price of copper sulfate went to $ 0.478 per pound. Phibro believed that, because the price was above $.38 per pound, it was entitled to an increased payment. Heritage responded that the increase would not occur until the price went above $.48. Phibro then looked at the agreement and for the first time noticed the $ 0.1 term. Phibro contacted Heritage to say that the $ 0.1 term was a typo and not what the two parties had originally agreed in the Delta Crown Room. Heritage refused to amend the agreement and Phibro filed suit. You Be the Judge: Should the court enforce the contract as written or as the parties agreed in their Crown Room meeting? Which number is correct -- $.10 or $.01?

2008 U.S. Dist. LEXIS 329 United States District Court for the Southern District of Indiana © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Argument for Phibro: In the Delta Crown Room, the two negotiators agreed to a $15 per ton increase in the price of TBCC for each 1¢ increase in copper sulfate price. Then by mistake, the contract said 10¢. After their first meeting, the two parties never even discussed the 10¢ provision, much less agreed to change it. The court should revise this contract to be consistent with the parties’ agreement, which was 1¢. Argument for Heritage: The parties conducted negotiations by sending drafts back and forth, rather than by talking on the phone. Each party was represented by a team of lawyers. Ultimately, the agreement went through eight drafts, and this pricing term was never altered despite several other changes and additions. Moreover, the change in price was in return for other provisions that benefited Philbro. Certainly, there is no clear and convincing evidence that both parties were mistaken about what the document actually said. Ultimately, the parties agreed to 10 cents, and that is what the court should enforce. Holding: the Court finds in favor of the plaintiff, Heritage Technologies, L.L.C. The court declares that the term means a dime, $0.10. Question: Who changed the contract price measure from $0.01 to $0.1? Answer: Phibro-Tech changed the term. Question: Which party received the benefit of that change? Answer: Heritage. Question: Why do you think the court decided for Heritage? Answer: Because the contract went through eight drafts, and both parties were represented by teams of attorneys. Question: Do you agree with the court’s decision? Answer: Answers will vary.

Bonus Case: Minkler v. Safeco Ins. Co. of America, 49 Cal. 4th 315, Supreme Court of California, 2010

Facts: Scott Minkler alleged that when he was a child, his Little League baseball coach, David Schwartz, had molested him. During the period when these terrible events occurred, David was living at the home of his mother, Betty Schwartz, and some of the episodes had taken place at her house. Scott sued Betty, alleging that she had been negligent in supervising events in her own home. Betty had a homeowners’ policy with Safeco Insurance Company, which covered any harm caused by the unintentional acts of the home’s residents, including David. Since David’s acts were intentional, Safeco was not responsible for the claims against him. But Safeco also argued that it was not responsible for claims against Betty because the wrongdoing that had caused the harm (that is, David’s acts) had been intentional. Safeco’s interpretation of this provision was valid © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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under California law. However, her policy had an additional provision that stated, “This insurance applies separately to each insured.” In short, Betty’s policy was ambiguous. Safeco said the policy did not provide coverage if any insured had engaged in intentional wrongdoing while Betty argued that it did cover her if her own actions had been merely negligent. Issue: How should the court interpret ambiguous provisions in a contract? Excerpts from Justice Saxe’s Decision: Our goal in construing insurance contracts, as with contracts generally, is to give effect to the parties’ mutual intentions. If contractual language is clear and explicit, it governs. If the terms are ambiguous i.e., susceptible of more than one reasonable interpretation, we interpret them to protect the objectively reasonable expectations of the insured. Only if these rules do not resolve a claimed ambiguity do we resort to the rule that ambiguities are to be resolved against the insurer. The “tie-breaker” rule of construction against the insurer stems from the recognition that the insurer generally drafted the policy and received premiums to provide the agreed protection. Safeco could easily have removed any uncertainty. Safeco’s intent was not clearly expressed, and the ambiguity must be resolved in a way that preserves the objectively reasonable coverage expectations of the insured seeking coverage. Betty had no reason to expect that David’s residence in her home, and his consequent status as an additional insured on her homeowners policies, would narrow her own coverage, and the protection of her separate assets, against claims arising from his intentional acts, Betty’s coverage must be analyzed on the basis of whether she herself committed an act or acts that fell within the intentional act exclusion. Question: Why is ambiguity interpreted against the drafter? Answer: According to the text: 1) To protect laypeople from the dangers of form contracts that they have little power to change; 2) protect people who are unlikely to be represented by a lawyer; and 3) to encourage those who prepare contracts to do so carefully. Question: How does the court define “ambiguous?” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Susceptible of more than one reasonable interpretation. Question: How must the ambiguity in the contract at issue be resolved? Answer: In a way that preserves the objectively reasonable coverage expectations of the insured seeking coverage. Before signing a contract, read the important terms carefully. Before signing a contract, check carefully and thoughtfully the names of the parties, the dates, dollar amounts and interest rates.

13-2 The Structure of a Contract 13-2a Terms that Vary by Contract Title Contracts have a title, which generally is in capital letters, underlined and centered at the top of the page. The title should be as descriptive as possible.

Introductory Paragraph The introductory paragraph includes the date, the names of the parties and the nature of the contract. It should also include specific language indicating that the parties entered into an agreement. Traditional contracts tended to use archaic words—whereas and heretofore were common. Modern contracts are more straightforward, without so many linguistic flourishes.

Covenants Covenant: A promise in a contract. Now we get to the heart of the contract: What are the parties agreeing to do? Failure to perform these obligations constitutes a breach of the contract and damages will result. A legal term for a promise in a contract is covenant. It is a mistake to assume that everything will work itself out. Breach - To constitute a violation of the contract, the breach must be material. A material breach is important enough to defeat an essential purpose of the contract. Material breach: A violation of a contract that defeats an essential purpose of the agreement. Good Faith: Many of the covenants in a contract provide that the right must be exercised reasonably or the decision must be made in good faith. Reasonable means ordinary or usual under the circumstances. Good faith means an honest effort to meet both the spirit and letter of the contract. A party with sole discretion has the absolute right to make any decision he wants on that issue. There are three standards of behavior: Reasonably: Ordinary or usual under the circumstances. Good faith: An honest effort to meet both the spirit and letter of the contract. Sole discretion: The absolute right to make any decision on an issue. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Bonus Case: Dick Broadcasting Co. v. Oak Ridge FM, Inc., 395 S.W.3d 653, Supreme Court of Tennessee, 2013

Facts: Oak Ridge FM, Inc. and Dick Broadcasting Company (DBC) entered into a contract that gave DBC a right of first refusal to purchase all the assets of Oak Ridge’s radio station WOKI-FM. The agreement also provided that: No party may assign its rights, interests or obligations hereunder without the prior written consent of the other party, and any purported assignment without such consent shall be null and void and of no legal force or effect. When DBC asked permission to assign its rights to Citadel Broadcasting Company, Oak Ridge refused because it wanted to make its own deal directly with Citadel. DBC sued Oak Ridge, alleging that it had breached the contract’s implied covenant of good faith and fair dealing. The trial court dismissed the suit on a motion for summary judgment but the Court of Appeals overturned that decision. The Supreme Court of Tennessee agreed to hear the case. Issues: Is a covenant of good faith and fair dealing implied in this contract? In all contracts? Excerpts from Justice Lee’s Decision: It is well-established that in Tennessee, the common law imposes a duty of good faith in the performance of contracts. These decisions are in accord with section 205 of the Restatement (Second) of Contracts, which provides that “every contract imposes upon each party a duty of good faith and fair dealing in its performance and its enforcement. In some cases, the courts have expressed this principle as allowing the qualifying word reasonable and its equivalent reasonably to be read into every contract. The Defendants argue that the trial court was correct in finding that the Rightof-First-Refusal Agreement was unambiguous and complete and holding that to interpret the contract in accordance with the implied covenant of good faith and fair dealing would be in effect to add a new provision to the contract which the parties were free to add themselves.

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We disagree. The implied covenant of good faith and fair dealing does not create new contractual rights or obligations, it protects the parties’ reasonable expectations as well as their right to receive the benefits of their agreement. To avoid the imposition of the implied covenant of good faith and fair dealing, the parties must explicitly state their intention to do so. This case reflects the standard in Tennessee and in the Restatement (Second) of Contracts. Note, however, that about half the states disagree and do not imply a standard of good faith and fair dealing in contracts. Question: According to the court, what does the implied covenant of good faith and fair dealing protect? Answer: It protects the parties’ reasonable expectations and their right to receive the benefits of their agreement. Question: How is it possible for approximately half the states to disagree with the Court and not imply a standard of good faith and fair dealing in contracts? Answer: Each state has its own common law system. Question: What was Oak Ridge’s argument? Answer: That to interpret the contract in accordance with the implied covenant of good faith and fair dealing would be in effect to add a new provision to the contract that the parties were free to add themselves. Reciprocal Promises and Conditions: A contract may provide a list of what each party promises to do. In this format, each party is responsible for performance whether or not the other party breaches. These provisions are reciprocal promises, which means that they are each enforceable independently. The better approach is for the covenants to be conditional – a party agrees to perform them only if the other side has first done what it promised. Reciprocal promises: Promises that are each enforceable independently. Conditional: Promises that a party agrees to perform only if the other side also does what it promised.

Language of the Covenants: To clarify who exactly is doing what, covenants should use the active, not passive voice. “Producer shall pay artist…” not “artist shall be paid…” Representations and Warranties Representations and warranties: Statements of fact about the past or present.

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Covenants are the promises the parties make about what they will do in the future. Representations and warranties are statements of fact about the past or present; they are true when the contract is signed (or at some other specific, designated time).53

13-2b Boilerplate These standard provisions are typically placed in a section called “Miscellaneous.” These are not boring or irrelevant. It is worth remembering that the word “boilerplate” comes from the iron or steel that protects the hull of a ship -0 something that shipbuilders ignore to the passengers’ peril.

Choice of Law and Forum: Choice of law provisions: Determine which state’s laws will be used to interpret the contract. Choice of forum provisions: Determine the state in which any litigation would take place.

Case: Kedkad v. Microsoft Corporation, Inc.., 2013 U.S. Dist. LEXIS 126346, U.S. Dist. Ct. for Northern Dist. of CA, 2013

Facts: Microsoft Libya hired a Libyan citizen, Mahmoud Kedkad, to work as a Marketing Lead in Tripoli. Kedkad signed a one-year employment agreement (2010 Contract) providing that: This contract is subject to the prevailing labor law applicable in Libya. The Libyan courts shall have jurisdiction to decide any disputes that may arise in the future between the parties involved in this contract. The next year, Kedkad signed another contract (2011 Contract) with the following Article 10: This Contract is subject to the provisions of Libyan Labor law No. 58 and its amendments and all other decisions, decrees, or regulations which have not been specifically mentioned in this contract. During the term of the 2011 Contract, revolution erupted in Libya. Microsoft Libya shut down and evacuated all of its employees, including Kedkad, to the United States. Microsoft then reassigned Kedkad to Dubai, but he told the company he could not go because of the Post-Traumatic Stress Disorder (PTSD) he had acquired from his exposure to horrible violence in Libya. He asked either 53

Although, technically, there is a slight difference between a representation and a warranty, many lawyers confuse the two terms and the distinction is not important. We will treat them as synonyms, as many lawyers do. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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to be assigned to a job in the U.S. or to have his duties modified. Microsoft fired him. Kedkad sued Microsoft in the U.S., alleging that it had violated his contact by firing him and also that it had refused to accommodate his PTSD disability as required by U.S. law. Microsoft filed a motion to dismiss on the grounds that the case should be heard in Libya and under Libyan law. It argued that such a requirement was implied in the 2011 Contract and, furthermore, No. 58 of the Libyan Labor Law required it. However, because No. 58 had been repealed and replaced by Libyan Labor Law No. 12, Microsoft argued that No. 12 also applied and that this statute would also have required the case to be heard in Libya. Issue: Does Kedkad’s contract require that his lawsuit be tried in Libya? Excerpts from Judge Henderson’s Decision: Article 10 of the 2011 Contract does not, by its terms, contain a forum selection clause. This absence of forum selection language is particularly notable because the predecessor 2010 Contract contains both a choice of law provision and a forum selection provision: The Libyan courts shall have jurisdiction to decide any dispute that may arise in the future between the parties involved in this contract. *As for Microsoft’s second argument,+ Article 10 does not reference Law No. 12 at all. By contrast, the 2010 Contract arguably used clear and unequivocal terms to alert Plaintiff that his claims were to be adjudicated in Libyan courts. Rather, Article 10 references Labor Law No. 58, which appears to have been repealed nearly one year before the parties executive the 2011 Contract. Reference to a repealed statute hardly provides clear and unequivocal reference. Alternatively, *Microsoft argues+ Article 10’s catch-all provision could refer to Law No. 12: “This Contract is subject to…all other decisions, decrees or regulations which have not been specifically mentioned in this contract.” *T+he Court finds that the incorporation by reference here to non-enumerated sections of amending legislation to a repealed statute is too attenuated. The Court finds Article 10 does not sufficiently call to Plaintiff’s attention the statutory provision that purportedly act as a forum selection clause contained in either Labor Law No. 58 or Law No. 12. It is similarly unclear to the Court whether Labor Law 12 would have been known or easily available to Plaintiff. The Court finds that Article 10 is amorphous and would not have guided the reader to the purported forum selection clause in Law No. 12. Therefore, the Court declines to find Article 10 incorporates by reference a forum selection clause. Accordingly, the Court DENIES Defendant’s Motion to Dismiss. Question: Why do you think Microsoft made the employment contract with plaintiff subject to Libyan law, and not U.S. law? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Libyan laws almost certain provided less protection to employees than did U.S. law.

Question: According to the court, did Plaintiff’s 2011 contract contain a forum selection clause? Answer: No. No such clause was included. Question: Did Microsoft’s catch=all clause provide a forum selection clause through other Libyan statutes? Answer: No. The court ruled that the connection between the catch-all clause and any forum selection was too attenuated. Question: Why was it important that there be a strong connection between the catch-all clause and a forum selection clause? Answer: So that the Plaintiff would be given notice of what law applied to his contract. Question: Consider that after the revolution, the contract between the parties still referred to the law which no longer existed. Do you think this happens frequently? Answer: Answers will vary. Question: Is there a way to guard against the possibility that a foreign country may suffer a revolution, negating current laws and contracts? Answer: The drafter of the contract might consider incorporating an alternative foreign-selection clause, especially if foreign selection is a major issue. Modification - Contracts should contain a provision governing modification, and should state whether modifications are required to be in writing and signed by the party to be charged. Assignment of Rights and Delegation of Duties: Assignment of rights: A transfer of benefits under a contract to another person. Delegation of Duties: A transfer of obligations under a contract. Arbitration: Some contracts prohibit the parties from suing in court, and require that disputes be settled by an arbitrator. Arbitration has its advantages – flexibility and savings in time and money. It also has downsides. Attorney’s fees: As a general rule, if parties to a contract end up in litigation, they must pay their own legal fees, no matter who is in the wrong. But contracts may override this general rule and provide that the losing party in a dispute pays the attorney’s fees for both sides. Integration:

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During contract negotiations, the parties may discuss many ideas that are not ultimately included in the final version. The point of an integration clause is to prevent either side from later claiming that the two parties had agreed to additional provisions. Severability: If, for whatever reason, some part of the contract turns out to be unenforceable, a severability provision asks the court simply to delete the offending clause and enforce the rest of the contract. Force Majeure: Force majeure event: A disruptive, unexpected occurrence for which neither party is to blame that prevents one or both parties from complying with a contract. Force majeure events typically include war, terrorist attack, fire, flood or general Acts of God. Notices: After a contract is signed, there may be times when the parties want to send each other official notices – of a breach, an objection, or an approval, for example. In this section, the parties list the addresses where these notices can be sent and when the notice is effective. Closing: To indicate that the parties have agreed to the terms of the contract, they must sign it. A simple signature is sufficient, but contracts often contain flourishes. NOTE: one who signs in her own name and not on behalf of the company is personally liable. When a party to the contract is a corporation, the signature lines should read like this: Company Name, Inc. By: ___ Name: Title:

Chapter Conclusion You will sign many contracts in your life. Their length and complexity can be daunting. (In the movie contract, one of the paragraphs is 1,000 words long.) The goal of this chapter is to help you understand the structure and meaning of the most important provisions so that you can negotiate and analyze contracts more effectively.

Matching Questions Match the following terms with their definitions: _____A. Assignment of rights 1. Promises that a party agrees to perform only if the other side has first done what it promised _____B. Delegation of duties 2. Promises that are each enforceable independently _____C. Covenant 3. Statement of fact about the past or present _____D. Reciprocal promise 4. Transfer of obligations under a contract _____E. Conditional promise 5. Promise about what a party will do in the future _____F. Representation 6. Transfer of benefits under a contract © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answers: AA. 6 BB. 4 CC. 5 DD. 2 EE. 1 FF. 3

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 59. T F The same states must be named in the Choice of Law and Choice of Forum provisions. 60. T F For a modification to a contract to be valid, both parties must sign it. 61. T F A severability provision asks the court simply to delete the offending clause and enforce the rest of the contract. 62. T F A force majeure clause indicates who has the authority to write the first draft of the contract. 63. T F Unless the contract provides otherwise, both sides in a contract dispute pay their own legal fees.

Multiple Choice Questions 1. Daniel and Annie signed c contract providing that Daniel would lend $50,000 to Annie’s craft beer business at an interest rate of 8 percent. During negotiations, Daniel and Annie agreed that the interest rate would go down to 5 percent once she had sold 25,000 cases. This provision never made it into the contract. After the contract was signed, Daniel agreed to reduce the interest rate to 6 percent once volume exceeded 15,000 cases. The contract had an integration provision but no modification clause. Annie has sold 30,000 cases. What interest rate must she pay? A. 8 percent B. 6 percent C. 5 percent D. The contract is void because the terms are unclear. Answer: B. 2. A contract states (1) that Buzz Co. legally exists and (2) will provide 2,000 lbs. of wild salmon each week. Which of the following statements is true? A. Clause I is a covenant, and Clause 2 is a representation B. Clause 1 is a representation, and Clause 2 is a covenant. C. Both clauses are representations. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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D. Both clauses are covenants. Answer: B.

The following list provides reasons why a party would strongly consider putting a contract in writing. Which of these reasons is least important? A. The Statute of Frauds requires it. B. The deal is crucial to your life or the life of your business. C. The terms are complex. D. The parties do not have an ongoing relationships. E. The parties reside in different jurisdictions. Answer: E.

4. Michael and Scarlett cannot agree on the price he will pay her to manage his hotels in the third year of their contract. They agree to a provision stating that the price will be “reasonable.” This provision is _____. Parties should never include such a provision in a contract unless _______. A. Ambiguous; they are sure they will be able to reach agreement later B. Vague; they are sure they will be able to reach an agreement later C. Ambiguous; they would not mind if the other side’s interpretation prevails in litigation D. Vague; they would not mind if the other side’s interpretation prevails in litigation Answer: D.

5. Liesl purchased an insurance policy on her house. The policy stated that the insurance company was not liable for any damage to her house caused by vandalism or burglary. An arsonist burned down Lisl’s house. Is the insurance company liable? A. No, because arson is a form of vandalism. B. Yes, because arson is not a form of vandalism. C. Yes, because the language is ambiguous and should be interpreted against the insurance company. D. No, because the language is vague and should be interpreted against Liesl. Answer: C. 6. A contract provided, “On January 5, Purchaser shall provide Seller with a certified check in the amount of $100,000. Seller shall transfer a deed for the Property to Purchaser.” What is wrong with this provision? A. It is not clear who purchaser and seller are. B. The number $100,000 should be written in words. C. The promises are reciprocal. D. The promises are conditional. Answer: C

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Case Questions 1. Give an example of three types of contracts that should definitely be in writing, and one that probably does not need to be. Answer: Should be in writing: The sale of stock, a merger agreement, the sale of land, anything that falls under the statute of frauds. Need not be in writing: an agreement with friends in which not much money is involved – to chip in to buy a present together. It is with someone with whom you have an on-going relationship and who has proved to be trustworthy in the past, and you can afford the loss – a routine supplier. You do not have time to do a proper written contract and you would prefer to bear the risk of loss over the risk of not getting the deal done. 2. List three provisions in a contract that would be material, and three that would not be. Answer: Material: payment, item to be sold or services to be rendered, term of the contract, not material: notices, choice of law, arbitration, attorney’s fees. 3. Blair Co.’s top officers asked an investment bank to find a buyer for the company. The bank sent an engagement letter to Blair with the following language: If, within 24 months after the termination of this agreement, Blair is bought by anyone with whom Bank has had substantial discussions about such a sale, Blair must pay Bank its full fee. Is there any problem with the drafting of this provision? What could be done to clarify the language? Answer: The main problem is that the language about “substantial discussions” is vague or ambiguous, depending on whether or not the bank left the language deliberately unclear. The term “substantial discussions” is not defined. A better measure might be any referral of a potential buyer made by the bank to Blair. Both parties would have records to such occurrences. 4. Marc canceled his Comcast cable service. When the cable guy removed the Comcast equipment, he mistakenly left behind a modem worth $220. By some mix-up, this amount was sent to a collection agency. Upon discovering the error, Marc returned to modem to Comcast, which promised to correct his account. But the mistake remained on Marc’s credit report. Because of the error, Marc had to pay an additional $26,000 when he refinanced his mortgage. Did Comcast violate its duty of good faith? Answer: It certainly seems so. It was Comcast’s three errors, leaving the modem, charging him for it, and referring that “debt” to a credit reporting agency, that led to Marc’s losses. Yet Comcast did nothing to correct its mistakes. 5. Laure’s contract to sell her tortilla chip business to Hudson contained a provision that she must continue to work at the business for five years. One year later, she quit. Hudson refused to pay her the amounts still owing under the contract. Laurie alleged that he is liable for the full amount because her breach was not material. Is Laurie correct? Answer: No. The purpose of the contract was for Hudson to build up the business and make a profit. Laurie’s departure interfered with that goal. The court ruled that the breach was material and Hudson did not have to pay the sums still owing under the contract. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Discussion Questions 1. In the movie contract, which side was the more successful negotiator? Can you think of any terms that either party left out? Are any of the provisions unreasonable? Answer: Answers will vary. 2. In a contract, should sole discretion clauses be enforced if the party with the discretion behaves unreasonably? Should everyone have an obligation to behave reasonably? Answer: Answers will vary. 3. What are the advantages and disadvantages of hiring a lawyer to draft or review a contract? Answer: Advantages: Lawyers understand the law. They can protect you against unexpected events in the future. They can be the “bad guys” in negotiations – you can blame them for playing hardball. Important signal to the other side that you are well-protected. Contracts are more likely to be internally consistent without obvious mistakes. Less likely to make typographical errors. Disadvantages: Lawyers cost time and money. 4. ETHICS Sophia negotiated a contract with Pete under which she would buy his company for $10 million plus the amount of the company’s outstanding debt (approximately $1 million). But when Pete sent a draft of the contract, it stated that the purchase price would be $10 million less the company’s debt. What is Sophia’s ethical obligation to Pete? Should she tell him about the mistake? What Life Principles would you apply in this situation? Answer: Answers will vary. 5. Upon graduation from business school, Zoe has been offered a job as a product manager at a startup, Appsley Co. She would be Employee #18. But first she has to negotiate a contract with the CEO, Phil. He would like to pay her $75,000, which is half of what a product manager at a more established company would earn. However, Appsley has yet to earn a profit and Zoe might also be able to negotiate an equity interest in the company. Do a role-play with another student in your class in which one of you takes the role of Zoe and the other is Phil. What terms should each party consider? What does each side want? Draft the contract. Now compare your results with others in the class. Who has negotiated the best deal? Who has written the best contract? Answer: Answers will vary.

Suggested Additional Assignments Research: Lawyers and Public Opinion Students should conduct an informal survey of friends and associates to gather ideas on public perception of lawyers. They should categorize the comments and evaluate what types of people have a negative opinion of lawyers and what type have a positive opinion.

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Drafting: Contracts Students should draft a simple contract from the perspective of a provider of a service, such as house painting. Students must include specific terms on (1) price, (2) time and place of delivery, (3) method of payment, and (4) warranties. They should then pair with another student who will be the “buyer.” The “buyer” student should try to change the terms to more favorable ones. The “seller” students must do their best to ensure that any resulting contract stays close to the original terms. They should negotiate until they agree.

Chapter 14 – Sales* Chapter Overview Chapter Theme The Uniform Commercial Code enables merchants to form contracts quickly and easily. But along with this increased facility goes greater responsibility, as informal discussions may suddenly turn into a contract.

14-1 Sales 14-1a Development of the UCC In mid-20th century U.S., contract law required a reinvention. Two problems had become apparent: 1. Old contract law principles often did not reflect modern business practices. 2. Laws had become different from one state to another. The UCC was created as an attempt to solve these two problems. It was a proposal written by legal scholars and not a law drafted by members of Congress or state legislatures. All 50 states adopted many parts of the UCC. Article 2 of the UCC governs the sale of goods. Goods: Any movable physical object.

Noah and Nina, Revisited (opening scenario) Both filed suit, Noah for the sale of his land, Nina for the purchase of drones, but only one prevailed Noah’s contract was for the sale of land and governed by the common law of contracts. The common law Statute of Frauds requires any agreement for the sale of land to be in writing, and signed by the defendant (the buyer in Texas). The buyer never signed. Because Nina’s text about the drones involved the sale of goods, it was governed by Article 2 of the UCC. Since Nina and the seller were both merchants, her text could be enforced even against the defendant, who had never signed anything. The fact that Nina left out the price and other significant terms was not fatal to a contract under the UCC. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Merchants Merchant: Someone who routinely deals in the particular goods involved.

14-1b Contract Formation Formation Basics: § 2-204 UCC §2-204 provides three important rules that enable parties to make a contract quickly and informally: 1. Any Manner That Shows Agreement: The parties may make a contract in any manner sufficient to show that they reached an agreement. 2. Moment of Making is Not Critical: The UCC will enforce a deal even though it is difficult, in common law terms, to say exactly when it was formed. 3. One or More Terms May Be Left Open: Under the UCC, a court may enforce a bargain even though one or more terms were left open.

Case: Jannusch v. Naffziger 883 N.E.2d 711, Illinois Court of Appeals, 2008 Facts: Gene and Martha Jannusch owned Festival Foods, which served snacks at events throughout Illinois and Indiana. The business included a truck, servicing trailer, refrigerators, roasters, chairs, and tables. Lindsey and Louann Naffziger orally agreed to buy Festival Foods for $150,000, the deal including all the assets and the opportunity to work at events secured by the Jannuschs. The Naffzigers paid $10,000 immediately, with the balance due when they received their bank loan. They took possession the next day and operated Festival Foods for the remainder of the season. In a pretrial deposition, Louann Naffziger acknowledged orally agreeing the buy the business for $150,000. (Her admission under oath made the lack of a written contract irrelevant.) However, she could not recall making the agreement on any particular date. Gene Jannusch suggested the parties sign something, but the Naffzigers replied that they were “in no position to sign anything” because they had received no loan money from the bank and lacked a lawyer. Lindsey admitted taking possession of Festival Foods, receiving the income from the business, purchasing inventory, replacing equipment, and paying taxes and employees. Two days after the business season ended, they returned Festival Foods to the Jannusches, stating that the income was lower than expected. The Jannusches sued. The trial court ruled that there had been no meeting of the minds and hence no contract. The Jannusches appealed. Issue: Did the parties form a contract?

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Decision: Yes, the parties formed a contract. Reasoning: The Naffzigers argue that nothing was said in the contract about a price for good will, a covenant not to compete, the value of individual assets, release from earlier liens, or the consequences should their loan be denied. Under the UCC, a contract may be enforced even though some contract terms are missing or left to be agreed upon. However, if the essential terms are so uncertain that a court cannot decide whether the agreement has been broken, there is no contract. The essential terms were agreed upon. The purchase price was $150,000, and the parties specified all assets to be transferred. No essential terms remained to be agreed upon. The only action remaining was the performance of the contract, and the Naffzigers took possession and used all items as their own. Louann Naffziger could not recall making the oral agreement on any particular date, but parties may form a binding agreement even though the moment of its making is undetermined. Returning the goods at the end of the season was not a rejection of the Jannusches’ offer to sell; it was a breach of contract. The parties agreed to a sale of Festival Foods for $150,000, and the Naffzigers violated the agreement. Reversed and remanded. Question: Which law applied to the sale of the business – the UCC or common law? Answer: The UCC applied, even though the contract included the sale of an ongoing business, because it was primarily for the sale of goods. Question: Did the court find that a contract had been created? Answer: Yes. The court ruled that the essential terms were agreed upon. Question: Were terms missing from their contract that would ordinarily be in such a contract? If so, what were they? Answer: There was no date the agreement was made, no price for goodwill, no covenant not to compete, no listed value of the individual assets, no release from earlier liens, and nothing in the agreement addressed what would happen if the buyer’s loan did not come through. Question: Did buyers take possession of the goods? Answer: Yes, and they operated the business for the remainder of the season, then returned everything after the season was over. Question: What did they say was their reason for doing so? Answer: That the income was less than expected. Question: Were the parties wise in commending the agreement without lawyers or anything in writing? Answer: Answers will vary.

Bonus Landmark Case: ProCD, Inc. v. Zeidenberg 86F.3d 1447, U.S. Ct. App, 7th Cir. (1996) Facts: ProCD sold SelectPhone, a database containing information from 3,000 telephone directories. It sold the software to consumers for $150; business paid a much higher price. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Every box containing the consumer version of SelectPhone was wrapped in plastic shrinkwrap and prominently featured text notifying buyers that an enclosed license restricted use of the software. After removing the cellophane cover and opening the box, buyers could access the printed license. Upon downloading the product, the consumer could not use the software without first accepting the license posted on the screen. This license prohibited the buyers from using the database commercially. Graduate student Matthew Zeidenberg bought the consumer version of SelectPhone, but violated the license agreement by reselling the database’s information on the internet. ProCD sued Zeidenberg, who argued that the license did not apply to him because he never agreed to it. The district court ruled in his favor. It held that, under the UCC, the license did not bind Zeidenberg because it was on the inside of the shrinkwrapped box Thus, he had not seen it until after the bought the product. ProCD appealed. Issue: Did ProCD and Zeidenberg enter into a contract that included the terms of the license? Excerpts from Judge Easterbrook’s Decision: the district court held that placing the package of software on the shelf is an “offer,” which the customer “accepts” by paying the asking price and leaving the store with the goods. A contract includes only the terms on which the parties have agreed. One cannot agree to hidden terms. So far, so good -0 but one of the terms to which Zeidenberg agreed by purchasing the software is that the transaction was subject to a license. Transactions in which the exchange of money precedes the communication of detailed terms are common. Consider the purchase of an airline ticket. The traveler is quoted a price, reserves a seat, pays, and gets a ticket, in that order. The ticket contains elaborate terms, which the traveler can reject by canceling the reservation. To use the ticket is to accept the terms, even terms that in retrospect are disadvantageous. Consumer goods work the same way. Someone who wants to buy a radio visits a store, pays, and walks out with a box. Inside the box is a leaflet containing some terms, the most important of which usually is the warranty, read for the first time in the comfort of home Drugs come with a list of ingredients on the outside and an elaborate package insert on the inside. The package inse4rt describes drug interactions, contraindications, and other vital information -0 but, if Zeidenberg is right, the purchaser need not read the package insert, because it is not part of the contract. What does the UCC have to say? We think that the place to start is UCC §2-204(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.” A vendor, as master of the offer, may invite acceptance by conduct, and may propose limitations on the kind of conduct that constitutes acceptance. A buyer may accept by performing the acts the vendor proposes to treat as acceptance. And that is what happened. ProCD proposed a contract that a buyer would accept by using the software after having an opportunity to read the license at leisure. This Zeidenberg did. He had no choice because the software splashed the license on the screen and would not let him proceeding without indicating acceptance. So although the district judge was right to say that a contract can be, and often is, formed simply by paying the price and walking out of the store, the UCC permits contracts to be formed in other ways. ProCD proposed such a different way, and without protest Zeidenberg agreed. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Ours is not a case in which a consumer opens a package to find an insert saying “you owe us an extra $10,000” and the seller files suit to collect. Any buyer finding such a demand can prevent formation of the contract by returning the package, as can any consumer who concludes that the terms of the license make the software worth less than the purchase price. [The Seventh Circuit reversed the lower court and held for ProCD.] Question: Did Zeidenberg form a valid contract under common law or under the UCC? Answer: The UCC. Question: What section of the UCC primarily governed this contract? Answer: UCC §2-204(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.” Question: Zeidenberg claimed that he did not agree to the terms of the license. Was this true? Answer: The court noted that it would not be possible for him to proceed from the opening screen of the software if he had not accepted the license agreement. It splashed on the screen and required a positive response before the user could proceed to actually see and use the software. Question: Is the court correct that there are many times that contracts are formed even though the buyer does not know the full details? Answer: Yes; the court cited several of them, including airline tickets with additional terms on the tickets, radio purchases with warranty information inside the box, prescription drug purchases with package inserts for details, contraindications, and the like. Question: Do you think this contract would have been formed under common law? Answer: Answers will vary.

Statute of Frauds UCC Statute of Frauds: The UCC requires a writing for any sales of goods priced $500 or more. UCC §2-201 requires a writing for any sale of goods worth $500 or more. However, under the UCC, the writing need not completely summarize the agreement, and it need not even be entirely accurate. The Code only requires a writing sufficient to indicate that the parties made a contract. In other words, the writing need not be a contract. If the writing demonstrates the two sides reached an agreement, it satisfies §2-201 even if it omits important terms or states them incorrectly. But one term is essential: quantity. The Code will enforce the contract only up to the quantity of goods stated in the writing. In general, the writing must be signed by the defendant.

Enforceable Only to the Quantity Stated The Code will enforce the contract only up to the quantity of goods stated in the writing.

Merchant Exception When two merchants make an oral contract, and one sends a confirming memo to the other within a reasonable time, and the memo is sufficiently definite that it could be enforced against the sender herself, then the memo is also valid against the merchant who receives it, unless he objects within 10 days.

Added Terms: Section 2-207 Additional terms: Proposed contract terms that raise issues not included in the offer. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Under §2-207, an acceptance that adds or alters terms will often create a contract. UCC Section 2-207 deals with the “battle of the forms” that can arise when a buyer places an order using its pre-printed form and the seller acknowledges with its own pre-printed form. Each party’s form contains self-serving language, so the two forms rarely agree. Section 2-207 establishes the legal consequences of such conflicting forms.

Intention The parties must still intend to create a contract.

Additional or Different Terms Additional terms: terms that raise issues not covered in the offer. When both parties are merchants, additional terms generally become part of the bargain. Different terms cancel each other out. The code then supplies its own terms, called gap-fillers. Different Terms: Proposed contract terms that raise issues not contained in the original offer. Gap-fillers: UCC rules for supplying missing terms.

14-1c Performance and Remedies Buyer’s Remedies Conforming goods: Satisfy the contract terms. If seller receives non-conforming goods, he has the right to cure. If seller breaches, buyer may cover, and then obtain the difference between the contract price and the cover price, plus incidental and consequential damages, minus expenses saved. Cover: To reasonably obtain substitute goods because another party has not honored a contract. Incidental and Consequential Damages: Consequential damages: Damages resulting from the unique circumstances of the injured party. An injured buyer is generally entitled to incidental and consequential damages. A buyer expecting to resell goods may obtain the loss of profit caused by the seller’s failure to deliver.

Seller’s Remedies If buyer breaches before seller has delivered the goods, seller may refuse to deliver the goods. If the resale is commercially reasonable, the seller may recover the difference between the resale price and contract price, plus incidental damages, minus expenses saved.

14-2 Warranties Warranty: A contractual assurance that goods will meet certain standards.

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Express warranty: A guarantee created by the words or actions of the seller, that goods will meet certain standards.

You Be The Judge: Strumlauf v. Starbucks Corp., 2016 U.S. Dist. LEXIS 87574, 2016 WL 3361842, U.S. D. C., N.D., California (2016) Facts: A latte (which means “milk” in Italian) is a coffee drink made with milk and often topped with milk foam. According to the Starbucks menu, its Grande lattes contained 16 fl. Oz. A group of heated Grande-latte-drinkers sued Starbucks for breach of express warranty, alleging that the coffee company consistently underfilled its lattes by 25 percent. That is, they claimed, the Grande-sized lattes contained only 12 ounces of coffee topped with about an inch of foam, instead of the promised 16 ounces of liquid coffee. The plaintiffs offered the following evidence: Starbucks provided baristas with pitchers that had “fill to” lines that were too low for the finished product to actually be 16 oz. Additionally, the latte recipe instructed baristas to “leave at least ¼ inch of space below the rim of the serving cup.” But the serving cup’s capacity was exactly 16 oz., which meant that the Grande lattes could not possibly contain the promised amount. Starbucks filed a motion to dismiss, arguing that the plaintiffs should just relax and get another cup of coffee. You Be the Judge: Did Starbucks breach an express warranty by underfilling its lattes? Argument for Plaintiffs: Your honors, the Starbucks menu clearly represented that its Grande lattes contained 16 fluid ounces. Any reasonable consumer would understand that statement as a promise to deliver 16 ounces of liquid coffee, not 12 ounces of coffee with a 4-ounce foamy filler on top. My clients would not have paid as much as they did for the latte if they had known it was only 12 ounces of actual coffee. Starbucks breached its express warranty and injured my clients, who received much less than what was promised. Moreover, Starbucks knew what it was doing because its company-wide policy instructed baristas to underfill latte cups. Starbucks needs to stand by its word. Argument for the Defendant: Your honors, Starbucks did not expressly warrant that it would deliver 16 ounces of liquid coffee. Instead, it promised to deliver a 16 ounce latte – and that is exactly what it did. The definition of a latte is a milk-based coffee drink topped with milk foam. Any reasonable latte-drinker knows that the foam added to the top of the coffee is part of the drink and counts toward the total fluid ounce measurement. If a consumer does not want foam in her coffee, she is free to drink an Americano, a macchiato, or the drip coffee of the day.

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Holding: The claim for breach of an express warranty survives the Motion to Dismiss, and the jury will decide, based on the “reasonable consumer” standard, whether Starbuck’s actions constitute breach of an express warranty. Question: What is a latte? Answer: A latte is a coffee drink made with milk, and perhaps topped with milk foam. Question: What was the express warranty plaintiffs claim Starbucks made? Answer: Plaintiffs claimed that Starbucks advertised a 16 oz. drink called a Grande, which contained only 12 ounces of coffee. The rest was milk or milk foam. Question: What other factors did plaintiffs cite as evidence of underfilling? Answer: Plaintiffs said that baristas were given a “fill to” cup for serving which regularly yielded less than 16 oz. of coffee, and that they were told to leave ¼ inch of the top of the cup unfilled, for milk foam. Also, the cup itself was 16 oz. if filled to the brim, which, obviously, it wasn’t. Question: Why does this breach the express warranty, in their view? Answer: Because it is not possible to put 16 oz. of coffee into those cups, given their size, and the instructions to the baristas. Question: What do plaintiffs contend a reasonable consumer would assume about the advertised 16 oz. Grande? Answer: That it would contain 16 oz. of coffee, not 12 oz. of coffee plus 4 oz. of milk Question: What other complaint do they make about price? Answer: That they would not have paid so much for the Grande if they knew it contained only 12 oz. of coffee. Question: If the case goes to trial, what do you think the jury will decide, using the “reasonable consumer” standard? Answer: Answers will vary. Question: What do you think? Answer: Answers will vary.

14-2b Implied Warranties Implied warranties: Guarantees created by the Uniform Commercial Code and imposed on the seller of goods. Implied warranties are those created by the Code itself, not by any act or statement of the seller.

Implied Warranty of Merchantability Implied warranty of merchantability: Goods must be of at least average, passable quality in the trade. The implied warranty of merchantability is the most important warranty in the Code. Unless excluded or modified, a warranty that the goods shall be merchantable is implied in a contract for their sale if the seller is a merchant with respect to goods of that kind. Merchantable means that the goods are fit for the ordinary purposes for which they are used. The rule contains several important principles:  Unless excluded or modified means seller has a chance to escape this warranty  Merchantability requires that goods be fir for their normal purposes.  Implied means that the law itself imposes this liability on seller.  A merchant with respect to goods of that kind means that seller is someone who routinely deals in these goods or holds himself out as having special knowledge about these goods.

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Case: Goodman v. Wenco Foods, Inc.54 Facts: Fred Goodman and a friend stopped for lunch at a Wendy’s restaurant in Hillsborough, North Carolina. Goodman had eaten about half of his double hamburger when he bit down and felt immediate pain in his lower jaw. He took from his mouth a triangular piece of cow bone, about one-sixteenth to one-quarter inch thick and one-half inch long, along with several pieces of his teeth. Goodman’s pain was intense, and his dental repairs took months., The restaurant purchased all of its meat from Greensboro Meat Supply Company (GMSC). Wendy’s required its meat to be chopped and “free from bone or cartilage in excess of 1/8 inch in any dimension.” GMSC beef was inspected continuously by state regulators and was certified by the United States Department of Agriculture (USDA). The USDA considered any bone fragment less than threequarters of an inch long to be “insignificant.” Goodman sued, claiming a breach of the implied warranty of merchantability. The trial court dismissed the claim, ruling that the bone was natural to the food and that the hamburger was therefore fit for its ordinary purpose. The appeals court reversed this, holding that a hamburger could be unfit even if the bone occurred naturally. Wendy’s appealed to the state’s highest court. Issue: Was the hamburger unfit for its ordinary purpose because it contained a harmful but natural bone? Decision: Even if the harmful bone occurred naturally, the hamburger could be unfit for its ordinary purpose. Reasoning: When an object in food harms a consumer, the injured person may recover even if the substance occurred naturally, provided that a reasonable consumer would not expect to encounter it. A triangular, one-half inch, inflexible bone shaving may be inherent to a cut of beef, but whether a reasonable consumer would anticipate it is normally a question for the jury. Wendy’s hamburgers need not be perfect, but they must be fit for their intended purpose. It is difficult to imagine how a consumer could guard against bone particles, short of removing the hamburger from tis bun, breaking it apart, and inspecting its small components. Wendy’s argues that since its meat complied with federal and state standards, the hamburgers were merchantable as a matter of law. However, while compliance with legal standards is evidence for juries to consider, it does not ensure merchantability. A jury could still conclude that a bone this size in hamburger meat was reasonably unforeseeable and that an injured consumer was entitled to compensation. Question: Does the ruling mean that Wendy’s has breached its implied warranty of merchantability? Answer: No. The trial court had dismissed the merchantability claim, preventing Goodman from even making his case to the jury. This court’s ruling means that Goodman will have the chance to

333 N.C. 1, 423 S.E.2d 444, 1992 N.C. LEXIS 671 Supreme Court of North Carolina, 1992 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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prove his case at trial and that, after hearing the evidence, a jury may determine that Wendy’s breached this implied warranty. Question: If a defendant has breached the implied warranty of merchantability does it mean the defendant has also been negligent? Answer: No. There are three theories on which plaintiffs bring claims of product liability: breach of warranty, negligence, and strict product liability. A defendant’s liability on one theory does not necessarily mean the defendant is liable on one of the other theories. Question: How could Wendy’s be in breach of its implied warranty when the meat it purchased was inspected continuously by state regulators and certified by the USDA? Answer: Remember that merchantability means the goods are fit for their normal purposes. The evidence regarding inspection and USDA certification may be relevant to a claim that Wendy’s breached its duty of due care—i.e., to a claim that Wendy’s was negligent—but does not necessarily answer whether the beef was merchantable. Question: Bone is not a foreign substance in meat; it is not something that was accidentally added during processing. How can it be in breach of the implied warranty of merchantability to serve a food in its natural state? Answer: Other things occur naturally in meat, too: cartilage, hair, horns, intestines. That does not mean a person biting into a hamburger won’t be surprised to discover them. The court says that the test is the “reasonable expectation of the consumer.” Even if the substance occurs naturally, it can breach the implied warranty of merchantability to serve it if a reasonable consumer would not expect to encounter it. Question: How will a jury decide what a reasonable consumer would expect to encounter in food? Answer: By hearing testimony from both sides and by applying its experience and common sense to the issue. Question: This ruling creates a serious difficulty for Wendy’s and its lawyer, in terms of arguing to the jury. What is that difficulty? Answer: Wendy’s must convince the jury that a reasonable consumer anticipates finding sharp, jagged pieces of bone in a hamburger. That is not an easy argument to make. Update When the remanded case went to trial, Goodman stated (out of court) that he had originally offered to settle for $2,000, the cost of his dental bills, and that he still was not trying to capitalize on his situation. The lawyer for Wendy’s argued that there was no neutral eyewitness who could testify that there ever had been bone in the hamburger. Goodman claims that he gave the bone to the store’s manager. Unfortunately, that manager had left Wendy’s and Goodman’s lawyer was unable to locate him. Research located no report of a jury verdict or appeal, indicating that the parties probably settled.

Implied Warranty of Fitness for a Particular Purpose Implied warranty of fitness for a particular purpose: If the seller knows that the buyer plans to use the goods for a particular purpose, the seller generally is held to warrant that the goods are in fact fit for that purpose. Where the seller, at the time of contracting, knows about a particular purpose for which the buyer wants the goods, and knows that the buyer is relying on the seller’s skill or judgment, there is (unless excluded or modified) an implied warranty that the goods shall be fit for the purpose.

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Disclaimer: A statement that a particular warranty does not apply.

Case: CCB Ohio, LLC v. Chemque, Inc. 649 F.Supp.2d 757, U.S. Dist. Court for Southern District of Ohio, 2009 Facts: CCB Ohio specializes in upgrading power lines in a way that makes it possible to offer broadband service over an electrical grid. Chemque manufactures Q-gel. Transformers reduce the 100,000 or more volts flowing through a typical power line to the 120 volts that actually arrive at the outlets in your home. But unfortunately, transformers completely block digital signals. And so, to offer broadband over an electrical grid, data must take a detour around transformers. Couplers allow for this detour. CCB and its contractors purchased Q=gel. This substance was supposed to create a waterproof seal that would bind newly installed couplers to power lines. Unfortunately, the gel did not gel, at least not for long. Within 18 months, 40 percent of CCB Ohio’s couplers were leaking liquefied Q=-gel. Ultimately, 90 percent of the couplers throughout the Cincinnati area leaked and caused millions of dollars in losses. CCB Ohio sued for breach of warranty. Chemque argued that it had disclaimed all implied warranties by giving CCB a specification sheet that read, “All information is given without warranty or guarantee.” Chemque moved for summary judgment. Issue: Should Chemque’s motion for a summary judgment on CCB’s warranty claims be granted? Decision: No, the motion for summary judgment should not be granted. Reasoning: In this state, companies that sell consumer goods may not disclaim implied warranties. However, the contract at issue here does not involve consumer goods. To disclaim implied warranties for other kinds of transactions, the seller must show that the buyer actually received the disclaimer and that it was so conspicuous, a reasonable person would have noticed it. There is no evidence in the record that CCB did get the specification sheet in question. The company also argues that, even if it did receive the sheet, the disclaimer was not clear and conspicuous. With these significant issues in dispute and unresolved, it would be inappropriate to grant Chemque’s motion for summary judgment. Motion for summary judgment denied. Question: What kind of warranty is at issue in this case? Answer: The implied warranty of merchantability is at issue in this case. Question: Did the court find that it had been disclaimed? Answer: No. Question: Does this mean that the case has been resolved? Answer: No, it only means that the court cannot enter summary judgment in favor of Chemque, so the case will go to trial. Question: Was this a consumer contract? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No, it was a contract between two firms for the purchase of Q-gel, a lubricant.

Chapter Conclusion The development of the UCC was an enormous and ambitious undertaking. Its goal was to facilitate the free flow of commerce across this large nation. By any measure, the UCC has been a success. Remember, though: The terms of the UCC are precise. Failure to comply with these exacting provisions can close opportunities – and open courtroom doors.

Matching Questions Match the following terms with their definitions: _____A. Additional terms 1. An implied warranty that goods are fit for their ordinary purpose _____B. Written express warranties 2. Generally become part of a contract between merchants _____C. Merchantability 3. Cannot be disclaimed _____D. Different terms 4. Generally cancel each other out Answers: GG. 2 HH. 3 II. 1 JJ. 4

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 64. T F In a contract for the sale of goods, the offer may include any terms the offeror wishes; the offeree must accept on exactly those terms or reject the deal. 65. T F Sellers can be bound by written warranties but not by oral statements. 66. T F The description of products in promotional materials can create express warranties. 67. T F A contract for the sale of $300 worth of decorative stone must be in writing to be enforceable.

Multiple Choice Questions 1.

Which one of the following transactions is not governed by Article 2 of the UCC?

A. Purchasing an automobile for $35,000 B. Leasing an automobile worth $35,000 C. Purchasing a sound system worth $501 D. Purchasing a sound system worth $499 Answer: B. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Marion orally agrees to sell Ashley her condominium in Philadelphia for $700,000. The parties have known each other for 20 years and do not bother to put anything in writing. Based on the agreement, Marion hires a moving company to pack up all her goods and move them to a storage warehouse. Ashley shows up with a cashier’s check, and Marion says, “You’re going to love it here.” But at the last minute, Marion declines to take the check and refuses to sell. Ashley sues and wins 2.

A. Nothing B. The condominium C. $700,000 D. The difference between $700,000 and the condominium’s market value E. Damages for fraud Answer: A. Seller’s sales contract states that “The model 8J flagpole will withstand winds up to 150 mph, for a minimum of 35 years.” The same contract includes this: “This contract makes no warranties, and any implied warranties are hereby disclaimed.” School buys the flagpole, which blows down six months later, in a 105-mph wind. 3.

A. Seller is not liable because it never made any express warranties. B. Seller is not liable because it disclaimed any warranties. C. Seller is liable because the disclaimer was invalid. D. Seller is liable because implied warranties may not be disclaimed. Answer: C. Manufacturer sells a brand-new, solar-powered refrigerator. Because the technology is new, Manufacturer sells the product “as is.” Plaintiff later sues Manufacturer for breach of warranty and wins. Plaintiff is probably 4.

A. A distributor with no understanding of legal terminology B. A retailer who had previously relied on Manufacturer C. A retailer who had never done business before with Manufacturer D. A retailer who failed to notice the “as is” label E. A consumer Answer: E.

5. CPA QUESTION Which of the following conditions must be met for an implied warranty of fitness for a particular purpose to arise? I. The warranty must be in writing. II. The seller must know that the buyer was relying on the seller in selecting the goods. A. I only © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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B. II only C. Both I and II D. Neither I nor II Answer: B.

Case Questions 1.

Nina owns a used car lot. She emails Seth, a used car wholesaler who has a huge lot of cars in the same city. The email reads, “Confirming our agrmt—I pick any 15 cars from your lot—30% below blue book value.” Seth reads the email, laughs, and deletes it. Two weeks later, Nina arrives and demands to purchase 15 of Seth’s cars beneath market. Is he obligated to sell? Answer: Probably. Under UCC §2-201(2), a signed memo between merchants that would be binding against the sender is sufficient to satisfy the statute of frauds against the recipient if he reads it and fails to object within 10 days.

2. YOU BE THE JUDGE: WRITING PROBLEM United Technologies advertised a used Beechcraft Baron airplane for sale in an aviation journal. Attorney Thompson Comerford spoke with a United agent who described the plane as “excellently maintained” and said it had been operated “under §135 flight regulations,” meaning the plane had been subject to airworthiness inspections every 100 hours. Comerford arrived at a Dallas airport to pick up the plane, where he paid $80,000 for it. He signed a sales agreement stating that the plane was sold “as is” and that there were “no representations or warranties, express or implied, including the condition of the aircraft, its merchantability or its fitness for any particular purpose.” Comerford attempted to fly the plane home but immediately experienced problems with its brakes, steering, ability to climb, and performance while cruising. (Otherwise it was fine.) He sued, claiming breach of express and implied warranties. Did United Technologies breach express or implied warranties? Argument for Comerford: United described the airplane as “excellently maintained,” knowing that Mr. Comerford would rely. The company should not be allowed to say one thing and put the opposite in writing. Argument for United Technologies: Comerford is a lawyer, and we assume he can read. The contract clearly stated that the plane was sold as is. There were no warranties. Answer: United Technologies won. United had made express warranties but had effectively disclaimed both the express and all implied warranties. Ace, Inc. v. Maynard, 108 N.C. App. 241, 423 S.E.2d 504 (N.C. Ct. App. 1992). 3. Lewis River Golf, Inc., grew and sold sod. It bought seed from defendant, O. M. Scott & Sons, under an express warranty. But the sod grown from the Scott seeds developed weeds, a breach of Scott’s warranty. Several of Lewis River’s customers sued, unhappy with the weeds in their grass. Lewis River lost most of its customers, cut back its production from 275 acres to 45 acres, and destroyed all remaining sod grown from Scott’s seeds. Eventually, Lewis River sold its business at a large loss. A jury awarded Lewis River $1,026,800, largely for lost profits. Scott appealed, claiming that a plaintiff may not recover for lost profits. Comment. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Scott is wrong. Lost profits and goodwill are both consequential damages, and both are potentially recoverable. The court can measure lost profits by contracts actually cancelled, by the decreased sod production, and by diminished sales. Goodwill refers to future business lost, and for that a court can rely on financial forecasts made by experts, based on the buyer’s history of sales. A buyer expecting to resell may obtain the loss of profit caused by the seller’s breach. The court affirmed Lewis River’s verdict. Lewis River Golf, Inc. v. 0. M. Scott & Sons, 120 Wash. 2d 712,845 P.2d 987 (1993). 4. When Sony released its PlayStation 4 (PS3), it represented that the gaming system: (1) connected to the PlayStation Network, (2) had the ability to run other operating systems, and (3) was expected to last for over ten years. But the product’s terms of service provided that future updates might disable some functions. Four years later, Sony’s software update forced users to choose between features (1) and (2) listed above. Disgruntled gamers sued, claiming that Sony made an express warranty that the PS3 would work as promised for ten years, but took away a fundamental product feature after only four years. Was Sony’s representation an enforceable express warranty? Answer: The court on appeal reversed the dismissal of claims under the Consumer Legal Remedies Act. Plaintiffs sufficiently allege that Sony’s representations mischaracterized the dual functionality of the PS3 and suffered damages in the form of lost “premium” payments. Sony eventually settled. Gamers who used the “other OS” function received $55 and gamers who chose to continue using their PS3 for the Play Station Network features were entitled to $9 if they could prove that they bought their PS3 during the relevant time frame. 2014 U.S. App. LEXIS 187, 2014 WL 31217 (2014).

5. When the Whitehouses decided to breed horses, they went horse shopping at the Lange’s ranch. Although the Whitehouses had owned horses, they had no experience in horse breeding. Knowing the buyers would breed the horse, the Langes suggested a particular mare. After the sale, the Whitehouses discovered that this mare was infertile and sued for breach of warranty. Will the buyers win? If so, under which UCC warranty? Answer: Whitehouse v. Lange, 128 Idaho 129 (1996). Because the court found this use of the horse to be nonordinary, the buyers were entitled to an implied warranty of fitness.

Discussion Questions 1. Marco’s backyard pool, which measured 35 feet by 18 feet, needed a new filter. A sales brochure stated, “This filter will keep any normal backyard pool, up to 50 feet by 25, clean and healthy all summer for a minimum of 5 years.” Marcos signed a sales contract, which included this disclaimer: “The filter will work to normal industry standards. This is the only warranty. No other statements, written or oral, apply. Pools vary widely, and the Seller cannot guarantee any specific level of performance or cleanliness. Buyer agrees to this disclaimer.” The filter failed to keep Marco’s pool clean, and he sued for breach of warranty. Who should win? Answer: Strategy: Sellers are often able to disclaim oral warranties, but usually not written ones. Here, the initial promise and the disclaimer were in different documents. Does that change the outcome? Finally, Marcos was a consumer. Courts treat consumers differently from corporate buyers. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Result: It is difficult or impossible for sellers to disclaim written warranties, even if the promise and disclaimer are in different documents. A disclaimer that would unfairly surprise the buyer is void. Marcos relied on the sales brochure—as the company intended—and the seller will probably lose. Furthermore, most states give extra protection to consumers, knowing that they are less sophisticated buyers. A court is likely to find in favor of Marcos based on the seller’s express warranty, as well as the implied warranties of merchantability and fitness. 2. A seller can disclaim all implied warranties by stating that goods are sold “as is” (or by using other, more specific language). Is this fair? The UCC’s implied warranties seem reasonable -0 that goods are fit for their normal purposes, for example. Should it be so easy for sellers to escape their obligations? Answer: Answers will vary. 3. After learning more about implied warranties and disclaimers, would you ever buy an item sold “as is”? Imagine a car salesman who offers you a car for $8,000, but who also says that he can knock the price down to $6,500 if you will buy the car “as is.” If you live in a state that does not give consumers special protections, which deal would be more appealing? Answer: Answers will vary. 4. Under the UCC’s Statute of Frauds, sale-of-goods contracts for $500 or more must be in writing to be valid. But since Article 2 only covers sale-of=goods contracts, agreements to sell services are not subject to the rule. Should the common law change so that all contracts valued at $500 or more have a writing requirement, or would that place an undue burden on business? Answer: Answers will vary. 5. When an acceptance contains additional terms, the UCC and the common law contain different rules. The common law’s mirror image rule makes the acce3ptance ineffective, and no contract is formed. But he UCC rules “save” the contract. Which rule do you think is more sensible? Answer: Answers will vary.

Suggested Additional Assignments Drafting: UCC 2-207 Students should draft a short offer form to be used by the seller of goods. Students must include specific terms on (1) price, (2) time and place of delivery, (3) method of payment, and (4) warranties. Students must do their best to ensure that any resulting contract includes only these terms.

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Chapter 15 – Negotiable Instruments* Chapter Overview Chapter Theme This chapter addresses the law of Negotiable Instruments, something students already encounter in their everyday lives. Students will learn the important fundamentals: the types of negotiable instruments, the concept of negotiability, and the rights of a holder in due course. The Role of Commercial Paper Students use commercial paper all the time, without realizing its legal name. Everyone in the class will have written or received a check at some point. Question: What types of commercial paper have you used in the last month? Answer: Possible answers include promissory notes, certificates of deposit, checks, cashier’s checks, and traveler’s checks. Question: Have you ever signed a promissory note? For what purpose? Answer: Possible answers include student loans and car loans.

15-1 Negotiable Instruments 15-1a Commercial Paper The law of commercial paper is important to anyone who borrows money or writes checks. If done right, it acts as a substitute for currency. The opening scenario illustrates how common – and important – commercial paper is. That scenario saw the clash of two important rules:  Transfer warranties (anyone who accepts a check from a wrongdoer is liable), and  The Imposter Rule (anyone who issues a check to an imposter is liable)

15-1b Types of Negotiable Instruments There are two types of commercial paper: negotiable and non-negotiable. There are two categories of negotiable instruments: Notes and drafts. Note: The maker of the instrument promises to pay a specific amount of money. Also called a promissory note. Maker: The issuer of a promissory note. Payee: Someone who is owed money under the terms of an instrument. Draft: The drawer of this instrument orders someone else to pay money. Check: The most common form of a draft; It is an order telling a bank to pay money. Drawer: The person who pays a draft. In the case of a check, the bank is the drawee. Drawee: The person who issues a draft. Issuer: The maker of a promissory note or the drawer of a draft. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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15-1c Negotiation To work as a substitute for money, commercial paper must be freely transferable in the marketplace. It must be negotiable. The possessor of non-negotiable commercial paper has an unconditional right to be paid, so long as: (1) the paper is negotiable, (2) it has been negotiated to the possessor, (3) the possessor is a holder in due course, and (4) the issuer cannot claim a valid defense. Negotiable The transferee of negotiable commercial paper has more rights than the person who made the original contract. The transferee’s rights are unconditional. The rules are different for the transferee of non-negotiable commercial paper. His rights are the same – no more, no less – as the person who made the original contract. They are conditional. Order paper: An instrument that includes the words, “pay to the order of” or their equivalent. Bearer Paper: A note is bearer paper if it is made out to “bearer” or to cash.

To be negotiable: 1. 2. 3. 4. 5. 6.

The Instrument must be in writing. The Instrument must be signed by the Maker or Drawer. The Instrument must contain an unconditional promise or order to pay. The Instrument must state a definite amount of Money that is clear “within its four corners.” The Instrument must be payable on demand or at a definite time, and The Instrument must be payable to order or to bearer.

The rules for checks are different from other negotiable instruments. If properly filled out, checks are negotiable. And sometimes they are negotiable even if not completed correct. Discussion: Question: Why are these requirements essential for negotiability? Answer: Without them, a subsequent holder cannot be sure how much the instrument is worth. Question: Why is a negotiable instrument like a courier without luggage? Answer: The possessor of non-negotiable commercial paper has the same rights as the person who made the original contract. In other words, he has the same luggage that the original person had. However, with a negotiable instrument, the possessor takes free of many of the claims (much of the luggage) of the original parties to the contract. Question: Is the quote completely accurate? Answer: No, because the holder of a negotiable bill is subject to both personal and real defenses unless he is a holder in due course, in which case he takes subject only to real defenses. It is more accurate to say that “the holder in due course of a negotiable bill or note is a courier who has checked much of his luggage.”

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Interpretation of Ambiguities When the terms in a negotiable instrument contradict each other, three rules apply:  Words beat numbers.  Handwritten terms prevail over typed and printed terms.  Typed terms win over printed terms.

You Be the Judge: Blasco v. Money Services Center55 Facts: Christina Blasco borrowed $500 from the Money Services Center (MSC). To repay the loan, she gave MSC a check for $587.50 which it promised not to cash for two weeks. This kind of transaction is called a “payday loan” because it is made to someone who needs money to tide him over until the next paycheck. (Note that in this case, Blasco is laying 17.5% interest for a two-week loan, which is an annual compounded rate of 6500% percent. This is the dark side of payday loans – interest rates are often exorbitant.) Before MSC could cash the check, Blasco filed for bankruptcy protection. Although MSC knew about Blasco’s filing, it deposited the check. It is illegal for creditors to attempt to collect a debt once a debtor has filed for bankruptcy, except that creditors are entitled to payment on negotiable instruments. Ordinarily, checks are negotiable instruments, but only if they are for a definite amount. This check had a wrinkle. The numerical amount on Blasco’s check was $587.50, but the amount written in words was “five eighty-seven and 50/100 dollars.” Did the words mean “five hundred eighty-seven” or “five thousand eighty-seven” or perhaps “five million eighty-seven”? Was the check negotiable despite this ambiguity? You Be the Judge: Was this check for a definite amount? Was it a negotiable instrument? Argument for Blasco: For a check to be negotiable, two rules apply: 1. The check must state a definite amount of money, which is clear within its four corners. 2. If there is a contradiction between the words and numbers, words beat numbers. Words prevail over numbers, which means that the check is for “five eighty-seven and 50/100 dollars.” This amount is not definite. A holder cannot be sure of the precise amount of the check. Therefore, the check is not a negotiable instrument, and MSC had no right to submit it for payment. Argument for MSC: Blasco is right about the two rules. However, she is wrong in their interpretation. If there is a contradiction between the words and numbers, words take precedence over numbers. In this case, there was no contradiction. The words were ambiguous but they did not contradict the numbers. If the words had said “five thousand eighty-seven,” that would have been a contradiction. Instead, the numbers simply clarified the words. Even someone who was a stranger to this transaction could figure out the amount of the check. Therefore, it is negotiable, and MSC is not liable.

2006 Bankr. LEXIS 2899, United Stated Bankruptcy Court for the Northern District of Alabama, 2006. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Holding: Yes, the note was negotiable, it was for a definite amount. According to the court, to determine whether the check was a negotiable instrument, it must state a promise to pay a definite amount of money. The numerical amount of the check was “$587.50”, but the amount stated in words was “five eighty-seven and 50/100 dollars.” For the words to prevail over the numbers, the two have to be contradictory. The words “five eighty-seven and 50/100 dollars” did not contradict the numbers $587.50; the numbers clarified the ambiguity in the words. Question: To be negotiable, what must a note look like? Answer: It must:  Be in writing  Be signed by the maker or drawer  Contain an unconditional promise or order to pay  State a definite amount of money  Be payable on demand or at a definite time, and  Be payable to order or to bearer. Question: Was this note in writing? Answer: Yes. Question: Was it signed by Blasco? Answer: Yes. Question: Did it contain an unconditional promise or order to pay? Answer: The court held that it did because although the written amount was ambiguous, it did not contradict the stated numerical amount ($587.50). Question: Presumably Blasco knew the amount of the check, after all she wrote it. Why then did she sue saying the check was not negotiable? Answer: She had just filed for bankruptcy protection, she did not have the money to pay the loan back.

Negotiated Negotiated: An instrument has been transferred to the holder by someone other than the issuer. Indorsement: The signature of a payee. The possessor of a piece of commercial paper has an unconditional right to be paid, as long as (1) The paper is negotiable, (2) It has been negotiated to the possessor, (3) The possessor is a holder in due course, and (4) The issuer cannot claim a valid defense. To be negotiated, order paper must first be indorsed and then delivered to the transferee. Bearer paper must simply be delivered to the transferee; no indorsement is required.

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Research: Indorsements If students undertook the indorsements research, copy some samples on the board and ask students to identify the different types.

15-2 Holder in Due Course The fundamental rule of this chapter tells us that a holder in due course has an automatic right to receive payment for a negotiable instrument (unless the issuer can claim a valid defense). In other words, a holder in due course has a greater probability of being paid than a mere holder—a fact that gives negotiable instruments tremendous value and fuels market demand for them.

15-2a Requirements for Being a Holder in Due Course Holder in due course: Someone who has given value for an instrument, in good faith, without notice of outstanding claims or other defenses. Holder: For order paper, anyone in possession of the instrument if it is payable to or indorsed to her. For bearer paper, anyone in possession Value: The holder has already done something in exchange for the instrument.

Holder A holder in due course must, first of all, be a holder.

Value A holder in due course must give value for an instrument.

Good Faith There are two tests to determine if a holder acquired an instrument in good faith. The holder must meet both of these tests:  Subjective Test: Did the holder believe the transaction was honest in fact?  Objective Test: Did the transaction appear to be commercially reasonable?

Discussion: Question: What are the requirements for a holder in due course? Answer: A holder in due course is a holder who has given value for the instrument, in good faith, without notice of outstanding claims or other defects. Question: Why are holders in due course entitled to this special treatment? Answer: The theme throughout this chapter is that an instrument has little value unless the holder can be reasonably sure she will be paid. An innocent holder, who has no reason to believe there is any underlying problem with the instrument, deserves to be paid. However, someone who took the instrument knowing there was a problem does not deserve the same treatment. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Note in particular that in defining a holder in due course, value has a different meaning than it does in the contract law concept of consideration (see text, Chapter 12, Consideration). Under the common law of contracts, a promise to do something in the future can be consideration, but that would not be value supporting a holder in due course. Here, value means that the holder has already done something in exchange for the instrument.

Notice of Outstanding Claims or Other Defects In the following circumstances, a holder is on notice that an instrument has an outstanding claim or other defect: 1. The Instrument Is Overdue 2. The Instrument is Dishonored 3. The Instrument is Altered, Forged, or Incomplete 4. The Holder Has Notice of Certain Claims or Disputes

Case: In re Brican Am. LLC Equip. Lease Litig. 2015 U.S. Dist. LEXIS 5923; 2015 WL 235409, U.S. D. C., Southern Dist. Fla, (2015). Facts: Brican LLC was running a scam. The victims were dentists who wanted to lease multimedia systems (called “Exhibeos”) for use in their waiting rooms. Each Exhibeo consisted of a computer and a television which could, say, demonstrate proper flossing technique and show ads for expensive cosmetic procedures. The sales process worked this way: Brican would sell an Exhibeo to NCMIC Finance Corporation, which would then lease the equipment to a dentist. Brican promised all the dentists that another company, Viso Lasik, would buy enough advertising on the Exhibeos to cover the monthly lease payments. Further, if Viso ever stopped its advertising, Brican would buy the Exhibeos back from the dentists and they could cancel their contracts. In short, Brican lured the dentists with the promise that the Exhibeos were effectively free. This plan not only sounded too good to be true, it was. Brican sold each Exhibeo to NCMIC for $24,000. But Brican was also paying Viso for the ads it placed with the dentists, which amounted to $29,000 over five years. In short, Brican was losing money on every Exhibeo it sold but would pocket the $24,000 from NCMIC upfront and then worry later about the $29,000 it owed in Viso ads. The only way this system could work, in the short run, was if Brican kept selling more and more machines. In the long run – well there was no chance of a long run. NCMIC was attracted to the deal because dentists typically have a good credit rating and were agreeing to pay a high interest rate. It is possible that, at the beginning, NCMIC was unaware of Brican’s scam. However, once NCMIC discovered the truth, it responded by sharply increasing its lending to a rate of ten times more than it had been the year before.

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Eventually, the inevitable happened. Brican sales declined, it ran out of cash and then stopped paying for Viso ads on the Exhibeos. The dentists quit making their lease payments and NCMIC sued them. Because the leases were legally the same as a promissory note, the dentists alleged that NCMIC could not enforce the agreement because it was not a holder in due course -0 it had no acted in good faith because it was aware of Brican’s fraud. Issue: Had NCMIC acted in good faith? Was it a holder in due course? Decision: NCMIC was not a holder in due course. Reasoning: To be a holder in due course, the holder must have acquired an instrument in good faith. Good faith requires not only that the holder believed the transaction was honest but that it appeared to be commercially reasonable. A holder cannot ignore suspicious circumstances that cry out for investigation. NCMIC knew that Brican had promised the dentists that the Exhibeos were effectively free (because the advertising fees would offset the lease payments) and that the dentists could cancel their leases at any time. Once it had reason to be suspicious, NCMIC ignored its own procedures for investigating fraud and, indeed, increased its lending tenfold. Any reasonable investigation would have revealed Brican’s shaky financial position and that it was losing money on every Exhibeo it sold. NCMIC could not prove that it acted in good faith. Therefore, it is not a holder in due course. Question: What were the legal issues in this case? Answer: Whether NCMIC had acted “in good faith” and “without notice” of Brican’s scam. Question: What was the court’s holding on those issues? Answer: As to good faith, the court found that NCMIC had taken no action when it discovered Brican’s fraud, and in fact, had increased its lending. The court found that NCMIC had not acted with honesty in fact or with the observance of reasonable commercial standards of fair dealing. Question: What was the court’s holding that NCMIC was not “without notice” of Brican’s scam? Answer: The court found that NCMIC ignored circumstances that cried out for investigation, and that, although it had established procedures for investigating fraud, it did not use them. Question: Were the leases enforceable against the dentists? Answer: No, because NCMIC was not a holder in due course.

Bonus Case: Hartford Accident & Indemnity Co. v. American Express Co.56 Facts: Stratford Skalkos was a manager at Avon Products. He issued Avon checks to pay his personal debts. So that no one in the company would know what he was doing, he disguised the name of the payees. For example, to pay his American Express bill, he issued an Avon check to “Amerex Corp.” Avon sued the recipients of the checks, demanding that the funds be returned. The trial court ruled against Avon and granted defendants’ motion for summary judgment, concluding that defendants were holders in due course and thus took the checks free of any claims or defenses. Avon appealed. Issue: Were the defendants holders in due course? 56

N.Y.2d 153, 542 N.E.2d 1090, 1989 N.Y. LEXIS 881 New York Court of Appeals, 1989 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Holding: American Express and the others were holders in due course. There was no reason why they should have been suspicious simply because Skalkos was paying his bills with company checks. Many companies pay entertainment and other expenses for their employees. Therefore, American Express was not “on notice of any claims or disputes”. Question: Is this a fair result? Answer: As the court observed, Avon was the company that (1) had hired a dishonest employee and (2) had such lax controls that it did not realize he was paying personal bills with corporate funds. Avon is certainly more at fault than American Express. Question: Should American Express have been on notice when it received checks payable to Amerex? Similarly, should the Metropolitan Opera Company have wondered why it got checks made out to “Metropolitan Oprtg. Co.?” Answer: It would certainly be possible to have a rule that checks are invalid if the payee’s name is not precisely accurate. However, that would place a heavy burden on commerce.

Bonus Case: Rosenbaum v. Bulow57 Facts: Maude Rosenbaum wanted to post bail to get out of prison. Harvey Bowen agreed to post bail of $7,500 in return for a $7,500 promissory note signed by Rosenbaum and secured by her house. Bowen was not a licensed bondsman and therefore, under state law, was not entitled to any payment for posting bail. To solve this problem, Bowen asked Rosenbaum to sign a second note to his niece’s husband, W. F. Bulow (who was not a bondsman, either). Issues: Did Bulow give value for the promissory note? Did he act in good faith? Holding: Bulow cannot collect on the note. At best, Bowen was trying to make a gift to Bulow of his illegally obtained profit. Bulow did not give value to Rosenbaum. Nor did Bulow act in good faith. He could not have believed that Rosenbaum simply wanted to make a gift to him of $7,500. If he did not already know why she was signing the note to him, he should have investigated. Question: What did Rosenbaum and Bowen agree to do? Answer: Rosenbaum agreed to give Bowen a promissory note for $7,500, secured by her house. In return, Bowen agreed to post $7,500 bail. Question: What does “secured by her house” mean? Answer: If she failed to pay the note, Bowen could sell her house and recover $7,500. (If the house sold for more than $7,500, she could keep the excess.) Question: Is this arrangement fair? Answer: No. As long as Rosenbaum returns to prison when ordered by the court, Bowen will get his $7,500 back from the court. Under his deal with Rosenbaum, Bowen will also get another $7,500 from her. The typical fee in a case such as this would have been $750, not $7,500. The $750 covers the professional bondsman’s risk that some people will not show up some of the time. Question: Is this arrangement with Rosenbaum legal? Answer: No. Only licensed bail bondsmen can receive payment for posting bond. Question: Why did Rosenbaum agree to Bowen’s deal? 57

1997 Bankr. LEXIS 555 United States Bankruptcy Court for the Eastern District of North Carolina, 1997 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: She was desperate to get out of prison and no one else would help. Question: Why did Bowen ask Rosenbaum to sign a second note to Bulow? Answer: Bowen realized that he could not enforce the first note, since he had obtained it illegally. Question: Could Bulow enforce the second note? Answer: No. The court held that he was not a holder in due course because he had neither given value nor acted in good faith. Question: Why hadn’t he given value? Answer: He did not give Rosenbaum anything. This note was essentially a gift from Bowen. Question: Why hadn’t he acted in good faith? Answer: The court felt that he probably knew why someone was giving him a $7,500 promissory note. If he did not know, he should have asked. Question: Both Bowen and Rosenbaum were wrong. She reneged on the deal; he illegally accepted a bond fee. Why should Rosenbaum win? Answer: Illegal behavior trumps breach of contract. No one who engages in illegal behavior is entitled to have his deal enforced by the courts.

Additional Example A financial columnist for the Chicago Tribune received this question from a reader: “I received a promissory note and accompanying letter (copies enclosed). The letter attests to the legitimacy and negotiability of the note, which is for $1 million. Is this really a valid document? Can I convert this to cash before the maturity date? ” The note was for one million dollars, payable 20 years later. Question: If you received such a promissory note in the mail, what difficulties might you have in enforcing it? Are you a millionaire? Answer: First, the person who signed the note does not have to pay you anything for 20 years. Even if he has the money now, he might not in 20 years, and you might not be able to locate him anyway. Second, you have not given consideration. This is a personal defense, which is valid against you as a holder. Therefore, you cannot enforce the note. Third, suppose you sell the note to a third party. The buyer would argue that she can enforce the note because she has given value and is, therefore, a holder in due course. The maker of the note would claim, however, that no one would pay real money for such a note without investigating. If the buyer finds out the truth, she could not pass the objective test, because the transaction did not appear to be commercially reasonable. If the buyer does not investigate, a court might also hold that she has not taken it in good faith. 58

“Promises, Promises! But Will They Make You a Millionaire?” by Phil Vettel, Chicago Tribune, Feb. 24, 1985,

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15-2b Defenses against a Holder in Due Course The issuer of a negotiable instrument is not required to pay if: 

His signature on the instrument was forged.



After signing the instrument, his debts were discharged in bankruptcy.



He was underage (typically under 18) when he signed the instrument.



The amount of the instrument was altered after he signed it. (If he left the instrument blank, however he is liable for any amounts later filled in.)



He signed the instrument under duress, while mentally in capacitated, or as part of an illegal transaction.



He was tricked into signing the instrument without knowing what it was and without any reasonable way to find out.

The following bonus case illustrates the value of being a holder in due course. Remember that, to be a holder, you must be in possession of the instrument.

Case: Creative Ventures, LLC v. Jim Ward & Associates59 Facts: When Creative Ventures, LLC borrowed $3 million from defendant Jim Ward & Associates, it signed promissory notes, payable to Ward. Thereafter, Ward sold this loan to 54 individual investors, but kept possession of the notes. When Creative made payments under the loan to Ward, it paid the investors their share. Under California law, the interest rate on a loan cannot be greater than 8 percent, except in certain circumstances. Those circumstances include loans by a licensed real estate broker. Ward claimed that it was such a broker, but it was not. When Creative discovered this lie, it sued Ward and the investors to obtain a refund of all interest it had paid under the loan, as is permitted by California law. The investors argued that they were entitled to keep the interest because, as holders in due course, they had taken the note free of the claim against Ward. Issues: Were the investors holders in due course? Were they entitled to keep the interest that Creative had paid on the illegal loan? Decision: The investors were not holders in due course and could not keep the interest Creative had paid. Reasoning: A holder in due course must, first of all, be a holder. A holder is someone in possession of a negotiable instrument that is payable either to that person or to bearer. The promissory notes in this case are payable to Ward, which is also in possession of the notes. Accordingly, Ward is the holder.

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Investors could have become holders if Ward had negotiated the notes by indorsing and transferring possession to the investors. But there is no evidence that Ward did so. Question: Why did Creative sue JWA and the Investors? Answer: Because Creative had been paying more than the 8% interest rate allowed under California law, making the loan usurious. Question: Was there any exception to the interest rate ceiling? Answer: Yes, for licensed real estate brokers. However, although JWA claimed it was a licensed real estate broker, it was not. Question: What was the defense of the Investors to Creative’s claim for a refund? Answer: That the Investors were holders in due course, who took free from any defect, including usury. Question: Did the court find that argument persuasive? Why or why not? Answer: Ironically, the Investors never took possession of the notes, nor indorsed them, so they were not holders in due course. In order to be a holder in due course, a party must first be a holder.

Discussion: Real Defenses vs. Personal Defenses Question: Why are both real and personal defenses valid against a holder; but only real defenses are valid against a holder in due course? What is the difference between real and personal defenses? Answer: Real defenses deal with fundamental challenges to the basic validity of the instrument itself. These are challenges that render the instrument void from the beginning–as if it had never existed. It is not a question of a dispute arising later between the initial parties to the instrument. Personal defenses, on the other hand, generally relate to subsequent disputes between the initial parties to the instrument. Question: In the discussion of personal defenses in the text (p.547), why is Ross a “mere holder,” and not a holder in due course? Answer: A holder in due course must take an instrument in good faith, for value, without notice of outstanding claims or other defects. Ross, as party to the contract, knows of outstanding claims or other defects. In addition, he may not have acted in good faith if he knew the plane was defective when he gave it to Paige.

15-2c Consumer Exception Consumer credit contract: A contract in which a consumer borrows money from a lender to purchase goods and services from a seller who is affiliated with the lender.

The FTC requires all promissory notes in consumer credit contracts to contain the following language: NOTICE: ANY HOLDER OF THIS CONSUMER CREDIT CONTRACT IS SUBJECT TO ALL CLAIMS AND DEFENSES WHICH THE DEBTOR COULD ASSERT AGAINST THE SELLER OF GOODS OR SERVICES OBTAINED WITH THE PROCEEDS HEREOF. Under the UCC, no one can be a holder in due course of an instrument with this language. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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In the following bonus case, consumers found that a home improvement contract, far from improving their home, almost caused them to lose it.

Bonus Case: Antuna v. Nescor, Inc.60 Facts: Steven Vlohotis was a salesman for NESCOR, a home improvement company. He convinced the Antunas to sign a consumer credit contract with NESCOR to install vinyl siding and windows. The contract provided that the Antunas would pay for the improvements in installments. NESCOR assigned the contract to First Consumer Credit, LLC, which reassigned it to The Money Store (TMS). In keeping with FTC requirements, the contract contained the following language: “Any holder of this consumer credit contract is subject to all claims and defenses which the debtor could assert against the Seller of the goods or services pursuant hereto or with the proceeds hereof.” Connecticut law (the Act) provides that, “No home improvement contract shall be valid or enforceable against an owner unless it is entered into by a registered salesman or a registered contractor.” The NESCOR salesman, Vlohotis, was not registered. Unhappy with NESCOR’s work, the Antunas stopped making payments under the contract. TMS filed suit, seeking to foreclose on their house. The Antunas moved for summary judgment, arguing that TMS could not enforce the contract because it was not a holder in due course. Issue: Does TMS have the right to foreclose on the Antunas’ home? Was TMS a holder in due course? Excerpts from Judge Shortall’s Decision: In employing Vlohotis to call on the plaintiffs as its salesman NESCOR was performing an illegal act, one explicitly prohibited. Accordingly, the court finds that NESCOR’s noncompliance with [the statute] renders the home improvement contract invalid and unenforceable and precludes it from enforcing the consumer credit contract against the plaintiffs. The plaintiffs are seeking summary judgment against TMS on its counterclaim, which seeks to foreclose upon the plaintiffs’ home because of their default under the consumer credit contract now held by TMS. They argue that summary judgment is appropriate because NESCOR’ s violation of the Act bars any recovery by TMS. It is only by giving consumers like the plaintiffs a shield against enforcement of these consumer credit contracts that the Act’s declaration that a contract is invalid and unenforceable has any meaning. The language appearing in the consumer credit contract held by TMS, viz., that the contract is “subject to all claims and defenses which” the plaintiffs could assert against NESCOR is mandated in all such contracts by the FTC to prevent the seller of goods from cutting off the consumer’s right to assert claims and defenses against the seller’s assignee. So, in this case, where the Act, itself, gives the plaintiffs the right to defend against enforcement of the home improvement contract, the language in the consumer credit contract held by TMS gives them the same right as against TMS.

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Accordingly, because the TMS is subject to those same claims and defenses under the very language of its contract with the plaintiffs, TMS may not enforce the consumer credit contract it holds by foreclosing on the plaintiffs’ property for nonpayment. The plaintiffs’ motion for summary judgment is granted.

Bonus Case: Scott v. Mayflower Home Improvement Corp.61 Facts: Mary Johnson signed a contract with Mayflower to perform repair work on her home for a fee of $25,900. Mayflower arranged for Johnson to pay for this work by borrowing money from Sterling Resources. The note she signed with Sterling had an unconscionably high price of $50,108.60 and an interest rate of 17.98%. Johnson alleges that Mayflower was running a scam, hiring unlicensed salespeople to target minority neighborhoods for home repairs. Its contracts contained deceptive or incomplete specifications and payment terms. The actual work was shoddy or incomplete, using poor quality materials. Sterling routinely loaned money to Mayflower customers. Sterling then sold the loans to banks and other financial institutions. Johnson failed to make the payments due on the note and the Lender sued, moving for summary judgment against Johnson on the grounds that, as a holder in due course, it was entitled to enforce the note regardless of her claims against Mayflower or Sterling. She responded that, under the FTC consumer exception rule, the Lender was not a holder in due course and therefore subject to whatever defenses she had against Sterling or Mayflower. Issue: Was the Lender a holder in due course? Holding: Summary judgment is granted for Johnson. The purpose of the Act is to prevent the seller of goods or service provider from cutting off the consumer’s right to assert claims and defenses against the seller’s or provider’s assignee. NESCOR’s maTanyaal noncompliance with the Act renders the home improvement contract invalid and unenforceable and precludes it from enforcing the consumer credit contract against the plaintiffs. Question: What was going on in this case? Answer: Mayflower was running a scam. It would persuade minorities in poor neighborhoods to do repairs on their houses. It would charge exorbitant prices and interest rates to perform shoddy work. Question: Why didn’t Mayflower keep the note that Mary Johnson signed? Answer: Because if it kept the note itself, it wouldn’t be a holder in due course and Johnson could raise defenses against it. Question: Was the Lender, in the end, a holder in due course? Answer: No, the court held that it wasn’t because the note Johnson signed had the FTC Holder Rule printed on it. Question: Why did Mayflower and the Lender think they could enforce a note that contained this language? 61

363 N.J. Super. 145; 831 A.2d 564; 2001 N.J. Super. LEXIS 524 SUPERIOR COURT OF NEW JERSEY, 2001 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: They hoped that Johnson would not understand her rights.

Chapter Conclusion Commercial paper provides essential grease to the wheels of commerce. It is worth remembering, however, that the terms of the UCC are precise and that failure to comply with these exacting provisions can lead to unfortuante consequences.

Matching Questions Match the following terms with their definitions: _____A. Drawer 1. Someone who issues a promissory note _____B. Drawee 2. The person who issues a draft _____C. Issuer 3. The person who pays a draft _____D. Maker 4. Anyone in possession of an instrument if it is indorsed to her _____E. Holder 5. The maker of a promissory note or the drawer of a draft Answers: KK. 2 LL. 3 MM. NN. 1 OO. 4

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 68. T F The possessor of a piece of commercial paper always has an unconditional right to be paid 69. T F Three parties are involved in a draft. 70. T F To be negotiable, bearer paper must be indorsed and delivered to the transferee. 71. T F Negotiation means that an instrument has been transferred to the holder by the issuer. 72. T F A promissory note may be valid even if it does not have a specific due date.

Multiple Choice Questions 1

CPA QUESTION: In order to negotiate bearer paper, one must: A. Indorse the paper B. Indorse and deliver the paper with consideration © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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C. Deliver the paper D. Deliver and indorse the paper Answer: C. 2

The possessor of a piece of order paper does not have an unconditional right to be paid if: A. The paper is negotiable. B. The possessor is not the payee. C. The paper has been indorsed to the possessor. D. The possessor is a holder in due course. E. The issuer changed his mind after signing the instrument.

Answer: B. 3

An instrument is negotiable unless: A. It is in writing. B. It is signed only by the drawee. C. It contains an order to pay. D. It is payable on demand. E. It is payable only to bearer. Answer: B.

Chloe buys a motorcycle on eBay from Junior. In payment she gives him a promissory note for $7,000. He immediately negotiates the note to Terry. After the motorcycle arrives, Chloe discovers that it is not as advertised. One week later, she notifies Junior. She still has to pay Terry because: A. On eBay, the rule is “buyer beware.” B. Terry’s rights are not affected by Junior’s misdeeds. C. Terry indorsed the note. D. Chloe is the drawee. E. Chloe waited too long to complain.

Answer: B. 5.

Donna gives a promissory note to C. J. Which of the following errors would make the note invalid? A. The instrument was written on a dirty sock. B. The instrument promised to pay 15,000 euros. C. The note stated that Donna owed C. J. “$1,500: One thousand and five dollars.” D. Donna signed the note without reading it. E. The due date was specified as “three months after Donna graduates from college.” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: E.

Case Questions 1.

Kay signed a promissory note for $220,000 that was payable to Investments, Inc. The company then indorsed the note over to its lawyers to pay past and future legal fees. Were the lawyers holders in due course? Answer: The lawyers could not be holders in due course unless they had given value for the note. The answer depends on whether the prior legal fees had real value.

2. Shelby wrote the check shown below to Dana. When is it payable and for how much?

Answer: It is payable on August 3, 2009 (because handwritten terms prevail over typewritten terms) for $382 (because words control figures.) 3.

In the prior question, who are the drawer, drawee, and payee of this check? Answer: Shelby Case is the drawer; Last National Bank of Alvin is the Drawee; Dana Locke is the Payee.

4. Tanya and Jerry entered into a contract with a real estate developer who stated that he would build the house of their dreams on a lot that he owned. In payment for the property and the house, T&UJ signed a promissory note that was payable “upon closing on sale of the house to be constructed on the below described lot or one year from the date of this Note, whichever event first occurs.” Is this note negotiable? Answer: No. To be negotiable, a note must be payable on demand or at a definite time. The due date of this note is unknowable at the time it was executed. 5.

Duncan Properties, Inc. agrees to buy a car from Shifty for $25,000. The company issues a promissory note in payment. The car that Duncan bought is defective. If Shifty still has the note, does Duncan have to pay it? Answer: No, because Shifty is just a holder, not a holder in due course, so all the contract defenses are valid against him. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Shifty sells that note to Honest Abe for $22,000. Does Duncan have to pay Abe? Answer: Yes, as long as Abe did not know of any problems with the car contract when he acquired the note.

Abe gives the note to his daughter, Prudence, for her birthday. Is Prudence a holder in due course? Does Duncan have to pay Prudence? Answer: Prudence is not a holder in due course because she did not give value. However, under the Shelter Rule, Duncan must still pay her.

8. Ian was CEO of a company. He stole money from the company by writing a series of checks made out to “Cash” which he deposited in his own personal account at Bank. (Please do not try this at home.) Of course, he then spent the money. The company sued the Bank to get the money back. Was the Bank a holder in due course? Answer: The court ruled that the Bank was a holder in due course because it did not know of Ian’s wrongdoing. McConnico v. Third Nat'l Bank, 499 S.W.2d 874 (Tenn. 1973)

Discussion Questions 1. Catherine suffered serious physical injuries in an automobile accident and became acutely depressed as a result. One morning, she received a check for $17,400 in settlement of her claims arising out of the accident. She indorsed the check and placed it on the kitchen table. She then called Robert, her longtime roommate, to tell him the check had arrived. That afternoon, she jumped from the roof of her apartment building, killing herself. The police found the check and a note from her, stating that she was giving it to Robert. Had Catherine negotiated the check to Robert? Answer: The court held that Wagner had negotiated the check to Scherer. By indorsing the check and leaving it on the table, she had completed constructive delivery. Scherer v. Hyland, 380 A.2d 698, 1977 N.J. LEXIS 267 (N.J. 1977). 2. ETHICS In desperate financial trouble and fearful of losing his house, Abbott asked his friend Taylor for help. Taylor had been an officer of the Bank, so she put Abbott in touch with some of her former colleagues there. When a $300,000 loan was ready for closing, Taylor informed Abbott that she expected a commission of $15,000. Taylor threatened to block the loan if her demands were not met. Abbott was desperate, so he agreed to give Gardner $4,000 in cash and a promissory note for $1 1,000. On what grounds might Abbott claim that the note is invalid? Would this be a valid defense? Even if Gardner was in the right legally, was she in the right ethically? Answer: Answers will vary. 3. The Blasco case involved a payday loan, for which she was paying 6,500 percent interest. Some states outlaw such loans or heavily regulate the interest rates. Should the law permit these loans? Answer: Proponents of the loans argue that these are desperate measures for desperate people. No © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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one who has other choices would borrow money this way. Do you want people to starve waiting for their next paycheck? Opponents say that the payday loan companies are exploiting the poor who do not realize how high the interest rate is. Also, borrows get trapped in a cycle where they have to keep borrowing to pay past loans. 4. Kendall raised hogs. The Grain Company would provide him with hogs and grain and, in return, he would sign a promissory note in an amount equal to the value of these items. Once the pigs were grown, Kendall would sell them and repay the loan. One time, an officer of the Grain Company asked Kendall to sign not only his own but also his wife’s name to the promissory note. Kendall did so, but put his initials, KH, after her name to indicate that he was the one who had signed the note. Grain Company sold this note to Bank. It turned out that the Grain Company did not actually own the hogs it had given Kendall and the true owner took them away. Bank sued Kendall for payment on the promissory note. Are Kendall and/or his wife liable on the note? Answer: The court ruled that Kendall was not liable because the Bank had not taken the note in good faith and, thus, was not a holder in due course. When the bank got the note, it could see Kendall’s initials. Thus it knew that Kendall’s wife had not signed the note and, therefore, the transaction was not honest in fact. Arcanum Nat'l Bank v. Hessler, 69 Ohio St. 2d 549 (Ohio 1982) 5. Kendall raised hogs. The Grain Company would provide him with hogs and grain and, in return, he would sign a promissory note in an amount equal to the value of these items. Once the pigs were grown, Kendall would sell them and repay the loan. One time, an officer of the Grain Company asked Kendall to sign not only his own but also his wife’s name to the promissory note. Kendall did so, but put his initials, KH, after her name to indicate that he was the one who had signed the note. Grain Company sold this note to Bank. It turned out that the Grain Company did not actually own the hogs it had given Kendall and the true owner took them away. Bank sued Kendall for payment on the promissory note. Are Kendall and/or his wife liable on the note? Answer: The court ruled that Kendall was not liable because the Bank had not taken the note in good faith and, thus, was not a holder in due course. When the bank got the note, it could see Kendall’s initials. Thus it knew that Kendall’s wife had not signed the note and, therefore, the transaction was not honest in fact. Arcanum Nat'l Bank v. Hessler, 69 Ohio St. 2d 549 (Ohio 1982) 5. On October 12, James Camp agreed to provide services to Shawn Sheth by October 15. In payment, Sheth gave Camp a check for $1,300 that was post-dated October 15. On October 13, Camp sold the check to Buckeye Check Cashing for $1,261.31. On October 14, fearing that Camp would violate the contract, Sheth stopped payment on the check. Also, on October 14, Buckeye deposited the check with its bank, believing that the check would reach Sheth’s bank on October 15. Buckeye was unaware of the stop payment order. Sheth’s bank refused to pay the check. Buckeye filed suit against Sheth. Was Buckeye a holder in due course? Must Sheth pay Buckeye? Answer: The court ruled that Buckeye was not a holder in due course. It passed the subjective “honesty in fact” test because it is clear that Buckeye accepted the check from Camp in good faith. However, it did not pass the objective prong of the good faith test because Buckeye did not conduct itself in a commercially reasonable manner. The presentation of a postdated check should put a check cashing company on notice that the check might not be good. Therefore, some attempt at verification should be made before cashing the check. Such a failure to act does not constitute taking an instrument in good faith under the current objective test of “reasonable commercial standards.”+ Buckeye Check Cashing, Inc. v. Camp, 159 Ohio App. 3d 784 (App. Ct, Ohio 2005)

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Suggested Additional Assignments Research: Indorsements Ask students to look at the checks that have been returned with their bank statements and find as many different types of indorsements as they can: blank, special, or restrictive. Ask them to bring photocopies of the indorsements to class.

Chapter 16 –Secured Transactions* Chapter Overview Chapter Theme Secured transactions are essential to modern commerce. Without them, many consumers would never own a car or stereo, and many businesses would be unable to grow. But unless these debts are repaid, the economy will falter. Secured transactions are one method for ensuring that creditors are paid.

16-1 Article 9: Terms and Scope Article 9 of the Uniform Commercial Code (UCC) governs secured transactions in personal property. Article 9 employs terms not used elsewhere, so we must lead off with some definitions: Fixtures: Goods that have become attached to real estate. Security interest: An interest in personal property or fixtures that secures the performance of an obligation. Secured party: A person or company that holds a security interest. Collateral: Property that is subject to a security interest. Debtor: A person who has original ownership interest in the collateral. Security agreement: A contract in which the debtor gives a security interest to the secured party. Repossession: Occurs when the secured party takes back collateral because the debtor has defaulted. Perfection: A series of steps that the secured party must take to protect its rights in the collateral against people other than the debtor. Financing Statement: A document that the secured party files to give the general public notice that it has a security interest in the collateral. Record: Information written on paper or stored in an electronic or other medium. Authenticate: Means to sign a document or to use any symbol or encryption method that identifies the person and clearly indicates she is adopting the record as her own.

16-1a Scope of Article 9 Article 9 applies to any transaction intended to create a security interest in personal property or fixtures.

Types of Collateral The personal property that may be used as collateral includes: Goods, which are things that are movable. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Inventory, meaning goods held by someone for sale or lease, such as all the beds and chairs in a furniture store. Instruments, such as drafts, checks, certificates of deposit, and notes. Investment property, which refers primarily to securities and related rights. Other property, including documents of title, accounts, general intangibles (copyrights, patents, goodwill, and so forth), and chattel paper.

16-2 Attachment of a Security Interest Attachment: A three-step process that creates an enforceable security interest. The three steps are: 1. The two parties made a security agreement, and either the debtor has authenticated it or the secured party has obtained possession of control. 2. The secured party has given value to obtain the security agreement. 3. The debtor has rights in the collateral.

16-2a Agreement Without an agreement, there can be no security interest. The agreement may be written on paper and signed by the debtor or electronically recorded, and must identify the collateral. At a mini8mum, a security agreement might:  State that Happy Homes, Inc. and Martha agree that Martha is buying an Arctic Co. refrigerator, and identify the exact unit by its serial number;  Give the price, the down payment, the monthly payments, and interest rate;  State that because Happy Homes is selling Martha the refrigerator on credit, it has a security interest in the refrigerator; and  Provide that if Martha default, Happy Homes is entitled to repossess the refrigerator.

16-2b Possession If the parties have an oral agreement and the secured party has possession, no writing is needed.

16-2c Value For the security interest to attach, the secured party must give value.

16-2d Debtor Rights in the Collateral The debtor can grant a security interest in goods only if he has some legal right to those goods himself.

16-2e Attachment to Future Property The parties may agree that the security6 interest attaches to after-acquired property. After-acquired property: Item’s that the debtor obtains after the parties have made their security agreement.

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Once the security interest has attached to the collateral, the secured party is protected against the debtor, (but it may not be protected against anyone else). There are several kinds of perfection, including:  Perfection by filing  Perfection by possession  Perfection of consumer goods, In some cases, the secured party will have a choice of which method to use; in other cases, only one method works.

16-3a Perfection by Filing The most common way to perfect an interest is by filing a financing statement with the appropriate state agency.

Contents of the Financing Statement A financing statement is sufficient if it provides the name of the debtor, the name of the secured party, and an indication of the collateral.

Place and Duration of Filing Article 9 specifies where a security party must file. These provisions vary from state to state, so it is essential to check local law. Generally speaking, a party must file in a central filing office located in the state where an individual debtor lives or where an organization has its executive office. The statement is effective for 5 years, unless renewed.

16-3b Perfection by Possession For most types of collateral, in addition to filing, a secured party generally may perfect by possession or control. However, possession imposes one important duty: A secured party must use reasonable care in the custody and preservation of collateral in her possession.

16-3c Perfection of Consumer Goods Purchase money security interest (PMSI): An interest taken by the person who sells the collateral or advances the money so the debtor can buy it. The UCC gives special treatment to security interests in most consumer goods. Note: A PMSI in consumer goods perfects automatically, without filing. [See Exhibit 16.3, not available at the time this IM chapter was created.]

16-4 Protection of Buyers Buyers in the ordinary course of business (BIOC): Someone who buys goods in good faith from a seller who routinely deals in such goods. Generally, once a security interest is perfected, it remains effective regardless of whether the collateral is sold, exchanged, or transferred in some other way.

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The key exception to this rule is that the Code gives buyers in the ordinary course of business ((BIOC) special protection. A BIOC is generally not affected by the security interest in the goods. A buyer in the ordinary course of business takes the goods free of a security interest created by its seller even though the security interest is perfected. Because the BIOC exception undercuts the basic protection given to a secured party, the courts interpret it narrowly. BIOC status is available only if the seller created the security interest. If the buyer purchases from someone who did not create the security interest, the buyer is not a BIOC. Should that rule be strictly enforced even when the results are harsh? You make the call.

You Be the Judge: Conseco Finance Servicing Corp. v Lee62 Facts: Lila Williams purchased a new Roadtrek 200 motor home from New World R.V. Inc. She paid about $14,000 down and financed $63,000, giving a security interest to New World. The RV company assigned its security interest to Conseco Finance, which perfected. Two years later, Williams returned the vehicle to New World (the record does not indicate why), and New World sold the RV to Robert and Ann Lee, for $42,800. A year later, Williams defaulted on her payments to Conseco. The Lees sued Conseco, claiming to be BIOCs and asking for a court declaration that they had sole title to the Roadtrek. Conseco counterclaimed, seeking title based on its perfected security interest. The trial court ruled that the Lees were BIOCs, with full rights to the vehicle. Conseco appealed. You Be the Judge: Were the Lees BIOCs? Argument for Conseco: Under the UCC, a BIOC takes free of a security interest created by the buyer’s seller. The buyers were the Lees. The seller was New World. New World did not create the security interest – Lila Williams did. There is no security interest created by new World. The security interest held by Conseco was created by someone else. (Williams) and is not affected by the Lees’s status as BIOCs. The law is clear, and Conseco is entitled to the Roadtrek. Argument for the Lees: Conseco weaves a clever argument, but let’s look at what they are really saying. Two honest buyers, acting in perfect good faith, can walk into an RV dealership, spend $42,000 for a used vehicle, and end up with – nothing. Conseco claims it is entitled to an RV that the Lees paid for because someone that the Lees have never dealt with, never even heard of, gave to this RV seller a security interest that the seller, years earlier, passed on to a finance company. Conseco’s argument defies common sense and the goals of Article 9. Holding: Judgment for Conseco. The court devoted only a few sentences to this issue. Section 9-320 enables a BIOC to take free and clear of a security interest created by the seller. Unfortunately, Lila Williams, not the seller, created this security interest. Section 9-320 does not help the Lees, and Conseco’s security interest is valid and enforceable. Question: The Lees’ argument is far more persuasive. Common sense tells me they should win and I thought the UCC tried to create reasonable, sensible results. Why Conseco win?

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Answer: Lawyers have a saying: When the law is not on your side, argue the facts; when the facts are not on your side, argue the law. The emotional appeal of the Lees’ argument notwithstanding, the law—U CC §9-320—is squarely behind Conseco in this case. Question: What does §9-320 provide? Answer: A buyer in ordinary course of business takes the goods free of a security interest created by his seller, even though the security interest is perfected. Question: Did the seller—New World R.V. Inc.—create this security interest? Answer: No. Lila Williams created it when she borrowed money from New World to finance her acquisition of the RV. Question: Did New World still hold Williams’ debt when the Lees purchased the RV? Answer: No. New World assigned the security interest to Conseco. Question: What does that mean? Answer: Typically, it means that Conseco purchased Williams’ loan from New World at a discount to its face value. New World receives cash it can use to make new loans and Conseco has the right to receive all future loan payments. Question: So although New World was an original party to Williams’ security interest, §9-320 does not apply because New World did not create the interest. Answer: Yes. Question: Does that leave the Lees without any legal remedy? Answer: No. They can sue New World, which knew both that Williams created a security interest in this RV and that Conseco held the interest.

16-5 Priorities among Creditors Priority: The law sets out three rules to establish which creditors have better claims. There are three rules:

Rule #1: A party with a perfected security interest takes priority over a party with an unperfected interest. Rule #2: If neither secured party has perfected, the first interest to attach gets priority. Rule #3: Between perfected security interests, the first to file or perfect wins.

Case: In Re Roser 613 F.3d 1240, U.S. Ct. App, Tenth Cir., 2010

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Facts: Robert Roser obtained a loan from Sovereign Bank, which he promptly used to buy a car. Nineteen day slater, Sovereign filed a lien with the state of Colorado. The bank expected that, with a perfected interest, it would have priority over everyone else. Unknown to Sovereign Bank, Roser had declared bankruptcy only 12 days after he purchased the car. Later, the bankruptcy trustee argued that he had priority over Sovereign because the bankruptcy filing happened before Sovereign perfected its security interest. When the court found for the trustee, Sovereign Bank appealed. Issue: Did Sovereign Bank, a PMSI holder, obtain priority over the bankruptcy trustee? Decision: Yes, the PMSI holder obtained priority. Reasoning: On the day that Roser entered bankruptcy, Sovereign Bank had not filed its financing statement, which means that its security interest was not yet perfected. Ordinarily, a bankruptcy trustee would take priority over all security interests that are unperfected on the day that a debtor files a bankruptcy petition. However, there is an exception to this rule: If the creditor files a financing statement for a PMSI within 20 days after the de3btor receives the collateral, that security interest is deemed to have been perfected as of the date the debtor receives the collateral, not the day on which the financing statement was filed. In this case, the bank filed within that 20-day grace period, so its security interest took priority over the bankruptcy trustee. Reversed and remanded. Question: Sovereign Bank had not filed its security interest by the time Roser filed for bankruptcy. How did they win? Answer: Sovereign Bank won because the law provided for a 20-day grace period within which the creditor could files a PMSI financing statement and still be on time, if the debtor had already received the collateral. Question: Why do you think the law provided a 20-day grace period for creditors of PMSI liens? Answer: Answers will vary, but it seems to be a recognition of the fact that a business financing such transactions would need time to accomplish the filing, while continuing to conduct business.

16-6 Default and Termination We have reached the end of the line. Either the debtor has defaulted or it has performed its obligations and may terminate the security agreement.

16-6a Default Generally, a debtor defaults when he fails to make payments due or enters bankruptcy proceedings.

Taking Possession of the Collateral When the debtor defaults, the secured party may take possession of the collateral in either of two ways: The secured party can file suit against the debtor to obtain a court order requiring the debtor to deliver the collateral, or the secured party may act on its own and simply take the collateral, provided this can be done without a breach of the peace. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Breach of the peace: Occurs when a repossession disturbs public tranquility or order.

Case: Chapa v. Traciers & Associates, Inc. 267 S.W.3d 386, Texas Court of Appeals, 2008 Facts: Marissa Chapa defaulted on her car loan, so Ford Motor Credit Corp. hired Traciers & Associates to repossess her white Ford Expedition. Paul Chambers, Traciers’s field manager, staked out the address on file, waiting for a chance to make his move.

One morning, Chambers saw a woman drive a white Expedition out of the driveway and leave it running in the street while she ran back into the house. He made his move, quickly hooking up the car to his tow truck, and driving away. Chambers may have been fast, but he was wrong about two things. First, he took the wrong car. This similar vehicle belonged to Marissa’s sister-in-law Maria, who was not in default. Second, Maria’s two children were in the back seat. When Maria realized that her car and her children had disappeared, she hysterically dialed 911. Within minutes, Chambers discovered the two Chapa children and immediately returned the kids and the car to a frantic Maria. Maria sued Ford, the repossession company, and the bank, claiming they had committed a breach of the peace. The trial court dismissed the case and she appealed. Issue: Did Chambers commit a breach of the peace in repossessing the car? Decision: No, the repo man’s error was not a breach of the peace. Reasoning: When a borrower defaults, a secured party may repossess the collateral without a court order as long as it does not breach the peace. A “breach of the peace” is any conduct that disturbs public order and tranquility, such as violent or forceful action or threats. If the borrower objects during the repossession, t5hen, to avoid confrontation, the secured party must immediately desist and pursue its remedy in court. Here, although Chambers made some mistakes, he did not breach the pace. He removed an apparently unoccupied car from a public street without immediate confrontation, violence, threats, or objection. Chambers returned the vehicle minutes later, as soon as he realized there were children in the car. Chambers’s repossession, while very upsetting to Maria, was not a breach of the peace. Question: Did Chambers take the right car? Answer: No, he took a similar car (also a white Expedition), but not the car that was the subject of the defaulted lien. Question: Did he know the children were in the car at the time? Answer: No, apparently not. When he discovered them, he immediately returned them and the car. Question: Why did the court find that this was not a breach of the peace? Answer: Because Chambers’s mistakes did not constitute violence, threats, or the like. Question: Do you think Chambers will look in the back seat next time? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Answers will vary.

Disposition of the Collateral Once the secured party has obtained possession of the collateral, it has two choices. The secured party may (1) dispose of the collateral or (2) retain the collateral as full satisfaction of the de3bt. The secured party may sell, lease, or otherwise dispose of the collateral in any commercially reasonable manner. The debtor is liable for any deficiency.

16-6b Termination When the debtor pays the full debt, the secured party must complete a termination statement a document indicating that it no longer claims a security interest in the collateral. (An UCC-3 statement). For a consumer debt, the secured party must file the termination statement in every place that it filed a financing statement, within certain time limits.

One important takeaway is that the law of secured transactions can be unforgiving. An inconsistency on a UCC filing can be fatal to a creditor’s claim. The following case ends the chapter with some drama. A lawyer made a $1.5 billion mistake – and no one was sympathetic.

Case: In Re Motors Liquidation Co. 2015 U.S. App. 859; U.S. Ct. App. 2nd Cir. (2015)

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Facts: General Motors was the debtor on two unrelated secured transactions. The first was a $300 million loan (known as the “Synthetic Lease”); the second was a $1.5 billion term loan (the “Term Loan”). JPMorgan Chase Bank was the secured party on both transactions. When GM decided to pay off the Synthetic Lease, it instructed its lawyers at the firm of Mayer Brown to prepare the necessary termination statements for that loan. A partner at the firm assigned an associate, who then instructed a paralegal to perform a search for all the financing statements against GM recorded in Delaware. The search yielded both the Synthetic Lease and the Term Loan. Unaware that the Term Loan was unrelated to the Synthetic Loan, Mayer Brown prepared the documentation to terminate them both and circulated it for GM, JPMorgan, and JPMorgan’s lawyers (at another law firm named Simpson Thacher) to review. All the parties approved the documents, which were promptly filed with Delaware’s secretary of state. No one realized that terminating security for the Term Loan was a mistake. When General Motors filed for bankruptcy the following year, JPMorgan discovered the error. Without a security interest, the Term Loan was much less likely to be repaid. The bank asked that its security interest in the Term Loan be reinstated because the UCC-3 filing had been a mistake. GM’*s unsecured creditors argued that the termination statement was valid and the Term Loan was now unsecured. According to Delaware law, a filing is valid if it is authorized by the secured party. Whether or not the party intended or understood the filing’s consequences is irrelevant. The bankruptcy court ruled that the UCC-3 was ineffective because JPMorgan did not authorize it. The unsecured creditors appealed. Issue: Was the termination statement valid? Is the Term Loan unsecured? Decision: Yes, the termination statement is valid. the Term Loan is unsecured. Reasoning: In determining the validity of a termination statement, the secured party’s intent is irrelevant. Here, JPMorgan and its lawyers knew that GM’s lawyers were preparing the draft UCC-3 termination statements, which would be filed upon their approval. They approved the UCC-3 for the Term Loan, without expressing any concerns. JPMorgan and its lawyers then gave GM’s lawyers the authority to act on its behalf in filing the approved UCC-3. Nothing more is needed to terminate the security of the Term Loan. Question: What went wrong here? Answer: The search for the Delaware financing statement made by the paralegal revealed two financing statements filed against GM. She reported these to the associate attorney, who then proceeded to draft termination statements for both loans, the one that was intended, and the other, much larger loan, that was not intended to be released. Question: Did anyone else review the work? Answer: Yes. Lawyers from all the firms involved, as well as the firms themselves, all reviewed the draft termination statements, but no one caught the error. Question: What effect did this have on GM’s bankruptcy? Answer: The creditor would be much less likely to collect on the $1.5 billion owed to it. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Chapter Conclusion Secured transactions are essential to modern commerce. Without them, many consumers would never own a car or stereo, and many businesses would be unable to grow. But unless these debts are repaid, the economy will falter. Secured transactions are one method for ensuring that creditors are paid.

Matching Questions Match the following terms with their definitions: _____A. Attachment 1. Someone who buys goods in good faith from a seller who deals in such goods. _____B. BIOC 2. Steps necessary to make a security interest valid against the whole world _____C. Perfection 3. A security interest taken by the person who sells the collateral or advances money so the debtor can buy it _____D. PMSI 4. The order in which creditors will be permitted to seize the property of a bankrupt debtor _____E. Priority 5. Steps necessary to make a security interest valid against the debtor, but not against third parties Answers: PP. 5 QQ. 1 RR. 2 SS. 3 TT. 4

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 73. T F A party with a perfected security interest takes priority over a party with an unperfected interest. 74. T F A buyer in the ordinary course of business takes goods free of an unperfected security interest but does not take them free of a perfected security interest. 75. T F When a debtor defaults, a secured party may seize the collateral and hold it, using reasonable care, but may not sell or lease it. 76. T F A party may take a security interest in tangible things, such as goods, but not in intangible things, such as bank accounts. 77. T F Without an agreement of the parties, there can be no security interest.

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1. CPA QUESTION Under Article 9 of the UCC, perfection of a security interest by a creditor provides added protection against other parties in the event the debtor does not pay its debts. Which of the following parties is not affected by perfection of a security interest? (a) Other prospective creditors of the debtor (b) The trustee in a bankruptcy case (c) A BIOC (d) A subsequent personal injury judgment creditor Answer: C. 2. Jim’s birth certificate lists him as “James Brown Smith;” his driver’s license identifies him as “Jim Smith;” his business card reads “J.B. Smith” and his friends call him Jimbo. How should the financing statement list this debtor’s name? (a) James Smith (b) J.B. Smith (c) Jim Smith (d) James Brown Smith Answer: C. The 2013 revisions require the financing statement to list the same name as the debtor’s driver’s license. The statement should read “Jim Smith.” 3. CPA QUESTION Mars, Inc., manufactures and sells VCRs on credit directly to wholesalers, retailers, and consumers. Mars can perfect its security interest in the VCRs it sells without having to file a financing statement or take possession of the VCRs if the sale is made to which of the following: (a) retailers (b) wholesalers that sell to distributors for resale (c) consumers (d) wholesalers that sell to buyers in ordinary course of business Answer: C. CPA Examination, May 1993, #47. 4.

Which case does not represent a purchase money security interest?

(a)

Auto Dealer sells consumer a car on credit.

(b)

Wholesaler sells Retailer 5,000 pounds of candy on credit

(c)

Bank lends money to Retailer, suing Retailer's existing inventory as collateral

(d)

Bank lends money to Auto Dealer to purchase 150 new cars, which are the collateral.

(e)

Consumer applies to Credit Agency for a loan with which to buy a yacht. Answer: E.

Millie lends Arthur, her next-door neighbor, $25,000. He gives her his diamond ring as collateral for the loan. Which statement is true? 5.

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(a) Millie has no valid security interest in the ring because the parties did not enter into a security agreement. (b)

Millie has no valid security interest in the ring because she has not filed appropriate papers.

(c)

Millie has an attached, unperfected security interest in the ring.

(d) filing.

Millie has an attached, unperfected security interest in the ring but can perfect her interest by

(e)

Millie has an attached, perfected security interest in the ring.

Answer: E.

Case Questions 1. Sears sold a lawn tractor to Cosmo Fiscante for $1,481. Fiscante paid with his personal credit card. Sears kept a valid security interest in the lawnmower but did not perfect. Fiscante had the machine delivered to his business, Trackers Raceway Park, the only place he ever used the machine. When Fiscante was unable to meet his obligations, various creditors attempted to seize the lawnmower. Sears argued that because it had a purchase money security interest (PMSI) in the lawnmower, its interest had perfected automatically. Is Sears correct? Answer: No. A PMSI in consumer goods perfects automatically. A consumer good is one that is used primarily for personal, family, or household purposes. Many lawnmowers are consumer goods, but this one was not, and Sears’s security interest was not perfected. IN RE Cosmo Nick Fiscante, 141 Bankr. 303, 1992 Bankr. LEXIS 907 (W.D. Pa. 1992).

2. When Corona leased farmland to a strawberry farmer named Armando Munoz Juarez, it claimed a security interest in his strawberry crop. Corona’s financing statement listed the farmer’s name as “Armando Munoz,” even though his state-issued ID card identified his last name as “Juarez.” When the farmer contracted to sell strawberries to Frozsun, it filed its own financing statement securing the strawberries. This statement listed the debtor’s name as “Armando Juarez.” When the farmer defaulted, both Corona and Frozsun claimed an interest in the same strawberries. Which party prevails—Corona or Frozsun? Why? Answer: Frozsun prevails because Corona did not list the debtor’s name correctly on the financing statement. The UCC requires the debtor’s name to be the same as on his driver’s license or stateissued ID. 3. Alpha perfects its security interest by properly filing a financing statement on January 1, 2010. Alpha files a continuation statement on September 1, 2014. It files another continuation statement on September 1, 2018. When will Alpha’s financing statement expire? Why? Answer: The interest will expire on September 1, 2019. After filing, a financing statement is valid for five years. A party can renew for any number of additional 5 year terms if a continuation statement is filed within six months of the expiration date. So, the September 1, 2014 continuation statement resets the clock for five years. The attempt to renew on September 1, 2018 is ineffective, because the continuation statement is filed more than six months before expiration. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. The state of Kentucky filed a tax lien against Panbowl Energy, claiming unpaid taxes. Six months later, Panbowl bought a powerful drill from Whayne Supply, making a down payment of $11,500 and signing a security agreement for the remaining debt of $220,000. Whayne perfected the next day. Panbowl defaulted. Whayne sold the drill for $58,000, leaving a deficiency of just over $100,000. The state filed suit, seeking the $58,000 proceeds. The trial court gave summary judgment to the state and Whayne appealed. Who gets the $58,000? Answer: It went to Whayne’s world. Taking the money from the taxpayer’s creditor Whayne rather than the taxpayer Panbowl resulted in a windfall to the state. Whayne has a perfected PMSI in the equipment and superiority over all other security interests in the equipment, including prior filed security interests. Whayne Supply Company, Inc. v. Commonwealth of Kentucky Revenue Cabinet, 925 S.W.2d 185; 1996 Ky. LEXIS 64; 30 U.C.C. Rep. Serv. 2d (Callaghan) 948. 5.

ETHICS The Dannemans bought a Kodak copier worth over $40,000. Kodak arranged financing by GECC and assigned its rights to that company. Although the Dannemans thought they had purchased the copier on credit, the papers described the deal as a lease. The Dannemans had constant problems with the machine and stopped making payments. GECC repossessed the machine and, without notifying the Dannemans, sold it back to Kodak for $12,500, leaving a deficiency of $39,927. GECC sued the Dannemans for that amount. The Dannemans argued that the deal was not a lease but a sale on credit. Why does it matter whether the parties had a sale or a lease? Is GECC entitled to its money? Finally, comment on the ethics. Why did the Dannemans not understand the papers they had signed? Who is responsible for that? Are you satisfied with the ethical conduct of the Dannemans? Kodak? GECC? Answer: If the transaction is actually a sale with a security interest, Article 9 governs–and that is precisely what the court held. The court granted the Danneman’s motion for summary judgment. The agreement, though called a lease, was actually a financing arrangement with a security interest. The “lessor” retained no real burdens of ownership. Further, GECC made a sweetheart sale back to the manufacturer, leaving the Danneman’s with a substantial deficiency. GECC failed to comply with the requirements of Article 9 and was not entitled to any money. As to the ethics, one could argue that the Danneman’s are responsible for signing, but in reality, no one other than a lawyer would recognize the document for what it was. The document was drafted by Kodak, which knew or should have known what kind of a transaction it was. The sweetheart sale does not look good in the light of day, and many would find the court’s holding legally and ethically right. G.E. Capital Corp. v. Dannemann Assoc, Inc., 1995 Del. Super. LEXIS 131 (Super. Ct. Dela. 1995).

Discussion Questions 1. Collateral may change categories depending on its holder and how it is being used at the time of default. Classify a refrigerator in the following circumstances: (a) When sold by an appliance store; © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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(b) When used by a restaurateur in his business; and (c) When installed in a homeowner’s kitchen. Answer: (a) Inventory and a good (b) Equipment and a fixture (c) Consumer good and a fixture 2. After reading this chapter, will your behavior as a consumer change? Are there any types of transactions that you might be inclined to avoid? Answer: Answers will vary. 3. After reading this chapter, will your future behavior as a businessperson change? What specific steps will you be most careful to take to protect your interests? Answer: Answers will vary. 4. A perfected security interest is far from perfect. We examined several exceptions to normal perfection rules involving BIOCs, consumer goods, and so on. Are the exceptions reasonable? Should the UCC change to give the holder of a perfected interest absolute rights against absolutely everyone else? Answer: Answers will vary. 5. After a federal judge refused to dismiss criminal charges against him, Michael Reed took revenge by electronically filing a UCC financing statement listing the judge, the prosecuting attorney, and former Secretary of the Treasury Timothy Geithner as $3.4 million debtors. Reed himself was listed as the secured party. The lien became part of the public record. When Reed was later prosecuted for violating a statute intended to prevent harassment of public officials, he argued that he was innocent because the financing statement listed no real or personal property as collateral – and would never have succeeded in perfecting a claim. What should the judge rule? Answer: Based on US v. Reed, 668 F.3d 978 (8th Cir. 2012). The judge ruled that Reed caused the financial harassment intended. Although the filing would not have succeeded in perfecting a priority claim to any property as a matter of commercial law, that was not a defense. Suggested Additional Assignments Good Faith Students should write a short description of realistic commercial behavior that skirts the border between lawful, aggressive business dealing and bad faith. Students should know in their own mind whether or not the behavior is legitimate. Students will then exchange examples, read them out loud, and analyze each other’s cases. Drafting: UCC 2-207 Students should draft a short offer form to be used by the seller of goods. Students must include specific terms on (1) price, (2) time and place of delivery, (3) method of payment, and (4) warranties. Students must do their best to ensure that any resulting contract includes only these terms.

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Research and Drafting Exercise: Warranties Ask students to find a sales slip with a warranty on it, read the warranty, and then rewrite the warranty in plain English. Explain exactly what the company will pay for and will not pay for if something goes wrong. Are they satisfied with the warranty? Are its terms reasonable? Comprehensible to classmates?

Ethics Problem: To Seize or Not to Seize To the Students: You are the manager of a small bank in the western United States. Your bank loaned $75,000 to a young farmer to help him purchase a tractor, planter, and harvester for his modest-sized organic vegetable farm. Your bank has a security interest in all of this equipment. Unfortunately, the farmer has fallen behind on payments and is just barely staying out of bankruptcy court. It is time for him to plant new crops and he has begged you to let him keep the equipment to do that. You have the right to seize the collateral, but if you do, he will have no way of generating income and will go bankrupt, losing his farm and other assets. What will you do? Research: Security Interests Students should assume that they are loan officers. They are considering making a loan to a retail company–any such company that is actually located near the school. They want to use as collateral as many of the company’s assets as possible. They must (1) research the state records to see whether there are outstanding security interests in any or all of the company’s assets, and (2) decide how much they would be willing to loan, by estimating the approximate worth of company assets that are not already securing another creditor’s loan. Research: Financing Statements Have students pick a local company and look online at the Secretary of State’s Office website for the UCC filings for that company. To whom does that company owe money? What has been pledged as collateral and to whom? If you were a loan officer at a bank, what would you look at to determine whether this company is a good risk?

Drafting and Role Play: Contract Warranties and Remedies The students will negotiate and draft a computer contract. Half of the students will represent Profit & Densom, a firm of 10 accountants. The others will represent Ibex, a computer consulting firm. The parties have agreed that Ibex will create and install a new computer system for P & D. Ibex will purchase all of the various hardware and software components, install them, and train P & D’s staff. The parties have agreed on the parameters of the system. They both expect the total fee for installation to be about $95,000, plus additional money for training. They are now negotiating warranties and liability. The two groups should negotiate and draft a contract that covers five basic issues:  What happens if the system never performs at all? Must P & D still pay for all or part of it? Suppose Ibex has spent $35,000 purchasing and preparing components. What if Ibex has provided some training that has benefited P & D employees?  What happens if the system functions for a while but then crashes? What if it works for one week? For six months? How long does Ibex remain responsible?  What happens if the system works well but crashes after P & D makes some minor modifications? It is common for buyers to begin tinkering with new systems, to modify the computer for their needs. Does Ibex retain any responsibility?

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What happens if the system fails, in whole or in part, and P & D suffers financial losses? Is Ibex responsible for lost time? Lost profits? Lost accounts? What happens if the system harms a third party? The system might cause P & D to prepare income tax returns improperly, or it could lose data, causing erroneous evaluations of a company’s financial status.

Chapter 17 – Agency* Chapter Overview Chapter Theme Once again, the subject is trade-offs. You can accomplish more if other people do things for you. On the other hand, you also face liability for their actions. Being a manager means getting things done through other people; but other people make mistakes. In this chapter, we look at how agency relationships are created and then we look at liability issues. It is virtually impossible to run a business without using agents. But using an agent dramatically increases the risk of liability–in both contract and tort. Because of this increased risk, it is important to understand agency law. It affects virtually everyone at some point in their lives.

17-1 The Agency Relationship Does an agency relationship exist? Principal: In an agency relationship, the person for whom an agent is acting. Agent: In an agency relationship, the person who is acting on behalf of a principal.

17-1a Creating an Agency Relationship To create an agency relationship, there must be:  A principal and  An agent  Who mutually consent that the agent will act on behalf of the principal and  Be subject to the principal’s control,  Thereby creating a fiduciary relationship. Consent: To establish consent, the principal must ask the agent to do something, and the agent must agree. Bonus Example: Consider the following examples from the Restatement of Agency (2nd). Is there an agency relationship? Question: Antonia wants to buy a car. The dealer permits her to take an automobile home to show her mother. On the way home, she gets into an accident. Is Antonia an agent for the dealer? (If she is, the dealer is liable for the damage she caused.) Answer: No, Antonia is not the dealer’s agent because she is acting for herself, not the dealer. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Suppose that Martin asks Beverly to return a shirt to the store where he recently purchased it. Is she an agent for Martin? Does it matter that he is not paying her? Answer: No, consideration is not required to create an agency relationship. Yes, she is his agent. Question: Are the directors of a corporation agents of the shareholders? Answer: No, because they are not under any obligation to do what the shareholders tell them -they are not under the shareholders’ control. They are fiduciaries of the shareholders, because they must act in the shareholders’ best interest, but they are not agents. Question: What about a truck driver who agrees to make a detour to take a hitchhiker to her destination? Is the truck driver an agent of the passenger? Answer: No, the truck driver is acting for the hitchhiker, but not under her control. Control: Principals are liable for an agent’s acts because they exercise control over that person.

Example: DEA Agent? A Federal Express employee in West Palm Beach noticed that a package smelled like laundry soap. Cocaine is often packed in laundry products to mask its smell. The employee checked the telephone directory and did not find the shipper’s name. He called the local Drug Enforcement Administration (DEA). While a DEA officer watched, the Federal Express employee opened the package and discovered cocaine. The package was addressed to Lacy Koenig. After obtaining a search warrant for Koenig’s residence, the DEA searched it and discovered other drugs. At her trial, Koenig asked the court to suppress the evidence, arguing that it was the fruit of an illegal search. She asserted that the Federal Express employee was acting as an agent of the government at the time he opened the package. Therefore, the search was illegal because the employee did not first obtain a search warrant, as the government would have been required to do. (The exclusionary rule applies only to searches by the government.)63 Question: Was the Federal Express employee an agent of the DEA? Answer: The court ruled against Koenig on the grounds that the government had not influenced the employee’s actions. The Federal Express employee had acted independently, not by agreement with the government or under the government’s control. Note: If students prepared a list of five instances in which they have acted as an agent for someone else or someone else has acted as an agent for them, this is a good time to discuss their examples.

Bonus Case: You Be The Judge: Gagnon v. Coombs64 Facts: Eighty-five year old Francis Gagnon and his wife lived on a farm in Shelburne, Massachusetts. They also owned land in Hillsborough, New Hampshire. They had two children: Joan Coombs, who lived 20 miles from Shelburne, and Frank Gagnon who lived in a trailer on a far corner of the farm. Joan suggested that her parents sign powers of attorney appointing her as their agent so that she could take care of them and their property.

United States v. Koenig, 856 F.2d 843, 1988 U.S. App. LEXIS 12655 United States Court of Appeals for the Seventh Circuit, 1988 64 39 Mass. App. Ct. 144; 654 N.E.2d 54; 1995 Mass. App. LEXIS 545 Massachusetts Appeals Court 1995 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Frank found out about the power of attorney when he checked his mother into a nursing home. Frank then moved his trailer in to the main house and convinced his father to revoke the power. Francis did so, but never told Joan explicitly. Two months later, Mrs. Gagnon died and Mr. Gagnon signed a purchase and sale [P&S] agreement for the Shelburne farm. He gave the property in Hillsborough to Frank. When Mr. Gagnon told Joan about the sale of the land and his intention to move to Hillsborough to live with Frank, she crafted her own plan. Not realizing that her power of attorney had been revoked, she used it to transfer the Shelburne property to a trust that she had created and that she controlled. Francis’s lawyer wrote to Joan demanding that she return the Shelburne property to him. She refused. The trial court found that Joan had the authority under the power of attorney to convey the Shelburne property to the trust. Francis appealed. You Be The Judge: Did Joan have the right to convey the Shelburne farm to a trust that she had established? Does the property belong to the trust or to Francis? Holding: Judgment for Joan reversed. The court ruled that Joan had violated her fiduciary duties to Francis by acting in her interest, not his. Also, he had “lost” the property when he signed a P&S on it and, therefore, her power of attorney did not permit her to transfer it. Question: What is a power of attorney? Answer: It is a document authorizing someone to be an agent. Question: When does it expire? Answer: It expires when the principal revokes it, when the principal dies or if the principal becomes incapacitated. (The one exception is a durable power of attorney, which is valid even if the principal becomes incapacitated.) Question: Francis never told Joan that he revoked her power of attorney. If Joan did not know, how could her authority be revoked? Answer: Francis told Joan indirectly. When she found out that he had signed a purchase and sale agreement to sell the property to someone else she could infer that he no longer intended for her to act as his agent, at least for that property. Question: But even after Francis signed the P&S, he still owned the property. Couldn’t Joan transfer it to the trust? Answer: It didn’t matter if he still owned the property. Joan knew that he had taken control of it and that knowledge revoked the power of attorney. Question: Francis was elderly. Wasn’t Joan doing what was best for him? Answer: The court ruled that Francis was of sound mind. He had the right to decide what was best for him. Question: Was Joan really doing what was best for Francis? Answer: Joan didn’t tell him that she had transferred the property. Also, she tried to transfer the property to a trust that benefited her. Question: What is the moral of this story? Answer: People don’t always behave well when there is money at stake. Money is sometimes thicker than blood.

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Kenny Willis and his neighbors, Rick and Joyce Taylor, were good friends. Rick helped Kenny repair his truck and Kenny cut the Taylors’s yard because they did not own a lawnmower. One day, while the Taylors were out, Kenny began to cut their grass. Joyce returned home and saw what he was doing but made no effort to stop him. Kenny negligently ran the mower over a stretch of gravel. A piece of the gravel shot through the air and struck Jackie Gill in the eye. She filed suit against both Willis and the Taylors. A jury found the three defendants jointly and severally liable. Question: Why would the Taylors be liable for Kenny’s negligence? Answer: The jury found that Kenny was an agent acting for the Taylors. Question: Why? Answer: The jury believed that Kenny was acting on the principals’ behalf and under their control. Question: Was there an explicit agency agreement? Answer: No, but an agency relationship may be implied from the conduct of the parties even without an explicit agreement. Question: Did the Taylors have control over their yard? Could Joyce have asked Kenny to stop mowing her yard? Answer: Yes, but having control over your yard is different from having control over your neighbor. Question: Was Kenny acting as an agent for the Taylors? Answer: The Supreme Court of Arkansas held that he was not an agent because the Taylors did not control the precise manner in which he mowed the lawn. They simply had the authority to ask him to stop, but that is not enough to establish an agency relationship. Fiduciary Relationship Agents have a fiduciary duty to their principals. Fiduciary relationship: One of trust in which a trustee acts for the benefit of the beneficiary, always putting the interests of the beneficiary before his own.

Example While serving as outside auditors for the consulting firm of Stern, Stewart & Co., KPMG discovered how much money Stern, Stewart was earning from its financial management and incentive compensation consulting practice. KPMG sent six of its employees to a Stern, Stewart seminar to learn about this consulting practice. It then hired two of Stern, Stewart’s consultants and started its own competing business.65 Question: Did KPMG do anything wrong? Answer: The judge ruled that KPMG had violated its fiduciary duty to Stern, Stewart. Question: What is a fiduciary duty? Answer: A duty to act in good faith and put one’s own needs behind those of the principal. Question: If KPMG wanted to start a consulting business, what should it have done? Answer: KPMG should have resigned from its position as Stern, Stewart’s outside auditors and then started the consulting business without hiring any of Stern, Stewart’s employees or using any information it learned from working for this former client.

Elizabeth MacDonald, “KPMG Is Dealt Setback in Fiduciary Case,” Wall Street Journal, July 16, 1997, p. B9 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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17-1b Duties of Agents to Principals Duty of Loyalty As part of their fiduciary duty to the principal, agents owe a duty of loyalty. The agent has an obligation to put the principal first, to strive to accomplish the principal’s goals. The following case reveals the outcome of the opening scenario.

Case: Pure Power Boot Camp, Inc. v Warrior Fitness Boot Camp, LLC. 813 F. Supp. 2d 489, United States District Court for the Southern District of New York, 2011 Facts: Based on the facts in the opening scenario, Brenner filed suit against Belliard and Fell, alleging that they had violated their duty of loyalty to her. Issue: Did Belliard and Fell violate their duty of loyalty to Brenner? Decision: Yes, they did. Reasoning: In all employment relationships, whether contractual or at will, an agent owes his employer the utmost good faith and loyalty. Although these employees had the right to make preparations to compete with their employer, even while still working for her, they did not have the right to do so at her expense, or use her resources, time, facilities, or confidential information. Whether or not they had signed an agreement not to compete, they could not, while still employed by her, solicit her clients, copy her business records for their own use, or actively divert her business for their own personal benefit. And, even in the absence of a trade secret agreement, they were not permitted to copy her client list. Belliard and Fell’s ongoing and deliberate conduct, taking place over the course of several months, constituted a clear breach of the duty of loyalty owed by employees. They must pay her damages of $245,000. Question: What is the duty of loyalty? Answer: An agent has a fiduciary duty to act loyally for the principal’s benefit in all matters connected with the agency relationship. Question: In this case, is an express contractual relationship necessary for a duty of loyalty to arise? Answer: No. This duty exists even when the relationship is at-will employment. Question: Besides the duty of loyalty, what additional area of the law likely protects an employer’s client list? Answer: Trade secret law.

Bonus Case: Reading Radio, Inc. v. Fink66 Facts: David Kline was the station manager and sales manager for Reading Radio, Inc., a/k/a WAGO Radio. As manager, Kline was in charge of supervising the station’s sales representatives. Molly Fink and Isaac Ulrich, two of WAGO’s top sales representatives, had both signed non-compete agreements with 66

2003 PA Super 353; 833 A.2d 199; 2003 Pa. Super. LEXIS 3181 Superior Court of Pennsylvania, 2003 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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WAGO that prohibited them from taking a radio or television broadcasting job, within fifty miles of Reading, Pennsylvania, for six months after leaving WAGO. Kline did not have a covenant not to compete. Reading Eagle Company approached WAGO about possibly buying the station. The sale fell through but Eagle offered Kline a job as manager of its station, WEEU. Kline accepted the position and resigned from his job at WAGO. Kline agreed to stay at WAGO for 30 days to smooth the transition, but the transition was not smooth. Kline cancelled programming without notice, transferred to Eagle a significant advertising account that also gave him personal benefits, and offered jobs at Eagle to Fink and Ulrich despite their non-competition agreements with WAGO. After Fink and Ulrich left, sales revenue at WAGO fell by $1.6 million dollars. WAGO sued both Kline and Eagle. The jury returned a verdict for WAGO in the amount of $1,105,000. The defendants appealed. Issue: Did Kline violate his duty of loyalty to his employer, WAGO? Holding: Judgment for WAGO affirmed. While still employed by WAGO, Kline actively encouraged Fink and Ulrich to leave WAGO and go to work at WEEU. He also refused to enforce their covenants-not-tocompete. These acts were clear violations of his duty of loyalty. Question: Kline showed how not to move from one job to another. What did he do wrong? Answer:  He hired away two of the WAGO’s top salespeople.  He cancelled his popular bluegrass program.  He transferred a big advertising account from WAGO to its competitor WEEU. Question: What should he have done? Answer: He had an obligation to put WAGO’s interests first. Question: Kline knew that Fink and Ulrich were good at their jobs. Why couldn’t he hire them to work at his new station? Answer: Because it was disloyal. Kline offered them jobs at the new station while he was still their boss at WAGO. That was bad enough, but to make it worse Kline ignored the fact that Fink and Ulrich had non-compete agreements with WAGO. Question: Why does that make it worse? Answer: The noncompete agreements protected WAGO. It was Kline’s job as station manager to enforce those agreements. Not only did he not enforce them, he induced Fink and Ulrich to breach them. Example: Taking Client Lists Stockbroker Ronald Waitemeyer left Merrill Lynch to go to work for Dean Witter. Merrill Lynch sued to prevent him from taking his client list with him. Fortunately, for him, a heavy snowstorm on the day he left Merrill Lynch shut the Baltimore federal court for three days. This interlude gave him the 67 opportunity to sign up his old clients before Merrill Lynch could obtain a restraining order against him. Question: Was Waitemeyer violating his duty of loyalty when he solicited clients after leaving Merrill Lynch. 67

Michael Siconolfi, “Brokers and the Firms They Leave Battle To Keep Clients,” Wall Street Journal, March 18, 1996, p. 1. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No, but Merrill Lynch felt that he was taking confidential information that belonged to the firm (much like Klein’s use of the Beatles’ royalty information.) Question: Some brokerage houses offer clients a reduced commission rate if they will stay with their old firm instead of following their broker when she leaves. Are there any limits to what the firm can do to keep clients? Answer: Offering a reduced commission rate is fine, but some brokerage houses have (untruthfully) told clients that their broker was fired for incompetence. That sounds like libel. Question: Who owns the client lists? Answer: Merrill Lynch argued that the clients belonged to the firm because the firm made such a heavy investment in training brokers. It also asserted that clients choose a broker because of the Merrill Lynch name. But a spokesperson for Smith Barney testified in a court case, “We would like to think that it is the name of the firm, but that is not true.”

The Employee’s Duty of Loyalty During their careers, students will inevitably face issues involving the duty of loyalty to an employer. In determining whether an action would violate this duty, they may find the Ethics Checklist in Chapter 2 helpful. For instance, under the Light of Day test, they should consider whether they would want their boss to know what they are about to do. If not, they may be violating their duty of loyalty. Of course, when in doubt about the duty of loyalty, they could always protect themselves by informing their principal of the activity, and obtaining his permission to engage in it. If they are afraid to tell, that is a bad sign. After all, the purpose of an agency relationship is to benefit the principal. Who knows better than the principal whether an activity benefits him? If the principal does not object, then a court will not either (unless, of course, the activity is illegal).

Bonus Case: Otsuka v. Polo Ralph Lauren Corporation68 Facts: Justin Kaiser and Germania became friends while working together at a Ralph Lauren Polo store. When Germania left the store, Kaiser allowed Germania to buy clothing using merchandise credits made out to fake people, and he also allowed her to use his employee discount. Both of these activities were against store policy. Polo sued Kaiser alleging that he had violated his duty of loyalty. Kaiser filed a motion to dismiss on the grounds that he was such a low-level employee, he had no duty to the company. Issue: Do all employees owe a duty of loyalty to their employer? Holding: Yes, all employees owe a duty of loyalty to their employer, Kaiser’s motion to dismiss is denied. According to the court, Polo argues that there is a duty of loyalty akin to a fiduciary duty that all employees owe to their employer. While the cases cited by Polo address fiduciary duty with respect to higher-ranking employees, according to the Third Restatement, all employees are agents, and that “*a+s agents, all employees owe a duty of loyalty to their employers.” This is true regardless of how ministerial or routinized a work assignment may be. 68

2007 U.S. Dist. LEXIS 86523, United States District Court for the Northern District of California, 2007. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Does it make sense to hold low-level employees to the same standard as high-ranking employees? Answer: The court thinks so. Applying different standards regarding a fiduciary duty of different level employees will create confusion among employees and employers, and among courts. In addition, releasing an employee from their fiduciary duty undermines the structure and cohesion of a corporation by allowing some employees to put their needs above the corporation’s.

Outside Benefits. An agent may not receive profits unless the principal knows and approves. Confidential Information. Agents can neither disclose nor use for their own benefit any confidential information they acquire during their agency.

Bonus Case: ABKCO Music, Inc. v. Harrisongs Music, Ltd.

Facts: Bright Tunes Music Corp. (Bright Tunes) owned the copyright to the song “He’s So Fine.” The company sued George Harrison, a Beatle, alleging that the Harrison composition “My Sweet Lord” copied “He’s So Fine.” At the time the suit was filed, Allen B. Klein handled the business affairs of the Beatles. Klein (representing Harrison) met with the president of Bright Tunes to discuss possible settlement of the copyright lawsuit. Klein suggested that Harrison might be interested in purchasing the copyright to “He’s So Fine.” Shortly thereafter, Klein’s management contract with the Beatles expired. Without telling Harrison, Klein began negotiating with Bright Tunes to purchase the copyright to “He’s So Fine” for himself. To advance these negotiations, Klein gave Bright Tunes information about royalty income for “My Sweet Lord”—information that he had gained as Harrison’s agent. The trial judge in the copyright case ultimately found that Harrison had infringed the copyright on “He’s So Fine” and assessed damages of $1,599,987. After the trial, Klein purchased the “He’s So Fine” copyright from Bright Tunes and with it, the right to recover from Harrison for the breach of copyright. Issue: Did Klein violate his fiduciary duty to Harrison by using confidential information after the agency relationship terminated? Holding: Yes, Klein was in violation because an agent has a duty not to use confidential knowledge acquired in his employment to compete with his principal. This duty continues after the agency terminates. Excerpts from Judge Pierce’s Decision: There is no doubt that the relationship between Harrison and [Klein] prior to the termination of the management agreement was that of principal and agent, and that the relationship was fiduciary in nature. [A]n agent has a duty not to use confidential knowledge acquired in his employment in competition with his principal. This duty exists as well after the employment is terminated as during its continuance. On the other hand, use of information based on 69

722 F.2d 988, 1983 U.S. App. LEXIS 15562 United States Court of Appeals for the Second Circuit, 1983 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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general business knowledge or gleaned from general business experience is not covered by the rule, and the former agent is permitted to compete with his former principal in reliance on such general publicly available information. The evidence presented herein is not at all convincing that the information imparted to Bright Tunes by Klein was publicly available. While the initial attempt to purchase *the copyright to “He’s So Fine”+ was several years removed from the eventual purchase on *Klein+’s own account, we are not of the view that such a fact rendered [Klein] unfettered in the later negotiations. Taking all of these circumstances together, we agree that *Klein’s+ conduct did not meet the standard required of him as a former fiduciary. Question: What did Klein do wrong? Answer: He used for his own benefit information he had obtained as Harrison’s agent. He was using Harrison’s information to compete against Harrison for the purchase of the copyright. Question: Klein felt he had been unfairly fired by the Beatles. What if he had simply told Bright Tunes information about “My Sweet Lord” out of spite, not to benefit himself? Answer: No change in the outcome. A fiduciary has an obligation to keep confidential any information he learns from the principal. Question: Suppose that, during his employment by the Beatles, Klein develops relationships with all the top music industry executives. After he leaves the Beatles, he represents other music groups, negotiating contracts, etc. If it weren’t for his relationship with the Beatles, no one would return his phone calls, but now he has a thriving business. Has he violated his fiduciary duty to the Beatles by using information he learned while working for them to represent other groups? Answer: The court in ABKCO says that an agent can “use information based on general business knowledge or gleaned from general business experience.” Klein could use his contacts with music industry executives after he left the Beatles.

Competition with the Principal. Agents are not allowed to compete with their principal in any matter within the scope of the agency business.

Conflict of Interest between Two Principals. Unless otherwise agreed, an agent may not act for two principals whose interests conflict. Secretly Dealing with the Principal. If a principal hires an agent to arrange a transaction, the agent may not become a party to the transaction without the principal’s permission.

Appropriate Behavior. An agent may not engage in inappropriate behavior that reflects badly on the principal. This rule applies even to off-duty conduct.

Other Duties of an Agent Duty to Obey Instructions. An agent must obey her principal’s instructions unless the principal directs her to behave illegally or unethically.

Duty of Care. An agent has a duty to act with reasonable care. Duty to Provide Information. An agent has a duty to provide the principal with all information in her possession that she has reason to believe the principal wants to know. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Principal’s Remedies when the Agent Breaches a Duty A principal has three potential remedies when an agent breaches her duty:  Damages: The principal can recover from the agent any damages the breach has caused.  Profits: If an agent breaches the duty of loyalty, he must turn over to the principal any profits he has earned as a result of his wrongdoing.  Rescission: If the agent has violated her duty of loyalty, the principal may rescind the transaction.

17-1c Duties of Principals to Agents The principal must: 1) Pay the agent as required by the agreement, 2) Indemnify (i.e., reimburse) the agent for reasonable expenses, and 3) Cooperate with the agent in performing agency tasks.

17-1d Terminating an Agency Relationship Here are the options for ending an agency relationship:      

Term Agreement. The principal and agent can agree in advance how long their relationship will last Achieving a purpose: The principal and agent can agree that the agency relationship will terminate when the principal’s goals have been achieved. Mutual agreement: No matter what the principal and agent agree on at the start, they can always change their minds later on, so long as the change is mutual. Agency at Will: If they make no agreement in advance about the term, either principal or agent can terminate at any time. Wrongful termination: Either party always has the power to terminate. They may not, however, have the right. If one party’s departure violates the agreement and causes harm to the other party, the wrongful party must pay damages. Inability to perform required duties. The agreement terminates if either the principal or agent becomes unable to perform his required duties.

Discussion: termination of an agency: Question: Oliver and Campbell signed a contract agreeing that Campbell would represent Oliver in his divorce. Near the end of the trial, Oliver decided he would handle the case himself and fired Campbell. Does Oliver have the right to fire Campbell? Campbell wanted to finish the case because a “big win” would enhance his reputation. Answer: Oliver had the right to fire Campbell, but Oliver had to pay the balance owing on the contract. In other words, Oliver had to pay Campbell as if Campbell had done all the work, but Oliver had the right to choose who would represent him.70

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Based on Oliver v. Campbell, 273 P.2d 15 California Supreme Court, 1954 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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17-2a Principal’s Liability for Contracts The principal is liable for the acts and statements of his agent if the agent had authority. There are three types of authority: express, implied, and apparent. Express authority: Either by words or conduct, the principal grants an agent permission to act. Implied authority: The agent has authority to perform acts that are necessary to accomplish an authorized transaction, even if the principal does not specify them. Apparent authority: A principal does something to make an innocent third party believe that an agent is acting with the principal’s authority, even though the agent is not authorized.

Role Play: Apparent Authority This skit requires no rehearsal; any three students can play the roles. Provide a copy to each of the students a few minutes before class so that they have an opportunity to read it in advance. (Use highlighter to indicate their lines.) Anne Dawson, to class: Hello, my name is Anne Dawson. I am a salesperson for the Pure Brush Company. James Fraser, to class: My name is James Fraser. I am director of sales at Pure Brush Company and Anne’s boss. Connie Lynch, to class: My name is Connie Lynch. I live in Kansas City. James Fraser to Anne Dawson: I’m terribly afraid, Anne, that we will have to let you go. You have missed your sales quota three out of the last four months. Frankly, I just don’t think you are working hard enough. I’m terribly sorry, but my boss, Franklin, is breathing down my neck to get sales up, and you are simply not pulling your weight. Anne Dawson: I can’t believe you guys are doing this. You know my husband has been sick, and I haven’t been able to work a full week. But I’m the best salesperson you’ve got. Please just let me get over this crisis and I’ll be your best producer. I promise. James Fraser: I’m really sorry, Anne. I know it’s been tough for you. But I don’t have any choice. Franklin is in my face all the time about you. Look, give me back your samples and forms now. Take the rest of the week off, and I’ll see you get paid for this week and one more. I’m really sorry. Anne Dawson (looking sneaky): I’ve used up all my forms and my sample case was stolen out of my car last week. I’m out of here now. You guys are going to regret this. [She stomps off.] James Fraser: You’re probably right. I’m sorry and good luck. Anne Dawson ringing Connie Lynch’s doorbell. Anne Dawson (very upbeat): Hi, Connie! I’m Anne Dawson from the Pure Brush Company. How ya doing? Connie Lynch: Oh, yeah, hi. Anne Dawson: We’ve got this fabulous new product you’ll just love–it’s a brush for cleaning blinds. I remember last time you told me that your husband has asthma. Did you know that dust is the major cause of asthma attacks? The Mayo Clinic health letter had an article about asthma just last month. If you use this fabulous brush regularly, your husband’s asthma will be so much better! Let me show you a sample. Connie Lynch (hesitating): Well, it seems like a good idea. How much is it? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Anne Dawson: Normally, it’s $99, but right now we’re having a super special. It’s reduced to only $69 if you pay cash. Connie Lynch: Gee, I don’t know. It still seems kind of expensive. Anne Dawson: Expensive? What is money when it comes to your husband’s health? You ought to have at least three of these–one for each room with blinds. That way you can whisk the dust off any time! Connie Lynch: You’re right. I’ll buy three of them. Anne Dawson: Just sign this form right here. Question: Does Anne Dawson have express authority to act for the Pure Brush Company? Answer: No. The company has not authorized her to act. Question: Does she have implied authority? Answer: No, because her actions were not reasonably necessary to accomplish an authorized act. Question: Does Dawson have any authority? Answer: Apparent authority. This means that the principal has not authorized her to act but the principal has done something to make an innocent third party believe she was authorized. Question: What has Pure Brush Company done to make Connie Lynch believe that Dawson was authorized to act? Answer: It did not retrieve her samples and forms. Many companies require their sales staff to put down a substantial deposit so that they will have an incentive to return samples and forms. Question: Is there anything else the company could have done? Answer: It could notify its customers that Dawson no longer works for them. That would have prevented the problem with Lynch, since she had been a customer previously.

Bonus Case: Dickinson v. Charter Oaks71 Facts: Marlee and Richard Snowdon bought a house next door to Hal and Carol Dickinson. Carol had owned the house for 30 years; Hal had moved in 10 to 15 years later when he and Carol married. Hal had no ownership interest in the property. The Snowdons decided to clean out an area of overgrowth adjacent to the Dickinson land. Richard spoke with Hal, who okayed the work. Marlee hired Charter Oaks for the project. Hal expressed impatience to Richard over the lack of progress and Richard told Hal that Charter was coming soon. As Charter was working the first day, Hal came out into the yard to look at what was going on and then went back into the house. The next day, Carol returned from an out-of-town trip and was upset to see what Charter had done. She ordered the company to stop work. She then filed a lawsuit seeking damages for the harm to her property. Charter admitted that Carol had not personally given permission for the landscaping work, but claimed it had relied on Hal’s apparent authority. The jury returned a verdict for Charter on Carol’s trespass and damage to vegetation claims and Carol appealed. Issue: Did Hal Dickinson have apparent authority to make decisions about Carol Snowdon’s property?

2003 Ohio 2055; 2003 Ohio App. LEXIS 1940 Court of Appeals of Ohio, 2003 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Holding: Judgment for Charter Oaks affirmed. A husband and wife are not necessarily agents for each other. However, in this case, Hal worked frequently in the Dickinson yard, both alone and with his wife. He also dealt with contractors, including a tree service Carol hired. No one ever told the Snowdons that Hal was not authorized to make decisions about landscaping. Therefore, it was reasonable for the Snowdons to assume that Hal did have authority on landscaping matters. Question: Who owned the house that the Dickinsons lived in? Answer: Carol did. Question: Did Hal have actual authority to make decisions on landscaping? Answer: According to Carol, he did not. Question: Did Carol tell Charter Oaks that Hal had authority? Answer: No. Question: Did Carol give approval to Charter Oaks for the work they did? Answer: No. Question: So wouldn’t Charter Oaks be liable for the damage they did to Carol’s property? Answer: No, because the court ruled that Hal had apparent authority. Question: Do all spouses have apparent authority for each other. Answer: No, the court explicitly says that they do not. Question: Then why does Hal have apparent authority? Answer: He did landscaping work himself and he supervised contractors who worked in the yard. The court felt that it was reasonable for outsiders to assume that Hal was authorized, at least on landscape matters. Question: The fact remains, though, that this was Carol’s property and she did not approve Charter Oak’s work. Is the result in this case fair? Answer: Carol was is in a better position to prevent the harm than either the Snowdons, who drew common-sense conclusions from the facts they saw, or Charter Oaks, who was just following instructions. All Carol had to do was discuss with her husband what work was acceptable to her. [Yet another example of how important communication is in marriage!]

Writing Exercise: Apparent Authority If students prepared the apparent authority writing exercise, ask them to share examples of apparent authority. What elements do they have in common with Dickinson v Charter Oaks? Does the class agree that they are valid examples of apparent authority? Example This letter appeared in the legal advice column of the Chicago Tribune: “I signed a lease and lived with a roommate. He had financial trouble and, as a result, we didn’t pay the rent for the past month. One night I went back to my apartment and found the locks changed. The landlord informed me that my roommate had told him that we had moved out and that my roommate had returned the apartment keys to him. My roommate has moved out of town and I don’t know where 72 he is. The landlord refuses to let me back in the apartment, where all my belongings are located.””

Robert A. Boron, “Double Cross; Lies and Fast Exit Leave Roommate Out in the Cold,” Chicago Tribune, June 24, 1994,

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This is a good example of an instance where there is not apparent authority. After two cases in which an employee had apparent authority, it is also useful to give students an example of the alternative. Question: Did the roommate who left town have apparent authority in this case? Answer: Probably not. Under apparent authority, the third party must reasonably believe that the agent is authorized. By jointly signing the lease, the two roommates may have given the impression that each was the agent of the other. However, once the landlord realized that lots of furniture remained in the apartment, he no longer had reasonable grounds to believe that the tenant was telling the truth about both roommates having moved out.

17-2b Agent’s Liability for Contracts An agent’s liability on a contract depends upon how much the third party knows about the principal. Disclosure is the agent’s best protection against liability. Fully Disclosed Principal An agent is not liable for any contracts she makes on behalf of a fully disclosed principal. A principal is fully disclosed if the third party knows of his existence and his identity.

Bonus Case: Van Damme v. Gelber73, Facts: Alexandre Van Damme was eager to buy a painting by the artist Gerhard Richter. Nahum Gelber was willing to sell his Richter entitled “A.B. Diffus”. Van Damme hired Christophe Van De Weghe to inspect the painting at the Toronto apartment of Gelber’s son. Van De Weghe was not officially told whose apartment it was, but Gelber’s son was present and Van De Weghe saw a letter on the kitchen table addressed to Gelber. Van Damme’s agent signed a contract with Gelber’s agent, Gasiunasen Gallery, to buy the painting for $2.6 million. Gasiunasen signed the contract “Gasiunasen Gallery as Seller by Seller’s Agent.” Between the time the contract was signed and Van Damme wired the purchase price to Gasiunasen, a different Richter painting has sold at auction for $5.55 million. Believing he had made a bad deal, Gelber refused to accept Van Damme’s payment. Van Damme sued Gasiunasen for breach of contract. Gasiunasen moved to dismiss on the grounds that he was an agent for a fully disclosed principal. Issue: Was Van Damme a fully disclosed principal? Was agent Gasiunasen liable under the contract? Holding: Van Damme was not a fully disclosed principal, and Yes, Gasiunasen was liable under the contract; his motion to dismiss was denied. According to the court, an agent of a fully disclosed principal cannot be personally liable under a contract. Van De Weghe did not know who the seller was when he inspected the painting at the Toronto apartment. He “inferred: the seller’s identity from an envelope lying on the kitchen counter. Although this inference turned out to be correct, the disclosure of a principal’s identity cannot depend on a person’s ability to make inferences. Gelber’s name does not 73

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appear in the contract. Gelber’s name as the owner does appear in an e-mail from Gasiunasen to the escrow agent, but there are no allegations that Van Damme was privy to this e-mail. According to the court, a principal whose identity has not been disclosed, although the agency relationship is known is referred to “partially disclosed”. The agent for a partially disclosed principal will be liable on any contract that he makes on behalf of his principal, unless the parties to the contract expressly agree that the agent will not be liable. An agent who enters into a contract on behalf of a partially disclosed principal is jointly and severally liable with the principal. Question: Who signed the contract? Answer: Van De Weghe on behalf of Van Damme and Gasiunasen Gallery signed the contract “as Seller by Seller’s Agent.” Question: Did Van Damme know that Gelber owned the painting? Answer: Yes. Question: If Van Damme knew that Gelber was the owner of the painting, then why does the court consider Gelber a partially disclosed principal? Answer: Because Van De Weghe did not officially know that Gelber was the owner, nor did he officially know that he was at the apartment of Gelber’s son. Van De Weghe met with Gasiunasen at the apartment and signed the contract with Gasiunasen, not Gelber. Gelber’s name does not appear in the contract. Question: But Van De Weghe knows that Gasiunasen is not the owner, right? Answer: True, but the court stated that a partially disclosed principal is one whose identity is not known, but the agency relationship is known to exist. If an agent enters into a contract on behalf of a partially disclosed principal, the agent is jointly and severally liable with the principal. Question: What is joint and several liability? Answer: Joint and several liability is where all members of a group are liable. They can be sued as a group or any one of them can be sued for the full amount.

Unidentified Principal The third party can recover from either the agent or the principal. (An unidentified principal is also sometimes called a “partially disclosed principal.”) Jointly and severally liable: All members of a group are liable. They can be sued as a group, or any one of them can be sued individually for the full amount owed. But the plaintiff cannot recover more than the total she is owed.

Undisclosed Principal In the case of an undisclosed principal, the third party can recover from either the agent or the principal. See Exhibit 17.1 in the text. As that exhibit illustrates, the principal is always liable, but the agent is only liable when the principal’s identity is unknown. A third party is not bound to the contract with an undisclosed principal if (1) the contract specifically provides that the third party is not bound to anyone other than the agent, or (2) the agent lies about the principal because she knows the third party would refuse to contract with him.

17-2c Principal’s Liability for Negligent Physical Torts Respondeat superior: An employer is liable for certain torts committed by an agent. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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An employer is liable for physical torts negligently committed by an employee acting within the scope of employment. Employee: There are two kinds of agents: (1) employee and (2) independent contractor. Generally, a principal is liable for the physical torts of an employee but is not liable for the physical torts of an independent contractor. Employee or Independent Contractor? When determining if agents are employees or independent contractors, courts consider whether:  The principal supervises details of the work  The principal supplies the tools and place of work  The agents work full time for the principal  The agents receive a salary or hourly wages, not a fixed price for the job  The work is part of the regular business of the principal  The principal and agents believe they have an employer-employee relationship  The principal is in business

You Be the Judge: Lancaster Symphony Orchestra v. NLRB, 822 F.3d 563, U.S.Ct.App, D.C Cir. 2016 Facts: The orchestra in Lancaster, Pennsylvania hired musicians to play about four classical music concerts each year. These musicians could choose to play in however many concerts they wished. They then signed a Musician Agreement, which stated that they were independent contractors. The musicians sought to unionize, but only employees, not independent contractors, have the right to join a union. The National Labor Relations Board ruled that the musicians were employees. The symphony disagreed and appealed the decision: You Be the Judge: Are the musicians employees or independent contractors? Argument for the Orchestra: The musicians are independent contractors because:  They are highly skilled and receive little supervision. They are responsible for rehearsing on their own.  The musicians provide their own tools - their instruments.  They do not work full time for the Orchestra but have other jobs as well.  They are paid by the job – for each concert.  The musicians do not believe they are employees - they signed a contract stating that they are independent contractors. Argument for the Musicians: The musicians are employees because:  The Orchestra regulates virtually all aspects of the musicians’ performance, including their dress and posture: o They are not permitted to cross their legs. o When the conductor signals for the orchestra to acknowledge applause, the musician handbook states that they must stand immediately, turn to face the audience, and smile. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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    

During rehearsals, musicians are not permitted to talk about anything other than the rehearsal. They may not talk at all when the conductor is on the podium. o The conductor determines the musicians’ volume and pitch, and the technique they use (such as the way they bow or use vibrato). Although the musicians supply their own instruments, the Orchestra supplies other crucial tools: music, stands, chairs, and concert hall Musicians are in effect paid by the hour because they receive additional pay for each 15 minutes that a rehearsal or concert exceeds two and a half hours. Their work is part of the regular business of the employer. Just because the Orchestra says the musicians are independent contractors does not mean the musicians believe that to be true. The principal is in business.

Holding: Although the court noted that some factors pointed toward employee status, and some toward independent contractor status, the court determined the musicians to be employees. The court determined that the Orchestra regulated virtually all aspects of the musicians performance, controlling their posture, requiring them to remain attentive throughout the performance, forbidding conversations during rehearsals unless about the rehearsal, and prohibiting them from talking at all at any time while the conductor was on the podium. These and other rules were enforced by the Orchestra, including reprimanding an employee who talked to a colleague during a rehearsal. The court found even more significant that the Orchestra’s conductor exercised virtually dictatorial authority over the manner in which the musicians played, referring to the testimony of a musician that the job of the musicians was to mold the performance into the conductor’s personal interpretation of the score. Thus, the Orchestra controlled the means and manner of the musicians’ performance. The court also noted that the work of the musicians was “part of the regular business of the employer” Factors suggesting independent contractor status included the requirement of a high degree of skill, the fact that musicians were engaged for only a short amount of time, that the contract between the parties stated that musicians were independent contractors, and that the orchestra would not withhold taxes (indicating they believed themselves to be independent contractors). Nevertheless, the court found the musicians to be employees of the Orchestra. Question: Which are the factors that indicated that the musicians were independent contractors? Answer: The musicians were highly skilled and responsible for rehearsing on their own. They provided their own instruments (tools). They did not work full time for the Orchestra. They were paid by the job. They signed a contract agreeing that they were independent contractors, and that the Orchestra would not withhold taxes from their pay. Question: Which are the factors that indicated that the musicians were employees? Answer: In particular, the degree to which their performance of music was controlled, not only as to musical attributes, but also the conduct of the musicians. They were not permitted to talk at rehearsal, except about the rehearsal, or at any time when the conductor was on the podium. They were not permitted to cross their legs. They were told how to respond when acknowledging applause from the audience. The Orchestra supplied other tools for the performance including music, stands, chairs, and concert hall. They were, in effect, paid by the hour, and their work was part of the regular business of the Orchestra. Question: Do you find this case ambiguous? Could another court have determined the musicians to be independent contractors? Answer: Answers will vary. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: What do you think? Were the musicians employees or independent contractors? Answer: Answers will vary. The Gig Economy: In four years, Uber went from zero drivers to 400,000. Its drivers could work full time, or just a few hours a week, during the day or only at night. They logged onto an app rather than punching a clock. The gig economy is based on companies that, instead of hiring full-time employees, use mobile apps to facilitate peer-to-peer transactions that pay per job. This employment practice is increasingly common. Almost one-third of American workforce does some gig work. But are these workers employees or independent contractors? Uber drivers in several states have filed lawsuits contending they are employees, and should receive employee benefits. Negligent Hiring: A principal is liable for the physical torts of an independent contractor if the principal has been negligent in hiring or supervising her. Remember that under respondeat superior, the principal is liable without fault for the torts of employees. The case of independent contractors is different: The principal is liable only if he was at fault by being careless in his hiring or supervising.

Discussion: The Doctrine of Respondeat Superior A master is liable for physical harm caused by the negligent conduct of servants within the scope of employment. Question: What is a master? Answer: “Master” is simply an old-fashioned word for principal. Question: What is a servant? Answer: A servant is an agent. Question: Are all agents servants? Answer: No. All servants are agents, but not all agents are servants. An agent can be either a servant or an independent contractor. Question: What kind of agent is an employee? Answer: An employee is a servant. Question: Why do we care whether an agent is a servant or an independent contractor? Answer: Because a principal is liable for the torts of a servant but is generally not liable for the torts of an independent contractor. Question: You said “generally not liable for the torts of an independent contractor.” When is a principal liable for these torts? Answer: The principal is liable only if he has been negligent in hiring or supervising the independent contractor. For a summary of the principal’s liability, see Exhibit 17.2, not available at the time this IM was prepared.

Scope of Employment An employee is acting within the scope of employment if the act:  Is one that employees are generally responsible for,  Takes place during hours that the employee is generally employed,  Is part of the principal’s business, © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Is similar to the one the principal authorized, Is one for which the principal supplied the tools, and Is not seriously criminal.

Authorization: An act is within the scope of employment, even if expressly forbidden, if it is of the same general nature as that authorized or if it is incidental to the conduct authorized. Was the employee in the following case acting within the scope of his employment while driving to work? You be the judge.

You Be the Judge: Zankel v. United States of America74 Facts: Staff Sergeant William E. Dreyer was a recruiter for the United States Marine Corps, working 16 to 18 hours a day, seven days a week. He was required to ask permission before using his Marine Corps car to commute to or from work. Late one night, Dreyer’s personal car would not start, so he drove his government car home. He did not ask permission because he thought it was too late to call his boss. Dreyer believed that, had he called, his boss would have said it was okay because he had given approval in similar situations in the past. Driving to work in the government car at 6:40 the next morning on the way to an early training session, Dreyer struck and killed 12-year-old Justin Zankel. You Be the Judge: Was Dreyer acting within the scope of employment when he killed Zankel? Is the government liable? Argument for the Zankels: At the time of the accident, Dreyer was driving a government vehicle. Although he had not requested permission to drive the car, if he had done so, permission certainly would have been granted. Moreover, even if Dreyer was not authorized to drive the Marine Corps car, the government is still liable because his activity was of the same general nature as that authorized and it was incidental to the conduct authorized. Also, Dreyer was on the road early so that he could attend a required training session. The Marine Corps must bear responsibility for this tragic accident. Argument for United States: The government had a clear policy stating that recruiters were not authorized to drive a government car without first requesting permission. Dreyer had not done so. Moreover, it is well-established that an employee commuting to and from work is not within the scope of employment. If Dreyer had been driving from one recruiting effort to another, that would be a different story. But in this case, he had not yet started work for the Marine Corps and therefore the government is not liable. Holding: After considering and weighing all the evidence presented by the parties and applying the controlling law to the court’s factual findings, this court finds, although it is a close question, that Dreyer was acting within the scope of his employment with the Marine Corps at the time of the accident on January 27, 2005. Pursuant to the Westfall Act, 28 U.S.C. § 2679(d)(3), the court certifies that Dreyer was acting within the scope of his employment and orders that the United States is hereby substituted as defendant for William E. Dreyer and that William E. Dreyer is hereby 74

2008 U.S. Dist. LEXIS 23655, United States District Court for the Western District of Pennsylvania, 2006 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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dismissed as a defendant in this case. The court finds that this court has subject-matter jurisdiction over plaintiffs’ claim under the FTCA, because Dreyer was within the scope of his employment with the government at the time of the accident underlying plaintiffs’ claim. Question: What is the Latin term for the principle of liability relevant to this case and what is its English translation? Answer: The principle of liability is respondeat superior, which translates to “let the master answer.” Question: In general, are employers liable for torts committed by employees on their commutes to and from work? Answer: No. It has actually been well-established by the courts that commuting to and from work is beyond the scope of employment and, thus, employers are not liable for torts that occur during those commutes. Question: If employers are not liable for torts committed during an employee’s commute, why was the US government held liable here? Answer: The court indicated that it was a close call, but after weighing the evidence, found that Dreyer was acting in the scope of his employment. It felt that although Dreyer did not have explicit permission to drive the vehicle to work, it was clear that such permission would have been granted if requested. Driving the vehicle was also a regular part of Dreyer’s job and no time restrictions were placed upon his completion of that job. Abandonment. The principal is liable for the actions of the employee that occur while the employee is at work, but not for actions that occur after the employee has abandoned the principal’s business. The McDonald’s case below is perhaps the high-water mark for employer liability.

Bonus Case: California, Inc.75

O’Connor v. McDonald’s Restaurants of

Facts: From about 8 P.M. until 2 A.M. the next day, Evans and several co-workers scoured the children’s playground at a McDonald’s restaurant. This special cleaning prepared the restaurant for inspection as part of McDonald’s “spring-blitz” competition. At McDonald’s request, Evans–who aspired to a managerial position–worked without pay in the cleanup party. His voluntary contribution of work and time was the type of extra effort necessary for advancement in the McDonald’s organization. After completing the cleanup, Evans and four fellow workers went to Joe Duffer’s house. Duffer had also participated in the evening’s work. Evans and the others talked shop and socialized into the early hours of the morning. On his way home at about 6:30 A.M., Evans collided with a motorcycle driven by Martin O’Connor. The motorcyclist was seriously injured, losing his left leg below the knee. The trial court found that Evans was acting outside the scope of his employment at the time of the accident, thus the court granted summary judgment for McDonald’s. Issue: Was Evans acting within the scope of his employment at the time of the accident?

220 Cal. App. 3d 25, 1990 Cal. App. LEXIS 448 California Court of Appeals, 1990 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Holding: The appeals court reversed the summary judgment, holding that a triable issue of fact remained about whether Evans was acting within the scope of employment. Where the employee is pursuing a business errand and a personal objective simultaneously, he is acting within the scope of his employment. Question: After work, Evans went to someone’s house to socialize. On his way home from the party, he ran into O’Connor. How could that possibly be within the scope of the McDonald’s business? Answer: The court held that if the employee is engaged in both business and pleasure, he may still be acting within the scope of his employment. Question: But the accident didn’t happen at Duffer’s house, it happened on the way home from Duffer’s. Does that mean that any commuter on the way to or from work is acting within the scope of employment? Answer: No. In this case, Evans had been up all night working for McDonald’s. His fatigue may have increased the probability he would get into an accident. Question: Does that mean that a hospital is liable if a resident gets into a car accident while driving home from an all-night shift? Answer: Good question. Question: Why the different result in the Kashin and O’Connor cases? Answer: Evans may have gotten into the accident because he was so tired from the work that he had been doing for McDonald’s. There was no evidence that Kent’s work contributed to the accident.

Bonus Case: You Be the Judge: Kashin v. Kent76 Facts: Douglas Kent was the Consul General of the United States in Vladivostok, Russia. One evening, he drove from his office to a gym and then home. On the way home, he was involved in an accident that left Aleksandr Kashin severely injured. Kashin sued the United States government, claiming that Kent was within the scope of his employment at the time of the accident. You Be The Judge: Was Kent acting within the scope of his employment while driving home from the gym? Holding: Kent was not acting within the scope of his employment at the time of the accident. Question: Why would Kashin care if Kent was acting within his scope of employment? Answer: Because if Kent was acting within the scope of his employment, the government would be liable for his actions. Question: Was Kent driving to or from work when the accident happened? Answer: No, he was on his way home from the gym. Question: Was he involved in any diplomatic activity at the time of the accident? Answer: No, he had left work for the day. Question: Why was Kent at the gym? Answer: So that he could pass the medical exam required by his job. 76

333 F. Supp. 2d 926; 2004 U.S. Dist. LEXIS 17381 United States District Court for the Southern District of California, 2004 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Was he going to do any more work that day? Answer: Hard to tell, but he was on call at night, he sometimes worked from home and he often had to leave home in the middle of the night on official business. Question: Who leased his apartment? Answer: The U.S. Department of State leased and furnished his apartment. Question: Was he acting within the scope of employment? Answer: The court held that he was not.

17-2d Principal’s Liability for Intentional Physical Torts A principal is not liable for the intentional torts of an employee unless (1) the employee intended to serve some purpose of the employer; or (2) the employer was negligent in hiring or supervising this employee.

Bonus Case: Doe v. Liberatore77 Facts: - A number of priests wrote to James Timlin, the Bishop of Scranton, warning him that Father Albert Liberatore was engaging in a sexual relationship with one of his male students. Bishop Timlin transferred Liberatore from the school to a parish church. Fourteen-year-old John Doe was a member of Liberatore's parish. Liberatore befriended Doe, taking him on outings and giving him expensive gifts. Doe routinely slept in Liberatore's bed. A number of priests told Bishop Timlin that they feared Liberatore was sexually abusing Doe. One witness reported that she had seen Doe put his hand down Liberatore's pants. Eventually, Doe himself told a priest that he was being sexually abused. The priest instructed Doe to forgive Liberatore and not to tell other people because it would ruin Doe's life and the lives of others. Only after Liberatore pleaded guilty to multiple counts of sexual abuse did the Church dismiss him from the priesthood. Doe filed suit against the Church and Bishop Timlin, alleging that they were liable for the torts committed by Liberatore. The defendants filed a motion to dismiss. Issue: Was Liberatore acting within the scope of his employment? Was the Church negligent in hiring and supervising him? Was the Church liable for his criminal acts? Excerpts from Judge Caputo’s Decision: -Under Pennsylvania law, an employer is held liable for the negligent acts of his employee which cause injuries to a third party, provided that such acts were committed during the course of and within the scope of the employment. The conduct of an employee is considered within the scope of employment if: 1. it is of a kind and nature that the employee is employed to perform; 2. it occurs substantially within the authorized time and space limits; 3. it is actuated, at least in part, by a purpose to serve the employer; and 4. if force is intentionally used by the employee against another, the use of force is not unexpected by the employer. 77

478 F.Supp. 2d 742, 2007 U.S. Dist. LEXIS 19067, United States District Court for the Middle District of Pennsylvania, 2007. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Here, it is clear that Liberatore's sexual molestation of Plaintiff was not within the scope or nature of his employment as a priest. Indeed, the activity of which Plaintiff now complains is wholly inconsistent with the role of one who is received into the Holy Orders as an ordained priest of the Roman Catholic Church. Moreover, the acts of sexual abuse perpetrated by Liberatore were both outrageous and certainly not actuated by any purpose of serving the Diocese, Sacred Heart, or Bishop Timlin. Therefore, the Court will grant summary judgment in favor of the Diocese, Sacred Heart, and Bishop Timlin as to [this issue]. Plaintiff next claims that the Diocese, Sacred Heart, and Bishop Timlin are liable for negligence in their hiring, supervision, and retention of Liberatore as a Diocesan priest. [A]n employer owes a duty to exercise reasonable care in selecting, supervising and controlling employees. The Supreme Court of Pennsylvania has held that, to fasten liability on an employer, it must be shown that the employer knew or, in the exercise of ordinary care, should have known of the necessity for exercising control of his employee. In the instant case, the Diocese, Sacred Heart, and Bishop Timlin may be liable if they knew or should have known that Liberatore had a propensity for committing sexual abuse and his employment as Pastor at Sacred Heart might create a situation where his propensity would harm a third person, such as Plaintiff. [A] reasonable jury could conclude that the Diocese, Sacred Heart, and Bishop Timlin were negligent or reckless in supervising and retaining Liberatore. However, the Court concludes that a reasonable jury could not find that the Diocese, Sacred Heart, and Bishop Timlin were negligent or reckless in hiring Liberatore because there is no evidence suggesting that Liberatore was or would become a child sex predator when he was hired. Question: Liberatore’s abuse of Doe happened while Liberatore was employed by Sacred Heart, how then could the court conclude that the abuse did not happen during the scope of Liberatore’s employment? Answer: Although the abuse did happen while Liberatore was employed by Sacred Heart, and in fact was most likely enabled because Liberatore was a priest, the conduct was not the type of conduct for which Sacred Heart employed Liberatore. In fact, according to the court, the conduct was wholly inconsistent with the duties of a priest, and was not committed by a purpose to serve the Diocese, Sacred Heart, or Bishop Timlin. Question: What does the Court mean when it says “a reasonable jury could conclude that the Diocese, Sacred Heart, and Bishop Timlin were negligent or reckless in supervising and retaining Liberatore” and also “a reasonable jury could not find that the Diocese, Sacred Heart and Bishop Timlin were negligent or reckless in hiring Liberatore”? Answer: In order for the Defendants to be liable for negligence in hiring, supervising, and retaining Liberatore, the Defendants must have known or should have known that Liberatore had a propensity for committing sexual abuse, and that his employment at Sacred Heart might create a situation where his propensity would harm a third party. The court concluded that while there may not have been enough evidence to show negligent hiring because there was no evidence suggesting Liberatore was or would become a child sex predator when he was hired, there was enough evidence to show that the defendants were negligent or reckless in retaining and supervising Liberatore. Question; What evidence was there that the Defendants were negligent or reckless in retaining or supervising Liberatore? Answer: Liberatore gave Doe expensive gifts, Doe routinely slept in Liberatore’s bed at the rectory, a number of observers told priests in the Diocese that they feared Liberatore was abusing Doe, and © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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one witness reported seeing Doe put his hand down Liberatore’s pants. Eventually, Doe told a priest that Liberatore was sexually abusing him. Question: Do we know whether the Diocese, Sacred Heart or Timlin knew that Doe was sleeping in Liberatore’s bed at the rectory? Does that matter? Answer: There is no evidence that the Defendants knew of these things. However, the standard is whether they knew or should have known that Liberatore’s employment at Sacred Heart would create a situation where his propensity would harm a third person. Thus, as his employer, they should have exercised reasonable care in supervising Liberatore, and reasonable care would have included preventing Liberatore from having Doe sleep in his bed at the rectory.

17-2e Principal’s Liability for Nonphysical Torts Nonphysical tort: One that harms only reputation, feelings, or wallet. Nonphysical torts (whether intentional or unintentional) are treated like a contract claim: The principal is liable only if the employee acted with express, implied, or apparent authority.

17-2f Agent’s Liability for Torts The focus of this section has been on the principal’s liability for the agent’s torts. But it is important to remember that agents are always liable for their own torts. Agents who commit torts are personally responsible whether or not their principal is also liable. This rule makes obvious sense. If the agent and principal are both liable, the injured third party sues both, and they are jointly and severally liable.

Chapter Conclusion Agency is an area of the law that affects us all because each of us has been and will continue to be both an agent and a principal many times in our lives.

Matching Questions Match the following terms with their definitions: _____A. Term agreement 1. When two parties make no agreement in advance about the duration of their agreement _____B. Apparent authority 2. When an agent has authority to perform acts that are necessary to accomplish an assignment _____C. Agency at will 3. When two parties agree in advance on the duration of their agreement _____D. Express authority 4. When behavior by a principal convinces a third party that the agent is authorized, even though she is not _____E. Implied authority 5. When a principal gives explicit instructions to an agent Answers: UU. 3 VV. 4 WW. XX. 5 YY. 2

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True/False Questions Circle T for true or F for false: (Correct answers are bolded) 78. T F A principal is always liable on a contract, whether he is fully disclosed, unidentified, or undisclosed. 79. T F When a contract goes wrong, a third party can always recover damages from the agent, whether the principal is fully disclosed, unidentified, or undisclosed. 80. T F An agent may receive profits from an agency relationship even if the principal does not know about the profits, so long as the principal is not harmed. 81. T F An agent may never act for two principals whose interests conflict. 82. T F An agent has a duty to provide the principal with all information in her possession that she has reason to believe the principal wants to know, even if he does not specifically ask for it.

Multiple Choice Questions 1. Someone painting the outside of a building you own crashed through a window, injuring a visiting executive. Which of the following questions would your lawyer not need to ask to determine if the painter was your employee? A. Did the painter work full time for you? B. Had you checked the painter’s references? C. Was the painter paid by the hour or by the job? D. Were you in the painting business? E. Did the painter consider herself your employee? Answer: B. 2. Which of the following duties does an agent not owe to his principal? A. Duty of loyalty B. Duty to obey instructions C. Duty to reimburse D. Duty of care E. Duty to provide information Answer: C. 3. Finn learns that, despite his stellar record, he is being paid less than other salespeople at Barry Co. So he decides to start his own company. During his last month on the Barry payroll, he tells all of his clients about his new business. He also tells them that Barry is a great company, but his fees will be lower. After he opens the doors of his new business, most of his former clients move with him. Is Finn liable to Barry? A. No, because he has not been disloyal to Barry -- he praised the company. B. No, because Barry was underpaying him. C. No, because his clients have the right to hire whichever company they choose. D. Yes, Finn has violated his duty of loyalty to Barry. Answer: D. 4. Kurt asked his car mechanic, Quinn, for help in buying a used car. Quinn recommends a Ford Focus © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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that she has been taking care of its whole life. Quinn was working for the seller. Which of the following statements is true? A. Quinn must pay Kurt the amount of money she received from the Ford’s prior owner. B. After buying the car, Kurt discovers it needs $1000 in repairs. He may recover that amount from Quinn, but only if Quinn knew about the needed repairs before Kurt bought the car. C. Kurt cannot recover anything because Quinn had no obligation to reveal her relationship with the car’s seller. D. Kurt cannot recover anything because he had not paid Quinn for her help Answer: B. 5. Figgins is the dean of a college. He appointed Sue acting dean while he was out of the country and posted an announcement on the college web site announcing that she was authorized to act in his place. He also told Sue privately that she did not have the right to make admissions decisions. While Figgins was gone, Sue overruled the admissions committee to admit the child of a wealthy alumnus. Does the child have the right to attend this college? A. No, because Sue was not authorized to admit him. B. No, because Figgins did not ratify Sue’s decision. C. Yes, because Figgins was a fully disclosed principal. D. Yes, because Sue had apparent authority. Answer: D. 6. CPA QUESTION A principal will not be liable to a third party for a tort committed by an agent: A. unless the principal instructed the agent to commit the tort B. unless the tort was committed within the scope of the agency relationship C. if the agency agreement limits the principal’s liability for the agent’s tort D. if the tort is also regarded as a criminal act Answer: B.

Case Questions 1. An elementary school custodian hit a child who wrote graffiti on the wall. Is the school district liable for this intentional tort by its employee? Answer: Yes, because the custodian thought he was serving the purpose of his employer. 2. What if the custodian hit one of the schoolchildren for calling him a name? Is the school district liable? Answer: No, because the custodian was not serving the purpose of his employer. 3. One afternoon while visiting friends, tennis star Vitas Gerulaitis fell asleep in their pool house. A mechanic had improperly installed the swimming pool heater, which leaked carbon monoxide fumes into the house where he slept, killing him. His mother filed suit against the owners of the estate. On what theory would they be liable? Answer: Principals are liable for the torts of their independent contractors only if they have been negligent in hiring the contractors. Presumably, Gerulaitis’s mother will try to prove that the owners were negligent in hiring the mechanic who installed the heater. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. Fernando worked for Affinity, which made furniture deliveries for Sears. Fernando signed a contract stating that he was an independent contractor. He was paid $23 per delivery. He typically worked five to seven days a week, but Affinity would call him each day to tell him whether or not he would be working the following day. Fernando was not required to, but he did, lease his truck from Affinity. The company handled upkeep on the truck. Affinity required all drivers to buy their mobile telephones and their uniforms from the company. It also established personal grooming requirements. Was Fernando an employee or an independent contractor? Answer: Fernando was an employee. 5. A year ago, Hot Air Systems installed a new heating system in Dolly’s house. A month ago, Chuck called Dolly and told her he worked for Hot Air and it was time to perform the yearly inspection. After his inspection, Chuck, said it was lucky he had called, because her system needed urgent repairs. He then charged her $500 for the repairs. Later, Dolly discovered there had been nothing wrong with her system and Chuck had never worked for Hot Air. Is the company liable for Chuck’s wrongdoing? Answer: No, if the company had nothing to do with Chuck’s conduct. If the firm did anything to lend him apparent authority, that would be different, but he seems to have been a free-lancer.

Discussion Questions 1. ETHICS Mercedes has just begun work at Photobook.com. What a great place to work! Although the salary is not high, the company has fabulous perks. The dining room provides great food from 7a.m. to midnight, five days a week. There is also a free laundry and dry-cleaning service. Mercedes’s social life has never been better. She invites her friends over to Photobook for meals, and has their laundry done for free. And because her job requires her to be online all the time, she has plenty of opportunity to stay in touch with her friends by g-chatting, tweeting and checking Facebook updates. She is, however, shocked that one of her colleagues takes paper home from the office for his children to use at home. Are these employees behaving ethically? Answer: Answers will vary. 2. Kevin was the manager of a radio station, WABC. A competing station lured him away. In his last month on the job at WABC, he notified two key on-air personalities that if they were to leave the station, he would not hold them to their noncompete agreements. What can WABC do? Answer: Kevin has violated his duty of loyalty and would be liable to WABC. However, he had apparent authority to release the two on air personalities, so WABC is bound by that decision. 3. Jesse worked as a buyer for the Vegetable Co. Rachel offered to sell Jesse 10 tons of tomatoes for the account of Vegetable. Jesse accepted the offer. Later, Jesse discovered that Rachel was an agent for Sylvester Co. Who is liable on this contract? Answer: Because Greenery was a fully disclosed principal, Greenery is liable but Jesse is not. Rachel, on the other hand, is an undisclosed principal, which means that both Sylvester and Rachel are liable. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. The Pharmaceutical Association holds an annual convention. At the convention, Brittany, who was president of the Association, told Luke that Research Corp. had a promising new cancer vaccine. Luke was so excited that he chartered a plane to fly to Research’s headquarters. On the way, the plane crashed and Luke was killed. Is the Pharmaceutical Association liable for Luke’s death? Answer: No, the Pharmaceutical Association had no control over the plane flight. Thus, there is no agency relationship and no liability 5. Betsy has a two-year contract as a producer at Jackson Movie Studios. She produces a remake of the movie Footloose. Unfortunately, it bombs, and Jackson is so furious that he fires her on the weekend the movie opens. Does he have the power to do this? Answer: Jackson does not have the power to fire her unless the contract gives the studio the power to do so. If there is a clause defining these expectations unambiguously, or tying her continued performance to some unambiguous benchmark of success, then the studio would have the power to fire her.

Suggested Additional Assignments Personal Experiences: Agency Ask students to prepare a list of five instances in which they have acted as an agent for someone else, or someone else has acted as an agent for them. Sports Agents For many students, agency law will immediately conjure images of the Tom Cruise film Jerry Maguire and the relationship among professional athletes, their agents, and their teams. Some students may be interested in sports agency as a career. Ask them to describe what they believe to be the nature of the legal relationship between athletes and agents. Are they surprised by what they learn in this chapter? Writing Exercise: Apparent Authority Apparent authority is often a difficult concept for students to understand. Ask students to prepare and bring to class a two-paragraph example of apparent authority. Bonus Research: Straw Buyers Have students research ways in which “straw buyers” are used in real estate transactions. They will find many examples of straw buyers in fraudulent transactions, so ask them to search specifically for transactions in which straws, i.e. undisclosed principals, serve a legitimate business purpose.78 They should prepare a brief summary to share in class, describing one use of straw buyers that was abusive and one that was legitimate. 78

“Playing Secret Agent for Mickey Mouse; Lawyers Ran Dummy Companies, Bought Real Estate for Disney,” by Tim O‟Reiley, Legal Times, January 10, 1994; see also “The „Public Use‟ Requirement in Eminent Domain Law: A Rationale Based on Secret Purchases and Private Influence,” by Daniel B. Kelly, John M. Olin Center for Law, Economics, and Business Fellows Discussion Paper Series, Discussion Paper #5, Jul. 2005, pp. 3-5 http://www.law.harvard.edu/programs/olin_center/ © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Chapter 18 – Employment and Labor Law* Chapter Overview Chapter Theme Employment and labor laws are important—and difficult—areas of law to study. They are important because they affect almost everyone, directly or indirectly. They are difficult because they are changing rapidly. Even now, employment law can vary dramatically from state to state, and the impact of labor law is evolving. So stay tuned . . .

18-1 Employment at Will Historically, the employment relationship was governed by rule of conduct in which people stayed in the job they were born into (mostly agrarian), and their employers cared for them if they fell ill. The Industrial Revolution changed everything. Workers left farms and came to the city to work in factories. Bosses no longer knew their workers personally, so felt little responsibility toward them. Because workers could leave the factories any time they liked, the cour4ts allowed employers to fire them at any time they liked, emphasizing freedom of contract. An employee at will could be fired for a good reason, a bad reason, or no reason at all. However evenhanded this common-law rule may have sounded in theory, in practice it could lead to harsh results. The lives of factory workers were grim. It was not as though they could pack up and leave. Conditions were no better elsewhere. Courts and legislatures gradually began to recognize that individual workers were unable to negotiate fair contracts with powerful employers. Since the beginning of the 20th century, employment law has changed dramatically. But note: In the absence of a specific legal exception, the rule in the U.S. is still that an employee at will can be fired for any reason. But today, there are several important exceptions to this rule.

18-2 Employment Security 18-2a Common-Law Protections Wrongful Discharge: Violating Public Policy Wrongful discharge: An employer may not fire a worker for a reason that violates basic social rights, duties, or responsibilities. The concept of wrongful discharge prohibits an employer from firing a worker for certain particularly bad reasons. In essence, the public policy rule prohibits an employer from firing a worker for a reason that violates fundamental social rights, duties, or responsibilities. Refusing to Violate the Law: As a general rule, employees may not be fired for refusing the break the law. Exercising a Legal Right: As a general rule, an employer may not discharge a worker for exercising a legal right if that right supports public policy. Supporting Societal Values: Courts are sometimes willing to protect employees who do the right thing, even if they violate the boss’s orders.

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You Be the Judge: Roe v. TeleTech Customer Care Mgmt. (Colo.) LLC79 Facts: The voters of Washington State passed the Medical Use of Marijuana Act (MUMA) which stated that: Humanitarian compassion necessitates that the decision to authorize the medical use of marijuana by patients with terminal or debilitating illnesses is a personal, individual decision, based upon their physician’s professional medical judgment and discretion. Qualifying patients and medical practitioners shall not be found guilty of a crime under state law for their possession and limited use of marijuana. This act is intended to provide clarification to law enforcement and to all participants in the judicial system. Any person meeting the requirements appropriate to his or her status under this chapter shall not be penalized in any manner, or denied any right or privilege, for such actions. Nothing in this chapter requires any accommodation of any on-site medical use of marijuana in any place of employment. Jane Roe suffered from debilitating migraine headaches that caused chronic pain, nausea, blurred vision, and sensitivity to light. Because other medications were not effective, she obtained a prescription for medical marijuana. It alleviated her symptoms without side effects and allowed Roe to work and care for her children. She ingested marijuana only in her home. TeleTech Customer Care Mgmt. offered Roe a position as a customer service representative. Although she told the company about her medical marijuana use, it fired her for failing a required drug test. Roe sued TeleTech for wrongful discharge, alleging that her termination had violated public policy. (She filed suit under a pseudonym because medical marijuana use is illegal under federal law.) You Be the Judge: Did TeleTech violate public policy when it fired Roe? Was this discharge wrongful? Arguments for Roe: Roe is exactly the sort of person this statute is intended to protect. Medical marijuana changed her life---now she can hold a job and care for her family. But, of course, she cannot hold a job if employees terminate her for using this legal medication. TeleTech is undermining the whole point of the statute and jeopardizing its clear policies. A ruling in favor of TeleTech would inhibit other people from using medication that citizens voted to make available. Furthermore, the statute specifically states that, “No person…shall be penalized in any manner, or deny any right or privilege, for such actions.” Being fired is a substantial penalty. No one is asking TeleTech to tolerate drug-impaired workers. Marijuana should be treated like any other medication---it cannot be used if it hurts job performance. But there is no evidence that it did so. Arguments for TeleTech: Just because medical marijuana is legal in Washington does not mean it is an important social right. Indeed, employers can fire workers for many legal behaviors, such as smoking, or being disagreeable. The purpose of MUMA is to protect doctors and patients from criminal liability, not to create an unlimited right to use medical marijuana. The statute does not explicitly prevent employers 79

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from banning its use. And how can marijuana use be an important public policy when it is still illegal under federal law? Ruling: Judgment for TeleTech. Summary Judgment was properly granted. Question: Why did the Plaintiff file suit under a pseudonym? Answer: Because medical marijuana use is still illegal under federal law. Question: What does the public policy rule prohibit employers from doing? Answer: The public policy rule prohibits an employer from firing a worker for a reason that violates basic social rights, duties, or responsibilities.

Contract Law Traditionally, many employers and employees thought that only a formal, signed document qualified as an employment contract, but some casual promises are enforced, and some are implied. Promises Made During the Hiring Process: Promises made to job applicants are generally enforceable, even if not approved by the company’s top executives. Employee Handbooks: A court may hold that an employee handbook creates a contract. Covenant of Good Faith and Fair Dealing: Most of these cases arise in situations in which an employer fires a worker to avoid paying promised income or benefits. Tort Law Qualified privilege: Employers who give references are liable only for false statements that they know to be false or that are primarily motivated by ill will. Defamation: Employers may be liable for defamation when they give false references about an employee. More than half of the states recognize a qualified privilege for employers who give references about former employees. Most courts have held that employers do not have a legal obligation to disclose information about former employees. But in the case of violence, courts are divided. Generally, courts have held that employers do not have a legal obligation to disclose information about former employees. But in the case of violence, courts are divided. Workplace Bullying: About 25% of employees have been bulled at work. So far, courts and legislatures have been reluctant to consider bullying a violation of public policy. Intentional Infliction of Emotional Distress: Employers who condone cruel treatment of their workers may face liability under this tort.

18-2b Family and Medical Leave Act The Family and Medical Leave Act (FMLA) guarantees both men and women up to 12 weeks of unpaid leave each year for childbirth, adoption, or a serious health condition of their own or in their immediate family. The FMLA applies only to companies with at least 50 workers, and to employers who have been with the firm full time for at least a year. As a result, only about 60% of workers are covered by this statute. Bonus Notes: Some examples of a “serious health condition” under this statute are:  Any health issue that requires hospitalization © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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 

A condition that requires more than one visit to a health care provider A condition that requires only one visit to a healthcare provider but that also requires a course of treatment such as physical therapy or prescription medication

So, the FMLA would apply to a heart attack, ongoing kidney dialysis and an ear infection requiring antibiotics. But it would not cover food poisoning that did not require hospitalization, the common cold, or a sprained ankle.

18-2c Whistleblowing Whistleblower: Someone who discloses wrongdoing. No one likes to be accused of wrongdoing even if (or, perhaps, especially if) the accusations are true. This is exactly what whistleblowers do: they are employees who disclose illegal behavior on the part of their employer. Whistleblowers are protected in the following situations:   



Defrauding the government. This is a statute that permits lawsuits against anyone who defrauds the government. The recovery is shared between the government and the whistleblower. This act prohibits employers from firing workers who file suit under the statute. Employees of public companies. The Sarbanes-Oxley Act of 2002 protects employees of publicly traded companies who provide evidence of fraud to investigators (whether in or outside the company). A successful plaintiff is entitled to reinstatement, back pay, and attorney’s fees. Violations of securities or commodities laws. Under the Dodd-Frank Act, anyone who provides information to the government about violations of securities or commodities laws is entitled to a payout of from 10 to 30 percent of whatever award the government receives, provided that the award tops $1 million. If a company retaliates against tipsters, they are entitled to reinstatement, double back-pay and attorney’s fees. Common law. Most states do not permit employers to fire workers for reporting illegal activity.

18-3 Workplace Freedom and Safety 18-3a Off-Duty Activities In the absence of a specific law to the contrary, employers do have the right to fire workers for offduty conduct. Employees have been fired or disciplined for such extra-curricular activities as taking part in dangerous sports (such as skydiving), dating coworkers, smoking, or even having high cholesterol. Lifestyle Laws: A few states, such as California, have passed lifestyle laws that protect the right of employees to engage in any lawful activity or use any lawful product when off duty. Smoking: Smokers tend to take more sick days and have higher healthcare expenses than other employees. In roughly 60% of the states, however, employers cannot prohibit workers from smoking. Alcohol and Drug Use: Private employers: Under federal law, private employers are permitted to test for alcohol and illegal drugs. However, the Equal Employment Opportunity Commission (EEOC), which is the

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federal agency charged with enforcing federal employment laws, prohibits testing for prescription drugs unless a worker seems impaired. Government Employers: Governments are sometimes allowed to conduct drug and alcohol tests of their employees. Public safety workers, such as police and firefighters, can be randomly tested for illegal drugs, and they may also be required to report legal drug use that could compromise their ability to perform their jobs. If their drug use (legal or not) is a threat to public safety, they may be suspended or fired from their jobs. Other government employees whose work does not involve public safety, can be tested only if they show signs of impairment.

18-3b The Right to Free Speech National Labor Relations Act The National Labor relations Act (NLRA) is well known as pioneer legislation that protects employees’ right to unionize. However, many people do not realize that the NLRA protects all employees (1) who engage in collective activity (2) in connection with work conditions and (3) who are not supervisors. Even non-unionized workers cannot be fired for complaining about their jobs, so long as these complaints are shared with other employees and are not inappropriately hostile or violent. In the following case, a teacher in the theater department got dramatic. Could the school fire him?

Case: Dalton School, Inc. and David Brune 2015 NLRB LEXIS 399, National Labor Relations Board, 2016 Facts: For 12 years, David Brune taught theater and drama at the Dalton School, an elite private school in New York City. Like other Dalton faculty, he worked on a renewable one-year contract. The school chose Thoroughly Modern Millie as the middle school’s annual play and made Brune the production manager. However, a month before the premiere, the school halted the production because some parents were offended by the play’s stereotypical depiction of Asians. But then students were upset about not being able to perform. The school ultimately opted to allow a rewritten, sanitized version of the play to go forward. All these changes required significant time and effort from Brune and other members of the theater department, who had to produce the new version in only three days. Brune and his colleagues were frustrated with the school administration. They felt that the leadership had ignored their concerns, put additional burdens on them without recognizing the extra effort required, and mishandled communication throughout the school community To communicate their distress, Robert Sloan, the chair of the theater department, circulated to his faculty a draft letter that he proposed sending to Ellen Stein, the Head of School. Brune replied with a lengthy, ranting email to the group, proposing that the administration should be told: We have been grievously wronged and we would like an apology. You lied. Apologize for lying, for not being honest, forthright, upstanding, moral, considerate, much less intelligent or wise. Without Brune’s knowledge, Sloan gave a copy of this email to Stein, and she summoned Brune to a meeting. He denied having called her dishonest or immoral. Five weeks later, Stein met with Brune © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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again. This time, she showed him a copy of his email and he admitted he had written it. She then fired him, effective at the end of the school year. A month later, she told him he had been fired for lying. Issue: Did Stein violate the NLRA by firing Brune? Decision: Yes, Dalton committed a violation. Reasoning: The NLRA provides that “employees shall have the right to engage in concerted activities for the purpose of collective bargaining or other mutual aid or protection.” Even the actions of a single employee count as concerted activity if the goal is to enlist the support of fellow workers. Brune’s email was clearly intended to do that. The school argued that Brune was not fired for his email but rather for lying about it. However, Brune would never have lied if Stein had not carried out an improper investigation. He had no obligation to respond truthfully to wrongful questions. Stein could only have fired Brune if his behavior had been violent or had raised serious issues about his ability to do his job. But that is not the case. He did not engage in a face=-top=-face outburst to management, make malicious or untrue statements, use any obscenities, or threaten management. Here merely complained and demanded an apology. In a prior case, the NLRB held that an employee engaging in concerted activity could not be fired for saying that his supervisor was a “f-g liar.” Furthermore, Brune’s email went only to a limited number of colleagues, not to students, parents, or the general public. In fact, it was not intended to be seen by management and was not directly available to them. Dalton must retire Brune and reimburse him for any lost earnings and benefits. Question: Did Dalton School violate the NLRA by firing Brune? Answer: Yes. Brune had the right to make the statements he did. He could not be fired for saying what he did. Question: Was Brune’s email protected as concerted activity? If so, why? Answer: Yes, it was protected. Under the NLRA, employees have the right to confer with one another for the purpose of mutual aid. He wrote an email in response to his Department Chair’s proposed letter to management, and in the email, proposed what management should be told. The email was sent to the group of employees in the department, and not to management. Question: How did management get a hold of Brune’s email? Answer: Brune’s Department head gave a copy of the email to Stein, the Head of School. Question: Were the statements that Brune made violent or otherwise unprotected by the Act? Answer: No, they were certainly not violent, and no profanity was used. Brune’s statements were protected by the Act.

Social Media Policies Many companies now have social media policies that limit employee commentary. But, these policies violate the NLRA if they unreasonably limit employee speech about work conditions. Note, however, that to be protected, the employee speech must be “concerted.” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Privacy on Social Media The Stored Communications Act (SCA) prohibits unauthorized access to electronic communications, which includes email, voice mail, and social media. However, an employer has the right to monitor workers’ electronic communications if (1) the employee consents; (2) the monitoring occurs in the ordinary course of business, or (3) in the case of email, if the employer provides the computer system. This monitoring may include an employee’s social media activities.

18-3c Lie Detector Tests A polygraph exam is a type of lie detector test. Under the Employee Polygraph Protection Act of 1988, employers may not require, or even suggest, that an employee or job candidate submit to a lie detector test, except in the following cases:   

An employee who is part of an “ongoing investigation” into crimes that have already occurred, An applicant applying for a government job, or An applicant for a job in public transport, security services, banking, or at pharmaceutical firms that deal with controlled substances.

18-3d Employee Data Employers necessarily obtain personal data from their workers: date of birth, Social Security number, and banking information. Are employers liable when hackers steal this valuable data? In a recent case, an employer was found not liable since it is reasonable for employers to store sensitive employee data electronically, even knowing that some of it will inevitably be stolen.

18-3f Guns Employers have the right to prohibit guns in the workplace but, in almost half the states, Bring Your Gun to Work Laws prevent companies from banning firearms in their parking lots.

18-4 Financial Protection Congress and the states have enacted laws that provide employees with a measure of financial security. All of the laws in this section were created by statute, not by the courts.

18-5a Fair Labor Standards Act The Fair Labor Standards Act (FLSA) regulates wages and limits child labor nationally. It provides that hourly workers must be paid a minimum wage of $7.25 per hour, plus time and a half for any hours over 40 in one week. These wage provisions do not apply to salaried workers, such as managerial, administrative, or professional staff. The FLSA also prohibits “oppressive child labor,” which means that children under 14 may work only in agriculture and entertainment. Fourteen- and fifteen-year-olds are permitted to work limited hours after school in nonhazardous jobs. Sixteen- and seventeen-year-olds may work unlimited hours in nonhazardous jobs.

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18-5b Workers’ Compensation Workers’ compensation statutes ensure that employees receive payment for injuries incurred at work. Before workers’ comp, injured employees could recover damages only if they sued their employer. It was the brave worker who was willing to risk it.

18-5c Health Insurance Under the Patient Protection and Affordable Care Act, employers with 50 or more full-time employees must pay a penalty if they do not provide basic health insurance. Also, former employees must be allowed to continue their health coverage for 18 months after leaving their job, although they must pay the cost themselves.

18-5d Social Security The federal Social Security system began in 1935, during the depths of the Great Depression, to provide a basic safety net for the elderly, ill, and unemployed. Currently, the Social Security system pays benefits to workers who are retired, disabled, or temporarily unemployed and to the spouses and children of disabled or deceased workers. The social security program is financed through a tax on wages that is paid by employers, employees, and the self-employed. The Federal Unemployment Tax Act (FUTA), part of the social security system, provides support to the unemployed. A worker who quits voluntarily or is fired for just cause is ineligible for unemployment benefits.

18-5 Labor Unions The opening scenario provides a graphic example of how painful working conditions could be in the past (literally). For better pay and working conditions, workers in the 19th and 20th centuries sought strength through collective bargaining, joining together in unions. In 1935 Congress passed the Wagner Act, generally known as the National Labor Relations Act (NLRA). This is the most important of all labor laws. A fundamental aim of the NLRA is the establishment and maintenance of industrial peace, to preserve the flow of commerce. The NLRA ensures the right of workers to form unions and encourages management and unions to bargain collectively and productively. §7 of the NLRA guarantees employees the right to  Organize and join unions,  Bargain collectively through representatives of their own choosing, and  Engage in other concerted activities. Note that “supervisors” are not employees, and do not have the right to form a union. Supervisor: Anyone with the authority to make independent decisions on hiring, firing, disciplining, or promoting other workers. §8 prohibits employers from engaging in unfair labor practices:  Interfering with union organizing efforts  Dominating or interfering with any union  Discriminating against a union member  Refusing to bargain collectively with a union © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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18-5a Organizing a Union Exclusivity Under §9 of the NLRA, a validly recognized union is the exclusive representative of the employees. A collective bargaining unit is the precisely defined group of employees who will be represented by a particular union.

Organizing a Union Campaign: Union organizers talk with employees and persuade them to form a union. Authorization Cards: Union organizers ask workers to sign authorization cards, which state that the worker requests the specified union to act as her sole bargaining representative Petition: Assuming the employer does not voluntarily recognize a union, the union petitions the NLRB for an election. It must submit to the regional NLRB office authorization cards signed by at least 30% of the workers. If the regional office verifies that there are enough valid cards and an appropriate bargaining unit, it orders an election. Bargaining unit: A group of employees with a clear and identifiable community of interests. Election: The NLRB closely supervises the election to ensure fairness. All members of the proposed bargaining unit vote on whether they want the union to represent them. If more than 50% vote for the union, the NLRB designates that union as the exclusive representative of all members of the bargaining unit. Unions win these elections about 60% of the time.

18-5b Collective Bargaining Collective bargaining agreement (CBA): A contract between a union and management. The NLRA permits the parties to bargain almost any subject they wish, but it only requires them to bargain certain issues. Under the statute, mandatory subjects include wages, hours and other terms and conditions of employment. The union and the employer are not obligated to reach an agreement, but they are required to bargain in good faith.

Bonus Landmark Case: NLRB v. Truitt Manufacturing80 Facts: A union representing workers at Truitt Manufacturing Company requested a raise of 10 cents per hour for all members. The company countered with an offer of 2.5 cents, arguing that a larger increase would bankrupt the company. The union demanded to examine Truitt’s books, and when the company refused, the union complained to the NLRB. The NLRB determined that the company had committed an ULP by failing to bargain in good faith and ordered it to allow union representatives to examine its finances. A court of appeals found no ULP and refused to enforce the Board’s order. The Supreme Court granted certiorari. Issue: Did the company refuse to bargain in good faith?

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Excerpts from Justice Black’s Decision: While Congress did not compel agreement between employers and bargaining representatives, it did require collective bargaining in the hope that agreements would result. [T]he Act admonishes both employers and employees to exert every reasonable effort to make and maintain agreements. In their effort to reach an agreement here, both the union and the company treated the company’s ability to pay increased wages as highly relevant. Claims for increased wages have sometimes been abandoned because of an employer’s unsatisfactory business condition; employees have even voted to accept wage decreases because of such conditions. Good-faith bargaining necessarily requires that claims made by either bargainer should be honest claims. This is true about an asserted inability to pay an increase in wages. If such an argument is important enough to present in the give and take of bargaining, it is important enough to require some sort of proof of its accuracy. The Board concluded that under the facts and circumstances of this case, the respondent was guilty of an unfair labor practice in failing to bargain in good faith. We see no reason to disturb the findings of the Board. Reversed. Question: According to the Court, what does good-faith bargaining necessarily require? Answer: That claims made by either bargainer should be honest claims. Question: In their efforts to reach an agreement, what did both the union and the company treat as highly relevant? Answer: The company’s ability to pay increased wages. Question: According to the Court, what does the Act admonish both employers and employees to do? Answer: Exert every reasonable effort to make and maintain agreements.

18-5c Concerted Action Concerted action: Tactics taken by union members to gain bargaining advantage. The NLRA guarantees the right of employees to engage in concerted action for mutual aid or protection.

Strikes The NLRA guarantees employees the right to strike but with limitations: Cooling Off Period: Before striking to terminate or modify a CBA, a union must give management 60 days’ notice. Statutory Prohibition: Many states have outlawed strikes by public employees. Sit-down Strikes: Sit-Down Strike: Members stop working but remain at their job posts, blocking replacement workers. Partial Strikes: A union may either walk off the job or stay on it, but it may not alternate.

Replacement Workers Economic strike: One intended to gain wages or benefits. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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When employees go on strike, management has the right to use replacement workers to keep the business operating. May the employer offer the replacement workers permanent jobs, or must the firm give union members their jobs back after the strike? It depends on the type of strike: During an economic strike, an employer may hire permanent replacement workers. Striking workers need not get their jobs back, but cannot be discriminated against if the employer eventually hires more workers. After an unfair labor practices (ULP) strike, union members are entitled to get their jobs back, even if that means the employer must lay off replacement workers.

Bonus Case: Citizens Publishing & Printing Co. v. Nat’l Labor Relations Board81 Facts: Citizens Publishing was a family-owned corporation that published the Ellwood City Ledger and another local newspaper. Bud Dimeo had been the company’s sole photographer for over 35 years. When the needs for daytime photography declined, Citizens began requiring Dimeo to work at night and on weekends as well. Citizens also occasionally employed stringers, meaning independent photographers who were paid per-photo. Teamsters Local No. 261 was certified as the representative for certain Citizens’ employees, including photographers but excluding stringers. While the company and union were negotiating a contract, Dimeo retired, and Citizens assigned most of the night/weekend photography to stringers. The union filed a ULP charge with the NLRB, claiming that Citizens unilaterally changed the terms and conditions of employment without bargaining, by giving to stringers work previously done by Dimeo, a bargaining unit member. On July 23, fully 18 months after contract negotiations had started, the union met with employees and informed them that the NLRB intended to issue a complaint based on Citizens’ use of stringers. The members voted to strike, and walked out on July 24. The paper continued to publish, using family members, supervisors and non-striking employees. The following February, six months into the strike, Citizens reassured the union that that none of the replacement workers were considered permanent; the strikers could return if they wished. The parties met to bargain on March 14. The union representative indicated the union was prepared to return to work. Company representatives took a break to caucus; when the returned, they informed the union that all replacements were permanent. In other words, the strikers had lost their jobs. The next day, Citizens informed the replacement workers they were permanent. The NLRB found that the union’s job action was a ULP strike and ordered Citizens to offer the union members their jobs back. Citizens appealed. Issue: Was the job action a ULP strike? Holding: Judgment for NLRB affirmed.

263 F.3d 224 United States Court of Appeals for the Third Circuit, 2001 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Excerpts from the court’s opinion: An employer violates §8(a)(5) if, without bargaining to impasse, it effects a unilateral change of an existing term or condition of employment. By unilaterally changing the employees' terms and conditions of employment, an employer minimizes the influence of organized bargaining and emphasizes to the employees that there is no necessity for a collective bargaining agent. [The court reviewed the evidence and held this was an unfair labor practice strike.] Question: What difference does it make whether a strike is an economic strike or a ULP strike? Answer:  When a ULP strike ends, union workers are entitled to their jobs back, even if the company has to lay off replacement workers hired during the strike.  When an economic strike ends, the company is not obligated to lay off replacement workers, and thus union workers may not get their jobs back. Question: What specific facts support the court’s holding? Answer: The court relied on these facts:  Citizens Publishing's night/weekend work became an integral part of the regular full-time photographer's work, and thus, became bargaining unit work.  The night/weekend work became a necessary and integral part of the full-time photographer's position when Citizen’s Publishing assigned it to Dimeo without any additional remuneration.  When the union was certified the status quo thus included a full-time photographer's position with night/weekend work.  Therefore, Citizens Publishing violated the Act when it unilaterally subcontracted the bargaining unit work during the negotiations over the initial collective-bargaining agreement.  The Union convened a meeting of bargaining unit members on the day before the strike began. When they learned that Citizens Publishing's had subcontracted night/weekend work it prompted numerous employees to express their desire to go on strike, and the membership held a strike vote.  Based on these facts the Board's found that its decision to issue a complaint galvanized the bargaining unit members' belief that an unfair labor practice had been committed  Even if Citizens Publishing's subcontracting of night/weekend work did not constitute an unfair labor practice, its discharge of the striking employees on March 14 converted the strike into an unfair labor practice strike because it prolonged the strike. Discussion, Additional Assignment: Students who researched a current strike could present their findings here.

Picketing Secondary boycott: A picket line established not at the employer’s premises but at a different workplace. Picketing the employer’s workplace in support of a strike is generally lawful. Secondary boycotts are generally illegal.

Lockouts Lockout: Management prohibits workers from entering the premises. Most lockouts are legal. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Chapter Conclusion Since the first time one person hired another, there has been tension in the workplace. The law attempts to balance the right of a boss to run a business with the right of a worker to fair treatment. Different countries balance these rights differently. The U.S., for instance, guarantees its workers fewer rights than virtually any other industrialized nation. American bosses have greater freedom to manage their employees. Alternatively, in Canada, France, Germany, Great Britain, and Japan, employers must show just cause before terminating workers. Which system is best? On the one hand, being mistreated at work can be a terrible, life-altering experience, but on the other, companies that cannot lay off unproductive employees are less likely to add to their workforce, which may be one reason that Europe tends to have a higher unemployment rate than the United States.

Matching Questions Match the following terms with their definitions: _____A. Employee at will 1. A federal statute that ensures safe working conditions _____B. Public policy rule 2. When an employee is fired for a bad reason _____C. FLSA 3. Unlawful management interference with a union _____D. Wrongful discharge 4. An employee without an explicit employment contract _____E. OSHA 5. A federal statute that regulates wages and limits child labor _____F. ULP 6. States that an employer may not fire a worker for refusing to violate the law, exercising a legal right, or supporting basic societal values Answers: ZZ. 4 AAA. 6 BBB. 5 CCC. 2 DDD. 1 EEE. 3

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 83. T F An employee may be fired for a good reason, a bad reason, or no reason at all. 84. T F Oral promises made by the employer during the hiring process are not enforceable. 85. T F Any employer always has the right to insist that employees submit to a lie detector test. 86. T F Federal law limits the number of hours every employee can work. 87. T F Only workers, not their spouses or children, are entitled to benefits under the Social Security system. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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88. T F While organizing, workers may not discuss union issues on company property but may do so off the premises.

Multiple Choice Questions 1. When Brooke went to work at an advertising agency, his employment contract stated that he was, “at will and could be terminated at any time.” After 28 months with the company, he was fired without explanation. Which of the following statements is true? A. The company must give him an explanation for his termination. B. Because he had a contract, he was not an employee at will. C. He could only be fired for a good reason. D. He could be fired for any reason. E. He could be fired for any reason except a bad reason. Answer: E. He argued before the California Supreme Court that his contract implied that he could only be fired for cause, but the court rejected this argument. 2. Now 4 CPA QUESTION An unemployed CPA generally would receive unemployment compensation benefits if the CPA ____. A. was fired as a result of the employer’s business reversals B. refused to accept a job as an accountant while receiving extended benefits C. was fired for embezzling from a client D. left work voluntarily without good cause Answer: A. CPA Examination, November 1991, #33. 3. During a job interview with Venetia, Jack reveals that he and his wife are expecting twins. Venetia asks him if he is planning to take a leave once the babies are born. When Jack admits that he would like to take a month off work, he can see her face fall. She ultimately decides not to hire him because of the twins. Which of the following statements are true? A. Venetia has violated the FMLA. B. Venetia has violated the Pregnancy Discrimination Act. C. Venetia has violated Title VII. D. All of the above. E. None of the above. Answer: E. The FMLA only applies to people who have worked for the company for a year. Jack is not pregnant, so the Pregnancy Discrimination Act does not apply. 4. NOW 3 Which of the following statements is true? A. In about half the statutes, employees have the right to bring guns into their workplace. B. In about half the statutes, employees have the right to bring guns into their workplace parking lot. C. Both (a) and (b) are true. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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D. None of the above is true. Answer: B. 5. Alpha Company’s workers go on strike. The company hires replacement workers so that it can continue to operate its business. When the strike end, Alpha must rehire the original workers if the strike was over ____. A. wages B. a ULP C. both (a) and (b) D. None of the above Answer: D.

Case Questions 1. Reginald Delaney managed a Taco Time restaurant in Portland, Oregon. Some of his customers told Mr. Ledbetter, the district manager, that they would not be eating there so often because there were too many black employees. Ledbetter told Delaney to fire Ms. White, who was black. Delaney did as he was told. Ledbetter’s report on the incident said: “My notes show that Delaney told me that White asked him to sleep with her and that when he would not that she started causing dissension within the crew. She asked him to come over to her house and that he declined.” Delaney refused to sign the report because it was untrue, so Ledbetter fired him. What claim might Delaney make against his former employer? Answer: Ledbetter committed a wrongful discharge when he fired Delaney for refusing to commit the tort of defamation. Delaney v. Taco Time International, Inc., 297 Or. 10, 681 P.2d 114 (1984). 2. Catherine Wagenseller was a nurse at Scottsdale memorial Hospital and an employee at will. While on a camping trip with other nurses, Wagenseller refused to join in a parody of the song, “Moon River,” which concluded with members of the group “mooning” the audience. Her supervisor seemed upset by her refusal. Prior to the trip, Wagenseller had received consistently favorable performance evaluations. Six months after the outing, Wagenseller was fired. She contends it was because she had not mooned. Is illegal for the hospital to fire Wagenseller for this reason? Answer: The Arizona Supreme Court ruled that the hospital had violated public policy by firing

Wagenseller for refusing to break the law (indecent exposure). Wagenseller v. Scottsdale Memorial Hosp., 147 Ariz. 370 (Ariz. 1985). 3. Despite its detailed dress code for employees, Starbucks stores permitted workers to wear multiple pins and buttons, some of which, but not all, were related to its employee-reward and productpromotion programs. When a union tried to organize employees, management prohibited workers from wearing more than one pro-union pin at a time. (One employee had tried to wear eight union buttons.) is this rule an ULP?

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Answer: Although the NLRB ruled that this prohibition was an ULP, the 2nd Circuit overruled the Board, on the grounds that management had a legitimate interest in protecting the company’s image. NLRB v. Starbucks Corp., 679 F.3d 70 (2d Cir. 2012). 4. Triec, Inc., is a small electrical contracting company in Springfield, Ohio, owned by its executives Yeazell, Jones, and Heaton. Employees contacted the International Brotherhood of Electrical Workers, which began an organizing drive, and 6 of the 11 employees in the bargaining unit signed authorization cards. The company declined to recognize the union, which petitioned the NLRB to schedule an election. The company then granted several new benefits for all workers, including higher wages, paid vacations, and other measures. When the election was held, only 2 of the 11 bargaining unit members voted for the union. Did the company violate the NLRA? Answer: Yes, the company violated the NLRA by extending benefits during an organizing campaign, shortly before the election. An employer may not interfere or punish any worker, nor may it grant benefits in an effort to defeat the union. The timing here suggested anti-union motivation. Because the company committed certain other anti-union acts, the NLRB found its conduct extreme enough to justify a bargaining order, and the court of appeals affirmed. NLRB v. Triec, Inc., 1991 U.S. App. LEXIS 25709 (6th Cir. 1991).

5. When Theodore Staats went to his company’s “Council of Honor Convention,” he was accompanied by a woman who was not his wife, although he told everyone she was. The company fired him. Staats alleged that his termination violated public policy because it infringed upon his freedom of association. He also alleged that he had been fired because he was too successful—his commissions were so high, he outearned even the highest-paid officer of the company. Has Staats’s employer violated public policy? Answer: The court held that freedom of association is an important social right and should be protected. However, being fired for bringing a lover to an employer’s convention is not a threat to public policy. Nor is discharge for being too successful.

Discussion Questions 1. Debra Agis worked as a waitress in a Ground Round restaurant. The manager informed the waitress that “there was some stealing going on.” Until he found out who was doing it, he intended to fire all the waitresses in alphabetical order, starting with the letter “A.” Dionne then fired Agis. Does she have a valid claim against her employer? Answer: Answers will vary. 2. Hoffman Plastics fired Jose Castro because he was supporting the efforts of union organizers. During NLRB hearings concerning his termination, Castro revealed for the time that he was in the United States illegally. He had used false documents to obtain the job at Hoffman. Despite his illegal status, the NLRB found that Hoffman’s retaliatory firing violated the NLRA and ordered the company to pay Castro $66,951 in back pay. Hoffman challenged the order in court. Should Hoffman have to pay? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No. According to the U.S. Supreme Court, although the court found Hoffman’s behavior “crude” and “obviously illegal,” it ruled that undocumented immigrants like Castro were not entitled to back pay under the NLRA. Construing the NLRA, the court determined that “back pay” has a very specific meaning under the law. It is a monetary payment that compensates a worker for wages he or she would have earned had the employer not fired her – that is, if she had been able to continue working at the company. Castro’s undocumented status made future employment questionable. But the court also held that any worker, regardless of immigration status, is fully entitled to be paid for the time he or she has actually worked. Hoffman Plastic Compounds, Inc. v. National Labor Relations Board, 535 U.S. 137 (2002). 3.

ETHICS: Should employers be allowed to fire smokers? Nicotine is highly addictive and many smokers begin as teenagers, when they may not fully understand the consequences of their decisions. As Mark Twain, who began smoking at 12, famously said, “Giving up smoking is the easiest thing in the world. I know because I have done it thousands of times.” Answer: Answers will vary.

4. Noelle was the principal of a charter school and an employee at will.

The head administrator imposed a rule requiring cafeteria workers to stamp the hands of children who did not have sufficient funds in their lunch accounts. Some of these children were entitled to free lunches, others needed to ask their parents to replenish their accounts. Noelle directed the cafeteria workers to stop this humiliating practice. The administrator fired her. Does Noelle have a valid claim for wrongful termination? Answer: Is Noelle refusing to violate the law, performing a legal duty, exercising a legal right or supporting basic societal values? Is it a violation of public policy to fire her? This case has not yet been resolved.

5. The Teamsters Union is attempting to organize the drivers at We Haul trucking company. Workers who favor a union have been using the lunchroom to hand out petitions and urge other drivers to sign authorization cards. The company posts a notice in the lunchroom: “Many employees do not want unions discussed in the lunchroom. Out of respect for them, we are prohibiting further union efforts in this lunchroom.” Is this sign legal? Answer: No. Employees are entitled to engage in concerted activity, and in this case, they were doing so during other than working hours. 6. FedEx gave Marcie Dutschmann an employment handbook stating that: (1) she was an at will employee, (2) the handbook did not create any contractual rights, and (3) employees who were fired had the right to a termination hearing. The company fired Dutschmann, claiming that she had falsified delivery records. She said that FedEx was retaliating against her because she had complained of sexual harassment. FedEx refused her request for a termination hearing. Did the employee handbook create an implied contract guaranteeing Dutschmann a hearing? Answer: The Supreme Court of Texas ruled that there was no implied contract. Marcie was not entitled to a hearing.

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Suggested Additional Assignments Presentation: Employment Issues Ask students to choose an issue of employment law that they or a colleague has experienced at work. They should present the facts, an analysis of the legal issues and the ruling that they would issue if they were the judge in the case. This assignment can be either written or oral, prepared either individually or in teams.

Chapter 19 – Employment Discrimination* Chapter Overview Chapter Theme Before 1964, employment law was vastly different. Much has changed for the better, but discrimination still lives. Our working lives are a critically important part of our lives, and we should do what we can to make them better.

19-1 Equal Pay Act of 1963 Under the Equal Pay Act, a worker may not be paid at a lesser rate than employees of the opposite sex for equal work. “Equal work” means tasks that require equal skill, effort and responsibility under similar working conditions. Example: The Heidi Wilson vs. Citicorp case for failure to pay equal pay resulted in an award to Wilson of $340,000 in back pay.

19-2 The Civil Rights Act of 1964 Protected categories: Race, color, religion, sex, or national origin Under Title VII of the Civil Rights Act of 1964, it is illegal for employers with 15 or more employees to discriminate on the basis of race, color, religion, sex, or national origin. Discrimination under Title VII applies to every aspect of the employment process, from job ads to postemployment references, and includes hiring, firing, promoting, placement, wages, benefits, and working conditions of anyone who is in one or more of the so-called protected categories under the statute.

19-2a Prohibited Activities There are four types of illegal activities under this statute: disparate treatment, disparate impact, hostile environment, and retaliation.

Disparate Treatment Prima facie: from the Latin, meaning “from its first appearance,” something that appears to be true upon a first look. To prove a disparate treatment case, the plaintiff must show that she was treated differently because of her sex, race, color, religion, or national origin. The required steps in a disparate treatment case are: © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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1. The plaintiff presents evidence that the defendant has discriminated against her because of a protected trait. 2. The defendant must present evidence that its decision was based on legitimate, nondiscriminatory reasons. 3. To win, the plaintiff must now prove that the employer intentionally discriminated, although this motive can be inferred from differences in treatment.

Disparate Impact Disparate impact applies if the employer has a rule that, on its face, is not discriminatory, but in practice excludes too many people in a protected group. We studied Griggs v. Duke Power in Ch 4, but it is a landmark case in employment law, so worth reviewing again. 1. Plaintiff must present a prima facie case 2. Defendant must offer some evidence that the employment practice was a job-related business necessity. 3. To win, plaintiff must now prove either that the employer’s reason is a pretext or that other, less discriminatory rules would achieve the same results. The plaintiffs in Duke Power showed that the tests were not a job-related business necessity.

Bonus: Landmark Case: Griggs v. Duke Power Co.82

Facts: Before Title VII, Duke Power hired black employees only in the labor department, where the highest pay was less than the lowest earnings in the other departments. After Title VII, the Company required all new hires for jobs in the desirable departments to have a high school education or satisfactory scores on two tests that measured intelligence and mechanical ability. Neither test gauged the ability to perform a particular job. The pass rate for whites was much higher than for blacks and blacks were also less likely than whites to have a high school diploma. The new policy did not apply to the (exclusively white) employees who were already working in the preferred departments. These “unqualified” whites all performed their jobs satisfactorily. Black employees sued Duke Power, alleging that this hiring policy violated Title VII. The trial court dismissed the case. The Court of Appeals ruled that the policy was not in violation of Title VII because Duke Power did not have a discriminatory purpose. The Supreme Court granted certiorari. Issue: Does a policy violate Title VII if it has a discriminatory impact but no discriminatory purpose? Excerpts from Chief Justice Burger’s Decision: Congress did not intend by Title VII to guarantee a job to every person regardless of qualifications. What is required by Congress is the removal of artificial, arbitrary, and unnecessary barriers to employment when the barriers operate invidiously to discriminate on the basis of racial or other impermissible classification.

401 U.S. 424, 91 S. Ct. 849, 1971 U.S. LEXIS 134, United States Supreme Court, 1971. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The Act proscribes not only overt discrimination but also practices that are fair in form, but discriminatory in operation. The touchstone is business necessity. If an employment practice, which operates to exclude Negroes, cannot be shown to be related to job performance, the practice is prohibited. On the record before us, neither the high school completion requirement nor the general intelligence test is shown to bear a demonstrable relationship to successful performance of the jobs for which it was used. Both were adopted without meaningful study of their relationship to job performance ability. Rather, the requirements were instituted on the Company's judgment that they generally would improve the overall quality of the work force. The evidence, however, shows that employees who have not completed high school or taken the tests have continued to perform satisfactorily and make progress in departments for which the high school and test criteria are now used. [G]ood intent or absence of discriminatory intent does not redeem employment procedures or testing mechanisms that operate as "built-in headwinds" for minority groups and are unrelated to measuring job capability. Congress directed the thrust of the Act to the consequences of employment practices, not simply the motivation. More than that, Congress has placed on the employer the burden of showing that any given requirement must have a manifest relationship to the employment in question. History is filled with examples of men and women who rendered highly effective performance without the conventional badges of accomplishment in terms of certificates, diplomas, or degrees. Diplomas and tests are useful servants, but Congress has mandated the common sense proposition that they are not to become masters of reality. Nothing in the Act precludes the use of testing or measuring procedures; obviously, they are useful. What Congress has commanded is that any tests used must measure the person for the job and not the person in the abstract. The judgment of the Court of Appeals is reversed. Reasoning: Under Title VII, employers may establish job requirements that exclude more blacks than whites, but only if the requirements are necessary to do that particular work. In this case, there was no evidence that either a high school diploma or the two tests bore any relationship to the job in question. Indeed, white employees without any of these qualifications had been doing the jobs well for years, and had even been promoted. Whether or not Duke Power intended to discriminate is irrelevant. Title VII is concerned with the consequences of an employer’s practices, not its motivation. The burden is on the employer to show that all job requirements have an important relationship to the work in question. Any tests must measure the person for the job and not the person in the abstract. Question: What is a factor that the court looked at to determine if Duke Power had a discriminatory purpose? Answer: The consequences of the action. Question: What does disparate impact mean? Answer: The employer or management may enact a policy or regulation that is, on its face, nondiscriminatory. Disparate impact is proven, primarily, through statistical analysis of the groups that are and are not impacted.

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Case: You Be the Judge: Gulino v. Board of Education of the City School District of New York, 907 F.Supp.2d 492, U.S. Dist. Ct. for the Southern Dist. Of New York, 2012 Facts: A New York State task force on teacher qualifications decided that all teachers needed a basic understanding of liberal arts and sciences. National Evaluation Systems (NES), a professional test development company, was hired to develop the Liberal arts and Sciences Test (LAST) to measure this knowledge. NES began by establishing two committees of teachers and professors (Committees) to ensure that the LAST was both relevant to the job of a New York public school teacher and free from bias. The Committees reviewed a draft framework, a list of exam subtopics, and sample questions. NES then sent its draft framework and subtopics for review to twelve hundred New York public school teachers and education professors. It also tested some sample questions on students at various state education colleges. Teachers could not be licensed to teach in New York City unless they passed the test. Whites succeeded at a higher rate than African-Americans and Latinos. A group of minority teachers filed suit against the Board of Education for the City of New York (Board) alleging that the test violated Title VII. Issue: Did the test violate Title VII? Argument for the Board: Two committees of diverse teachers and professors reviewed the test to ensure that it was both relevant and free from bias. NES also consulted 1,200 teachers and education professors. And it tested specific questions. The test was designed and approved by experts, some of whom were minorities. What more can we do? Argument for the teachers: The fact that the test covered liberal arts and sciences does not prove that it was job related; arts and sciences is an extremely broad classification that encompasses far more than the basic knowledge teachers need to be competent in the classroom. To show the validity of the test, NES needed to create a list of the tasks teachers perform, and then determine what subtopics and questions could be used to evaluate their ability to do those jobs. NES should have presented evidence that the knowledge required by the test improves teacher performance and student results. It failed to do so. Excerpts from Judge Wood’s Decision: Under Title VII, an exam is job related if it has been properly validated. The essence of validation is in the requirement that the content of the test be related to the content of the job. There are several flaws in the way that NES developed [the LAST] that prevent the Court from finding that the company conducted a suitable job analysis. First, NES never created a list of the tasks teachers perform, nor determined whether the subtopics identify knowledge needed to perform those tasks. Second, NES representatives testified that the company collected materials from schools and colleges throughout the state, interviewed deans and administrators of liberal arts programs at colleges and © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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universities in New York, and consulted with education experts. The representatives, however, could not describe how the information collected was used or how it supported the choice of subtopics. It also appears that NES actually drafted the subtopics prior to collecting materials and conducting interviews. The third requirement is that the content of the exam must be directly related to the content of the job. The fact that the LAST is related generally to the liberal arts and sciences does not prove that the exam is job related; indeed, the liberal arts and sciences is an extremely broad field that encompasses far more than the basic knowledge all teachers need in order to be competent. Rather, to be job related, the LAST must test for the minimum level of knowledge about the liberal arts and sciences that is necessary to ensure that all teachers are competent to teach. There is no evidence in the record establishing the minimum level of knowledge about the liberal arts and sciences needed by all teachers. Consequently, the Court finds that the Board has failed to establish that the LAST is directly related to teachers’ jobs. [A court must also] determine whether the exam is scored in a way that usefully selects those applicants who can better perform the job. There is no evidence that the committees were given any guidance as to the definition of minimally-competent. At the same time, there was no evidence that higher scores on the LAST correlated with better teacher or student performance in the classroom. In conclusion, the Court finds that the LAST is not job related, and the Board violated Title VII by requiring plaintiffs to pass the exam in order to receive a teaching license. Question: What was the purpose of the LAST test? Answer: To ensure competency in the liberal arts and sciences by teachers who were applying for a teaching license. Question: What proof was there that the LAST tested this competency? Answer: None; in fact, the Court indicated that the preparation of the test failed in three ways. Question: What were the defects in the preparation of the LAST? Answer: First, the NES never created a list of the tasks teachers perform, nor determined whether the subtopics identified for inclusion on the test were needed to perform those tasks. Second, NEX representatives testified that the company collected materials from schools and colleges throughout the state and gathered other information, but could not describe how the information collected was used. In fact, it appeared that NES actually drafted the subtopics BEFORE the information was gathered. Third, There was no proof that the exam was job related. The field if Liberal Arts and Sciences is very broad. It would be necessary to test for the minimum level of knowledge required to make a teacher competent to teach. There was nothing in the record that anyone had determined what that knowledge might be, or what score on the test would represent it. The court also noted that there was no evidence that the committees were given any guidance as to the definition of minimally competent. And there was no evidence that higher scores on the LAST resulted in better teacher or student performance.

Hostile Work Environment Sexual harassment: involves unwelcome sexual advances, requests for sexual favors, and other verbal or physical conduct of a sexual nature.

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Employers violate Title VII if they permit a work environment that is so hostile towards people in a protected category that it affects their ability to work. This rule applies whether the hostility is based on race, color, religion, sex, or national origin. Many people assume that race and color are the same, but this is not necessarily the case. Title VII prohibits behavior that discriminates against people due to the shade of color of their skin, even by people of the same race. (As we shall see, this rule also applies to those treated badly because of pregnancy, age, or disability.) This concept of hostile environment first arose in the context of sexual harassment. Sexual Harassment. Everyone has heard of sexual harassment, but few people know exactly what it is. Sexual harassment involves unwelcome sexual advances, requests for sexual favors, and other verbal or physical conduct of a sexual nature. There are two major categories of sexual harassment: (1) quid pro quo and (2) hostile work environment. Quid pro quo: A Latin phrase that means “one thing in return for another.” Quid pro quo harassment occurs if any aspect of a job is made contingent upon sexual activity. In the Guzman case, the plaintiff alleged that a male editor had offered a permanent report job to a young female copy assistant in exchange for sexual activity. Bonus notes: Offensive jokes, intrusive comments about clothes or body parts, and public displays of pornographic pictures can create a hostile environment. These offensive remarks can be conveyed through any form of communication including texting, email and in person. The following case lays out the elements of a hostile work environment claim. It also illustrates the dangers of fishing off the company pier.

Case: Gatter v. IKA-Works, Inc. 2016 U.S. Dist. LEXIS 174816, U.S. Dist. Ct. , ED Pennsylvania, 2016 Facts: Courtney Gatter was a sales representative for IKA. The company was owned by the Stiegelmann family, which included René (who worked for the company), and his son, Marcel (who did not). Gatter reported to Refika Bilgic, who was both managing director and Rene’s romantic partner. Gatter was aware of rumors linking René romantically with various female employees. The company took all of its employees (and Marcel) on a sailing trip in the Mediterranean. Gatter had never met Marcel before the trip. On the first day, while Gatter was reclining on deck, René snapped a photograph “up her shorts.” Marcel, who did not have an assigned bedroom, had been sleeping on deck. On the third night, he complained that this arrangement was uncomfortable and asked Gatter if he could sleep in her room. Once in her room, they kissed and he suggested sexual intercourse, but Gatter rejected his advance. Because Gatter knew that René had liaisons with female employees, she felt “damned if she did, an damned if she didn’t” accept Marcel’s advances. Ultimately, Gatter gave in. Although René was upset when he learned that his son and his employee were in a sexual relationship, the affair continued during the trip.

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As the ship sailed on, Gatter grew more and more uncomfortable with the sexualized environment. On two occasions, she saw René naked: once while he was exiting the shower into a common area on the boat and, on another day, as a towel blew up while he changed into his bathing suit on the beach. On the final day of the trip, Gatter apologized to Bilgic and René for her affair with Marcel. René then berated her, asking her, “How can you spread your legs after the second day?” He gave Gatter an ultimatum: quit working for IKA or break up with Marcel, Gatter agreed to end the relationship. Although Marcel and Gatter never met again, they did continue to text. When Bilgic found out, she fired Gatter. Gatter filed suit against IKA alleging sexual harassment. IKA filed a motion for summary judgment. Issue: Was Gatter sexually harassed? Should summary judgment be granted? Decision: The motion for summary judgment was denied because a jury could reasonably decide that Gatter had been sexually harassed. Reasoning: To win, Gatter must show that (1) she suffered severe or pervasive intentional discrimination (2) that harmed her and (3) would have harmed any reasonable person. To prove intent, Gatter need only show that the behavior was intentional, not that the harasser intended hostility or abuse. The two incidents of René’s nudity showed bad judgment on his part, but there was no evidence that he intended to expose himself. Because Gatter initially rejected Marcel’s advances, a jury could reasonably decide that a sexual proposition from a part-owner of IKA constituted intentional sex discrimination. A jury could also conclude that Gatter, and any reasonable employee, would be harmed by this behavior because it altered the conditions of employment. An employer is liable for a hostile environment claim if the harassment culminates in a tangible employment action. Gatter was fired for sleeping with Marcel, even though she felt pressured to do so. Being fired is a tangible employment action. Question: Did this case go to trial? Answer: No, the defendant employer filed a Motion for Summary Judgment, seeking to avoid a trial. Question: If the case is not settled, who will decide whether the events constituted sexual harassment? Answer: The jury. Question: What proof was there that sexual harassment may have occurred? Answer: The jury may find sexual harassment based upon the photo taken of Gatter “up her shorts.” Also, the jury could find harassment based on Marcel’s initial proposal for sex with Gatter. Question: Does it matter that Gatter eventually agreed to have sex with Marcel? Answer: No. the fact that the relationship eventually became consensual does not change the initial facts and circumstances. Question: Do you think that Marcel’s position as a part-owner of Gatter’s employer is relevant to a decision about whether or not sexual harassment occurred? Answer: Yes, Marcel’s part ownership of the firm gives him unspoken authority over Gatter. Question: Does René’s demand that Gatter either stop seeing Marcel or leave her employment connect the harassment and her employment? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Yes.

Bonus Case: Lyle v. Warner Brothers Television Productions83 Students often believe that a company can be held liable for even mild sexual behavior on the part of employees. In reality, successful sexual harassment cases typically involve extreme behavior. The following case is an example where extreme behavior was found not to be sexual harassment. Facts: Amaani Lyle was a comedy writers’ assistant who worked on the production of the television show Friends. The show revolved around a group of young, sexually active adults, featured adultoriented sexual humor, and typically relied on sexual language and gestures to convey its humor. Before Lyle was hired, she had been warned in the interview that the show dealt with sexual matters and that as an assistant to the writers, she would be listening to and transcribing their sexual jokes and discussions about sex likely to be used for scripts. Lyle responded that sexual discussions would not make her uncomfortable. She was hired as a writers’ assistant. Four months later, Lyle was fired because of problems with her typing and her transcription. Lyle sued claiming the writers’ use of sexually coarse and vulgar language and conduct was sexual harassment based on a hostile work environment. Warner Brothers filed a motion for summary judgment claiming the behavior of the writers was not severe or pervasive. The trial court granted Warner Brother’s motion and Lyle appealed. Issue: Did the writers’ use of coarse and vulgar language constitute a hostile work environment? Holding: No, the defendant’s motion for summary judgment was affirmed. According to the court, Lyle testified that she had no recollection of any employee of the Friends production ever saying anything sexually offensive about her directly, nor anyone asking her out on a date or sexually propositioning her. No one ever demanded sexual favors from Lyle or physically threatened her. However, there were a number of offensive discussions and actions that occurred in the writers’ meetings that Lyle was required to attend. For example, the writers regularly discussed their preferences in women and sex in general. One writer spoke of his preference for blondes, a certain bra cup size and “getting right to sex” and “not messing around with too much foreplay.” Another writer discussed his love of young girls and cheerleaders, spoke of oral sex experiences, and told the group that when he and his wife would fight, he would “get naked” and then they would never finish the fight. A writer kept a notebook with graphic drawings that was sometimes left open on his desk or the writers’ assistants’ desks. The writers also spoke openly in a demeaning manner about one of the actresses on the show, making jokes about whether she was competent in sexually servicing her boyfriend. According to the court, in order to bring a successful hostile work environment claim, Lyle must show that the conduct complained of was severe or pervasive to alter her work conditions and create a hostile environment because of her sex. Thus, it is the difference in treatment based on Lyle’s sex, not the mere discussion of sex or use of vulgar language that is the essence of her claim. A hostile work environment claim is not established where a supervisor or coworker simply uses crude or inappropriate language in front of an employee or draws a vulgar picture without directing sexual innuendos or gender-related 83

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language at the employee or women in general. In addition, the court must look carefully at the social context in which this behavior occurred. Based on this, according to the court, the context of the show being a creative workplace focused on generating scripts for an adult-themed show with sexual themes is significant in assessing the existence of a hostile work environment. Both male and female writers discussed their sexual experiences to generate material for the show. The record shows that the sexual antics did not involve or were not aimed at Lyle or any other female employee. Moreover, there was no indication that the vulgar discussions affected Lyle’s work hours or duties. While the conduct was certainly sexual in nature, a court could not find that had Lyle been a man she would not have been treated in the same manner. Question: There was some graphic conversation at the writers’ table. How could the court not find it created a hostile work environment? Answer: The court felt that the comments were never directed at Lyle, her work conditions were never affected, despite the graphic nature of the discussions Lyle was not treated differently because she was a woman, and perhaps most significantly the conversations were part of developing scripts for an adult-oriented show. Question: Do you think it is meaningful that the writers warned Lyle in her interview that there would be lowbrow humor? Answer: The fact that Lyle was warned in the interview about the atmosphere is important to show that she knew what she was getting into by accepting the position, but not wholly relevant to her claim for hostile work environment. Warning that the atmosphere may be abusive does not make it any less abusive. The court noted, however that Lyle could not show that any of the conduct was aimed at her. Moreover, according to the court, the fact that Lyle was warned adds support for the social context of the conversations; that is the sexually charged conversations were part of developing sexually themed scripts for the show.

Additional Assignment: Students who researched sexual harassment policies could present their findings here.

Hostile Environment Based on Race. In Jones v. UPS Ground Freight, an African –American driver repeatedly found bananas and banana peels on his truck. Some employees wore Confederate shirts and hats. When he reported these events, two other drivers confronted him in the parking lot holding a crowbar, and asking him if he had reported them to the supervisor. Again, he found banana peels on his truck. The trial court found no hostile environment, but the appellate court overturned the case and remanded it for trial, ruling that these events could, indeed, have created a hostile work environment. Bonus Notes: Hostile Environment Based on Color. Although many assume that “race” is the same thing as “color,” that is not the case. Those with dark skin color can be discriminated based solely on skin color. Hostile Environment Based on National Origin. Discrimination based on country of origin is also prohibited. Examples include calling an employee “brown boy,” “spic,” and “wetback.” Such discrimination is itself a violation of Title VII, even if there is no evidence of adverse employment action.

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Employer Liability for Sexual Harassment. Employees who engage in illegal harassment are liable for their own wrongdoing. But is their company also liable? The Supreme Court has held that:  If the victimized employee has suffered a “tangible employment action” such as firing, demotion, or reassignment, the company is liable to her for harassment by a supervisor.  Even if the victimized employee has not suffered a tangible employment action, the company is liable unless it can prove that (1) it used reasonable care to prevent and correct harassing behavior and (2) the employee unreasonably failed to take advantage of the company’s complaint procedures.

Retaliation Title VII also prohibits employers from retaliating against workers who oppose discrimination, bring a claim under the statute, or take part in an investigation or hearing. Retaliation means that the employer has done something that would deter a reasonable worker from complaining about discrimination. Research indicates that retaliation occurs in as many as 60 percent of discrimination cases.

19-2b Religion Employers must make reasonable accommodation for a worker’s religious beliefs unless the request would cause undue hardship for the business.

19-2c Family Responsibility Discrimination In studies, participants repeatedly rank mothers as less qualified than other employees and fathers as most desirable, even when their credentials are exactly the same. Partly as a result, unmarried childless women earn 96% of what men do while married mothers earn 76%. Family responsibility discrimination is a violation of Title VII if it involves men and women being treated differently. For example, after Dawn Gallina, an associate at the Mintz, Levin law firm, revealed to her boss that she had a young child, he began to treat her differently from her male colleagues and spoke to her “about the commitment differential between men and women.” The court ruled that her belief of illegal discrimination was reasonable

19-2d Sexual Orientation The specific language of Title VII does not include sexual orientation as a protected category, but some courts now interpret the statute to include it as one. The reasoning is generally based on prohibiting discriminatory conduct based on the aggressor’s view of what it means to be a man or woman, “exactly the evil Title VII was designed to eradicate.” In addition, by executive order, the federal government prohibits this discrimination among its own employees, and among firms that work for it. In addition, almost half the states and hundreds of cities have statutes that prohibit discrimination based on sexual orientation.

19-2e Gender Identity and Expression The EEOC recently ruled that discriminating against someone for being transgender is a violation of Title VII. In addition, about one-third of states and hundreds of cities prohibit gender identity and © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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expression discrimination. Also, the federal government prohibits discrimination on gender identity among its employees, and among government contractors.

19-2f Immigration Under Title VII, it is illegal for employers to discriminate against non-citizens because “national origin” is a protected category.

19-2g Reverse Discrimination Reverse Discrimination: Making an employment decision that harms a white person or a man because of his gender, color, or race. Affirmative action programs: These programs remedy the effects of past discrimination.

Reverse discrimination, because it, by definition, means a decision based on race or gender, is prohibited. However, affirmative action is one exception to that rule. Affirmative action is not required by Title VII, nor is it prohibited. Affirmative action programs have three different sources: 1. Litigation: Courts have the power under Title VII to order affirmative action to remedy the effects of past discrimination. 2. Voluntary Action: Employers can voluntarily introduce an affirmative action plan to remedy the effects of past practices, or to achieve (but not to maintain) equitable representation of minorities and women, provided that the plan is not too unfair to majority members. 3. Government Contracts: The government may use affirmative action programs when awarding contracts only if (1) it can show that the programs are needed to overcome specific past discrimination, (2) they have time limits, and (3) nondiscriminatory alternatives are not available.

19-2h Defenses to Charges of Discrimination Under Title VII, the defendant has four possible defenses. Merit A defendant is not liable if he shows that the person he favored was the most qualified. Seniority A legitimate seniority system is legal, even if it perpetuates past discrimination. Bona Fide Occupational Qualification (BFOQ) Bona fide occupational qualification (BFOQ): An employer is permitted to establish discriminatory job requirements if they are essential to the position in question. The business must show that it cannot fulfill its primary function unless it discriminations. Example: Catholic schools may, if they choose, refuse to hire non-Catholic teachers. BROQ claims based on © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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customer preference are almost always rejected. However, the courts recognize three situations in which employers may consider customer preference: 

Safety: A maximum security men’s prison could refuse to hire women correctional officers.

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Privacy: An employer may refuse to hire women to work in a men’s bathroom.

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Authenticity: An employer need not hire a man for a woman’s role in a movie.

But note that only religion, sex, or national origin can be a BFOQ—never race or color.

Example: Bona Fide Occupational Qualification Increasingly, women prefer female gynecologists and obstetricians (OB-GYNs). Since 72 percent of the doctors in the field are men, women OB-GYNS are in high demand. Women OB GYN residents receive more job offers than their male colleagues, at higher starting salaries. Some women are opening all female practices and refusing to hire men. Question: If a hospital or clinic refused to hire male OB-GYNs, would it be in violation of Title VII? Answer: To win a disparate treatment case under Title VII of the Civil Rights Act, the plaintiff must show that he was treated differently because of his race, sex, color, religion, or national origin. A male doctor would certainly have a valid argument that he was being treated differently because of his sex. Question: Would the hospital have a defense? Answer: It would argue that sex is a bona fide occupational qualification (BFOQ) for a job as an OB GYN. Question: Is this a legitimate defense? Answer: It is difficult to predict how a court would rule. There are two countervailing arguments:  Customer preference does not justify a BFOQ. Thus, a hospital could not refuse to hire female neurosurgeons on the grounds that patients prefer men.  On the other hand, the major exception to this customer preference rule is sexual privacy. An employer may refuse to hire women to work in a men's bathroom.  An employer may also refuse to hire someone who is not “authentic” such as a man playing a female role in a movie.

19-3 Pregnancy Discrimination Act Under the Pregnancy Discrimination Act, an employer may not fire, refuse to hire, or fail to promote a woman because she is pregnant. An employer also violates this statute if the work environment is so hostile toward a pregnant woman that it affects her ability to do her job. The Act also protects a woman’s right to terminate a pregnancy. An employer must treat pregnancy and childbirth as any other temporary disability.

19-4 Age Discrimination Under the Age Discrimination in Employment Act (ADEA), an employer with 20 or more workers may not fire, refuse to hire, fail to promote, or otherwise reduce a person’s employment opportunities because he is 40 or older. Nor may an employer require workers to retire at a certain age. (This retirement rule does not apply to police and top-level corporate executives.) The standard of proof is tougher in an age discrimination case than in Title VII litigation. Under the ADEA, plaintiff must show that, but for his age, the employer would not have taken the action it did. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The goal of the statute is to counteract stereotypes about the abilities of older workers. A plaintiff in an age discrimination case can show discrimination in three ways: disparate treatment, disparate impact, and hostile work environment. The following case provides further support for the adage: “Loose lips sink ships.”

Case: Reid v. Google, Inc.84 Facts: Google’s vice-president of engineering, Wayne Rosing (aged 55), hired Brian Reid (52) as director of operations and director of engineering. At the time, the top executives at Google were CEO Eric Schmidt (47), vice-president of engineering operations Urs Hölzle (38), and founders Sergey Brin (28) and Larry Page (29). During his two years at Google, Reid’s only written performance review stated that he had consistently met expectations. The comments indicated that Reid had an extraordinarily broad range of knowledge, an aptitude and orientation towards operational and IT issues, an excellent attitude, and that he projected confidence when dealing with fast-changing situations, was very intelligent and creative, and was a terrific problem solver. The review also commented that “Adapting to Google culture is the primary task. Right or wrong, Google is simply different: Younger contributors, inexperienced first line managers, and the super-fast pace are just a few examples of the environment.” According to Reid, even as he received a positive review, Hölzle and other employees made derogatory age-related remarks such as his ideas were “obsolete,” “ancient,” and “too old to matter,” that he was “slow,” “fuzzy,” “sluggish,” and “lethargic,” an “old man,” an “old guy,” and an “old fuddy-duddy,” and that he did not “display a sense of urgency” and “lacked energy.” Nineteen months after Reid joined Google, he was fired. Google says it was because of his poor performance. Reid alleges he was told it was based on a lack of “cultural fit.” Reid sued Google for age discrimination. The trial court granted Google’s motion for summary judgment on the grounds that Reid did not have sufficient evidence of discrimination. He appealed. Issues: Did Reid have enough evidence of age discrimination to warrant a trial? Decision: The trial court was overruled and summary judgment denied. Reasoning: Google argued that the trial court should have ignored the ageist comments about Reid because they were “stray remarks,” made neither by decision makers nor during the decision process. But stray remarks may be relevant, circumstantial evidence of discrimination. The jury should decide how relevant. An ageist remark, in and of itself, does not prove discrimination. But when combined with other testimony, it may provide enough evidence to find liability. Question: Who is protected by the Age Discrimination in Employment Act (ADEA)? Answer: Workers over age 40. 84

50 Cal. 4th 512, 2010 Cal. LEXIS 7544; Supreme Court of California, 2010. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: What does the ADEA protect such individuals from? Answer: From being fired, kept from being promoted, having their employment opportunities otherwise reduced, or being forced to retire based on their age. Question: If it turned out that a key reason Google fired Reid was because another individual could do his job for a lower salary, would this have strengthened Reid’s case? Answer: No, this would substantially weaken Reid’s case. Courts have held that actions based on price differentials are legal. And, in order to win a case under the ADEA, the plaintiff must demonstrate that age was not just one factor, but that it was the deciding factor. Question: The California Supreme Court overruled the trial court and summary judgment was denied. Does this mean that Reid has proved age discrimination? Answer: No. The Supreme Court’s decision indicates that there is sufficient evidence that the case should be presented to a jury. Reid still needs to convince the jury that Google discriminated against him.

19-5 Americans with Disabilities Act Disabled person: Someone with a physical or mental impairment that substantially limits a major life activity, or someone who is regarded as having such an impairment. The Americans with Disabilities Act (ADA) prohibits employers with 15 or more workers from discriminating on the basis of disability. An employer may not refuse to hire or promote a disabled person so long as she can, with reasonable accommodation, perform the essential functions of the job. An accommodation is unreasonable if it would create undue hardship for the employer.

Bonus Case: Allen v. Southcrest Hospital85 Facts: After some years as a medical assistant at SouthCrest Hospital, Alethia Allen requested a transfer to work for a different physician in the same hospital. Unfortunately, Allen found her new job to be much more stressful than the old one. Indeed, it was so stressful that she began suffering severe migraine headaches several times a week. Prior to this new job, she had only had one migraine headache in her life. Ultimately, Allen resigned because of the migraines. The hospital asked that she stay on to cover for some assistants who were on vacation. Allen agreed to do so and then decided she did not want to quit after all. But before the hospital made a decision about whether she could stay, she left work one day to seek treatment for a migraine at the emergency room. That night, the doctors in her practice decided she could not continue in her job. After leaving SouthCrest, her migraines stopped. Allen filed suit against SouthCrest for violating the ADA. During discovery, she testified that on most days, she could care for herself and go to work, but that on days on which she took the migraine medication, she would come home from work and immediately “crash and burn.” In other words, she could not care for herself but instead would go straight to bed.

U.S. App. LEXIS 25488,UNITED STATES COURT OF APPEALS FOR THE TENTH CIRCUIT, 2011. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The trial court granted SouthCrest’s motion for summary judgment. Allen appealed. Issue: Did Allen have a disability that interfered with one or more major life activities? Decision: No, Allen failed to show that her disability interfered with any major life activities. Reasoning: Allen alleged that taking migraine medication interfered with her ability to care for herself in the evenings, which is a major life activity. But even the average person sometimes goes to bed early and is unable to care for herself when asleep. Allen had to show how much worse off she was than the average person who sometimes comes home from work exhausted. Furthermore, Ms. Allen needed to show: how much earlier she went to bed on migraine days, which activities she could not perform, how long she slept, and whether she could complete in the morning the activities she had failed to do the night before. Ms. Allen also alleged that her migraines interfered with her ability to work, which is certainly a major life activity. However, she had to show that she was unable to perform a general class of jobs for which she had appropriate training and skills, not one single specific job. Question: How many employees must an employer have before the American with Disabilities Act (ADA) prohibits discrimination on the basis of disability? Answer: 15 persons. Question: What is the definition of a disabled person under the American with Disabilities Act (ADA)? Answer: (1) Someone with a physical or mental impairment that substantially limits a major life activity or the operation of a major bodily function, or (2) Someone who is regarded as having such an impairment. Question: What did Ms. Allen need to show in order to establish that her migraines interfered with her ability to work? Answer: That she was unable to perform a general class of jobs for which she had appropriate training and skills, not one single specific job.

Bonus Case: Toyota v. Williams86 Facts: When Ella Williams’s doctor diagnosed her with carpal tunnel syndrome, Toyota transferred her from an assembly line position to a job in Quality Control Inspection Operations (QCIO). Employees in this department typically performed four different jobs, but Williams was initially assigned only two tasks. Toyota then changed its policy and required QCIO employees to rotate through all four jobs. Williams began to perform the “shell body audit.” After applying oil to the outside of cars, she visually inspected each car for flaws. To perform this task, she had to hold her hands and arms up around shoulder height for several hours at a time. A short while after beginning this job, she began to experience pain in her neck and shoulders. She asked permission to perform only the two tasks that she could do without difficulty. Williams claimed

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that Toyota refused this request. Toyota said that Williams simply began missing work regularly. Ultimately, Williams’s doctor told her she should not do any work of any kind. Toyota fired her. The Court of Appeals for the Sixth Circuit found that Williams was disabled under the terms of the ADA because her impairments substantially limited her in the major life activity of performing manual tasks. The Supreme Court granted certiorari. Issues: Was Williams disabled, within the terms of the ADA? Did Toyota violate the ADA? Holding: The Supreme Court reversed the appeals court, holding that to be disabled an individual must have an impairment that prevents or severely restricts activities that are of central importance to most people's daily lives. The impairment's impact must also be permanent or long-term. In this case, the fact that the plaintiff could not work with hands and arms extended at or above shoulder levels for extended periods of time, is not relevant because this is not an important part of most people's daily lives. As long as the plaintiff can tend to her personal hygiene and carry out personal or household chores, she is not disabled. Question: Could Williams perform her job at Toyota? Answer: No, she could not keep her arms raised at shoulder height for extended periods of time. Question: Could Williams operate without assistance in her personal life? Answer: Yes, she could tend to personal hygiene and perform most household chores. Question: Was she disabled, under the terms of the ADA? Answer: No, as long as she could perform most activities in her private life, she was not disabled. Question: Do you agree with this decision? Is it compassionate? Answer: The court seemed concerned that, if the ADA covered every worker with carpal tunnel syndrome or other ailments that simply hindered workplace performance, a huge percentage of the workforce would be covered. Such a ruling would conceivably wreak havoc in the workplace. Question: Why didn’t Toyota let her continue to perform just the two jobs she was capable of doing? Answer: Presumably, Toyota was concerned about setting a precedent.

Bonus Case: Sutton v. United Airlines, Inc.

United Airlines required its pilots to have uncorrected vision of at least 20/100. It refused to hire twin sisters with 20/200 vision, even though their vision could be corrected to 20/20. The sisters sued under the ADA, claiming that United Airlines was discriminating against them because of a disability. The Supreme Court held that the ADA did not apply because the sisters were not disabled. Although they could not satisfy the requirements of a particular job, airline pilot, they were not substantially limited in a major life activity–namely, working. There were many other jobs they could hold, such as flying instructor.88 Question: What is a disabled person? Answer: Someone with a physical or mental impairment that substantially limits a major life activity. Question: The twin sisters had 20/200 vision. Were they disabled?

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Answer: They thought they were because their poor eyesight prevented them from obtaining the job of their dreams–pilot at United Airlines. Question: Could you argue that they were not disabled? Answer: The Supreme Court held that their physical impairment did not substantially limit a major life activity. Question: But didn’t their impairment prevent them from getting the job they wanted? Answer: It may have prevented them from getting that particular job, but they were eligible for most jobs, or even most pilot jobs. United wouldn’t hire them to fly globally, but they could still get jobs as regional pilots or as flying instructors. Question: How many Americans currently have some disability as defined by the ADA? Answer: When passing the ADA, Congress estimated that 43 million Americans have some sort of disability. Question: How many people have correctable disabilities? Answer: According to the Supreme Court, more than 160 million Americans have a correctable disability. The court concluded that Congress could not have intended to include such a large number of people in its definition of disabled.

19-5a The Hiring Process An employer may not ask about disabilities before making a job offer. The interviewer may ask only whether an applicant can perform the work. Once a job offer has been made, the company may require a medical test if it is required of all entering employees in similar jobs.

19-6b Relationship with a Disabled Person An employer may not discriminate against someone because of his relationship with a disabled person. For example, an employer cannot refuse to hire an applicant because he has a child with Down’s syndrome or a spouse with AIDS.

19-5c Obesity According to the EEOC, just being overweight is not a disability unless it has some underlying physiological cause, such as thyroid disorder. However, being morbidly obese (defined as having double the normal body weight) is a disability, no matter what the cause.

19-5d Mental Disabilities Under EEOC rules, physical and mental disabilities are to be treated the same.

19-6 Genetic Information Nondiscrimination Act (GINA) Suppose you want to promote someone to CFO, but you know that her mother and sister both died young of breast cancer. Is it legal to consider that information in making a decision? Not since Congress passed the Genetic Information Nondiscrimination Act (GINA). Under this statute, employers (with 15 or more workers) may not require genetic testing or use information about genetic makeup or family medical history as a factor in hiring, firing, or promoting employees.

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Even an employee Wellness Program cannot require participants to answer questions about their family medical histories.

19-7 Hiring Practices The hiring process is an easy place for employers to go wrong. Here are pitfalls to avoid:

19-7a Interviews It used to be that interviewers would ask all sorts of inappropriate questions about topics such as marital status and plans to have children. The most common gaffe on the part of interviewers? Asking women about their childcare arrangements. That question assumes the woman is responsible for childcare.

Don’t Even Consider Asking

Go Ahead and Ask (if job related)

How many days were you sick last year?

Have you ever received a performance warning due to your attendance? Are you currently using drugs illegally? Are you authorized to work in the United States? What work experience have you had? Could you carry a 100-pound weight, as required by this job? Where did you go to college? What languages do you speak and write fluently? Have you ever been convicted of a crime that would affect the performance of this job? Can you work weekends? Travel extensively? Would you be willing to relocate?

What medications are you currently taking? Where were you born? Are you a U.S. citizen? How old are you? How tall are you? How much do you weigh? When did you graduate from college? How did you learn this language? Have you ever been arrested?

Do you plan to have children? How old are your children? What method of birth control do you use? What is your corrected vision? Do you have 20/20 corrected vision? Are you a man or a woman? Talk about the job itself! Are you single or married? What does your spouse do? What will happen if your spouse is transferred? What clubs, societies, or lodges do you belong to?

19-7b Social Media Almost all employers now rely on social media as part of their hiring process. They may review LinkedIn to find potential candidates or check Facebook for evidence of unprofessional behavior. But these searches sometimes reveal information that is illegal for employers to act on, such as age, religion, pregnancy, or illness. To help prevent this kind of liability, some employers keep the role of hiring separate from that of “cyber-vetting” and may hire outside consultants to do the checking.

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19-8 Enforcement Before a plaintiff can bring a suit under any of these statutes (except the Equal Pay Act), she must first file a charge with the EEOC. The EEOC conducts an investigation and attempts to mediate the dispute. If mediation fails, it may file suit, or give plaintiff a right to sue letter.

Chapter Conclusion The statutes in this chapter have changed America – it is far different now from when Sandra Day O’Connor first looked for a job. People are more likely to be offered employment because of their efforts and talents rather than their age, appearance, faith, family background, or health.

Matching Questions Match the following terms with their definitions: _____A. Equal Pay Act 1. An employee cannot be paid at a lesser rate for equal work than employees of the opposite sex _____B. BFOQ 2. Statute that prohibits discrimination on the basis of race, color, religion, sex, or national origin _____C. ADEA 3. Discriminatory job requirements that are essential to the job _____D. Title VII 4. Statute that prohibits age discrimination _____E. ADA 5. Statute that prohibits discrimination against the disabled

Answers: FFF.1 GGG. HHH. III. 2 JJJ. 5

3 4

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 89. T F In a disparate impact case, an employer may be liable for a rule that is not discriminatory on its face. 90. T F Title VII applies to all aspects of the employment relationship, including hiring, firing, and promotion. 91. T F If more whites than Native Americans pass an employment test, the test necessarily violates Title VII. 92. T F Employers that have contracts with the federal government are required to fill a quota of women and minority employees. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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93. T F Employers do not have to accommodate an employee’s religious beliefs if doing so would impose an undue hardship on the business.

Multiple Choice Questions 6. Which of the following steps is not required in a disparate treatment case: A. The plaintiff must file with the EEOC. B. The plaintiff must submit to arbitration C. The plaintiff must present evidence of a prima facie case. D. The defendant must show that its action had a nondiscriminatory reason. E. The plaintiff must show that the defendant’s excuse was a pretext. Answer: B. 7. An employer can legally require all employees to have a high school diploma if: A. All of its competitors have such a requirement B. Most of the applicants in the area have a high school diploma C. Shareholders of the company are likely to pay a higher price for the company’s stock if employees have at least a high school diploma D. The company intends to branch out into the high=tech field, in which case a high school diploma would be needed by its employees E. The nature of the job requires those skills Answer: E. 8. Which of the following employers has violated Title VII? A. Carlos promoted the most qualified employee. B. Hans promoted five white males because they were the most senior. C. Luke refused to hire a Buddhist to work on a Christian Science newspaper. D. Max hired a male corporate lawyer because his clients had more confidence in male lawyers. E. Dylan refused to hire a woman to work as an attendant in the men’s locker room. Answer: D. 9. Which of the following activities would not be considered sexual harassment? A. Shannon tells Conner she will promote him if he will sleep with her. B. Kailen has a screen saver that shows various people having sex. C. Paige says she wants “to negotiate Owen’s raise at the Holiday Inn.” D. Nancy yells “crap” at the top of her lungs every time her Rotisserie Baseball team loses. E. Quid pro quo Answer: D. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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10. Which of the following activities is legal under Title VII? A. When Taggart comes to a job interview, he has a white cane. Ann asks him if he is blind. B. Craig may refuse to hire Ben, who is blind, to work as a playground supervisor because it is essential to the job that the supervisor be able to see what the children are doing. C. Concerned about his company’s health insurance rates, Matt requires all job applicants to take a physical. D. Concerned about his company’s health insurance rates, Josh requires all new hires to take a physical so that he can encourage them to join some of the preventive treatment programs available at the company. E. Jennifer refuses to hire Alexis because her child is ill and she frequently has to take him to the hospital. Answer: B.

Case Questions 1. Atlas operated warehouses that stored food for grocery stores. Imagine the upset when a mystery employee began leaving his feces in a warehouse. To solve the mystery of the devious defecator, Atlas required cheek swabs from two of its workers so that it could compare their DNA with that of the feces. Was Atlas liable to the workers? Answer: A court held that Atlas had violated GINA< which prohibits employers from requesting genetic information from its workers. It doesn’t matter that the DNA did not match. Lowe v. Atlas Logistics Group Retail Servs, Atlanta, LLC, 102 F.Supp 3d 1360 (N.D. Ga. 2015) . 2. A high-end boutique in Phoenix would not permit Dick Kovacic to apply for a job as a salesperson. It only hired women to work in sales because fittings and alterations took place in the dressing room or immediately outside. The customers were buying expensive clothes and demanded a male-free dressing area. Has the Lillie Rubin store violated Title VII? What would its defense be? Answer: The store alleged that being female was a bona fide occupational qualification for this job. The EEOC, however, disagreed and found the store in violation of Title VII. Margaret A. Jacobs, “EEOC Reopens Issue of When Discrimination Is Legal,” Wall Street Journal, April 9, 1995, p. B4.

After the terrorist attacks of 9/11, the United States tightened its visa requirements. In the process, baseball teams discovered that 300 foreign-born professional players had lied about their age. (A talented 16-year-old is much more valuable than a 23-year-old with the same skills.) In some cases, the players had used birth certificates that belonged to other (younger) people. To prevent this fraud, baseball teams began asking for DNA tests on prospects and their families to make sure they were not lying about their identity. Is this testing legal? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: There have not been any cases yet, but commentators speculate that the testing would violate the Genetic Information Nondiscrimination Act. It seems clear the teams would be in violation if they used the information to predict whether a player is susceptible to disease. 4. Ronald Lockhart, who is deaf, worked for FedEx as a package handler. Although fluent in American Sign Language, he could not read lips. After 9/11, the company held meetings to talk about security issues. Lockhart complained to the EEOC that he could not understand these discussions. FedEx fired him. Has FedEx violated the law? Answer: The EEOC ruled that FedEx should have provided a sign-language interpreter during meetings and made other accommodations. The Fourth Circuit Court of Appeals ruled that FedEx had illegally retaliated against Lockhart. It affirmed a jury award of $100,000 in punitive damages, $8,000 in compensatory damages. 5. When the boss fired Clarence from his job at a moving company, she said it was because he could no longer lift heavy furniture; his salary was too high and, as he got older, he would have a hard time remembering stuff. Clarence is 60. Has the boss violated the law? Answer: It is legal to fire someone who can’t perform the job requirements or because his salary is too high. There may have been some age discrimination but there is no evidence that age was the deciding factor. Therefore, the firing was legal. 6. In 1961, NASA began admitting women into its astronaut training program. They performed well in the training but none of them ever served as astronauts because NASA changed its rules to require jet fighter experience for astronauts. Since women were not eligible to fly jet fighters, they could not qualify for space duty. Would these women have had a claim under Title VII? Answer: They would have a disparate impact claim. The jet fighter requirement has a disparate impact on a protected category. NASA would have to show that this requirement was a job related necessity. That seems unlikely, given that it had not previously been a requirement. Could NASA have used other, less discriminatory job requirements?

Discussion Questions 1. ETHICS Mary Ann Singleton was the librarian at a maximum security prison located in Tazewell County, Virginia. About four times a week, Gene Shinault, assistant warden for operations, insistently complimented Singleton; stared at her breasts when he spoke to her; on one occasion, he measured the length of her skirt to judge its compliance with the prison's dress code and told her that it looked "real good"; constantly told her how attractive he found her; made references to his physical fitness, considering his advanced age; asked Singleton if he made her nervous (she answered "yes"); and repeatedly remarked to Singleton that if he had a wife as attractive as Singleton, he would not permit her to work in a prison facility around so many inmates. Shinault told Singleton’s supervisor in her presence, "Look at her. I bet you have to spank her every day." The © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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supervisor then laughed and said, "No. I probably should, but I don't." Shinault replied, "Well, I know I would." Shinault also had a security camera installed in her office in a way that permitted him to observe her as she worked. Singleton reported this behavior to her supervisor, who simply responded, "Boys will be boys." Did Shinault sexual harass Singleton? Whether or not Shinault violated the law, what ethical obligation did Singleton’s supervisor have to protect her from this type of behavior? Answer: The Fourth Circuit Court of Appeals ruled that this behavior did not constitute sexual harassment. While boorish and offensive, it was not sexual in nature. Shinault never requested a sexual act, touched Singleton inappropriately, discussed sexual subjects, showed her obscene materials, told her vulgar jokes, or threatened her, Singleton did not allege that the complained of behavior interfered with her ability to perform her job. (2004 U.S. App. LEXIS 24059) 2. When Thomas Lussier filled out a Postal Service employment application, he did not admit that he had twice pleaded guilty to charges of disorderly conduct. Lussier suffered from post-traumatic stress disorder (PTSD) acquired during military service in Vietnam. Because of this disorder, he sometimes had panic attacks that required him to leave meetings. He was also a recovered alcoholic and drug user. During his stint with the Postal Service, he had some personality conflicts with other employees. Once, another employee hit him. He also had one episode of “erratic emotional behavior and verbal outburst.” In the meantime, a postal employee in Ridgewood, New Jersey, killed four colleagues. The Postmaster General encouraged all supervisors to identify workers who had dangerous propensities. Lussier’s boss discovered that he had lied on his employment application about the disorderly conduct charges and fired him. Is the Postal Service in violation of the law? Answer: The court held that Lussier had been dismissed solely because of his disability. The Postal Service was liable under the Rehabilitation Act of 1973, which prohibits federal agencies from discriminating against the disabled. Lussier v. Runyan, 1994 U.S. Dist. LEXIS 4668 (D. Me. 1994). 3. Lisa T. Jackson, who was white, worked at Uncle Bubba’s Seafood and Oyster House. She filed suit under Title VII, alleging that the restaurant discriminated against black employees. They6 had to enter through the restaurant’s rear entrance and could not use the customer bathrooms. Neither of these prohibitions applied to white staff. Jackson’s boss also repeatedly told racist jokes. Jackson stated that this behavior caused her great difficulty in managing the staff and also immense emotional distress because she had biracial nieces. In addition, one of her bosses asked her how she “looked so white,” given that her father was of Sicilian descent. Can Jackson recover under Title VII? Answer: No. Although earlier cases would have permitted such a suit, the court noted that the Supreme Court had revisited the issue of standing under Title VII claims, and reevaluated its prior reasoning. Following the new decisions, the District Court in this case held that plaintiff was not an “aggrieved party” under Title VII because her interests were not those arguably sought to be protected by the statute. AT best, Plaintiff is an accidental victim of the alleged racial discrimination. Workplace harmony is not an interest sought to be protected by Title VII. Jackson v. Deen, 959 F.Supp.2d 1346 (S.C. Ga. 2013). 4. Peter Oiler was a truck driver who delivered groceries to Winn-Dixie stores. He revealed to his boss that in his free time he liked to dress as a woman, even though he was happily married to a woman. Oiler had been diagnosed with transvestic fetishism with gender dysphoria and a gender identity © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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disorder. Winn-Dixie fired him for fear that, if customers found out, they would go elsewhere to guy their groceries. Does Oiler have a claim against Winn-Dixie? Answer: Oiler’s claim fails. The court ruled that the defendant’s actions were not proscribed by Title VII. Although it recognized that many would disagree with the defendant’s decision and rationale and find it morally wrong, it was the function of the Court not to raise the social conscience of defendant’s upper level management, but to construe the law in accordance with proper statutory construction and judicial precedent. The Court noted that the plain meaning of “sex” as that was understood at the time of passage of Title VII has not been amended in the intervening years to include issues such as sexual identity and sexual orientation, although there have been many attempts to do so. Oiler v. Winn-Dixie Louisiana, Inc., (E.D.LA. 2002) 5. Title VII does not prohibit discrimination against people who are unattractive. Should it be amended to include looks? Answer: Answers will vary.

6. Ryan could not stay awake at work – and was unable to remember and keep track of key parts of his job. When questioned, he told his boss that he had sleep apnea, a sleep disorder that causes a person to stop breathing during sleep. His report from his doctor said that it was possible Ryan did have sleep apnea, but there was no definitive diagnosis because Ryan refused to take the necessary tests. The report also said that Ryan’s sleepiness could be caused by bad habits, like irregular sleep times, a poor diet, and heavy caffeine consumption. What legal obligations does his employer have to Ryan? Can Ryan be fired? Answer: The Sixth Circuit ruled that Ryan was not protected by the ADA because, “only getting a few hours of sleep a night, while inconvenient, lacks the kind of severity required to say that the ailment qualifies as a substantial limitation.” He had not been diagnosed with sleep apnea. He had actually refused to have the tests for sleep apnea that the specialist recommended. In Willoughby, the court held that, if a disability is obvious, the employer must accommodate it. Here, it is not obvious. Neely v. Benchmark Family Servs, 640 Fed.Appx 429 (6yh Cir. Ohio 2016)

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Suggested Additional Assignments Research: Sexual Harassment Policies Ask students who are employed to find their company’s sexual harassment policy. What type of behavior does it prohibit? What are the procedures for complaining about harassment? Do they think it is comprehensive? What, if any, changes would they make to the policy? Presentation: Employment Issues Ask students to choose an issue of employment law that they or a colleague has experienced at work. They should present the facts, an analysis of the legal issues and the ruling that they would issue if they were the judge in the case. This assignment can be either written or oral, prepared either individually or in teams.

Chapter 20 – Starting a Business: LLCs and Other Options* Chapter Overview Chapter Theme No one form of organization is right for every business. The proper choice depends upon factors such as sources of financing, tax issues, liability concerns, and the entrepreneur’s goals (to go public, for instance). In choosing a form of organization, it is important for the entrepreneur to consider all of these issues.

Discussion: General Concepts Taxable versus Non-Taxable Entity Tax treatment under the Internal Revenue Code is often a primary consideration in choosing a form of organization. Business organizations are taxed either as partnerships or as corporations. To be “taxed as a partnership” means that the entity itself pays no income tax, only the owners of the organization pay tax on its earnings. C Corporations, on the other hand, pay federal income tax on their earnings and then shareholders also pay tax on any dividends. To be taxed as a corporation, then, is to be subject to double-taxation under the Internal Revenue Code Question: To say that an organization is “taxed as a partnership” or “not a taxable entity” is simply a euphemism for saying that it is not taxed at all. Some commentators argue that organizations receive valuable privileges— such as limited liability—and should, in return, pay taxes. Do you agree? Answer: A fair division of the country’s tax burden is always a controversial topic. Some argue that organizations provide valuable services–such as creating jobs–that more than offset whatever privileges they receive. Moreover, when the profits are paid out to individuals, they pay tax on it. Indeed, some politicians have long argued against the double taxation of corporations. Question: But does it make sense for some forms of organizations, such as C corporations, to pay taxes while S corporations and LLCs do not? Answer: The theory is that start-ups (such as S corporations or LLCs) need special nurturing, but established corporations do not. That theory will not carry much weight, however, if LLCs become standard for large businesses as well as small. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Traditionally, law firms and accounting firms were partnerships in which each partner faced unlimited liability for the partnership’s debts. The partnerships themselves were not taxable entities. With LLCs and LLPs, the liability burden is much lighter but the tax burden is no heavier. Is this fair? Answer: There is no reason why liability issues and tax burden should necessarily be linked. Should state legislatures and the Treasury Department develop a consistent plan for linking these two issues, or at least a consistent plan for treating all organizations the same? Would it be politically feasible to simply eliminate taxation on all organizations? Limited Liability versus Unlimited Liability Unlimited liability means that an owner of a business is personally liable for the business’s financial obligations to the full extent of the owner’s personal assets. In other words, a business creditor may be able to seize and sell any of the owner’s personal assets to satisfy business debts. Limited liability means that an owner is liable for the debts of the business only to the extent of the owner’s investment in the business. If an owner has limited liability then business creditors may seize and sell all assets owned by the business, but may not look to the owner’s personal assets to satisfy business obligations. In other words, the owner can lose everything she invested in the business, but not other, unrelated, assets.

20-1 Sole Proprietorships Sole proprietorship: An unincorporated business owned by one person. Flow-through tax entity: An organization that does not pay income tax on its profits but passes them through to its owners who pay the tax at their individual rates. The advantages of a sole proprietorship are: Ease of Formation: No formal steps are necessary to create one. Taxes: A sole proprietorship is a flow-through tax entity The disadvantages of a sole proprietorship are: Liability. The owner is responsible for all debts. Limited Capital. The owner has limited options for financing her business. Question: Why do 76 percent of all small businesses choose to operate as sole proprietorships? Answer: Many are too busy to consult a lawyer. Others are avoiding the legal and filing fees.

20-2 Corporations Corporations are the dominant form of organization because they have been around for a long time, and the law that regulates them is well-developed. Despite suspicions about their shield from liability, economists now suggest that this form of organization, combined with technological advances, provided the Western hemisphere with an enormous economic advantage. The corporate form has permitted the creation of large, enduring businesses because corporations can attract outside investors and are more likely than partnerships to survive the death of their founders.

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Advantages of a Corporation Limited Liability. A corporation shields managers and investors from personal liability for the debts of the corporation and the actions of others, but not against liability for their own torts and crimes. Discussion: Limited Liability Although employees and individual shareholders have no personal liability for corporate debts, it is important to remind students that individuals are always liable for their own negligence. An entrepreneur who incorporates her business will still be liable if she commits a tort. Question: Suppose that Loretta opens a candy shop on Main Street. Wary about her potential liability serving food to the public, she incorporates her business. However, she fails to follow the manufacturer’s suggestions and refrigerate her fudge. As a result, every mother in town falls ill after eating gifts of fudge on Mother’s Day. The business has a bank account with a few thousand dollars. Loretta has $100,000 in savings in a mutual fund account. Will the injured mothers have a right to the mutual funds, or only the bank account? Answer: Loretta herself was negligent–she failed to follow the manufacturer’s instructions. The successful plaintiffs in a tort case will have a right to both the business’ bank account and her personal savings in the mutual funds.

Transferability of Interests. Corporations provide flexibility for enterprises small (with one owner) and large (with thousands of shareholders). As we will see, partnership interests are not transferable without the permission of the other partners, whereas corporate stock can be bought and sold easily. Duration. When a sole proprietor dies, legally so does the business. But corporations have perpetual existence: they can continue without their founders. Disadvantages of a Corporation Logistics. Corporations require substantial expense and effort to create and operate. The cost of establishing a corporation includes legal and filing fees, not to mention the cost of the annual filings that states require. Corporations must also hold annual meetings for both shareholders and directors. Minutes of these meetings must be kept indefinitely in the company minute book. Taxes. Because corporations are taxable entities, they must pay taxes and file returns. See Exhibit 3.1 for a comparison of the tax paid by members of an LLC over shareholders.

20-2b Special Types of Corporations S Corporations S corporation: A corporation that provides limited liability to its owners and the tax status of a flowthrough entity C corporations: A corporation that provides limited liability to its owners, but is a taxable entity Congress created S corporations (aka “S corps”) to encourage entrepreneurship by offering tax breaks. The name “S corporation” comes from the provision of the Internal Revenue Code that created this form of organization. Shareholders of S corps have both the limited liability of a corporation and the tax status of a flow-through entity Like a partnership, an S corp. is not a taxable entity—all the company’s profits and losses pass through to the shareholders, who pay tax at their individual rates. It avoids the © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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double taxation of a regular corporation (called a “C corporation”). If, as is often the case, the startup loses money, investors can deduct these losses against their other income. S corps do face some major restrictions: • There can be only one class of stock (although voting rights can vary within the class). • There can be no more than 100 shareholders. • Shareholders must be individuals, estates, charities, pension funds, or trusts, not partnerships or corporations. • Shareholders must be citizens or residents of the United States, not non-resident aliens. • All shareholders must agree that the company should be an S corporation. Although most states follow the federal lead on S corporations, a small number require these companies to pay state corporate tax.

Close Corporations Close corporation: A corporation with a small number of shareholders whose stock is not publicly traded and whose shareholders play an active role in management; it is entitled to special treatment under state law. Although the rules of close corporations vary from state to state, generally, these organizations share certain features:  Protection of minority shareholders  Transfer restrictions  Flexibility  Dispute resolution Students are often confused about the differences among C corporations, S corporations, and close corporations. State statutes authorize the creation of a corporation, but the IRS determines its tax status. Thus, state law determines if an organization is a regular corporation or a close corporation. IRS regulations determine if the corporation is a taxable entity. Both a close corporation and a regular corporation can be either an S corporation or a C corporation. Question: Who establishes the rules to determine if a corporation is an S corp. or a C corp? Answer: The IRS. Question: Who establishes the rules to determine if a corporation is a close corporation? Answer: Each individual state does. Question: Are the limitations on S corporations (one class of stock, etc.) serious restraints that dramatically impede an entrepreneur’s options or minor technicalities? Answer: The S restrictions essentially eliminate the possibility of venture capital financing. Most venture capitalists are corporations or limited partnerships. Moreover, it is typical in venture capital deals to issue more than one class of stock to reflect the different rights of the shareholders.

20-3 Limited Liability Companies An LLC offers the limited liability of a corporation and the tax status of a flow-through entity. Limited liability companies are a relatively new form of organization. They offer the limited liability of a corporation and the tax status of a partnership, but they avoid the restrictions of an S corporation.

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Members are not personally liable for the debts of the company. They risk only their investment, as if they were shareholders of a corporation. Are the members of the LLC liable in the following case? You decide.

You Be The Judge: Ridgaway v. Silk89 Facts: Norman Costello and Joseph Ruggiero were members of Silk, LLC, the owner of Silk Stockings and Cafe Del Mar, which was a bar and adult entertainment nightclub in Groton, Connecticut. Anthony Sulls was drinking heavily one night at Silk Stockings and, although he was obviously drunk, employees at Silk Stockings continued to serve him. Giordano (another member of the LLC) and Costello were working there that night. They both greeted customers (who numbered in the hundreds), supervised employees and performed “other PR work.” When Sulls left the nightclub at 1:45 a.m. with two friends, he drove off the highway at high speed, killing himself and one of his passengers, William Ridgaway. Ridgaway’s estate sued Costello and Giordano personally. The defendants filed a motion for summary judgment seeking dismissal of the complaint. You Be The Judge: Are Costello and Giordano personally liable to Ridgaway’s estate? Argument for Costello and Giordano: The defendants did not own Silk Stockings; they were simply members of an LLC that owned the nightclub. The whole point of an LLC is to protect members against personal liability. The assets of Silk, LLC, are at risk, but not the personal assets of Costello and Giordano. Argument for Ridgaway’s Estate: The defendants are not liable for being members of Silk, LLC, they are liable for their own misdeeds as employees of the LLC. They were both present at Silk Stockings on the night in question, meeting and greeting customers and supervising employees. It is possible that they might actually have served drinks to Sulls, but in any event, they did not adequately supervise and train their employees to prevent them from serving alcohol to someone who was clearly drunk We do not want to live in a world where employees are free to be as careless as they wish, knowing that they are not liable because they are members of an LLC. Holding: Costello and Giordano’s motion for summary judgment was denied. The claims against Giordano and Costello on not based on their ownership of the limited liability company. Instead, plaintiff alleges that these two defendants were personally negligent on the night that Ridgaway died. Giordano and Costello were both present, supervising other employees. Therefore, this case cannot be resolved on a motion for summary judgment. Question: Are members of an LLC personally liable for the debts of the business. Answer: No, not as members, they’re not. Question: Isn’t it obvious, then, that the court should grant the motion for summary judgment? Answer: The court did not grant the motion. Question: Isn’t the whole point of an LLC to protect personal assets from business liabilities? Why would the court deny the motion for summary judgment? Answer: The claims against them are not based on the fact that they were members of the LLC. These claims were based on the fact that they were running the nightclub that evening. Question: Were the two defendants negligent that night? 89

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Answer: It’s not clear. This is why the court ruled that a trial must be held. Only by holding a trial could the court determine if the two defendants had been personally negligent. Question: What could the defendants have done to protect themselves against suit? Answer: They should not have been running the nightclub. If they engage in running the business, there is nothing they can do to protect themselves against claims that they were personally negligent. Question: Is their status as LLC members useless? Answer: No. Being members of an LLC would protect them if, say, Silk couldn’t pay its rent.

20-3b Formation It is easy to form an LLC; the only required document is a charter. In addition, an LLC should have an operating agreement that sets out the rights and obligations of the members.

Case: Ferret v. Courtney 32 Mass. L. Rep. 592, Superior Court of Massachusetts, 2015 Facts: Eric Ferret and Stephen Courtney founded Sci.X Science Studio, LLC, a Delaware LLC. Sci.X’s operating agreement required that all disagreements be decided by arbitration rather than litigation. But neither member ever signed the agreement. Five years later, after a series of conflicts, Ferret sued Courtney. In response, Courtney filed a motion to dismiss, arguing that the operating agreement required Ferret’s claim to be arbitrated. Issues: Is the unsigned Sci.X operating agreement enforceable? Does Ferret have to arbitrate his claim? Decision: This unsigned operating agreement is enforceable unless it violates the Statute of Frauds. Ferret must arbitrate his claim. Reasoning: The unsigned operating agreement states that Delaware law applies. Under Delaware law, an oral operating agreement is enforceable unless it violates the Statute of Frauds. Under the Statute of Frauds, contracts that cannot possibly be performed within a year must be in writing. Ferret did not provide the court with information on this issue. If he had argued this point, he might have been released from the contract. But since courts can only consider the information the parties provide, this court must ignore the Statute of Frauds issue altogether. Thus, the only matter before the court is whether an oral operating agreement is enforceable and Delaware law is very clear that it is. Question: Did the operating agreement need to be signed to be enforceable? Answer: No. Under Delaware law, it need not be signed to be enforceable. In fact, even oral operating agreements are enforceable in Delaware. Question: Ferret had sued in court. Under the operating agreement, was he permitted to do this? Answer: According to the operating agreement, all disputes were to be resolved by arbitration. Question: Does that mean the case is going to arbitration? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No. the court ruled that although the agreement need not be signed to be enforceable under Delaware law, the agreement was still subject to the Statute of Frauds, which might still raise issues as to the agreement’s enforceability. Question: What issue in particular did the court refer to under the Statute of Frauds? Answer: The requirement that a provision that cannot be performed within one year, would require that the agreement be signed to be enforceable. Question: So the court decided the case on the basis of the Statute of Frauds? Answer: No. the court could not decide the case based on claims under the Statute of Frauds, because no claims were made based on the Statute of Frauds; in particular, no claim was raised about whether any provision of the agreement could not be performed within a year.

Bonus Case: Huatuco v. Satellite Healthcare90 (Note, this case appears in the text at fn 5) Facts: Satellite Dialysis of Tracy, LLC (Company) owned and operated dialysis facilities in California. The Company had two members, Dr. Aibar Huatuco and Satellite Health Care (Satellite), each of which owned 50 percent of the Company. Satellite managed the dialysis centers and Dr. Huatuco served as the medical director. The Company’s LLC Agreement, provided: Except as otherwise required by applicable law, the Members shall only have the power to exercise any and all rights expressly granted to the Members pursuant to the terms of this Agreement. The Agreement also provided that the company could only be dissolved if more than half the members voted in favor. Given that there were only two members, this provision meant that either party could prevent dissolution. But this Satellite was spinning out of control. Huatuco believed that Satellite was, in a sneaky and underhanded fashion, trying to force him out as medical director, while maintaining control of the Company itself. He tried to reach agreement with Satellite to dissolve the Company, but Satellite clearly felt that it had the upper hand and so refused his requests. With nowhere else to turn, Huatuco filed suit, asking the court to dissolve the Company under Section 8802 of the Delaware Code which states, “On application by or for a member or manager the Court may decree dissolution of a limited liability company whenever it is not reasonably practicable to carry on the business in conformity with a limited liability company agreement. Satellite filed a motion to dismiss Huatuco’s suit. Issue: Does Huatuco have the right to obtain dissolution of the Company in court? Excerpts from Justice Glasscock’s Decision: The parties specifically considered, and addressed, dissolution and dissolution rights in [a section] of the LLC Agreement [which provides] for dissolution only where a super-majority of the members so approve. The parties did not agree to a right to judicial dissolution, and, instead rejected all default rights under the Act unless explicitly provided for in the LLC 90

2013 Del. Ch. LEXIS 298; 2013 WL 6460898 Court of Chancery of Delaware, 2013. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Agreement or “otherwise required by law. As Satellite points out, a right to seek judicial dissolution under the Delaware Code is not “required” by law. Permitting waiver of a contractual right to judicial dissolution, is consistent with the broad policy of freedom of contract underlying the LLC Act, and comports with the Act’s approach of supplying default provisions around which members may contract if they so choose. Huatuco argues that the Defendants have not demonstrated that the Plaintiff knowingly and intelligently waived his right to judicial dissolution. Sophisticated parties entering unambiguous LLC agreements are presumed to understand the consequences of the language they have chosen, and are bound thereby, lest contract rights be subject to endless second-guessing and opportunistic revision. Additionally, Huatuco argues that even if the LLC Agreement does foreclose judicial dissolution, as a matter of public policy the Court should not deprive [him] of such a remedy where no alternative exit options are available. [A]s Satellite correctly points out, the explicit policy of the LLC Act is to “give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements. Permitting judicial dissolution where the parties have agreed to forgo that remedy in the LLC Agreement would frustrate that purpose, and change in a fundamental way the relationship for which these parties bargained. Because a right to judicial dissolution is not required by law or expressly granted in the LLC Agreement, and because reading the Agreement as a whole it is clear that the parties meant to exclude any right to judicial dissolution, I find that the Plaintiff does not have a right to seek a dissolution under [the Delaware Code+. Satellite’s Motion to Dismiss is therefore granted. Question: Why is there legal uncertainty with LLCs? Answer: LLCs are a relatively new form of organization without a consistent and widely developed body of law. Question: According to the Court, what is the explicit policy of the LLC Act? Answer: To “give the maximum effect to the principle of freedom of contract and to the enforceability of limited liability company agreements.”

20-3c Flexibility Unlike S corporations, LLCs can have members that a corporations, partnerships or nonresident aliens. LLCs can also have different classes of stock. Unlike corporations, LLCs are not required to hold annual meetings or maintain a minute book.

20-3d Transferability of Interests As a general rule, unless the operating agreement provides otherwise, existing members of an LLC cannot transfer the ownership rights, nor can the LLC admit a new member without the unanimous permission of the other members.

20-3e Duration It used to be that LLCs automatically dissolved upon the withdrawal of a member (owing to, for example, death, resignation, or bankruptcy). The current trend in state laws, however, is to permit an LLC to continue in operation even after a member withdraws. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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20-3f Going Public Once an LLC goes public, it loses its favorable tax status, and is taxed as a corporation, not a partnership. So there is no advantage to using the LLC form of organization for a publicly traded company. And there are some disadvantages: Unlike corporations, publicly traded LLCs do not enjoy a well-established set of statutory and case law that is relatively consistent across many states. For this reason, privately held companies that begin as LLCs often change to corporations when they go public.

20-3g Piercing the Company Veil Piercing the company veil: A court holds members of an LLC personally liable for the debts of the organization. A court may pierce an LLC’s veil if members:  Fail to observe formalities  Commingle assets  Fail to provide adequate capital  Commit fraud In the following case, the defendant seemed not to have bad intent but was simply careless. Nonetheless, he was liable.

Case: BLD Products, LTC v. Technical Plastics of Oregon91 Facts: Mark Hardie was the sole member of Technical Plastics of Oregon, LLC (TPO). The company operated out of Hardie’s home, and Hardie regularly used TPO’s accounts to pay such expenses as landscaping and housecleaning. TPO also paid some of Hardie’s personal credit card bills, loan payments on his truck, the expense of constructing a deck on his house, his stepson’s college bills, and the cost of family vacations, as well as miscellaneous bills from Wrestler’s World, K-Mart and Mattress World. At the same time, Hardie deposited cash advances from his personal credit cards into the TPO checking account. Hardie did not draw a salary from TPO. When TPO filed for bankruptcy, it owed BLD Products approximately $120,000 for goods that it had purchased. BLD filed suit asking the court to pierce TPO’s company veil and hold Hardie personally liable for the organization’s debts. Issues: Should the court pierce TPO’s company veil? Should Hardie be personally liable for TPO’s debts? Decision: Yes, this LLC’s veil should be pierced. Hardie is personally liable for TPO’s debts. Reasoning: An LLC’s veil can be pierced if the following three test are met: 1. the member (that is, Hardie) controlled the LLC (in this case, TPO); 2. the member engaged in improper conduct; and

2006 U.S. Dist. LEXIS 89874, United States District Court for the District of Oregon, 2006. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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3. as a result of that improper conduct plaintiff (BLD) was unable to collect on a debt against the insolvent corporation. Hardie, as the sole member and manager of TPO, clearly controlled the company. In addition, he engaged in improper conduct when he paid his personal expenses from the TPO business account. These amounts were more than occasional dips into petty cash – they indicated a disregard of TPO’s separate LLC identity. Moreover, he did not keep records of these personal payments. It is not clear whether Hardie’s improper conduct prevented BLD from collecting its entire $120,000 debt. A jury will have to determine the amount that Hardie owes BLD. Question: If Hardie was the only member of the LLC, why does it matter that he used LLC money to pay for his personal expenses? Answer: It matters that Hardie used LLC money to pay for his personal expenses because LLC’s (and other business forms) are separate, independent legal entities, and as such they must be treated separately from their owners and shareholders. By maintaining this independence, the law ensures that the business is accountable, regardless of the status of the owners and shareholders. However, when owners cross the line and treat the business as an extension of themselves personally, as Hardie did, the court will hold shareholders personally accountable for the debt of the business. General Question: Piercing the corporate veil is a very difficult argument to win and courts usually warranted in extraordinary circumstances. Why do you think that is so? Answer: A court may be reluctant to apply the doctrine because generally it is more preferable to encourage business and entrepreneurship; however, this must be balanced with promoting justice and protecting innocent victims of people who use the corporate form to commit fraud or otherwise do not act like a corporation. This balance may be very difficult to strike.

20-3h Legal Uncertainty LLCs are a relatively new form of organization without a consistent and widely developed body of law. An important area of legal uncertainty involves managers’ duties to the members of the organization. Managers do certainly owe a duty to the LLC itself (as opposed to its members), but do members have the right to enforce this duty?

20-3i Choices: LLC v. Corporation When starting a business, which form makes the most sense – LLC or corporation?  The tax status of an LLC is a major advantage over a corporation.  The S corp has the same tax status, but also has limitations.  Once an LLC is formed, it is simpler to operate.  But venture capitalists prefer to invest in C corporations.

20-4 Social Enterprises Social enterprises: These organizations pledge to behave in a socially responsible manner even as they pursue profits. More than half the states now offer charters to some type of socially conscious organization, collectively referred to as social enterprises. They are not nonprofits. Social enterprises pledge to behave in a socially responsible manner, even as they pursue profits. Their focus is on the tripe bottom line: “people, planet, and profits.” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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To comply with the Model Benefit Corporation Act, an organization must:  State in its charter that it is a benefit corporation  Obtain approval of its charter from Two-thirds of its shareholders  Measure its social benefit using a standard set by an objective third party; and  Prepare an annual benefit report assessing its performance in creating a company benefit Businesses that have become social enterprises include Etsy, Method Products, Patagonia, and Warby Parker. Internationally, there are over 1,000 social benefit organizations in 33 countries. Most are small, with fewer than 50 employees.

20-5 General Partnerships Partnership: An unincorporated association of two or more co-owners who operate a business for profit. General partner: One of the owners of a general partnership.

20-5a Tax Status Partnerships are flow-through tax entities.

20-5b Liability Each partner is personally liable for the debts of the enterprise whether or not he caused them. Partners have joint and several liability. Discussion on Partnerships: Few people now affirmatively elect to form a partnership because so many other options are available. Even professionals such as lawyers and accountants now have other choices. As we will see in the next chapter, many partnerships are created accidentally by people unfamiliar with partnership law. In addition, entrepreneurs who unsuccessfully attempt to form another type of entity, may find that they are general partners instead. For example, if two people intend to form, say, a limited liability company and fail to satisfy the state’s filing requirements, they will find themselves in a general partnership, a potentially ugly realization if their business is sued and they, as partners, are personally liable. Question: Why would anyone choose to form a partnership? Answer: There was a time when lawyers and accountants had no other choice. Now in most states they can form professional corporations, LLCs, or LLPs. Barring unusual circumstances, a partnership is really only appropriate as a joint venture between two corporations. The corporations have no concerns about liability.

20-5c Formation A partnership is easy to form. In fact, nothing is required in the way of forms or filings or agreements. If two or more people do business together, sharing management, profits and losses, they have a partnership whether they know it or not, and are subject to all the rules of partnership law.

20-5d Raising Capital The capital needs of the partnership must be provided by contributions from partners or by borrowing

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20-5e Management Management Duties Partners have a fiduciary duty to the partnership. This duty means that:  Partners have an obligation of good faith and fair dealing to each other and to the partnership.  Partners are liable to the partnership for gross negligence or intentional misconduct.  Partners cannot compete with the partnership.  A partner may not take an opportunity away from the partnership unless other partners consent.  If a partner engages in a conflict of interest, he must turn over to the partnership any profits he earned from that activity. In the following bonus case, one partner bought partnership properly secretly. Is that a conflict of interest?

Bonus Case: Marsh v. Gentry 642 S.W.2d 574, Kentucky Supreme Court, 1982 Facts: Tom Gentry and John Marsh were partners in a business that bought and sold racehorses. The partnership paid $155,000 for Champagne Woman, who subsequently had a foal named Excitable Lady. The partners decided to sell Champagne Woman at Keeneland, the world’s premier thoroughbred horse auction. At the auction, Gentry bid on the horse personally, without telling Marsh. He bought Champagne Woman for $135,000. Later, Gentry told Marsh that someone from California had approached him about buying Excitable Lady. Marsh agreed to the sale. Although he repeatedly asked Gentry the name of the purchaser, Gentry refused to tell him. Not until 11 months later did Marsh learn that Gentry had been the purchaser of both horses. Marsh became the Excitable Man. Issue: Did Gentry violate his fiduciary duty when he bought partnership property without telling his partner? Excerpts from Justice O’Hara’s Decision: Admittedly, at an auction sale, the specific identity of a purchaser cannot be ascertained before the sale, but [Kentucky partnership law] required a full disclosure by Gentry to Marsh that he would be a prospective purchaser. As to the private sale of Excitable Lady, Marsh consented to a sale from the partnership, at a specified price, to the prospective purchaser in California. Even though Marsh obtained the stipulated purchase price, a partner has an absolute right to know when his partner is the purchaser. Partners scrutinize buyouts by their partners in an entirely different light than an ordinary third-party sale. This distinction is vividly made without contradiction when Marsh later indicated that he would not have consented to either sale had he known that Gentry was the purchaser. [P]artners, in their relations with other partners, [must] maintain a higher degree of good faith due to the partnership agreement. The requirement of full disclosure among partners as to partnership © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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business cannot be escaped. Had Gentry made a full disclosure to his partner of his intentions to purchase the partnership property, Marsh would not later be heard to complain of the transaction. Finally, Gentry maintains that it is an accepted practice at auction sales of thoroughbreds for one partner to secretly bid on partnership stock to accomplish a buyout. We would emphatically state, however, for the benefit of those engaged in such practices, that where an “accepted business practice” conflicts with existing law, the law, whether statutory or court ordered, is controlling. To hold otherwise would be chaotic. Question: What is the issue in this case? Answer: The issue is whether or not Gentry breached his fiduciary duty as a partner. Question: What action(s) did he take which led the court to conclude that he did breach his fiduciary duty? Answer: He secretly purchased partnership property, not once, but twice. Question: What reason did Gentry give regarding why he bid on Champagne Woman at the thoroughbred auction? Answer: Gentry said that it was an accepted business practice at such auctions for partners to secretly bid on partnership stock in order to achieve a buy-out. Question: Did the court find this reason justifiable? Answer: No. In fact, the court made it clear that such a “business practice” was in violation of state law, and should be stopped.

20-5f Transfer of Ownership A partner cannot sell his share of the organization without the permission of the other partners.

20-5g Terminating a Partnership: Dissociation Dissociation: When a partner leaves a partnership. If a partnership chooses to terminate the business, it must follow these steps:  Dissolution: A partnership dissolves anytime the business cannot continue, such as when (1) a partner leaves and the remaining partners cannot agree unanimously to continue, (2) the partners decide to end the partnership, or (3) the partnership business becomes illegal.  Winding up: During this process, the debts of the partnership are paid, and the remaining proceeds are distributed to the partners.  Termination: Termination happens automatically once winding up is finished. The partnership is not required to do anything official.

20-6 Limited Liability Partnerships A limited liability partnership (LLP) offers the limited liability of a corporation and the tax status of a flow-through organization. It is a general partnership in which the partners are not liable for the debts of the partnership, but they are liable for their own misdeeds. To form an LLP, the partners must file a statement of qualification with state officials and the LLP must file an annual report. Why would a business elect to be an LLP rather than an LLC? In some states, professionals such as lawyers and accountants are not permitted to operate as an LLC. This form is their best option. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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In the following bonus case, the failure of limited partners to renew their annual registration lost them their limited liability status.

Bonus Case: Apcar v. Gaus92 Facts. Smith & West, LLP had two partners: Michael L. Gaus and John C. West. The partnership registered in Texas as a limited liability partnership. The Texas statute requires LLPs to renew their registrations each year, but Smith & West never did so. Four years after its initial registration, the partnership entered into a lease with MF Partners (which subsequently assigned the lease to Apcar). Three years into the lease, Smith & West stopped paying rent and abandoned the premises. Apcar filed suit against the two partners individually and against the partnership. Gaus, West, and Apcar each filed a motion for summary judgment. The trial court granted Gaus and West’s motions while denying Apcar’s. Issue: Were Gaus and West personally liable for payments due under Smith & West’s lease? Holding: Judgment for Gaus and West reversed, case remanded for further proceedings. Under Texas law, an LLP must renew its registration each year, or its LLP status expires. Smith & West did not renew their application before the expiration date, therefore, its status as a limited liability partnership expired one year after the initial filing. Smith & West entered into the lease three years after this expiration. Therefore, Gaus and West are not protected from individual liability for the lease obligations. Question: Smith & West registered as an LLP once. Why does it matter that it didn’t continue to renew its registration? Answer: The statute required it to renew annually. There are times when technicalities are important. This is one of them. Close only counts in hand grenades and horseshoes.

20-7 Professional Corporations Few businesses would now elect to be a Professional Corporation (PC). But many remain because in the past, this was the only option available to professionals other than a general partnership. PCs offer the limited liability of a regular corporation. If a member of a PC commits malpractice, the corporation’s assets are at risk, but not the personal assets of the innocent members. PCs are a separate taxable entity, not a flow-through organization. Therefore the tax issues can be complicated.

20-8 Franchises Franchises are not, strictly speaking, a separate form of organization. They are included here because they represent an important option for entrepreneurs. Bonus notes: Franchises are increasingly common, being popular with down-sized executives, women bumping up against the glass ceiling, employees tired of the corporate rat race, and people who simply aspire to owning their own business. All franchisors must comply with the Federal Trade Commission’s Franchise rule. In addition, some states also impose their own requirements.

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Franchise Disclosure Document (FDD): A disclosure document that a franchisor must deliver to a potential purchaser. All franchisors must comply with the FTC’s Franchise Rule. The FTC’s Franchise rule requires that a franchisor deliver the FDD to a potential purchaser at least 14 calendar days before a contract is signed or money paid. The FDD must provide information on:  The history of the franchisor and its key executives  Litigation with franchisees  Bankruptcy filings by the company and its officers and directors  Costs to buy and operate a franchise  Restrictions, if any, in suppliers, products, and customers  Territory – any limitations (in either the real or virtual worlds) on where the franchisee can sell or any restrictions on other franchisees selling in the same territory  Business continuity – under what circumstances the franchisor can terminate the franchisee and the franchisee’s rights to renew or sell the franchise  Required advertising expenses  A list of current franchisees and those that have left in the prior three years (a significant number of departures may be a bad sign) The purpose of the FDD is to ensure that the franchisor discloses all material facts. As the following case illustrates, under current law, the franchisor has much of the power in a franchise relationship.

Case: National Franchisee Association v. Burger King Corporation93 Facts: The Burger King Corporation (BKC) would not allow franchisees to have it their way. Instead, BKC forced them to sell the double-cheeseburger (DCB) for $1.00, which was below cost. Burger King franchisees filed suit alleging that (1) Burger King did not have the right to set maximum prices and (2) that even if Burger King had such a right, it had violated its obligation under the franchise agreement to act in good faith. The court dismissed the first claim because the franchise agreement unambiguously permitted Burger King to set whatever prices it wanted. But the court allowed the plaintiffs to proceed with the second claim. Issue: Was Burger King acting in good faith when it forced franchisees to sell items below cost? Decision: Yes, Burger King was acting in good faith. Reasoning: This case hinges on Burger King’s motives. To show bad faith, plaintiffs must prove that Burger King’s goal, in setting these prices, was to harm the franchisees. For example, the franchisees could show that Burger King’s motive was to weaken them so much that the company could take them over itself. 93

2010 U.S. Dist. LEXIS 123065 United States District Court for the Southern District of Florida, 2010 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Alternatively, the plaintiffs could show (1) that no reasonable person would have set the price of a DCB at $1.00 and (2) this pricing caused severe harm to the franchises. Clearly, the plaintiffs would never have agreed to a contract that permitted unreasonable and harmful behavior. The franchisees cannot meet any of these tests. First, there is no evidence that Burger King had any motive other than helping the franchisees. Second, selling below cost is not nec3ssarily irrational. Indeed, there are lots of good reasons why stores might adopt such a strategy – to build customer loyalty, lure customers away from competitors, or serve as loss leaders to generate increased sales on other, higher-priced products (French fries, anyone?). Third, there is no evidence that the franchises were unprofitable or in danger of bankruptcy. Note: The franchisees agreed to dismiss the lawsuit and entered into an agreement giving the franchisees more input on the price of items on its value menu and on how long special deals run. Question: Were Burger King’s action done in bad faith? Answer: No; damage to the franchisees overall business was not so severe as to deprive them of their reasonable expectations under the contract. Suggested Additional Assignment If your students obtained a copy of a franchise offering circular, this would be a good time to discuss it. Question: In examining a franchise circular, what factors should a potential purchaser look at most closely? Answer: Three issues are of particular importance: (1) the financial terms, (2) the success of the franchises, and (3) the relationship between the franchisor and its franchisees. A buyer should look at the total cost of the initial investment and annual fees charged as well as any requirements that goods be purchased from the franchisor. A buyer should also know how many of these franchises go out of business annually. Be aware, however, that sometimes the franchisor will take over a failing franchisee, which does not show up in the failure statistics. A buyer should be wary of any franchisor who is engaged in significant litigation with current or former franchisees. Moreover, of course, no one should make an investment without reading the offering circular carefully!

Chapter Conclusion The process of starting a business is immensely time consuning. Not surprisingly, entrepreneurs are sometimes reluctant to spend their valuable time on legal issues that, after all, do not contribute directly to the bottom line. No customer buys more tacos because the franchise is a limited liability company instead of a corporation. Wise entrepreneurs know, however, that careful attention to legal issues is an essential component of success. The idea for the busienss may come first, but legal considerations should occupy a close secon place.

Matching Questions Match the following terms with their definitions: _____A. S corporation 1. The first step in the process of terminating a partnership _____B. Dissociation 2. Created by federal law © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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_____C. Close corporation _____D. Dissolution _____E. Partnership Answers: KKK. LLL. 5 MMM. NNN. OOO.

3. The owners are liable for debts of organization 4. Created by state law 5. A partner leaves the partnership

2 4 1 3

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 94. T F Sole proprietorships must file a tax return. 95. T F Ownership in a partnership is not transferable. 96. T F Benefit corporations (social enterprises) are nonprofits. 97. T F In both a general partnership and a limited liability partnership, the partners are not personally liable for the debts of the partnership. 98. T F Privately held companies that begin as corporations often change to LLCs before going public.

Multiple Choice Questions 1. A sole proprietorship: A. Can easily raise capital B. Requires no formal steps for its creation C. Must register with the secretary of state D. May sell stock E. Provides limited liability to the owner Answer: B. 2. CPA QUESTION Assuming all other requirements are met, a corporation may elect to be treated as an S corporation under the Internal Revenue Code if it has: A. Both common and preferred stockholders B. A partnership as a stockholder C. 100 or fewer stockholders D. The consent of a majority of the stockholders Answer: C. CPA Examination, May 1992, #15. 3. A limited liability company: © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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A. Is regulated by a well-established body of law B. Pays taxes on its income C. cannot have members that are corporations D. is a form of organization favored by venture capitalists E. can have an oral operating agreement Answer: E. 4. While working part time at a Supercorp restaurant, Jenna spills a bucket of hot French fries on a customer. Who is liable to the customer? A. Supercorp alone B. Jenna alone C. Both Jenna and Supercorp D. Jenna, Supercorp, and the president of Supercorp E. Jenna, Supercorp, and the shareholders of Supercorp Answer: C. 5. A limited liability partnership: A. Protects partners from liability for their own misdeeds B. Protects the partners from liability for the debts of the partnership C. Must pay taxes on its income D. Both (A) and (B) E. (A), (B), and (C) are all correct Answer: B.

Case Questions 1. Alan Dershowitz, a law professor famous for his prominent clients, joined with other lawyers to open a kosher delicatessen, Maven’s Court. Dershowitz met with greater success at the bar than in the kitchen—the deli failed after barely a year in business. One supplier sued for overdue bills. What form of organization would have been the best choice for Maven’s Court? Strategy/Answer: A sole proprietorship would not have worked, because there was more than one owner. A partnership would have been a disaster because of unlimited liability. They could have met all the requirements of an S corporation or an LLC. (See the “Result” at the end of this Case Questions section.) Result: In this situation, most entrepreneurs would choose an LLC because it would be easier than forming an S corp and registering with the IRS. However, they really should have a good operating agreement. 2. Ned and Sarah formed an LLC to buy and renovate apartment buildings. They did not sign an operating agreement but they orally agreed that they would dissolve the LLC if they could not get along. The two owners argued repeatedly and Ned refused to meet with Sarah, although he was willing to take her phone calls. Ned continued to work on the renovation that was then underway. Sarah asked a court to dissolve the LLC. Under state law, an LLC without an operating agreement © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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could only be dissolved if (1) the management of the entity is unwilling to reasonably promote the stated purpose of the entity or (2) continuing the entity is financially unfeasible. What result in Sarah’s lawsuit? What is the moral of this story? Answer: Although there is no written operating agreement, an oral agreement is enforceable in some states, unless it violates the statute of frauds. If it is possible that the apartment buildings could be renovated in one year, then the Statute of Frauds would not apply and the oral operating agreement would be enforceable. But if it was not enforceable, the court is unlikely to dissolve the LLC under the provisions of the state law. Ina similar case, a court did not. The moral of the story is to have a good operating agreement! Who wants to litigate all these issues? 3. According to the company’s website, “d.light is a global leader in delivering affordable solarpowered solutions designed for the two billion people in the developing world without access to reliable energy.” It is a for-profit enterprise. What form of organization makes the most sense for this business? Why? Answer: d.light should organize as a social enterprise, because it seeks to make a positive impact on the world, providing an environmentally safe product, and contributing to social needs, while it still seeks to earn a profit. 4. Huma and Zuma want to start Spring High, a business that would take high school students on safe, educational trips during spring break. Eventually, they hope to seek venture capital money and expand the business nationally. After reading up on the legal issues online, Huma thinks Spring High should be a close corporation, while Zuma proposes that it be an S corporation. Neither thinks they should choose an LLC. Who is right? Strategy/Answer: At the moment, they could qualify as a close corporation because they only have two shareholders. As long as neither of them is a nonresident alien, Spring High could also be an S corporation. Although Spring High could be an LLC, it is not a form favored by venture capitalists. (See the “Result” at the end of this Case Questions section.) Result: They are both right. Spring High should not be an LLC because that would discourage venture capital investment. The enterprise should probably be both a close corporation and an S corp. In some states, they would qualify for close corporation status without having to elect it. In any event, there is little downside to such an election. An S corporation is also a reasonable choice because, for now, it makes sense to limit their tax liability. Should they expand to the point that they no longer meet all of the S corp. requirements, it would be easy to become a C corporation. 5. Frankie and Johnny were friends who worked together to raise money for their college expenses. They shoveled snow, cut grass, and assembled IKEA furniture, but never chose a form of organization. One day when Frankie was in class, Johnny accidentally left a rake in a pile of leaves. A child jumped into the pile and was cut by the rake. Is Johnny liable? How about Frankie? Answer: Johnny is liable because of his own negligence in leaving the rake in the pile of leaves. Frankie is liable as a member of the partnership. At the time he acted negligently, Johnny was on partnership business, and so his negligence makes the partnership liable, and therefore, Frankie also.

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1. Leonard, an attorney, was negligent in his representation of Anthony. In settlement of Anthony’s claim against him, Leonard signed a promissory note for $10,400 on behalf of his law firm, an LLC. When the law firm did not pay, Anthony filed suit against Leonard personally for payment of the note. Is a member personally liable for the debt of an LLC that was caused by his own negligence? Answer: No. The promissory note was in the name of the LLC and only it is liable. 2. Think of a business concept that would be appropriate for each of: a sole proprietorship, a corporation, and a limited liability company. Answer: Answers will vary. 3. As you will see in Chapter 21, Facebook began life as a corporation, not an LLC. Why did the founder, Mark Zuckerberg make that decision? Answer: The venture capitalists who invested preferred a corporation. He expected to take the company public, which would be easier for a corporation. 4. ETHICS Corporations developed to encourage investors to contribute the capital needed to create large-scale manufacturing enterprises. But LLCs are often start-ups or other small businesses. Why do their members deserve limited liability? And is it fair that LLCs do not have to pay income taxes? Answer: Limited liability and favorable tax treatment encourage entrepreneurs to start businesses which creates jobs and aids the economy. 5. If you were to look online for a description of a professional corporation, yo8uo might find websites stressing that, in a PC, shareholders are still responsible for their own wrongdoing. For example: “In some states, these professionals can form a corporation, but with the distinction that each professional is still liable for their own wrongful professional actions.” Why is this statement at best unnecessary and at worst misleading? Answer: Because in every organization, the professional is responsible for his or her own wrongful acts.

Suggested Additional Assignments Interview: Entrepreneur Student could interview an entrepreneur to ask why he or she chose a particular form of business. Did the entrepreneurs understand the legal issues involved? Did they simply rely on lawyers in making their selections? Or, did they “fall into” a choice such as sole proprietorship or corporation without thinking? Research: Costs of Forming a Business Organization Ask students to find out how much it costs in your state to form different types of organizations. They can call the State House or log on to the Secretary of State’s Web site to find out about initial filing fees and annual charges. What about lawyer’s fees? Research: Close Corporation Statutes Ask students to find out whether your state has a close corporation statute. Must a corporation elect to be treated as a close corporation, or can any corporation take advantage of the special provisions if it meets the statutory requirements? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Research: Franchise Offering Circulars Ask students to obtain an offering circular for a franchise. They can order one from a franchisor that advertises in the Wall Street Journal or on-line at http://www.franchising.com/franchisors/. Students are often interested to see what these circulars look like and are impressed by their length. Research and Drafting Exercise: Choosing a Form of Business Organization Divide students into nine groups. Give each group a piece of paper with one form of organization written at the top: Sole Proprietorship; General Partnership; Limited Liability Partnership (LLP); Professional Corporation; Limited Partnership; Limited Liability Limited Partnership; C Corporation; S Corporation; Close Corporation; or Limited Liability Company (LLC). Ask each group to think of a business that would be appropriate for this form of organization. For instance, a group of students might decide that a sole proprietorship would be appropriate for a watercolor artist because her liability would be low and she would have little interest in selling stock in the business. Typically, students at all levels (from undergraduates through executive MBAs) engage in interesting and thoughtful discussions in their efforts to apply what they have read to specific business ideas. Students should capture their ideas on Power Point slides, overheads, or on paper to present during class. As the class discusses the forms of business organization, each group assigned to that form should present the reasons why this form is appropriate for its business. As each group makes its presentation, the instructor can ask questions and direct the discussion to cover all of this chapter’s important points.

Chapter 21 – Corporations* Chapter Overview Chapter Theme A fundamental problem of the modern corporation is that the interests of managers, shareholders and stakeholders often conflict.

21-1 Promoter’s Liability Promoter: Someone who organizes a corporation. Adopt: Agree to be bound by the terms of a contract. Novation: A new contract. A promoter is personally liable on any contract he signs before the corporation is formed. After formation, the corporation can adopt the contract, in which case, it is liable too. But the promoter continues to be liable unless the other party agrees to a novation – that is, a new contract with the corporation alone.

Bonus You Be the Judge: GS Petroleum, Inc., v. R and S Fuel, Inc. 2009 Del.Super. LEXIS 200; 2009 WL 1554680, Superior Court of Delaware, 2009 Facts: On March 13, GS Petroleum (GS) signed an agreement to sell a Shell gas station to R and S Fuel, Inc. (Fuel). On April 2, Fuel opened a corporate bank account and began writing checks on it. On April 15, Fuel took possession of the Shell station. Later, it took out insurance in the company’s’ name. Unfortunately, what Fuel did not do was pay the money it owed under the contract. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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So far, this looks like just a breach of contract case. But there is one more fact that greatly complicates this simple picture: Fuel did not actually come into existence until March 27, two weeks after the contract was signed. The introduction to the contract stated that it was “entered by and between R and S Fuel, Inc., and GS Petroleum, Inc. The signature lines at the end looked like this: Richard Simpson R and S Fuel, Inc. Buyer Susan Stamm and Richard Simpson In other words, although the names of both Stamm and Simpson are printed on the signature page, only Simpson actually signed the document. GS filed suit for $124,000 against the corporation but also personally against Richard Simpson and Susan Stamm. The two individuals filed a motion for summary judgment. You Be the Judge: Were Simpson and Stamm personally liable for the debts of Fuel? Argument for GS: The corporation did not exist when the contract was signed, so someone else has to be liable. Simpson and Stamm were the promoters, their names appear on the contract and Simpson actually signed it. No corporate title is attached to his name on the signature line, which indicates he was signing as an individual, not a corporate officer. And when Simpson signed the contract, he was acting as Stamm’s agent. So she is liable, too. The defendants argue that the business was a de facto corporation, but they need to read the textbook more carefully. To qualify, they must have made a good faith effort to comply with corporate law, but here they had not bothered to file the forms with the Secretary of State. That is not a good faith effort. While they are reviewing the text, Simpson and Stamm should also note that even if Fuel adopted the contract, they are still liable until the parties sign a novation. That did not happen here. And no provision of the contract explicitly or impliedly released the two defendants. To find Simpson and Stamm liable is the only fair result. Someone is going to be out a lot of money. It should be the people responsible for losing that money – not the innocent party who sold them a perfectly good business. Argument for Simpson and Stamm: It is true that Simpson’s signature line did not list a corporate title, but that was simply an oversight. He was clearly signing for the corporation. As for Stamm, she cannot be liable for an agreement she did not sign. Promoters who sign an agreement on behalf of a corporation are only liable if the parties intended that result. GS entered into this agreement with a corporation. Note that the document states it is an agreement with just Fuel; not Fuel, Simpson and Stamm. Everyone understood that to be the case. GS has not alleged that Fuel was a sham corporation. Even before the corporate documents were filed, Simpson and Stamm ran the business as a corporation. They opened a bank account in the company’s name, they used only business checks, they bought insurance in the corporate name. If GS wanted the two individuals to be liable, the document should have said so. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Also, R and S Fuel was a de facto corporation at the time the Agreement was signed. Simpson and Stamm were in the process of organizing it, they were making a good faith effort and they were using the corporation to conduct business. In the case of a de facto corporation, third parties such as GS have no right to challenge its validity. Holding: The court ruled that the parties had not intended Simpson and Stamm to be liable, so they were not. Question: What is the issue in this case? Answer: The issue is whether Susan Stamm and Richard Simpson are personally liable for the debt of Fuel, Inc., as promoters. Question: What is a de facto corporation? Answer: A de facto corporation is one that results when the promoter has made a good faith effort to incorporate and has actually used the corporation to conduct business. Question: Did that happen in this case? Answer: No. the “promoters” had not even filed the forms with the secretary of state, so there was no good faith attempt to form a corporation Question: What was the argument of GS as to why Simpson and Stamm should be liable? Answer: GS maintained that they were promoters, and so were liable even if Fuel adopted the contract, and would continue to be until the parties signed a novation. Question: What was the argument for Simpson and Stamm? Answer: They maintained that Simpson signed for the corporation, and simply omitted to list his title. They also said that Stamm never signed the contract, so could not be held liable. They also argued that it was clear that the parties never intended Simpson and Stamm to be liable, only the corporation. The contract on its face said that the contract was between GS and Fuel, not between GS, Fuel, Simpson and Stamm. Question: What did the court rule? Answer: The court ruled for Simpson and Stamm. Because it was clear that the parties never intended Simpson and Stamm to be personally liable, they were not.

21-2 Incorporation Process Because there is no federal corporation code, a company can incorporate only under state law. No matter where a firm actually does business, it may incorporate in any state. This decision is important because the organization must live by the laws of whichever state it chooses for incorporation.

21-2a Where to Incorporate? Domestic corporation: A corporation is a domestic corporation in the state in which it was formed. Foreign corporation: A corporation operating in a state in which it was not incorporated. No matter where a company actually does business, it may incorporate in any state. A corporation has to pay filing fees and franchise taxes in the state of incorporation, as well as in any state in which it does ongoing business. To avoid this double set of fees, a business that will be operating primarily in one state typically selects that state for incorporation. But if a firm is going to do business in several states, it might consider choosing Delaware.

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Delaware offers corporations several advantages:  Flexible laws that favor management  An efficient court system  An established body of law  A neutral arena Other states have all modified their corporate laws to attract incorporation business. Once a firm has decided where to incorporate, the next step is to prepare and file the charter, which may be called the Articles of Incorporation or the Articles of Organization. Discussion: Incorporation Question: If students completed the assignments on selecting a state of incorporation. Draw a chart on the board, listing the different states and the reasons for their selection. Do the results show any patterns? Answer: It may be that small owners are more likely to incorporate in the state in which they are doing business while large companies are more likely to choose a different state with more favorable laws. In addition, companies financed by venture capital firms may be more likely to choose Delaware because the venture capitalists will want a law with which they are familiar. Research: Corporate Names If students completed the corporate names research, how many found that the names they chose were unavailable?

21-2b The Charter The charter includes: Name: All corporations must use one of the following words in their name: Corporation, Incorporated, Company, or Limited. A new corporate name must be different from that of any corporation that already exists in that state. Address and Registered Agent: A firm must have an official address in the state in which it is incorporated so that the secretary of state knows where to contact it, and so that anyone who wants to sue the corporation can serve the complaint in the state. Since most companies incorporated in Delaware do not actually have an office there, they hire a registered agent to serve as their official presence in the state. Registered agent: Someone hired by a business to serve as its official presence in the state. Purpose: The corporation is required to give its purpose for existence. Most companies use a very broad purpose clause. Incorporators Incorporator: The person who signs the charter and files it with the secretary of state. The incorporator is not required to buy stock, nor does he necessarily have any future relationship with the firm. Often, the lawyer who prepares the charter serves as incorporator> If no lawyer is involved, typically, the promoter is also the incorporator. Mark Zuckerberg served as the incorporator of Facebook. The incorporator incurs liability only if he knows that something in the charter is not true when he signs it. See Ethics box on page 400 of text, not available at the time this IM was created. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Stock The charter must provide information about the company’s stock:

Par Value : Not market value; a nominal figure such as $1 per share. Number of Shares Authorized stock: Stock listed in a company’s charter – the maximum number of shares it can issue. Treasury Stock: Stock that a company has sold, but later bought back. Classes of Stock: Shareholders often make different contributions to a company. Some may be involved in management; some contribute financially. To reflect these varying contributions, a corporation can issue different classes of stock. Preferred stock: The owners of preferred stock have preference on dividends and also, typically, in liquidation.

21-3 After Incorporation Bonus notes: Once the charter has been filed and the filing fee paid, the corporation legally exists, but a few additional tasks remain. The incorporators elect the first set of directors. Thereafter, shareholders elect directors. Then, the directors elect the officers of the corporation. See Exhibit 21.1 in text, unavailable at the time of creating this IM> Written consent: A signed document that takes the place of a shareholders’’ or directors’ meeting. Minute book: A book that contains a summary of a corporation’s official actions. Bylaws: A document that specifies the organizational rules of a corporation or other organization, such as the date of the annual meeting and the required number of directors. Quorum: The percentage of stock that must be represented for a meeting to count.

21-4 Death of the Corporation Sometimes, business ideas are not successful and the corporation fails. This death can be voluntary (the shareholders elect to terminate the corporation) or forced (by a decision of the Secretary of State or by court order).

21-4a Voluntary Termination by the Shareholders To terminate a corporation, the shareholders undertake a three-step process:  Vote: The directors recommend to the shareholders that the corporation be dissolved, and a majority agree  Filing: The corporation files Articles of Dissolution with the secretary of state  Winding up: The officers of the corporation pay its debts and distribute the remaining property shareholders. When the winding up is completed, the corporation ceases to exist.

21-4b Termination by the State The secretary of state may dissolve a corporation that fails to comply with state requirements, such as paying the required annual fees. Many small corporations do not bother with the formal dissolution process. They simply walk away, and let the secretary of state act.

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A court may also dissolve a corporation if it is insolvent or if its directors and shareholders cannot resolve conflict over how the corporation should be managed. The court will then appoint a receiver to oversee the winding up.

Case: Shawe v. Elting 2017 Del. LEXIS 62, Delaware Supreme Court, 2017 Facts:. Operating from their shared business school dorm room, Elizabeth Elting and Philip Shawe founded TransPerfect Global, Inc. (TPG), in 1992. They each owned half of TPG’s stock, were co-chief executive officers, and were the only directors. At the time of this case, the company provided translation, website localization, and litigation support services from 92 offices in 86 cities worldwide, operating in 170 different languages. In 1997, when Elting broke off the couple’s plan to marry, Shawe promised to “create constant pain” for her (which certain confirmed the wisdom of her decision). His systematic harassment campaign included:  Intercepting Elting’s mail, monitoring her phone calls, and breaking into her email accounts.  Circulating an email to company employees wrongly accusing her of financial misdeeds.  Hiring numerous employees without her knowledge by creating “off book” arrangements and fabricating documents.  Interfering with TPG’s audit process.  Telling the police that she had assaulted him during a disagreement in the office. When he filed the police report, he deliberately referred to her as his “ex-fiancée” (17 years after their break up) knowing that, in domestic violence cases, the police had to arrest the assaulting party. Shawe and Elting also engaged in “mutual hostaging.” For example, Elting would not allow Shawe to hire employees or pay a lawyer’s bill unless he agreed to the profit distribution she wanted. Senior officers who took sides were threatened with firing, huge fines, or the withholding of compensation and promotions. As a result of this turmoil, major clients became reluctant to renew contracts. TPG executives called the feud the “biggest business issue” facing the Company. Shawe himself acknowledged the conflict’s “potential for grievously harming” TPG. Elting filed suit asking the Delaware Court of Chancery to order the sale of TPG. After mediation efforts failed, the court appointed a custodian to sell the Company. Shawe appealed. Issue: Should the court have ordered the sale of a highly profitable business? Decision: Yes, this remedy was appropriate. Reasoning: Delaware law provides that a custodian may be appointed when “the relationship among the directors is so hostile that “the business of the corporation is suffering or is threatened with irreparable injury.” “Irreparable injury” includes factors like harm to a corporation’s reputation, customer relationships, and employee morale. Although TPG was profitable, the deadlock and dysfunction between the founders was causing © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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irreparable harm. Moreover, the company was likely to continue on its downward path. Shawe is right that any order to sell a profitable company should be issued reluctantly and cautiously, after a consideration of other options. But the court did appoint a mediator first. The court also considered appointing a custodian to serve as a third director or some form of tie-breaker in company decision-making. But Shawe and Elting are both relatively young, and it seemed a mistake for the court to be involved in TPG potentially for decades. A sale has the added advantage of protecting TPG employees. Question: What possible remedies were available to the Court of Chancery to resolve the dispute between the founders? Why did the Court adopt the sale of the business? Answer: The court ordered mediation, but the dispute between the founders could not be resolved through mediation. The court could also have appointed a tie-breaking third party to the board of directors, but declined to do so, since it would be likely to enmesh the court in the affairs of this business corporation for many years, even decades. A sale seemed to be the only option. Question: If Elting had not filed suit, asking the court to intervene, what was likely to happen? Answer: The Company would have continued to lose customers, key employees, and revenues, and would have lost its value. A court also has the right to take a step that is much more damaging to shareholders than simply selling or dissolving the corporation – it can remove the shareholders’ limited liability.

21-4c Piercing the Corporate Veil Pierce the corporate veil: A court holds shareholders personally liable for the debts of the corporation Courts may pierce a corporate veil for:  Failure to observe formalities  Commingling assets  Inadequate capitalization  Fraud

Bonus Case: Azte Inc. v Auto Collection, Inc. 124 AD3d 811, (2d Dept 2015). Facts: Auto Collection, Inc. (Auto) operated a used car dealership that sold luxury vehicles to buyers in Eastern Europe. Steven Lever owned 90 percent of Auto; his wife and their son, Joshua, each owned 5 percent. Steven controlled Auto’s finances, including its bank accounts, checkbook, and bookkeeping records. While Steven generally maintained appropriate, separate corporate records, the address listed on Auto’s bank account was his personal address, not Auto’s place of business. Steven initially capitalized Auto with a few thousand dollars, but afterwards was not sure of the exact amount because he contributed funds as needed. He also claimed to have loaned $900,000 to Auto, but there was no documentation. He deposited and withdrew money from Auto’s bank account at his sole discretion. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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At one point, Auto stopped delivering cars, even ones that were paid for. Customers began demanding refunds. Meanwhile, Joshua started work for his father. During his year at Auto, he was paid $474,850, at a time when the company owed significant funds to its customers. AZTE, Inc. and the other plaintiffs paid more than $500,000 for several cars they never received. The plaintiffs filed suit against Auto, Steven, and Joshua. Issue: Should the court pierce Auto’s corporate veil? Are Steven and Joshua personally liable for Auto’s debts? Excerpts from Judge’s Demarest’s Decision: Piercing the corporate veil, while generally disfavored as incompatible with the protection afforded business owners from personal liability for the failings or transgressions of the corporate entity, is an equitable remedy designed to protect creditors or other victims from a fraudulent design by such owners to thwart recovery from the corporation for legitimate debts or injury. Even where outright fraud is not established, where a corporation is so dominated by its principal that its separate identity has been ignored, such that the principal’s interests take precedent over and control the business purpose of the corporation, and the corporation thus becomes the alter ego of the individual, the corporate veil may be pierced to avoid injustice. By virtue of his sole and exclusive control of all record keeping, Steven was aware of, and controlled, every transaction. As Steven openly admitted, he owned Auto and treated its assets and resources as his own. [H]e freely transferred Auto funds into his own personal bank account. This practice is the essence of commingling, self-dealing and disregard of the corporate form. Steven ignored a number of corporate formalities, including the use of his personal address on Auto’s bank statements and the failure to create loan documents with respect to the money he deposited into Auto. This court finds that Steven used his complete domination over Auto to prevent AZTE [and the other plaintiffs] from receiving either automobiles in exchange for their payments or a refund and, as a proximate result, [the plaintiffs] were damaged, justifying the piercing of the corporate veil to hold him liable for the corporation’s debt. [T]here is insufficient evidence, however, to pierce the corporate veil as to Joshua. Joshua was involved in the day to day operations of Auto and had the same access to the bank accounts and books and records of Auto as Steven. However, there was insufficient evidence to establish that Joshua, a mere 5% owner of Auto, otherwise owned and controlled by his father, treated the corporation as his alter ego. There was no evidence that Joshua, like Steven, ignored corporate formalities; Joshua did not receive the bank account statements at his personal address or issue loans to the corporation without any form of documentation. There was no evidence that Joshua commingled the assets of Auto with his own or used Auto’s assets for his personal purposes. Although Joshua was paid over $100,000 for only a few months’ work, such salary may well be justified. This payment alone, for services rendered, is insufficient to hold Joshua personally liable for the judgment against Auto.

Question: What type of remedy is piercing the corporate veil? Answer: It is an equitable remedy? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: What is piercing the corporate veil designed to do? Answer: It is designed to protect creditors or other victims from a fraudulent design by such owners to thwart recovery from the corporation for legitimate debts or injury. Question: What were some of the corporate formalities that Steven ignored? Answer: (1) The use of his personal address on Auto’s bank statements and (2) the failure to create loan documents with respect to the money he deposited into Auto.

21-5 Management Duties Manager: Both directors and officers. To protect outside investors, the courts have long ruled that directors and officers (who are also known as managers) owe a fiduciary duty to both the corporation and its shareholders.

21-5a The Business Judgment Rule The Unocal case and equivalent state statutes permit managers to consider the interests of stakeholders. But the relationship with shareholders is different: Managers have an affirmative duty to protect the interests to shareholders and the corporation. The officers and directors of a corporation owe a fiduciary duty to both the corporation and its shareholders. The business judgment rule accomplishes three goals:  It permits directors to do their jobs.  It keeps judges out of corporate management.  It encourages directors to serve.

Even if a manager violates the business judgment rule, he is still protected from liability (and his decision is upheld) under any of the following circumstances:   

The disinterested members of the board of directors form a special committee that approves the decision. The disinterested shareholders approve it. Neither board members nor shareholders approve the decision, but the court determines it was entirely fair to the corporation.

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21-5b Applications of the Business Judgment Rule Liability of Controlling Shareholders Anyone who owns enough stock to control a corporation has a fiduciary duty to minority shareholders and is subject to the business judgment rule. Self-Dealing Self-dealing means that a manager makes a decision benefiting either himself or another company with which he has a relationship

Case: In re Dole Food Co. 2015 Del. Ch. LEXIS 223; 2015 WL 5052214, Court of Chancery of Delaware, 2015 Facts: Dole Food Co. was one of the world’s largest producers of fresh fruit and vegetables. David Murdock was a controlling shareholder, chairman, CEO, and comptroller. Michael Carter served as president, COO, and general counsel. Murdock offered to buy out the other shareholders for $12.00 per share. Under Delaware law, a purchase offer from a controlling shareholder had to be approved by a committee of the independent members of the company’s board (the Committee) and also by the other shareholders. Murdock and Carter immediately began efforts to make the purchase offer look good by driving down Dole’s share price with the release of false information. To the public, Carter announced substantially worse cost estimates than the two men truly expected. To the Committee, he presented five-year financial projections that he had manipulated to look worse than they were. The false predictions did, indeed, cause Dole’s stock price to fall. The Committee, the board, and 50.9 percent of the other shareholders voted in favor of the sale. But some Dole shareholders sued Mu7rdock and Carter, alleging that the two men had violated the business judgment rule and were, therefore, personally liable for the difference between the price Murdock paid for Dole stock and a “fair” price. Issues: Did Murdock and Carter violate the business judgment rule? Did Murdock pay a fair price for the Dole stock? Decision: Murdock and Carter both violated the business judgment rule. The price Murdock paid was not fair. Reasoning: A self-dealing transaction is valid only if it is “entirely fair,” meaning that both the process and the price are fair. Carter engaged in fraud by deliberately depressing the stock price. By definition, a fraudulent process cannot be fair. The second issue is fair price. It was possible that the price was within a range of fairness but, even so, the minority shareholders are entitled to a “fairer” price. By engaging in fraud, Carter deprived the © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Committee of the information it needed to reject the deal or negotiate a better offer. It also deprived the stockholders of the right to protect themselves by voting down the deal. The business judgment rule includes a requirement of good faith, which means that the decision-maker must be honest and act in the best interests of the corporation and its shareholders. Carter did not act in good faith because his primary loyalty was to Murdock. Both men violated the business judgment rule by orchestrating an unfair, self-interested transaction from which Murdock personally benefited. Murdock and Carter are liable for $148,190,590.18. Question: What duties to Dole did Murdock breach? Answer: His duties of loyalty, good faith, and fair dealing. Question: How did Murdock get the Committee to approve the sale? Answer: He enlisted the help of Carter, who gave the committee false information about Dole’s prospects, including the amount of savings the company anticipated. Question: What about Carter? Was he liable? Answer: Carter was held personally liable for damages resulting from the sale. He was liable both as a director and as an officer of the corporation. He, too, breached his duty of loyalty to the corporation, so the Exculpatory Clause did not apply. Question: How much was the damages award? How much will Murdock and Carter have to pay? Answer: $148,190,590.18.

Bonus Case: In re S. Peru Copper Corp. Shareholder Derivative Litig94 Facts: Grupo Mexico was the controlling stockholder of Southern Peru Copper Corporation (SPC), an NYSE-listed mining company. Grupo also owned 99 percent of the stock of Minera Mexico, a Mexican mining company that was not publicly traded. Grupo offered to trade all its Minera stock for $3.1 billion of SPC shares. Because of Grupo’s self-interest, SPC’s board formed a special committee of disinterested SPC directors to evaluate the proposal. (The board knew that, in the event of litigation, the court would examine the underlying fairness of the transaction, but it hoped that approval by the special committee would influence the court’s decision.) The committee’s financial advisor, Goldman Sachs, used many scenarios to run the numbers, but could not find any way to value Minera’s stock at more than $2.8 billion. Rather than tell Grupo to go mine itself, the special committee stretched to develop some plausible story about why Minera was indeed worth the price Grupo was asking. So, for example, it tried “optimizing” Minera’s cash flows, but not SPC’s, ignoring the fact that Minera was struggling, while SPC was thriving and nearly debt-free. In the end, SPC’s committee approved Grupo’s offer and then stuck with it, even as SPC’s stock price climbed. In the end, SPC paid $3.75 billion for Minera. SPC’s minority shareholders filed suit against its board of directors, alleging that the Minera purchase was entirely unfair. The court, however, dismissed the case against the members of the special committee because SPC’s charter had an exculpatory clause that protected directors who had not 94

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received any improper personal benefit. The suit continued against the directors who were employed by Grupo. Issue: Were the board members liable for their decision? Holding: The Special Committee members were competent, well-qualified individuals with business experience. Moreover, the Special Committee was given the resources to hire outside advisors, and it hired respected, top tier of the market financial and legal counsel. [T]here is little question but that the members of the Special Committee met frequently. Their hands were on the oars. So why then did their boat go, if anywhere, backward? This is a story that is, I fear, not new. From the get-go, the Special Committee extracted a narrow mandate, to evaluate a transaction suggested by the majority stockholder. Thus, the Special Committee fell victim to a controlled mindset and allowed Grupo to dictate the terms and structure of the Merger. [T]his acceptance took off the table other options that would have generated a real market check and also deprived the Special Committee of negotiating leverage to extract better terms. Even if the practical reality is that the controlling stockholder has the power to reject any alternate proposal it does not support, the special committee still benefits from a full exploration of its options. What better way to “kick the tires of the deal proposed by the self-interested controller than to explore what would be available to the company if it were not constrained by the controller’s demands? *Instead, throughout+ the negotiation process, the Special Committee’s and Goldman’s focus was on finding a way to get the terms of the Merger structure proposed by Grupo to make sense, rather than aggressively testing the assumption that the Merger was a good idea in the first place. A reasonable third-party buyer free from a controlled mindset would not have ignored a fundamental economic fact that is not in dispute here—SPC stock could have been sold for the price at which it was trading on the New York Stock Exchange. What it did was to turn the gold that it held (market-tested SPC stock worth in cash its trading price) into silver (equating itself on a relative basis to a financially-strapped, non-market tested selling company), and thereby devalue its own acquisition currency. Goldman was not able to value Minera at more than $2.8 billion, no matter what valuation methodology it used, even when it based its analysis on Minera management’s unadjusted projections. For all these reasons, I conclude that the Merger was unfair. Because the deal was unfair, the defendants breached their fiduciary duty of loyalty. [The defendants must pay $1.347 billion.] Question: What is the duty of loyalty? Answer: The duty of loyalty prohibits managers from making a decision that benefits them at the expense of the corporation. It is the obligation of a manager to act without a conflict of interest. Question: How was the duty of loyalty violated given that a Special Committee was formed to evaluate the merger? Answer: The Special Committee was focused on finding a way to get the terms of the merger structured by Grupo to make sense rather than aggressively testing the assumption that the merger was a good idea.

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Corporate Opportunity Managers are in violation of the corporate opportunity doctrine if they compete against the corporation without its consent. Sometimes, managers do not seek permission in advance. The manager can still avoid liability by showing that the company would have been unable to benefit from the opportunity.

Bonus Case: Anderson v. Bellino95 Facts: Richard Bellino and Robert Anderson formed LaVista Lottery, Inc. (Lottery) to operate a restaurant, lounge, and keno game in LaVista, Nevada. They each owned 50 percent of the stock of Lottery, and both were officers and directors. Over the next nine years, the Lottery company grossed more than $100 million. Bellino and Anderson each received over $4 million in salary and dividends. Bellino spent more time than Anderson working for the company, in part, because of his personal relationship with Lottery’s lounge manager. Frustrated by Anderson’s unequal contribution, Bellino encouraged the city of LaVista to solicit new bids for the keno contract. Bellino incorporated LaVista Keno, Inc. (Keno) to bid on the contract. He was Keno’s sole shareholder. When Bellino submitted a bid on behalf of Keno, he was still an officer of Lottery, as well as a director and a 50% shareholder. Anderson also bid on the contract on behalf of Lottery. The city awarded the new contract to Keno. Anderson and Lottery sued Bellino and Keno, alleging that they had usurped a corporate opportunity. The trial court found for Anderson and Lottery. Issues: Did Bellino usurp a corporate opportunity? Is he liable to Lottery? Holding: Judgment for Anderson and Lottery affirmed. Bellino and Keno claim that if a corporate opportunity existed, it was limited to the opportunity to bid on the keno contract and that Bellino did nothing to impede Lottery from bidding. In fact, the corporate opportunity was the contract itself, not just the right to bid on it. Bellino should not have competed with Lottery. Question: What business was LaVista Lottery in? Answer: It ran a keno game for the town of LaVista, Nevada. Question: What is keno? Answer: It is a game of chance similar to bingo, except in keno the players choose the numbers on their ticket. Question: Was this a profitable business? Answer: The company grossed more than $100 million a year. The two owners – Bellino and Anderson – each received $4 million in salary and dividends. Question: So what was the problem? Answer: Bellino felt that he was doing more work for the company than Anderson was. Question: Did Bellino discuss his concerns with Anderson? Answer: Not exactly. 95

265 Neb. 577; 658 N.W.2d 645; 2003 Neb. LEXIS 49 Supreme Court of Nebraska, 2003 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: What did he do? Answer: He encouraged the city to put the keno license out to bid. He formed his own company and bid on the license. He won the bidding. Question: Is there anything wrong with that? Answer: The corporate opportunity doctrine requires any manager who comes across a good opportunity in his company’s line of business, to offer it to the company first. Only if the company turns the deal down can the manager take advantage himself. Question: What is the point of this doctrine? Answer: It protects shareholders. While working for their companies, managers come across many good opportunities. Shareholders would be ill-served if managers could cream off the best deals for themselves. Question: But both Bellino and Anderson had a chance to bid on the keno contract. Didn’t they both have the same opportunity? Answer: The court held that the opportunity was running the keno game not just the right to bid on running it. Bellino couldn’t take that opportunity away from the company he had formed with Anderson.

Bonus Case: Northeast Harbor Golf Club, Inc. v. Harris96 Facts: Nancy Harris was the president of the Northeast Harbor Golf Club in Maine for nearly 20 years. The club’s only major asset was a golf course in Mount Desert. Harris was definitely a generous president. She not only mowed the grass and did the gardening, she also used her own money to purchase equipment for the club. Twenty years ago, a real estate broker informed Harris that three parcels of land next to the golf course were for sale. The agent contacted Harris because she was the president of the club and he believed that the club would be interested in buying the property to prevent development. Harris immediately agreed to purchase the property in her name. Afterwards, she informed the club’s board that she had made the purchase and that she did not intend to develop the land. Harris purchased yet another parcel of land contiguous to the golf course. Again, she informed the board of directors after the purchase. The club continually experienced financial difficulties, operated annually at a deficit, and depended on contributions from the directors to pay its bills. There was evidence, however, that the club had occasionally engaged in successful fund-raising and had $90,000 in a capital investment fund. Five years after her last purchase, Harris began the process of obtaining approval for a five-lot housing development. The club sued her for violating the corporate opportunity doctrine. The trial court found that Harris had not usurped a corporate opportunity because the acquisition of real estate was not in the club’s line of business, and the corporation lacked the financial ability to purchase the real estate. The club appealed. Issue: Did Harris violate the corporate opportunity doctrine? Holding: Judgment for Harris reversed. Instead of determining on her own that the club could not afford the land, Harris should have given the board the opportunity to make that decision. Although the club was in the business of operating a golf course, owning land was an inherent part of that business. Harris’s new development could have infringed on the value of the club’s land and its ability to operate the course. However, the SJC ordered the case dismissed because the statute of limitations had run out before the club filed suit. 96

1999 ME 38, 725 A.2d 1018, 1999 Me. LEXIS 36 Maine Supreme Judicial Court, 1999 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: Did Harris compete with the golf course? Answer: The trial court held that she did not, because real estate was not in the club’s line of business and the club couldn’t have afforded it anyway. The SJC disagreed, holding that: 

Owning land is an inherent part of operating a golf club. Harris’s new development could well infringe on the value of the club’s land and its ability to operate a golf course.  Harris should have given the board the opportunity to determine if the club could afford the land. Question: To what damages would the club be entitled? Answer: All profits that Harris earned from her development of the property. Question: Is that what the club wants? Answer: Probably the club would prefer that the property not be developed at all. In other words, it would have preferred to purchase the land itself, rather than for Harris to develop the property and pay the profits to the club.

Informed Decision The duty of care requires mangers to make an informed decision - that is, with the care that an ordinarily prudent person would take in a similar situation.

Bonus Case: RSL Communications v. Bildirici97 Facts: Ronald S. Lauder founded RSL, Ltd., a multinational telecommunications corporation that provided voice, mobile, and data/internet services. RSL Plc was a subsidiary of RSL Ltd. The subsidiary began issuing $1.4 billion of bonds. A few years later, in July, Lauder provided RSL Plc with a $100 million line of credit. The company’s board of directors did not hold a meeting to approve the line of credit, but in August drew down $25 million from the loan. The following March, the company’s board held their first meeting in a year. Five days later, RSL Plc filed for bankruptcy. The issue before the court is whether the members of the board of directors of RSL Plc breached their duty of care to the company when they failed to hold a meeting for a year at a time when the company was in such a precarious financial position. Issue: Did the directors of RSL Plc violate their duty of care to the corporation? Holding: Yes, the board violated its duty of due care. According to the court, under New York law, a director shall perform his duties as director, in good faith and with that degree of care which an ordinarily prudent person in a like position would use under similar circumstances. This duty requires that a director’s decision be made on the basis of reasonable diligence in gathering and considering material information. When faced with allegations of misconduct, a director may raise the business judgment rule as a defense. The business judgment rule applies even where conclusions were stupid or irrational, as long as the process employed was either rational or employed in a good faith effort to advance the 97

2006 U.S. Dist. LEXIS 67548, United States District Court for the Southern District of New York, 2006. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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corporation. A director must show an exercise of judgment, not simply the existence of a business decision. Thus, where the director’s methodologies and procedures are so halfhearted or restricted in scope as to constitute a pretext or a sham, their acts are not protected by the business judgment rule. RSL Plc did not hold board meetings on behalf of RSL Plc during the time period relevant here. Despite this, RSL Plc still operated and took actions such as drawing down $25 million from the loan, apparently at the direction of RSL Ltd. However, no independent board meeting or discussions regarding the propriety of this and other business decisions were held on behalf of RSL Plc. The law does not tolerate inaction of this sort. RSL Plc allegedly failed to consider any information regarding the company’s financial health and allegedly failed to make a business judgment as a board regarding any financial decisions on behalf of RSL Plc. RSL Plc argues that closely held corporation with directors who are frequently in contact with one another do not have to abide by such formalities as board meetings when making business decisions. However, RSL Plc is not a small company; it has accrued $1.4 billion in debt. Although some of RSL Plc’s board members had some contact, there were no behind the scenes meetings where the business of RSL Plc was discussed. Lastly, RSL Plc argues that its board members were fully informed about the financial situation of the company because some RSL Plc board members were also RSL ltd board members, and thus they exercised their judgment on behalf of RSL ltd, the parent of RSL Plc. However, individuals who act in a dual capacity as directors of parent and subsidiary corporation owe the same duty of good management to both corporations. Question: The board members of RSL Plc and RSL Ltd overlapped. RSL Plc claims that because of this overlap, both boards were aware of what was going on with RSL Plc. Shouldn’t that make a difference when determining whether the board of RSL Plc was making an informed decision? Answer: The court does not think so. The court expressly rejected that argument, stating that it makes no difference that several RSL Plc board members were also RSL ltd board members. According to the court, there must be two distinct boards, each meeting to discuss relevant business in accordance with the law. Question: Does the fact that the board did not formally meet to discuss the loan or the draw down mean that the members acted improperly? Answer: Not necessarily. What the court said was that because the board did not meet, the directors failed to follow proper procedure. Because the directors are faced with allegations of misconduct, in order to defend themselves by using the business judgment rule, the directors would have to show that their decision was made in good faith and as a result of gathering relevant information. According to the court, without following proper procedure and having meetings to determine the legitimacy of the loan and the draw down, the board cannot claim that they used good faith. Thus, the business judgment rule does not provide a defense.

21-6 Shareholder Rights Shareholders have neither the right nor the obligation to manage the day-to-day business of the enterprise.

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21-6a The Relationship between Shareholders and Managers Bonus notes: Shareholders depend upon managers to run the companies they own. But the relationship between managers and shareholders has become increasingly contentious. But there has been a major change in stock ownership. Previously, most shareholders were individuals; now institutional investors – pension plans, mutual funds, asset management firms, hedge funds, insurance companies, banks, foundations, and university endowments – are the most important shareholders. Together, they own two-thirds of publicly traded companies, and they are also much more likely to vote their shares than individual investors are. If they are unhappy with management, it is difficult for them to do the “Wall Street walk” – that is, sell their shares – because a sale of their large stock holdings would depress the market price. And besides, where else would they invest? Bonus notes: In this century, we have already experienced two financial meltdown that starkly revealed the different incentives faced by shareholders and managers. Managers tended to take highly risky, short-term decisions which benefited them, not the corporation. Even if they were fired, they did well. The corporation did not. Activist investor: A shareholder with a large block of stock whose goal is to influence management decisions and strategic direction.

21-6b Right to Information Under the Model Act, shareholders acting in good faith and with a proper purpose have the right to inspect and copy the corporation’s minute book, accounting records, and shareholder lists.

Bonus You Be The Judge: Chopra v. Helio Solutions98 Facts: Facts: Paul Chopra was a minority shareholder and former director of Helio Solutions, Inc. Both he and Helio were in the business of reselling Sun Microsystems hardware and software. Chopra suspected that: (1) some of Helio’s majority shareholders had purchased a building and leased it to Helio at an excessive rent, (2) the company had broken a lease so that it could rent this building, (3) some shareholders had used assets of the corporation to secure a personal loan, (4) Helio had permitted exemployees to take away substantial business, and (5) the company had not collected a $1 million debt it was owed. In addition, he wanted to know if Helio was planning to issue stock and thereby dilute his ownership. Finally, he felt that his dividend of $1,952.55 was unreasonably low, given that Helio had $88 million in revenue. Chopra hired a forensic accountant to help him investigate Helio’s finances. At the accountant’s request, Chopra asked Helio for these documents: 1. Articles of incorporation; 2. Minutes for meetings of the board of directors and shareholders; 3. All financial statements; 98

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4. 5. 6. 7. 8. 9.

All tax returns; The general ledger with accompanying journals; Income and balance sheets; Schedule of accounts payable and received and inventory; Depreciation schedule for fixed assets; Supporting documents including bank loans, lines of credit, accrued payroll liabilities, sales tax liabilities, other receivables, loans to officers and owners, significant prepayments or deposits, and equipment lease agreements; 10. Monthly bank statements; 11. Company credit card statements; 12. Compensation records; 13. The following contracts: life insurance policies for officers and/or stockholders; pension plan and profit sharing plans; stock purchase plans; equipment and building leases; employment and bonus agreements for owners or key employees; covenants not to compete; loan agreements and credit information, documents connected with the company’s real property; option grants and each owner’s curriculum vitae; 14. A list of patents; 15. Budgets projections for the current year; 16. Company brochures and/or marketing information; 17. A list of key management personnel with job title; 18. An overview of company positions and objectives for each department manager; 19. Information regarding contingencies and lawsuits. Helio gave Chopra items 1-6 but refused to turn over the other materials. Chopra filed suit. The trial court found for Helio and Chopra appealed. You Be The Judge: Which of these documents must a company provide to its shareholders? Holding: For Helio, the trial court’s ruling was affirmed. According to Chopra, the documents he requested were necessary for assessing the value of Chopra’s investment in the company and determining whether his interests as a minority shareholder were being protected. The records previously provided by Helio were insufficient to make this determination. According to the court, a shareholder has an interest in the assets and business of the company and inspection of the company’s books may be necessary for the protection of his interest or for information as to the condition of the company and the value of his interests. However, the inspection rights of the shareholder are limited. Shareholder status does not, by itself, entitle an individual to unfettered access to corporate information. The right does not extend to records not reasonably related to the proper purpose for which they are sought. According to the Appellate court, the trial court was correct in ruling that Chopra’s stated reasons for inspection were vague and lacking in support. In addition, Chopra was asking for information about certain shareholders rather than information about the company. Chopra was engaged in a fishing expedition in which he was asking for information to support his unsubstantiated claims of corporate wrongdoing rather than seeking information to support his interest as a shareholder. Question: What was Chopra’s role at Helio? Answer: he was a minority shareholder and a former director of the company. Question: As a shareholder, isn’t he entitled to information about the company? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Yes, shareholders have a right to information about the company whose stock they own. However, they do not have an unlimited right to information. Question: Why type of information do shareholders have a right to receive? Answer: Shareholders acting in good faith and with a proper purpose can inspect and copy the corporation’s minute book, accounting records, and shareholder lists. Question: Was Chopra’s request broader than this? Answer: Chopra’s request was much broader. Chopra requested, among other information, documents regarding bank loans, compensation records, insurance policies for officers, pension plans, a list of patents, a key list of management personnel, an overview of the company’s objectives, and information regarding lawsuits. Question: Why was he not entitled to receive this information? Answer: According to the court there were a number of reasons why Chopra was not entitled to this information. First, the court did not believe he was making the request with a proper purpose. The court believed Chopra was looking for more than just information that would help him assess the value of his share (his stated purpose for the documents). Moreover, the court believed Chopra was seeking information regarding specific shareholders rather than information about the company as a whole. Lastly, the court believed the majority of the request was merely a fishing expedition designed to help Chopra compete against Helio. Question: Why is this wrong? Answer: Although board members have a duty to shareholders to maximize shareholder value, shareholders have no duty to the corporation. Thus, shareholders can use the information they seek for whatever purposes they wish. If corporations had to divulge everything, it would make it difficult for corporations to retain proprietary information and stay in business. Moreover, the court felt that complying with such a voluminous request would be unreasonably burdensome to Helio because it would take weeks to put the documents together.

21-6c Right to Vote A corporation must have at least one class of stock with voting rights. Typically, common shareholders have the right to vote and preferred shareholders do not, but there are many exceptions to this rule. A corporation must seek a shareholder vote before undergoing any of the following fundamental change:  Charter amendments  Merger  The sale of major assets  Dissolution Shareholder Meetings A corporation must hold some version of an annual shareholders meeting to conduct such matters as electing directors. Small, private companies often meet this requirement by signing unanimous written consents. Bonus notes: For public corporations, annual shareholders meetings are the norm. About half the states (including Delaware) permit corporations to hold shareholder meetings online rather than in person. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Proxies Shareholders have the right to appoint someone else to vote for them at a meeting of the corporation. Proxy: The person whom a shareholder appoints to vote forher at a meeting of the dforporation; also, the document a shareholder signs appointing this substitute voter. Proxy statement: Information a company provides to shareholders in preparation for the annual meeting. Annual report: A document containing detailed financial infrormation that public companies provide to their shareholders.

Election of Directors Plurality voting: To be elected, a candidate only needs to receive more votes than his opponent, not a majority of the votes cast. Majority voting: Directors must resign if more than half the shares that vote in an uncontested election withhold their vote from them. Zombie directors: Directors who serve on a board with less than majority support from shareholders. Proxy Access Under new SEC rules, a company must adopt proxy access if a majority of shareholders vote in favor. For publicly traded companies, independent directors must comprise:  A majority of the board, and  The entire audit, compensation, corporate governance, and nominating committees. Independent Directors: Members of the board of directors who are not employees of the company and do not have close ties to the CEO; also known as outside directors. Inside directors: Members of the board of directors who are also employees of the corporation.

Research: Board of Directors If students performed this assignment on boards of directors, they could discuss what they found. General Questions:  What percentage of directors were insiders versus outsiders?  How many directors have industry experience?  How many directors have close ties to the company CEO?  How many also service as directors on other corporate boards?  How would students evaluate this board of directors?

Executive Compensation Whatever explains CEO pay increases, it is not, by and large, improved performance. Pay for Per Performance: CEO pay has risen by twice the rate of the stock market.

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Total shareholder return: The percentage increase in stock price appreciation and dividends. Net returns on invested capital: The company’s return on its capital investments, such as plants and equipment, less the opportunity cost of those investments.

Bonus notes: Executive compensation that is unrelated to performance not only wastes shareholder money, it has other effects as well:  Companies whose CEOs have generous stock options experience more product recalls  There is a negative correlation between CEO pay and approval ratings by the company’s workers.

Why don’t directors use more accurate measures of performance? Several reasons:  Other people’s money  A cooperative culture  Benchmarking  Rationalization Government Regulation. The federal government has tried to change the landscape of corporate governance and executive compensation in the following ways:  Lead Director. The independent members of the board are required to meet regularly on their own, without management.  Clawbacks. A public company must establish a clawback policy, whereby it can require the CEO and CFO to reimburse the company for any bonus or profits they received from selling company stock within a year of the release of flawed financials.  Disclosure. The SEC now requires more complex disclosure of executive compensation.  Say-on-Pay. At least once every three years, companies must take a nonbinding shareholder vote on the compensation of the five highest-paid executives.

In the following case, shareholders voted against a pay plan. What was the board’s obligation?

Case: Raul v. Rynd99 Facts: Hercules Offshore, Inc. provided drilling services to the oil and natural gas industry. After a year in which its financial results and stock price had declined substantially, the Hercules board unanimously approved a compensation plan that raised executive pay by between 40 percent and 190 percent. In its proxy statement to shareholde3rs, Hercules stated that: Our compensation committee will continue to design compensation arrangements with the objectives of emphasizing pay for performance and aligning the financial interests of our executives with the interests of long-term stockholders.

929 F. Supp. 2d 333 United States District Court for the District of Delaware, 2013 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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When, as required by say-on-pay rules, the company presented this compensation plan to shareholders at the annual meeting, 59% of Hercules’ shares voted against it. The board ignored the shareholder vote and continued with the plan anyway. A Hercules shareholder brought suit, alleging that the board had breached its fiduciary duty by approving the compensation plan in the face of a negative shareholder vote. He also alleged that the compensation plan violated the company’s pay-for-performance philosophy as outlined in the proxy statement. Hercules filed a motion to dismiss. You Be the Judge: Did the Hercules board violate its fiduciary duty when it approved the compensation plan? Argument for the Hercules Shareholders: Because the company’s executive compensation increased dramatically in the face of a lower stock price, the shareholders, that is, the owners, of the company voted against the pay plan by a significant majority. The board has a fiduciary obligation to the shareholders. Ignoring the shareholder vote is a violation of that duty. Furthermore, the pay plan violates the board’s own guidelines, which emphasize pay for performance. Argument for the Board: The company is required by law to hold say-on-pay votes. But the law is also clear that these votes are non-binding, they do not overrule board decisions, and they do not create any fiduciary duty on the party of the board. Yes, pay for performance is part of the company’s philosophy, but the compensation plan is consistent with other goals, such as retaining officers. Furthermore, in determining compensation, the board considers not only past performance but also prospective contributions. Holding: Plaintiff relies heavily on the fact that the Hercules shareholders voted against the executive compensation plan yet the Board thereafter did nothing to rescind or modify that plan in response. However, [the Dodd-Frank statute] explicitly states that say-on-pay votes “shall not be binding” on a company or its board of directors. Dodd-Frank also explicitly states that the results of say-on-pay votes may not be construed in any of the following ways: (1) as overruling a decision by a company or its board of directors; [or] (2) to create or imply any change to the fiduciary duties of a company or its board of directors. Plaintiff’s allegations and arguments in this litigation fail to recognize these realities of Dodd-Frank. Plaintiff also relies heavily on his view that Hercules has adopted a strict pay-for-performance policy. It is true that Hercules’ Proxy Statement explains that pay for performance is part of the philosophy and objectives of the Company’s compensation programs. However, the same statement also identifies other goals. In fact, the Proxy Statement states that the Company’s executive compensation policy is designed: • to attract, retain, motivate, and reward executive officers who are capable of leading the Company in a complex, competitive, and changing industry; • to align the interests of our executive officers with those of our stockholders; [and] • to pay for performance. One of these goals merits particular discussion in light of Plaintiff’s allegations. This is the Company’s goal of retaining its executive officers, a goal that may have taken on increased importance precisely © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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because of the difficult financial circumstances in which the Company found itself. As the Proxy Statement explains: The Board of Directors and its Compensation Committee remain committed to retaining the existing management team, and as a result, have offered cash retention incentives to recover some of the shortfall in long-term incentive compensation levels. The committee believes that the implementation of this plan has been critical in deflecting efforts by competitors that can offer attractive compensation opportunities, and in keeping the management team focused on executing the current business strategy for future shareholder value creation. The goal of retaining an executive could, under certain circumstances, lead to increased executive compensation even if the Company is experiencing poor financial performance. In addition, Plaintiff’s allegations incorrectly presume that executive compensation is solely awarded retrospectively. As is common practice in executive compensation, the Proxy Statement makes clear that much of the Company’s executive compensation is prospective. Hence, Plaintiff’s characterization of the Hercules executive compensation policy as essentially mandating a strong correlation between certain financial aspects of the Company’s performance and the compensation of the Company’s executives is incorrect. The Hercules Motion to Dismiss is GRANTED. Question: What were the two arguments put forth by Plaintiff ? Answer: (1) Hercules shareholders voted against the executive compensation plan yet the Board thereafter did nothing to rescind or modify that plan in response. (2) Hercules adopted a strict payfor-performance policy. Question: What goal of Hercules’ proxy statement did the Court rely upon to grant Hercules Motion to Dismiss? Answer: Hercules’ goal of retaining its executive officers. Discussion: Executive Compensation Question: How much of corporate earnings should go to the top five earners in a company (given that there are millions of shareholders)? Answer: Students usually say something like 2 or 3%. In reality, 10% of corporate earnings of all publiclyheld corporations go to the five best paid officers.

Chapter Conclusion How can shareholders ensure that the corporation will operate in their best interests? How can managers make tough decisions without being second-g8uessed by shareholders? Balancing the interests of managers and shareholders is a complex problem the law struggles to resolve.

Matching Questions Match the following terms with their definitions: _____A. Authorized shares 1. Stock that the company has sold but later bought back _____B. Treasury stock 2. The company’s representative in its state of incorporation © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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_____C. Promoter _____D. Incorporator _____E. Registered agent Answers: PPP. QQQ. RRR. SSS.4 TTT.

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3. Someone who organizes a corporation 4. The person who prepares and files the charter 5. The shares listed in the company charter

5 1 3 2

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 99. T F A corporation can be formed in any state or under the federal corporate code. 100. T F Managers have a fiduciary duty to shareholders. 101. T F Most companies use a very broad purpose clause in their charter. 102. T F Shareholders own the corporation; thus they have the right to manage the corporate business. 103. T F A company must include in its proxy materials the names of all shareholder nominees for the board of directors.

Multiple Choice Questions 1. CPA QUESTION Generally, a corporation’s articles of incorporation must include all of the following except the: A. Name of the corporation’s registered agent B. Name of each incorporator C. Number of authorized shares D. Quorum requirements Answer: D. 2. CPA QUESTION A corporate stockholder is entitled to which of the following rights? A. Elect officers B. Receive annual dividends C. Approve dissolution D. Prevent corporate borrowing Answer: C. CPA Examination, May 1992, #18.

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3. If a manager violates the business judgment rule, which of the following answers will NOT protect him? A. The disinterested members of the board approved the transaction. B. The transaction was of minor importance to the company. C. The disinterested shareholders approved the transaction. D. The transaction was entirely fair to the corporation. Answer: C. 4. The duty of care: A. Is not a requirement of the business judgment rule B. Protects directors who make an uninformed decision if it was entirely fair to the company C. Protects a decision that has a rational business purpose, even if the activity was illegal D. Will not protect directors who make a decision that harms the company Answer: B. 5. The president of R. Hoe & Co., Inc. refused to call a special meeting of the shareholders although 55 percent of them requested it. One purpose of the meeting was to reinstate the former president. Do shareholders have the right to make these two requests? A. Yes to both B. No to both C. The shareholders have the right to call a meeting but not to reinstate the president. D. The shareholders have the right to reinstate the president but not to call a meeting. Answer: C. 6. Oil Co. was a controlling shareholder of Pogo, a company that drilled for oil and gas in the Gulf of Mexico. When some additional leases became available, Oil Co. purchased all of them for itself. Which of the following statements is true? A. To avoid liability, Oil Co. had to offer the leases to Pogo’s board of directors. B. To avoid liability, Oil Co. had to offer the leases to Pogo’s other shareholders. C. Oil Co. could avoid liability by proving that Pogo could not afford to pay for the additional leases. D. Both (A) and (B). E. (A), (B) and (C). Answer: C

Case Questions 1. Michael incorporated Erin Homes, Inc., to manufacture mobile homes. He issued himself a stock certificate for 100 shares for which he made no payment. He and his wife served as officers and directors of the organization, but, during the eight years of its existence, the corporation held only one meeting. Erin always had its own checking account, and all proceeds from the sales of mobile © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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homes were deposited there. It filed federal income tax returns each year, using its own federal identification number. John and Thelma paid $17,500 to purchase a mobile home from Erin, but the company never delivered it to them. John and Thelma sued Erin Homes and Michael, individually. Should the court “pierce the corporate veil” and hold Michael personally liable? Answer: The appeals court pierced the corporate veil and held the shareholder liable because the corporation had grossly inadequate capitalization, had disregarded corporate formalities, and the shareholder was also actively participating in the operation of the business. Laya v. Erin Homes, Inc., 177 W. Va. 343, 352 S.E.2d 93 (1986).

You Be the Judge: WRITING PROBLEM Stahl and Hyman owned and worked for a corporation named “Ampersand” that produced plays. Both men were employed by the corporation. Stahl decided to write Philly’s Beat, focusing on the history of rock and roll in Philadelphia. As the play went into production, however, the two men quarreled. So Stahl resigned from Ampersand and formed another corporation to produce the play. Did the opportunity to produce Philly’s Beat belong to Ampersand? Argument for Stahl: Ampersand was formed for the purpose of producing plays, not writing them. When Stahl wrote Philly’s Beat, he was not competing against Ampersand. Furthermore, Ampersand could not afford to produce the play even if it had had the opportunity. Argument for Hyman: Ampersand was in the business of producing plays, and it wanted Philly’s Beat. Answer: Producing “Philly’s Beat” was clearly within the scope of Ampersand’s business. Although it was not clear if Ampersand could have raised enough money to produce the play, any doubt should be resolved in favor of Ampersand. Stahl was ordered to disgorge any profits from the play. Ampersand Productions, Inc. v. Stahl (Feb. 20, 1986), No. 85-435 (Dt. Ct., E.D. Pa.).

3. Rodney Platt was the vice chairman of the board of Mylan. He was also one of the owners of an office park that Mylan leased, making him Mylan’s landlord. How could Mylan comply with the business judgment rule in connection with this transaction? Answer: Under the business judgment rule, either the disinterested members of the board of directors or the disinterested shareholders would have to approve the transaction. If they did not, then a court would have to determine whether the transaction was entirely fair. 4. Careless Inc. ran HIB/AIDS treatment clinics. Some of its employees violated federal law by paying kickbacks to doctors who referred patients to Careless facilities. But the Careless employee in charge of preventing this kind of behavior was careless. He did not see some obvious problems. The board had never asked about the company’s monitoring process. Was the board of directors liable for this employee’s wrongdoing? Answer: In a similar case, the court said that, under the duty of care, the board cannot be expected to know what every employee does, but it should have asked about the company’s overall monitoring process. 5. Congressional Airlines was highly profitable operating flights between Washington, D.C., and New York City. The directors approved a plan to offer flights from Washington to Boston. This decision turned out to be a major mistake, and the airline ultimately went bankrupt. Under what circumstances would shareholders be successful in bringing suit against the directors? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Even if the plan was bad, it met the standard of having a “rational business purpose.” Only if there had been self-dealing on the part of the board, or if they had made an uninformed decision would shareholders have a chance of being successful in their suit.

Discussion Questions 1. Corporate executives are not the only people to earn fabulous salaries. Some athletes earn even more than CEOs. What is the difference between athletes and executives (besides a hook shot)? Answer: Athletes’ salaries are negotiated at arm’s length with the team owner who will actually be paying the bill. Rather than spending other people’s money, the owner is using his own. Also, an athlete’s performance is transparent and easy to measure. 2. Under Delaware law, corporations have the right to decide that the corporate opportunity doctrine does not apply to its managers. Thousands of companies have done so. Why would a company do that? Should it? Does such a decision help or hurt shareholders? Answer: Answers will vary. 3. For several years, CSK Auto, Inc., fraudulently reported inflated earnings. During this period, Maynard Jenkins was the CEO. He was not involved in the fraud, however, and was never charged with a crime. Nonetheless, the SEC sought to clawback some of his earnings during this period. Is Jenkins financially responsible for fraud that occurred on his watch, even though he did not participate: Should he be liable? Answer: The SEC brought an action against Jenkins, seeking a clawback of $4 million. Jenkins motion to dismiss the action was denied, after which the case was settled for $2.8 million. Was this a message to CEOs to better monitor those who work under them? Answers will vary. 4. An appraiser valued a subsidiary of Signal Co. at between $230 million and $260 million. Six months later, Burmah Oil offered to buy the subsidiary at $480 million, giving Signal only three days to respond. The board of directors accepted the offer without obtaining an updated valuation of the subsidiary or determining if other companies would offer a higher price. Members of the board were sophisticated, with a great deal of experience in the oil industry. A Signal Co. shareholder sued to prevent the sale. Is the Signal board protected by the business judgment rule? Answer: No. The board members considered all information they could review in the time allowed, considered Signal’s cash needs and other factors, and voted to accept the offer. There was no requirement that they first obtain another evaluation. Gimbel v. Signal Companies, Inc., 316 A.2d 599 (Del.Ch. 1974) 5. Michael Ovitz earned $25 million a year as a founder of a premier Hollywood talent agency. He was also a longtime friend of Disney chairman Michael Eisner, who recommended that Disney hire Ovitz as president. Upon the advice of an independent compensation consultant, the Disney board approved Ovitz’s contract. However, the board did not really understand how much Ovitz would earn under the contract. After 14 months, Ovitz left Disney with $130 million in severance pay. Had the board violated the business judgment rule? ? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No. Although the board may have been negligent in relying on the advice of a financial consultant who never bothered to calculate how much Ovitz would be entitled to if he left early, ordinary negligence is not sufficient to constitute a violation of the fiduciary duty of care. In re the Walt Disney Company Derivative Litigation, 907 A.2d 693 (Del. Ch. 2005)

Suggested Additional Assignments Field Work: Selecting a State of Incorporation Ask students to call two or three businesses—at least one large and one small-- to find out where they are incorporated. If students actually talk to someone who has started her own business, they should ask her why she chose that particular state. Did she consider incorporating in another state? What factors most influenced her decision? Research: Corporate Names Ask students to choose a name for a new corporation and then check with their Secretary of State’s office, either by phone or on the Internet, to see if that name is available. Research: Approval by Written Consent In Delaware, shareholders and directors of a corporation can vote without holding a meeting simply by signing a written consent. While in many other states the consent must be unanimous, Delaware requires the same number of votes as would be required at a meeting. In other words, if majority approval is required at a meeting, only a majority need sign the consent. Ask students to investigate the rule in other states. Research: Boards of Directors Ask students to choose a publicly traded company that makes something they own. Then have them look up the company’s annual report on the SEC Web sitehttp://www.sec.gov . (They can also find out information at http://www.thecorporatelibrary.com . Using these and other Internet sites, what can they learn about this company’s directors? What percentage are insiders? Outsiders? How many have industry experience? How many have close ties to the company CEO? How would students evaluate this board of directors? Research: Executive Compensation Ask students to find out the following information for two publicly traded companies in different industries: How much did the CEO and the top five officers earn? How large is the company? How did the company perform in the prior year? The prior five years? Compensation includes salary, bonus, stock options, and other miscellaneous pay. Performance measures for the company can include stock price, earnings, profits, return on equity, or any other measure the students choose. Information about publicly traded companies is available at the SEC Web site: http://www.sec.gov and at http://www.thecorporatelibrary.com

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Chapter 22 – Bankruptcy* Chapter Overview Chapter Theme As in many areas of law, bankruptcy law must balance competing interests – in this case, the interests of the creditor and debtor. When an individual or business files for bankruptcy protection, generally neither debtor nor creditor comes out whole. Traditionally, American law was viewed as favoring debtors over creditors. Does the law favor one side over the other, or does it have the balance about right?

22-1 Overview of the Bankruptcy Code Bonus Notes: The federal Bankruptcy Code (Code) is divided into eight chapters. All chapters except one have odd numbers. Chapters 1, 3, and 5 are administrative rules that generally apply to all types of bankruptcy proceedings. These chapters, for example, define terms and establish the rules of the bankruptcy court. Chapters 7, 9, 11, 12, and 13 are substantive rules for different types of bankruptcies. All of these substantive chapters have one of two objectives—rehabilitation or liquidation. The U.S. Bankruptcy Code (The Code) has three primary goals: 1. To preserve as much of the debtor’s property as possible, 2. To divide the debtor’s assets fairly between the debtor and creditors, and 3. To divide the creditors’ share of the assets fairly among them. The following options are available under the Bankruptcy Code: Chapter 7 Liquidation The bankrupt’s assets are sold to pay creditors Chapter 11 Reorganization Businesses continue to operate Chapter 13 Consumer Reorganization For the typical individual The objective of Chapters 11 and 13 is to rehabilitate the debtor. These chapters hold creditors at bay while the debtor develops a payment plan. Chapter 7 provides for liquidation (a straight bankruptcy). Straight bankruptcy: Also known as liquidation, this form of bankruptcy mandates that the bankrupt’s assets be distributed to creditors, but the debtor has no obligation to share future earnings.

22-2 Chapter 7 Liquidation All bankruptcy cases proceed in a roughly similar pattern. We use Chapter 7 as a template to illustrate common features.

22-2a Filing a Petition Bankrupt: Someone who cannot pay his debts and files for protection under the Bankruptcy Code. Debtor: Another term for bankrupt. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Any individual, partnership, corporation, or other business organization that lives, conducts business, or owns property in the United States can file under the Code. Chapter 13 is only available to individuals. A case begins with the filing of a bankruptcy petition in Federal District court. Voluntary Petition Any debtor (business or individual) has the right to file for bankruptcy. It is not necessary that the debtor’s liabilities exceed assets. Debtors sometimes file a bankruptcy petition because cash flow is so tight they cannot pay their debts, even though they are not technically insolvent. However, individuals must meet two requirements before filing: 1. Within 180 days before the filing, an individual debtor must undergo credit counseling with an approved agency. 2. Individual debtors may only file under Chapter 7 if they earn less than the median income in their state or they cannot afford to pay back at least $7,475 over five years. Involuntary Petition Order for relief: An official acknowledgment that a debtor is under the jurisdiction of the bankruptcy court. Creditors may force a debtor into bankruptcy by filing an involuntary petition. The creditors’ goal is to preserve as much of the debtor’s assets as possible and to ensure that all creditors receive a fair share. An involuntary petition must meet all of the following requirements:   

the debtor must owe at least $15,775 in unsecured claims to the creditors who file; if the debtor has at least 12 creditors, 3 or more must sign the petition (if the debtor has fewer than 12 creditors, any one of them may file a petition); and the creditors must allege either that a custodian for the debtor’s property has been appointed in the prior 120 days or that the debtor has generally not been paying debts that are due.

22-2b Trustee U.S. Trustee: oversees the administration of bankruptcy law in a region. The trustee is responsible for gathering the bankrupt’s assets and dividing them among creditors.

22-2c Creditors Proof of claim: A form stating the name of an unsecured creditor and the amount of the claim against the debtor. After the court issues an order for relief, the U.S. Trustee calls a meeting of all of the creditors. Secured creditors do not file proofs of claim unless the claim exceeds the value of their collateral.

22-2d Automatic Stay Automatic stay: Prohibits creditors from collecting debts that the bankrupt incurred before the petition was filed. An automatic stay prohibits creditors from independently collecting debts that the debtor incurred before the petition was filed. Once the petition is filed, the debtor’s assets must be distributed according to the priorities set by law, not according to who can strong-arm the debtor most forcibly. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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The ability to stay creditors’ claims and obtain breathing room can be a powerful incentive for a struggling business to file for bankruptcy. Creditors may not sue a bankrupt to obtain payment, nor may they take other steps, outside of court, to pressure the debtor for payment.

Bonus Case: Jackson v. Holiday Furniture100 Facts: Cora and Frank Jackson purchased a recliner chair on credit from Dan Holiday Furniture. They made payments for seven months until November, when they filed for bankruptcy protection. Although the store knew about the bankruptcy filing, a collector called the Jacksons’ house ten times between November 15 and December 1 and left a card in their door threatening repossession of the chair. On Dec 1, Frank went to Dan Holiday to pay the $230.00 owed for November and December. He told the store about the bankruptcy filing, but allegedly added that he and his wife wanted to continue making payments directly to Dan Holiday. In early January, Dan Holiday employees learned that Frank had died the month before. Nonetheless, collectors telephoned Cora Jackson 26 times between January 14 and February 19. The store owner’s sister left the following message on Cora’s answering machine: Hello. This is Judy over at Dan Holiday Furniture. And this is the last time I am going to call you. If you do not call me I will be at your house. And I expect you to call me today. If there is a problem I need to speak to you about it. You need to call me. We need to get this thing going. You are a January and February payment behind. And if you think you are going to get away with it, you’ve got another think coming. When Cora returned home on February 18, she found seven bright yellow slips of paper in her door jamb stating that a Dan Holiday truck had stopped by to repossess her furniture. The threat to send a truck was merely a ruse designed to frighten Cora into paying. In fact, the store did not want the furniture back. What they wanted was to talk directly to her about making payments. The store also sent Cora a letter threatening repossession and legal action. Cora’s bankruptcy attorney then contacted the store and all collection activity ceased. Issues: Did Dan Holiday violate the automatic stay provisions of the Bankruptcy Code? What is the penalty for a violation? Excerpts from Judge Venters’s Decision: The automatic stay prohibits the commencement or continuation of any action against the debtor that arose before the commencement of the bankruptcy case and forbids any act by a pre-petition creditor to obtain possession of property of the bankruptcy estate. An individual injured by a creditor’s violation of the automatic stay shall recover actual damages, including costs and attorneys’ fees, and in appropriate circumstances, may recover punitive damages. In this case, there is no question that Dan Holiday repeatedly violated the automatic stay. [T]he Court finds that the Jacksons suffered financial damages in the amount of $230.00, which represents the coerced payments that Dan Holiday received from Frank Jackson on December 1. The Court finds that punitive damages are warranted in this case based on Dan Holiday’s egregious, intentional violations of the automatic stay. Dan Holiday’s conduct was remarkably bad in that, after it 100

309 B.R. 33; 2004 Bankr. LEXIS 548 United States Bankruptcy Court for the Western District of Missouri, 2004 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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had actual knowledge of the Jacksons’ bankruptcy, and after coercing payments from the Jacksons covering the months of November and December, it made no less than twenty-six telephone calls to the Jacksons’ household in January and February. Dan Holiday’s continued collection efforts were in flagrant violation of the protections Congress afforded to debtors under the automatic stay. In this matter the Court is somewhat hampered in assessing punitive damages by the lack of evidence concerning the ability of Dan Holiday to pay. [An owner] testified that Dan Holiday was a family-owned business that has been in existence for 52 years, and the Court assumes that it is a relatively small business. Under the circumstances of this case, the Court believes that an appropriate penalty would be $100.00 for each illegal contact with the Jacksons after December 1, when it is crystal clear that Dan Holiday had actual knowledge of the Jacksons’ bankruptcy filing, for a total of $2,800.00. The Court believes that this penalty will be sufficient to sting the pocketbook of Dan Holiday and impress upon Dan Holiday and its owners and employees the importance of debtor protections under the Bankruptcy Code, as well as to deter further transgressions. The Court also will award the Jacksons their attorneys’ fees and costs in the amount of $1,142.42, an amount the Court considers eminently fair and reasonable under the circumstances of this case. Question: What is the goal of the automatic stay? Answer: To protect both debtors and creditors. It gives the debtor a breathing spell to make rational decisions, and it ensures that all creditors are treated fairly. Question: How did Dan Holiday Furniture violate the automatic stay provisions? Answer: Dan Holiday engaged in persistent—even obnoxious—calls and visits to the Jacksons after it knew of their bankruptcy filing. And even after it learned that Frank Jackson had died. Question: But didn’t Frank Jackson say he wanted to continue paying the store? Answer: That doesn’t matter. The Bankruptcy code does not permit the debtor to cut special deals with creditors. If the Jacksons paid Dan Holiday, that meant their other creditors wouldn’t receive as much as they were entitled to. Question: The court awarded punitive damages to Jackson—would a court do that anytime a creditor violates the automatic stay? Answer: No—these facts are particularly egregious. The court awarded punitive damages to teach Dan Holiday a lesson. General Question: Even if the store’s behavior had been legal, was it ethical? Would the store’s owners have wanted to receive threatening phone calls and letters while they were grieving for the loss of a loved one?

22-2e Bankruptcy Estate Bankruptcy estate: The new legal entity created when a bankruptcy petition is filed. The debtor’s existing assets pass into the estate.

Exempt Property The Code permits individual (but not business organizations) to keep some property. The amount of property is determined by state law and varies dramatically from state to state. However, under the BAPCPA, debtors can take advantage of state exemptions only if they have lived in their state for two years. And they can exempt only $125,000 of any house acquired within 40 months of the bankruptcy. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Students who completed the Exempt Property assignment could present their findings at this time. General Questions: What is the law on exempt property in your state? General Question: After falling into debt, former baseball commissioner, Bowie Kuhn, traded in his New Jersey home for a million dollar mansion in Florida. His goal was to take advantage of Florida’s generous homestead laws (generally, in Florida, an individuals’ homestead is protected from judgment creditors – exceptions include, but are not limited to, mortgage, federal tax liens, mechanics liens, etc.). Was this an ethical decision? Question: Kuhn got into financial trouble when his law partnership filed for bankruptcy. One of his partners was convicted of defrauding clients and was sentenced to 70 months in prison. How do you think Kuhn rationalized his decision to buy a house in Florida? Answer: Undoubtedly, he thought that, since the debts had belonged to the partnership and had been caused in particular by the dishonest acts of one of his partners, he should not be penalized. In analyzing the ethics of his decision, you might consider:   

Who are the stakeholders? Who is harmed by his decision? Who is helped? Were there alternatives? Could Kuhn have worked out an agreement with his creditors? How would this alternative look in the light of day? Would he want everyone to know? Will this choice tarnish his reputation?  What are the consequences? Which alternative will cause the greatest good (or the least harm) to the most people?  Do his actions violate the Golden Rule? Would he like it if someone who owed him money did the same thing? General Questions: Is the BAPCPA fair? Does it strike the proper balance between the rights of creditors and debtors? Should a debtor be allowed to exempt a mansion as long as he has lived in it for 40 months before filing? Alternatively, would it be fair to allow all debtors to hang on to a home, no matter how valuable? Debtors do have to live someplace.

Voidable Preferences Preferences: When a debtor unfairly pays creditors immediately before filing a bankruptcy petition. The trustee can void any transfer (that took place in the 90-day period before the filing of a petition.

Fraudulent Transfers Fraudulent transfer: A transfer is fraudulent if it is made within the year before a petition is filed and its purpose is to hinder, delay, or defraud creditors.

22-2f Payment of Claims The trustee pays the bankruptcy estate to the various classes or claims in order of rank. Claims are paid in the following order: Secured Claims Creditors whose loans are secured by specific collateral are paid first (for example, a mortgage). © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Priority Claims There are seven subcategories of priority claims. Each subcategory is paid in order, with the first group receiving full payment before the next group receives anything:  Alimony and child support  Administrative expenses  Back wages to the debtor’s employees for work performed during the 180 days prior to the date of the petition, and  Income and property taxes Unsecured Claims Last, and frequently very much least, unsecured creditors have now reached the delicatessen counter. They can only hope that some goods remain.

Discussion: Payment of Claims Question: Why are claims paid in this order? Answer: Congress felt that this was a fair allocation of a debtor’s assets. Secured claims are paid first, because that is the whole point of having a security interest. Priority claims are generally thought to be more important than general unsecured claims. Question: Do students agree with these priorities? Answer: Students sometimes comment on the fact that fees of lawyers and accountants are at the top of the list under priority claims. No one would expect a creditor to lend additional unsecured money to a debtor, so should lawyers and accountants be expected to represent the debtor without assurances of being paid? If they were not sure of being paid they would, in effect, be lending the debtor the value of their time.

22-2g Discharge Fresh start: After the termination of a bankruptcy case, creditors cannot make a claim against the debtor for money owed before the initial bankruptcy petition was filed. Discharge: The debtor no longer has an obligation to pay a debt. Debts That Cannot Be Discharged The following debts are never discharged by bankruptcy, and the debtor remains liable in full until they are paid:  Recent income and property taxes;  Money obtained by fraud;  Cash advances on a credit card totaling more than $950 that an individual debtor takes out within 70 days before the order of relief;  Debts omitted from the Schedule of Assets and Liabilities;  Money that the debtor stole or obtained through a violation of fiduciary duty  Money owed for alimony, maintenance, or child support  Debts stemming from intentional and malicious injury  Debts stemming from a violation of securities laws.  Student loans. This topic requires more explanation

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For student loans not in default, there is an income-based repayment plan (IBFR); if debtors are accepted into IBR, their monthly payments are based on their income, not the size of their debt; IBR is available for government loans only, not private loans. Debtors not eligible for IBR may seek bankruptcy, but student loans cannot be discharged unless repayment would cause undue hardship. Proof is extremely difficulty. To demonstrate undue hardship, the debtor must show that, if he pays his loans, he cannot maintain a minimal standard of living and there is little hope for improvement in his financial situation during the term of the loan. Debtors who have been successful in obtaining discharge tend to be in dire circumstances, with serious illnesses. Carol Todd was 63 years old and autistic. She had been unemployed for a decade and was living on Social Security disability income payments. The court discharged her $340,000 in debt. In the following case, the debtors we4re not as successful.

Case: Kelly v. Mich. Fin. Auth. (In re Kelly101) Facts: Lisa and Adam Kelly had two children. Their son, Noah, 18 months old, was born with serious birth defects that affected his physical and intellectual development. He faced large on-going medical expenses. Under their health insurance plan, the family had to pay 20 p0ercent of the cost of their medical care. Lisa taught Special Education in an elementary school in Florida. Her husband, Adam, had a B.A. in Fine Arts with a concentration in Digital Cinema. He worked remotely from their home, so that he could care for Noah. The Kellys’ annual income was $70,000; but their combined educational loans exceeded $160,000. When the Kellys filed for bankruptcy, they asked the court to discharge these student loans. Issue: Would repayment of their student loans cause the Kellys undue hardship? Decision: No, they were financially able to pay these loans. Reasoning: The Kellys are not required to live in poverty, but they must take further steps to reduce their expenditures. They have recently taken a number of trips for the holidays and to visit family. If they reduced this travel, they could save $100 a month in gas. Likewise, they currently own two newer cars. If they really need two vehicles, they could trade down to less expensive models. They are also spending too much on food. According to the U.S. Department of Agriculture, a thrifty family can live on $550 a month, assuming that all food is purchased at the grocery store and prepared at home. But the Kellys are spending $800. If they reduced this expenditures to $625, they would have more money available to pay their student loans.

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Also, both of the Kellys are healthy, educated, and employed, Presumably, their income will continue to increase. In that case, they will have even more funds available to pay their loans. Noah’s medical condition presents some financial uncertainty, but courts do not discharge student loans because a debtor might have a precarious financial situation. A finding of undue hardship is an incredibly high hurdle to overcome. The Kellys have not done so. Question: How did the court determine whether or not the student loans would be dischargeable? Answer: They applied the Brunner test: 1) The Debtor cannot maintain, based on current income and expenses, a minimal standard of living for herself and her dependents if forced to repay the loans; (2) Additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period of the student loans; and (3) The Debtor has made good faith efforts to repay the loans. Question: Why did Congress choose to make student loans a debt than cannot be discharged? Answer: Congress clamped down on students because too many had been walking away from their federally guaranteed loans. These bad debts had begun to jeopardize the entire federal loan program. Question: What were the Kellys been unable to show undue hardship? Answer: They have failed to adjust their lifestyle sufficiently to demonstrate undue hardship. Bonus Notes: How can debtors predict the outcome of a case if they do ask for a discharge of their student loan? Research indicates that the following factors affect the success of a discharge case: Ill health of the debtor or his family  Whether the debtor actually got a degree  His employment status  His income the year before he filed  Who the creditor is (the government typically wins.)  Whether the case goes to trial (settling is better for the debtor.)  The judge who hears the case.

Question: What is the logic behind making these debts non-dischargeable? Answers:  Congress drafted the Code, and it wants to ensure that its taxes, fines, and penalties are paid.  Congress wanted to discourage consumers from purchasing luxury goods and then declaring bankruptcy.  Certain offenses are so bad that debtors should always be liable: fraud, malicious injury, violation of fiduciary duty, drunk driving.  Congress wanted to encourage debtors to include all their debts on the Schedule of Assets and Liabilities. Also, it is not fair to exclude a creditor who did not know about the bankruptcy.  Congress clamped down on students because too many had been walking away from their federally guaranteed loans. These bad debts had begun to jeopardize the entire federal loan program.  After Enron and similar cases, Congress wanted to ensure that corporate bad guys did not discharge their debts. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Circumstances that Prevent Debts from Being Discharged The Code also prohibits the discharge of debts under the following circumstances:  Business organizations. Under Ch. 7 (but not the other chapters) only the debts of individuals can be discharged.  Revocation. A court can revoke a discharge within one year if it discovers the debtor engaged in fraud or concealment.  Dishonesty or bad faith behavior. The court may deny discharge altogether if the debtor has made fraudulent transfers, hidden assets, and the like.  Repeated filings for bankruptcy. Congress fear that some debtors would make a habit of bankruptcy, so a debtor who has received a discharge under Ch 7 or 11 cannot receives another discharge under Ch 7 for eight years, and under Ch 13, for at least six years.

Bonus Case: Husky Int’l Elecs., Inc. v. Ritz 136 S.Ct. 1581, U.S. Supreme Court, 2016 Facts: Daniel Lee Ritz, Jr., was a controlling shareholder and director of Chrysalis Manufacturing Corp. He also used Chrysalis as his personal ATM: systematically transferring large sums from that company to other entities he controlled. Far from turning into a butterfly, Chrysalis was unable to pay its debts, including those to Husky International Electronics. When Husky sued Ritz, seeking to hold him personally liable for the Chrysalis debt, he filed for Chapter 7 bankruptcy. Husky asked the bankruptcy court not to discharge Ritz’s debts on the grounds that he had committed actual fraud. The trial court held that Ritz had not committed actual fraud and therefore his debts could be discharged in bankruptcy. The Fifth Circuit Court of Appeals affirmed. The Supreme Court granted certiorari.

Issue: Did Ritz commit actual fraud? Can his debts be discharged in bankruptcy? Excerpts from Justice Sotomayor’s Decision: The Fifth Circuit *held+ that a necessary element of “actual fraud” is a misrepresentation from the debtor to the creditor, as when a person applying for credit adds an extra zero to her income or falsifies her employment history. In transferring Chrysalis’ assets, Ritz may have hindered Husky’s ability to recover its debt, but the Fifth Circuit found that he did not make any false representations to Husky regarding those assets or the transfers and therefore did not commit “actual fraud.” “Actual fraud” has two parts: actual and fraud The word “actual” has a simple meaning in the context of common-law fraud: It denotes any fraud that “involves moral turpitude or intentional wrong.” *“F+rom the beginning of English bankruptcy practice, courts and legislatures have used the term “fraud” to describe a debtor’s transfer of assets that, like Ritz’ scheme, impairs a creditor’s ability to collect the debt.

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,t-he common law also indicates that fraudulent conveyances, although a “fraud,” do not require a misrepresentation from a debtor to a creditor. Fraudulent conveyances typically involve a transfer to a close relative, a secret transfer, a transfer of title without transfer of possession, or grossly inadequate consideration. In such cases, the fraudulent conduct is not in dishonestly including a creditor to extend a debt. It is in the acts of concealment and hindrance. In the fraudulent conveyance context, therefore, the opportunities for a false representation from the debtor to the creditor are limited. The debtor may have the opportunity to put forward a false representation if the creditor inquiries into the whereabouts of the debtor’s assets, but that could hardly be considered a defining feature of this kind of fraud. Relatedly, under [English law], both the debtor and the recipient of the conveyed assets were liable for fraud even though the recipient of a fraudulent conveyance of course made no representation, true or false, to the debtor’s creditor. That principal also underscores the point that a false representation has never been a required element of “actual fraud,” and we decline to adopt it as one today. We therefore reverse the judgment of the Fifth Circuit and remand the case for further proceedings consistent with this opinion. So ordered. Question: Did the debtor make any false statements? Answer: No. Question: Was the making of a false statement necessary to prove this kind of fraud? Answer: No, the Supreme Court defined the separate parts of “actual fraud,” and demonstrated by example that it did not require an affirmative representation to constitute fraud. Question: Now that the Supreme Court has determined the debtor’s conduct to constitute “actual fraud,” can the debt be discharged in bankruptcy? Answer: No. A debt arising from fraudulent conduct is not dischargeable in bankruptcy.

Reaffirmation Reaffirm: To promise to pay a debt even after it is discharged. Sometimes debtors are willing to reaffirm a debt, perhaps to save the collateral filed with the creditor. A reaffirmation must be approved by the court if the debtor is not represented by an attorney or if, as a result of the reaffirmed debt, the bankrupt’s expenses exceed his income. In the following case, the debtor sought to reaffirm the loan on his truck. He may have been afraid that if he did not, the lender would repossess it, leaving him stranded. It is hard to get around Dallas without a car. Should the court permit the reaffirmation?

Case: In re Grisham102 Facts: William Grisham owned a Dodge truck. When he filed for bankruptcy, the vehicle was worth $16,000, but he owed $17,500 on it. The monthly payments were $400. In addition, Grisham owed $200,000 in non-dischargeable debt and $70,000 in unsecured loans. Grisham sought to reaffirm the truck loan. Should the court allow him to do so? 102

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Issue: Would reaffirmation of this debt create an undue hardship for the debtor? Decision: The court did not approve the reaffirmation. Reasoning: The debtor’s expenses are$1,100 a month higher than his income. He owns no real estate and is living rent-free with a relative. The truck is worth less than he owes on it. The debtor also has enormous non-dischargeable debts. While the monthly payments on the vehicle are not eye-popping, they are nonetheless unduly burdensome for him. The whole point of a bankruptcy filing is to obtain a fresh start. It is about belt-tightening and shedding past bad habits. Too often, bankrupts do not understand this principle and instead want to go forward in a manner that will impair their fresh start and perpetuate bad habits from the past. The court presumes that the debtor wants to reaffirm the d3ebt to prevent the lender from repossessing the truck,. But the debtor never explained why he especially needed this vehicle. The time has come simply to say “good riddance” to it. To approve this reaffirmation would cause hardship for this debtor and does not otherwise seem justified. Question: Did the court agree to the reaffirmation? Answer: No; the court said this would hinder the debtor’s “fresh start.” Question: Is the debtor’s truck going to be reposed? Answer: Not sure; maybe the debtor and car lender can work something out. Question: What might be the debtor’s reason for the reaffirmation? Answer: He wanted (or needed) a car to get around town.

Bonus Case: In re: John & Julie Hoffman103 Facts: The Hoffmans filed Chapter 7 bankruptcy. Among their debts was a loan for $11,500 secured by their 1999 Dodge Caravan. The car was worth less than half the amount of the loan, thus, there was no economic sense to pay back twice the value of their car. However, Mrs. Hoffman’s mother was a cosigner on the car. If they defaulted, she would have to pay. To protect her, the Hoffmans signed a reaffirmation agreement promising to repay the car loan at the rate of $96 per week. The Hoffman’s monthly income of $4,799.12 was $35.87 less than their expenses. Because they had lost their house, they were living with his parents and paying $600 a month in rent. The Hoffman’s lawyer refused to approve the reaffirmation agreement because it had a negative monthly budget. The Hoffmans asked the Court to approve the agreement. Issue: Will the court approve a reaffirmation agreement that shows a negative monthly balance? Holding: No, according to the court the reaffirmation agreement would impose an undue hardship on the Hoffmans and thus would not be in their best interest. According to the court, there was no 103

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evidence supporting the conclusion that the Hoffmans can afford to make the payments required under the reaffirmation agreement. Their monthly deficit of $35.87 is possibly larger now than at the time of filing because “Mrs. Hoffman’s income will be reduced by $2,000 per month due to a change in employers.” According to the court, the Hoffman’s desire to protect Mrs. Hoffman’s mother is not enough to make their willingness to reaffirm their legal liability for their discharged debt to be in their best interest. Not approving the reaffirmation agreement does not necessarily mean that they will lost their car or that Mrs. Hoffman’s mother will be faced with a demand for payment. The Bankruptcy Code allows debtors to continue to make voluntary payments. Question: What is a co-signer? Answer: A co- signer is a person who signs a loan with another, often assuming obligations and providing credit support to be shared with the other signers. Question: What debt did the Hoffmans want to reaffirm? Answer: A loan that was secured by their car. Question: How did the status of Mrs. Hoffman’s mother as a co-signer discourage the Hoffmans from defaulting on the loan? Answer: Because Mrs. Hoffman’s mother was a co-signer, if the Hoffmans defaulted on the loan the creditor could seek payment from Mrs. Hoffman’s mother. The Hoffmans did not want Mrs. Hoffman’s mother to have to pay their loan. Question: What does reaffirmation mean? Answer: Reaffirmation means that a debtor, here the Hoffmans, is willing to promise to pay back a debt, even after discharge. Question: Why wouldn’t a court allow a debtor to pay back a debt voluntarily, it seems counter to the goals of bankruptcy? Answer: The goals of bankruptcy are to preserve as much of the debtor’s property as possible, to divide the debtor’s assets fairly between the creditors and the debtor, and to divide the debtor’s assets fairly among creditors. By not allowing the Hoffmans to enter into a reaffirmation plan that would operate at a negative balance, the court is trying to preserve as much of the Hoffman’s assets, their income, as possible. The court noted that it is commendable to want to protect Mrs. Hoffman’s mother, it is not financially in their best interest.

22-3 Chapter 11 Reorganization For a business, the goal of a Chapter 7 bankruptcy is euthanasia—putting it out of its misery by shutting it down and distributing its assets to creditors. Chapter 11 has a much more complicated and ambitious goal—resuscitating a business so that it can ultimately emerge as a viable economic concern, as General Motors did. Keeping a business in operation benefits virtually all company stakeholders: employees, customers, creditors, shareholders, and the community.

22-3a Debtor in Possession Debtor in possession: The debtor acts as trustee in an Chapter 11 bankruptcy.

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The U.S. Trustee typically appoints the seven largest unsecured creditors to the committee, which serves in the place of the neutral trustee. This committee generally protects the interests of its constituency and may play a role in developing the plan of reorganization.

22-3c Plan of Reorganization Once the bankruptcy petition is filed, an automatic stay goes into effect to provide the debtor with temporary relief from creditors. The next stage is to develop a plan of reorganization that provides for the payment of debts and the continuation of the business.

22-3d Confirmation of the Plan Cramdown: When a court approves a plan of reorganization over the opposition of some creditors. All the creditors and shareholders have the right to vote on the plan of reorganization. The court will approve a plan if a majority of the [creditors] in each class votes in favor of it, and if the “yes” votes hold at least two-thirds of the total debt in that class.

Bonus Case: In re Fox104 Facts: Unable to pay a $2 million fraud judgment owed to United Phosphorus, Ltd., Donald Fox filed a voluntary petition under Chapter 11 of the Bankruptcy Code. His plan of reorganization envisioned that he would use revenues from his company, Midland Fumigant, Inc., to pay off his creditors in full over five years, with interest. CPA Kirk W. Wiesner testified that the plan’s projections were conservative and could easily be met. Midland had six classes of creditors. All of the classes accepted the plan, except the two classes in which United was a member. The bankruptcy judge noted that United had an incentive to oppose Midland’s reorganization because this business was highly competitive and, if Midland were to cease operations, United would be able to raise its prices substantially. Issues: Was Fox’s plan of reorganization feasible and fair? Should the court impose a cramdown? Excerpts from Judge Robinson’s Decision: Debtor has proposed a plan which pays all creditors in full, with interest. United, the only objecting creditor, will be paid in full [within 16 months]. Debtor has provided a reasonable and orderly repayment of his debts. Debtor’s desire and intent to provide a mechanism for him to retain his business interests and assets is consistent with the purposes of the Bankruptcy Code. The plan may satisfy [the Code] even though the plan may not be one which the creditors would themselves design. United contends that the Plan is not feasible because the projections of Midland’s income and expenses are unreliable. The purpose [of the Bankruptcy Code] is to prevent confirmation of visionary schemes that promise creditors and equity security holders more than the debtor can possibly attain after confirmation.

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Will the reorganized debtor emerge from bankruptcy solvent and with a reasonable prospect of success? Debtor’s expert, Kirk Wiesner, analyzed Midland’s financial statements, and determined that Midland would have sufficient income and cash flow during the life of Debtor’s Plan, to make the anticipated distributions and loans that will fund Debtor’s Plan. Based on Wiesner’s Projections, which proved conservative in [the past], when Midland’s actual income doubled the projected income, the Court concludes that Midland will have a continuing ability to distribute and loan funds to the Debtor as contemplated. The Plan has a reasonable assurance of success and is not likely to be followed by liquidation, or the need for further financial reorganization. As such, the Debtor’s Plan meets the feasibility requirement. The Court further notes that the United States Trustee has filed a statement in support of confirmation of the Plan. [T]he Court finds that the Debtor’s Plan is fair and equitable and, as a result, the fact that [two] Classes did not accept the Plan does not preclude confirmation. The Debtor’s Plan is confirmed over the objection of United and over the dissenting votes of [two] Classes for the reasons stated. Question: Two out of six classes of creditors opposed Midland’s plan yet the court imposed a cramdown. Is this fair? Answer: Bankruptcy courts certainly listen to any objections that creditors offer to a plan. However, no class of creditors has an automatic veto right, especially in a case such as this in which a creditor has a conflict of interest. Question: What was United’s conflict of interest? Answer: United competed with Midland. If Midland were to cease operations, United could raise its prices. Question: Under what circumstances will a court accept a creditor’s objections and refuse to impose a cramdown? Answer: If the plan seems to be promising creditors and shareholders more than the debtor can possibly deliver. For a court to impose a cramdown, the plan must have a reasonable prospect of success.

22-3e Discharge A confirmed plan of reorganization is binding on the debtor, creditors, and shareholders. The debtor now owns the assets in the bankrupt estate, free of all obligations except those listed in the plan.

22-3f Small-Business Bankruptcy To aid the creditors of small businesses, Congress added provisions that speed up the bankruptcy proce3ss for entities with less than $2,566,050 million in debt.

22-4 Chapter 13 Consumer Reorganizations The purpose of Chapter 13 is to rehabilitate an individual debtor. It is not available at all to businesses or to individuals with more than $394,7255 in unsecured debts or $1,184,200 in secured debts. Under

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Chapter 13, the bankrupt consumer typically keeps most of her assets in exchange for a promise to repay some of her debts using future income.

22-4a Beginning a Chapter 13 case To initiate a Ch 13 case, the debtor must file a voluntary petition. Creditors cannot use an involuntary petition to force a debtor into Chapter 13.

22-4b Plan of Payment The debtor must file a plan of payment within 15 days after filing the voluntary petition. Only the bankruptcy court has the authority to confirm or reject a plan of payment. Creditors have no right to vote on it. However, to confirm a plan, the court must ensure that:  The plan is feasible and the bankrupt will be able to make the promised payments;  The plan does not extend beyond three years without good reason and in no event lasts longer than five years  If the plan does not provide for the debtor to pay off creditors in full, then all of the debtor’s disposable income for the next five years must go to creditors; and  The debtor is acting in good faith, making a reasonable effort to pay obligations.

22-4c Discharge Once confirmed, a plan is binding on all creditors whether they like it or not. The debtor is washed clean of all pre-petition debts except those provided for in the plan. But, if the debtor violates the plan, all of the debts are revived, and the creditors have a right to recover them under Chapter 7.

Chapter Conclusion Whenever an individual or organization incurs more debts than it can pay in a timely fashion, everyone loses. The debtor loses control of his assets and the creditors lose money. Bankruptcy laws cannot create assets where there are none ( or not enough), but they can ensure that the debtor’s assets, however limited, are fairly divided between the debtor and creditors. Any bankruptcy system that accomplishes this goal must be deemed a success. Is the U.S. Bankruptcy Code fair?

Matching Questions Match the following terms with their definitions: _____A. Discharge 1. Property that individual debto9rs can keep for themselves _____B. Fraudulent transfer 2. Debtors are not liable for money owed before the filing _____C. Exempt property 3. Debtor’s promise to pay a debt after discharge _____D. Reaffirmation 4. Payment to a creditor immediately before filing _____E. Voidable preference 5. Payment made within the year before a petition is filed with the goal of hindering creditors Answers: UUU.

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True/False Questions Circle T for true or F for false: (Correct answers are bolded) 104. T F Student loans can never be discharged. 105. T F Each of the Code’s chapters has one of two objectives - rehabilitation or liquidation. 106. T F A creditor is not permitted to force a debtor into bankruptcy. 107. T F The bankruptcy court issues an order for relief to give the debtor a chance to file a petition 108. T F The Code permits individual debtors (but not organizations)_ to keep some property for themselves.

Multiple Choice Questions 1. CPA QUESTION Decal Corp. incurred substantial operating losses for the past three years. Unable to meet its current obligations, Decal filed a petition of reorganization under Chapter 11 of the federal Bankruptcy Code. Which of the following statements is correct? A. A creditors’ committee, if appointed, will consist of unsecured creditors. B. The court must appoint a trustee to manage Decal’s affairs. C. Decal may continue in business only with the approval of a trustee. D. The creditors’ committee must select a trustee to manage Decal’s affairs. Answer: (a) A creditor’s committee generally consists of the seven largest unsecured creditors who are willing to serve. CPA Examination, May 1991, #35. 2. CPA QUESTION A voluntary petition filed under the liquidation provisions of Chapter 7 of the federal Bankruptcy Code: A. Is not available to a corporation unless it has previously filed a petition under the reorganization provisions of Chapter 11 of the Code B. automatically stays collection actions against the debtor except by secured creditors C. will be dismissed unless the debtor has 12 or more unsecured creditors whose claims total at least $5,000 D. does not require the debtor to show that the debtor’s liabilities exceed the fair market value of assets Answer: (d) Sometimes debtors file for bankruptcy protection because they are having cash flow problems even if their assets exceed liabilities. CPA Examination, May 1991, #30.

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3. CPA QUESTION Unger owes a total of $50,000 to eight unsecured creditors and one fully secured creditor. Quincy is one of the unsecured creditors and is owed $6,000. Quincy has filed a petition against Unger under the liquidation provisions of Chapter 7 of the federal Bankruptcy Code. Unger has been unable to pay debts as they become due. Unger’s liabilities exceed Unger’s assets. Unger has filed papers opposing the bankruptcy petition. Which of the following statements regarding Quincy’s petition is correct? A. It will be dismissed because the secured creditor failed to join in the filing of the petition. B. It will be dismissed because three unsecured creditors must join in the filing of the petition. C. It will be granted because Unger’s liabilities exceed Unger’s assets. D. It will be granted because Unger is unable to pay Unger’s debts as they become due. Answer: (d) CPA Examination, May 1991, #29.

A debtor is not required to file the following document with his voluntary petition: A. Budget statement for the following three years. B. Statement of financial affairs. C. List of creditors. D. Claim of exemptions. E. Schedule of income and expenditures Answer: A. 4.

5. Grass Co. is in bankruptcy proceedings under Chapter 11. _____________ serves as trustee. In the case of _____________ the court can approve a plan of reorganization over the objections of the creditors. A. the debtor in possession/a cramdown B. a person appointed by the U.S. Trustee/fraud C. the head of the creditors’ committee/reaffirmation D. the U.S. Trustee/voidable preference Answer: (a)

Case Questions 1. Mary Price went for a consultation about a surgical procedure to remove abdominal fat. When Robert Britton met with her, he wore a nametag that identified him as a doctor, and was addressed as “doctor” by the nurse. Britton then examined Price, touching her stomach and showing her where the incision would be made. It turned out that Britton was the office manager, not a doctor. Although a doctor actually performed the surgery on Price, Britton was present. It turned out that the doctor left a tube in Price’s body at the site of the incision. The area became infected, requiring corrective surgery. A jury awarded Price $275,000 in damages in a suit against Britton. He © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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subsequently filed a Chapter 7 bankruptcy petition. Is this judgment dischargeable in bankruptcy court? Answer: Under Chapter 7, fraud claims are not dischargeable. IN RE Britton, 950 F.2d 602, 1991 U.S. App. LEXIS 28487 (9th Cir. 1991). 2. To finance her education at DeVry Institute of Technology, Lydia borrowed $20,000 from a private lender. After graduation, she could not find a job in her field, so she went to work as a clerk at an annual salary of $12,500. Lydia and her daughter lived with her parents free of charge. After setting aside $50 a month in savings and paying bills that included $233 for a new car (a Suzuki Samurai) and $50 for jewelry, her disposable income was $125 per month. Lydia asked the bankruptcy court to discharge her debts. Would paying this debt impose an undue hardship on her? Answer: The court refused to discharge Lydia’s debts. It reasoned that anyone who can afford to buy jewelry and a new car, while saving money, can also afford to pay her educational loans. If there was hardship, it was clearly caused by her extravagant purchases. IN RE D’Ettore, 106 Bankr. 715 (Bankr. M.D. Fla. 1989). 3. Dr. Ibrahim Khan caused an automobile accident in which a fellow physician, Dolly Yusufji, became a quadriplegic. Khan signed a contract for the lifetime support of Yusufji. When he refused to make payments under the contract, she sued him and obtained a judgment for $1,205,400. Khan filed a Chapter 11 petition. At the time of the bankruptcy hearing, five years after the accident, Khan had not paid Yusufji anything. She was dependent on a motorized wheelchair; he drove a Rolls-Royce. Is Khan’s debt dischargeable under Chapter 11? Answer: The court would not permit this debt to be discharged because Dr. Khan was not acting in good faith. IN RE M. Ibrahim Khan, P.S.C., 34 Bankr. 574 (Bankr. W.D. Ky. 1983). 4. After filing for bankruptcy, Yvonne Brown sought permission of the court to reaffirm a $6,000 debt to her credit union. The debt was unsecured and she was under no obligation to pay it. The credit union had published the following notice in its newsletter: If you are thinking about filing bankruptcy, THINK about the long-term implications. This action, filing bankruptcy, closes the door on TOMORROW. Having no credit means no ability to purchase cars, houses, credit cards. Look into the future—no loans for the education of your children. Should the court approve Brown’s reaffirmation? Answer: The court refused to approve the reaffirmation because the credit union’s threats constituted duress. IN RE Brown, 95 Bankr. 35, 1989 Bankr. LEXIS 543 (Bankr. E.D. Va. 1989). 4. ETHICS. On November 5, Hawes, Inc., a small subcontractor opened an account with Basic Corp., a supplier of construction materials. Hawes promised to pay its bills within 30 days of purchase. Although Hawes purchased a substantial quantity of goods on credit from Basic, it made few payments on the accounts until the following March, when it paid Basic over $21,000. On May 14, Hawes filed a voluntary petition under Chapter 7. Why did Hawes pay Basic in March? Does the bankruptcy trustee have a right to recover this payment? Is it fair to Hawes’s other creditors if “Basic is allowed to keep the $21,000 payment? Answer: The bankruptcy court ruled that this payment was a voidable preference. It was not made in the ordinary course. Although Hawes was supposed to pay its bills within 30 days, it had in fact © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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made no payments for four months and then promptly made a large one just before it filed for bankruptcy. In re Fred Hawes Org., Inc., 957F.2d 239, 1992 U.S. App. LEXIS 2300 (6th Cir. 1990)

Discussion Questions 1. Look on the Internet for your state’s rules on exempt property. Compared with other states and the federal government, is your state generous or stingy with exemptions? In considering a new bankruptcy statute, Congress struggled mightily over whether or not to permit state exemptions at all. Is it fair for exemptions to vary by state? Why should someone in one state fare better than his her neighbor across the state line? How much should the exemption be? Answer: Answers will vary. 2. Some states permit debtors an unlimited exemption on their homes. Is it fair for bankrupts to be allowed to keep multimillion dollar homes, while their creditors remain unpaid? But other states allow as little as $5,000. Should bankrupts be thrown out on the street? What amount is fair? Answer: Answers will vary. 3. What about the rules regarding repeated bankruptcy filings? (See the chart in Exam Review.) Are these rules too onerous, too lenient, or just right? Answer: Answers will vary. 4. A bankrupt who owns a house has the option of either paying the mortgage or losing his home. The court cannot reduce the amount owed; its choice is to discharge the entire debt or leave it whole. Congress considered a bill that would permit a bankruptcy judge to adjust the terms of mortgages to aid debtors in holding onto their houses. Proponents argued that this change in the law would reduce foreclosures and stabilize the national housing market. Opponents said that it was not fair to reward homeowners for being irresponsible. How would you have voted on this bill? Answer: Answers will vary. (Ultimately, the Senate did not pass the bill.) 5. Between back taxes, alimony, child support, and student loans, debtors can leave the bankruptcy process with hundreds of thousands of dollars in debt that has not been discharged. What kind of fresh start is that? Should limits be placed on the total debt that cannot be discharged? Is the list of non-dischargeable debts appropriate? Answer: Answers will vary.

Suggested Additional Assignments Research: Exempt Property Under the Code, individual debtors are permitted to keep certain exempt property. However, the Code allows state law to establish the amount and type of this exempt property. Ask students to determine © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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your state’s law on exempt property. A list of state http://www.bcsalliance.com/bankruptcy_stateexemptions.html

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Chapter 23 – Securities and Antitrust* Chapter Overview Chapter Theme Securities and antitrust laws prevent businesses from becoming too economically powerful. Consumers benefit from competition.

23-1 Securities Laws The Securities Act of 1933 (the 1933 Act) and the Securities Exchange Act of 1934 (the 1934 Act) are the two most important securities laws.

23-1a What Is a Security? Security: Any transaction in which the buyer invests money in a common enterprise and expects to earn a profit predominantly from the efforts of others. This includes investments that are not necessarily called securities. They may be called orange trees, animal breeding arrangements, condominium purchases in which the developer promises the owner a certain level of income from rentals, and even athletes.

23-1b Securities Act of 1933 The 1933 Act requires that, before offering or selling securities, the issuer must register the securities with the SEC. Issuer: A company that sells its own stock The SEC does not, itself, evaluate or investigate the quality of any offering. It simply ascertains that, on the surface, the company has disclosed all required information about itself and the security it is selling. When the Green Bay Packers football team sold an offering of stock to finance stadium improvements, the prospectus admitted: “It is virtually impossible that any investor will ever make a profit on the stock purchase. The company will pay no dividends, and the shares cannot be sold.”

Liability Under the 1933 Act, the seller of a security is liable for making any material misstatement or omission, either oral or written, in connection with the offer or sale of a security. Material: Important enough to affect an investor’s decision

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Initial public offering(IPO): A company’s first public sale of securities. Secondary offering: Any public sale of securities by a company after the initial public offering. This is the process an issuer follows for either an IPO or a secondary offering: Registration statement. To make a public offering, the company must file a registration statement with the SEC. Registration statement: The document that an issuer files with the SEC to initiate a public offering of securities. Prospectus. All investors must receive a copy of the prospectus before purchasing the stock. Prospectus: A document that provides potential investors with information about a security. Sales effort. Even before the final registration statement and prospectus are completed, the investment bank representing the issuer begins its sales effort. Road show: As part of the sales process, company executives and investment bankers make presentations to potential investors. Going effective. Once the SEC finishes its review of the registration statement, it sends the issuer a comment letter listing required changes. After the SEC has approved a final registration statement, the issuer and underwriter agree on a price for the stock and the date to go effective, that is, to begin the sale. Comment letter: A letter from the SEC to an issuer listing changes that must be made to the registration statement. Go effective: The SEC authorizes a company to begin the public sale of its stock. Emerging growth company (EGC): An issuer with annual gross revenues of less than $1 billion. Research: IP0s If students completed the suggested research assignment on IPOs, ask them to present their findings.

Private Offerings Private offering: A sale of securities in which the issuer provides less disclosure in return for selling less stock to fewer investors than in a public offering. Regulation D. Regulation D: The most common and important type of private offering. Accredited investors: Institutions ( such as banks and insurance companies) or individuals (with a net worth of more than $1 million or an annual income of more than $200,000. The rules of Reg D control:  How much stock can be sold,  How many and what type of purchaser can buy the stock,  How the issuer can advertise,  What the issuer must disclose, and  When the securities can be resold. Crowdfunding. Regulation Crowdfunding permits privately held companies to sell up to $1 million in securities in any 12-month period provided they comply with many requirements.

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23-1c Securities Exchange Act of 1934 Most buyers do not purchase new securities from the issuer in an initial public offering. Rather they buy stock that is publicly traded in the open market. The stock is, in a sense, second hand because others have already owned it. The purpose of the 1934 Act is to provide investors with ongoing information about public companies Under the 1934 Act, an issuer must register with the SEC if:  it completes a public offering under the 1933 Act, or  its securities are traded on a national exchange (such as the New York Stock Exchange), or  it has at least 2,000 shareholders (or 500 who are unaccredited investors) and total assets that exceed $10 million. The 1934 Act requires public companies to file the following documents:  Annual reports on Form 10-K, containing audite4d financial statements and more.  Quarterly reports on Form 10-Q, which are less detailed than 10-Ks and contain unaudited financials.  Form 8-K to report any significant developments, such as a change in control, the resignation of a director over a policy dispute, or a change in auditing firms. A company’s CEO and CFO must certify that:  the information in the quarterly and annual is true  the company has effective internal controls, and  the officers have informed the company’s audit committee and its auditors of any concerns that they have about the internal control system.

Liability Section 10(b) (and Rule 10-b5) prohibit fraud in connection with the purchase and sale of any security, whether or not registered under the 1934 Act. Scienter: Acting with the intent to deceive or with deliberate recklessness as to the possibility of misleading investors. In the following case, Hewlett-Packard (HP) and its executives made inaccurate statements. But did they have scienter? You be the judge.

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You Be The Judge: In re HP Secs. Litig. Facts: Here is the timeline of events: 1. October: HP purchased Autonomy Corporation. February of the following year: In a conference call with investors, Lesjak attributed HP’s weak revenue numbers to “acquisition-related integration costs and accounting adjustments.”

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2. May 23: a. HP CEO Meg Whitman hired PricewaterhouseCoopers to investigate reports of serious accounting improprieties at Autonomy. b. On a call with analysts, Whitman said, “In my view, Autonomy is a terrific product.” 3. June 5: During a press interview, Whitman stated about Autonomy’s difficulties: “In my view, this is the classic case of scaling a business from startup to grownup. You can't run the organization at $1.5 billion the same way you did at $500 million. You just can't. I know exactly how this world works. I have every confidence that Autonomy will be a very big and very profitable business.” 4. August 22: On a conference call, Whitman said, “Autonomy still requires a great deal of attention and we've been aggressively working on that business.” 5. September 10: HP's Form 10-Q reported that: “At the time of the Autonomy acquisition in October 2011, the fair value of Autonomy approximated the carrying value.” 6. Fifteen months later, on November 20: HP announced that, because of the report it had just received from PriceWaterhouseCoopers, It was writing down the Autonomy investment by $8.8 billion. Shareholders filed suit alleging that the Whitman and HP had committed fraud under §10(b). You Be the Judge: Did the defendants have scienter? Did they act either intentionally or with deliberate recklessness? Argument for the Shareholders: Long after it knew of problems with the Autonomy purchase, HP executives made filings with the SEC and statements to investors that gave no hint of trouble. Whitman even made up a whole story about how Autonomy was just going through growing pains. She stated that “Autonomy is a terrific product” – an odd description for a fraudulent deal.

HP said in a filing that, at the time of the Autonomy acquisition in October, its fair value approximated the carrying value. The senior executives could not possibly have believed that statement to be true. In short, they deliberately duped and defrauded investors.

Argument for the Company and its Executives: Yes, there were rumors and allegations about Autonomy, but not until November 20, when the PriceWaterhouseCoopers investigation finished, did the defendants know for sure that the deal had been a fraud. As soon as the company knew, it made the public announcement. Taking time to investigate a situation before making disclosures to the investing public is not fraudulent, it is prudent and reasonable. Besides, Whitman’s statements were nothing but sales talk, and, therefore, create no liability.

The Autonomy purchase was a mistake, but no one intentionally engaged in wrongdoing. HP was the one who was duped. Holding: All charges were dismissed, except for the ones against: (1) Whitman, for her statements on May 23 and June 5 and (2) HP for its statements on September 10. The court ruled that Whitman’s statement on August 22 was accurate enough not to have scienter. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: What is scienter? Answer: A legal term meaning willfully, knowingly, or recklessly. Question: What is required for a defendant to be found liable under Rule 10b-5? Answer: The defendant must have (1) known (or been reckless in not knowing) that the statement was inaccurate and (2) intended for the plaintiff to rely on the statement.

23-1d Insider Trading Insider trading is illegal because:  It undermines the integrity of stock markets  It offends our fundamental sense of fairness; no one wants to play in a rigged game.  Investment banks typically “make a market” in stock; if an insider buy stock based on inside information, she earns profit at the expense of the market maker who sold her the stock. The 1934 Act bans three types of insider trading: short-swing trading, classic insider trading, and misappropriation.

Short-Swing Trading Section 16 applies to officers, directors, and controlling shareholders who own more than 10% of the company. There are two requirements:  Report. Anyone who becomes an insider must report this status to the SEC.  Disgorge. Insiders must turn over to the corporation any profits they make from the purchase or sale of company securities in a six-month period. Section 10(b): Classic Insider Trading Insiders. A corporate insider is guilty of insider trading under §10(b), if he:  Has material, nonpublic information and  Breaches a fiduciary duty to his company  By trading on the information  Whether or not he makes a profit Tippers. Insiders are liable as tippers if:  They reveal material, nonpublic information about their company in violation of their fiduciary duty  They know the information is confidential; and  They benefit (or expect to benefit) directly or indirectly

Tippees. Those who receive inside information, or tips, may also be liable, even if they do not have a fiduciary relationship to the company or the tipper. Tippees are liable when:   

They trade on the information, They know it is confidential, They know that it came from an insider who was violating his fiduciary duty, and

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The insider benefited (or expected to benefit) directly or indirectly

In the following case, two brothers started down a slippery slope of tipping that ended with a family member going to prison.

Case: Salman v. United States Facts: Maher and Michael Kara were brothers. As an investment banker, Maher learned about companies that were secretly developing innovative medical treatments. When their father became ill, Maher shared information about these companies with his brother. Eventually Maher realized that Michael was trading on this secret information. Although Maher disapproved of Michael’s trades and implored him to stop, Maher continued to give his brother tips. When Maher started dating &and ultimately married) Bassam Salman’s sister, Michael and Salman became friends. Without telling Maher, Michael began sharing Maher’s tips with Salman, who made over $1.5 million in profits. Salman knew the information was coming from Maher. All three men were charged with insider trading. Michael and Maher pleaded guilty and testified against Salman at his trial., (Talk about awkward family dynamics.) Salman was convicted of insider trading and sentenced to 36 months in prison. He appealed, arguing that he was not guilty of insider trading because the tipper (Maher) had not received a benefit. The Supreme Court granted certiorari. Issue: Did the tipper receive a benefit? Did Salman engage in illegal insider trading? Decision: Yes, Maher did receive a benefit, and Salman was guilty of insider trading. Reasoning: A tipper is only liable if he breaches his fiduciary duty by disclosing inside information for a personal benefit. Likewise, the tippee is only liable if he knows that the tipper has violated his fiduciary duty by disclosing for a personal benefit. When the tippee is a relative or friend, courts assume that the tipper received a benefit from passing on that information. In this case, Maher would have breached his duty had he traded on the information himself and then given the proceeds as a gift to his brother. It is obvious that Maher would personally benefit in that situation. But Maher effectively achieved the same result by disclosing the information to Michael, and allowing him to trade on it. Maher was guilty as a tipper and Michael as a tippee. Salman was also guilty because he knew that Maher had improperly disclosed the information. Question: Who was the tipper in this case? Answer: Maher Kara. Question: Who was the tippee? Answer: Both Michael Kara and Bassam Salman were both tippees. Question: When Maher began to give his brother inside information, did he know his brother would trade on it? Answer: No, but he learned after the fact that his brother, Michael, was trading on it. Question: After Maher learned that Michael was trading on the information, did he stop giving inside tips? Answer: No, but he should have. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: If Maher had traded on the confidential information himself, would he have been guilty of insider trading? Answer: Yes, he would have benefited directly. Question: How is Maher guilty of insider trading? What did he do wrong? Answer: He gave his brother information he knew to be confidential, knowing that his brother would trade on it. In effect, he achieved the same result as though he had traded on the information himself.

Misappropriation Misappropriation is a violation of §10(b). It is illegal for anyone:  with material, non-public information,  to breach a fiduciary duty to the source of the information  by revealing or trading on it Tippees are also guilty of misappropriation.

23-1e Blue Sky Laws Blue Sky Laws: State securities statutes. In 1911, Kansas became the first state to regulate the sale of securities through statutes. It was concerned that some securities, “had no more substance than so many cubic feet of Kansas blue sky.”1059 Currently, all states and the District of Columbia also regulate the sale of securities.

Legal or Illegal? Ask students to consider the following examples from a newspaper article on insider trading. Do they agree with the newspaper’s answers?

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1. You are a taxi driver who overhears a well-dressed passenger, clearly a corporate bigwig, ebulliently describe how his employer is about to receive approval for a new blockbuster cure for cancer. You tell your broker to buy 1,000 shares of the stock. Answer: Not illegal 2. You are the chauffeur for that same executive—he hired you with the understanding that everything you overhear stays in the car—and he talks of the impending approval. Answer: Illegal. 3. Your broker tells you to sell stock in a company because he just received a call from that company’s chief executive, who instructed him to dump all his holdings. You sell the stock. Answer: Probably illegal. 4. The same broker advises you to sell but does not say why. He says only that he has a strong belief that you should do it. Answer: Not illegal. 5. A friend tells you that he is depressed because his wife has learned that she will probably be laid off next week from her job as a top executive. Her company has discovered deep financial problems, he says, and will disclose them soon. You reassure him, but when he leaves, you call your broker and execute an order to sell short 5,000 shares of the company’s stock. Answer: Illegal. 6. At your country club, you play golf with a new member who talks about a great new product his company is about to introduce. He implies that the stock will rise sharply. The next day, you buy some of the stock. Answer: Illegal. 7. You play golf with that same new member, who talks about the new product but gives no hint that he is associated with the company or where he received the information. You buy. Answer: Not illegal. 8. At a party, you overhear an executive—whom you recognize but do not know—tell another guest that his company’s outlook has taken a turn for the worse that has not been reported. You call your broker and sell your interest in that company. Answer: Not illegal. From Stephen Labaton and David Leonhardt, “Whispers Inside, Thunder Outside,” The New York Times, June 30, 2002, Section 3, p 1.

23-2 Antitrust Congress passed the Sherman Act in 1890 to prevent businesses from becoming so powerful that they could control important markets. Because this statute was aimed at the Standard Oil Trust which then controlled the oil industry, it was termed antitrust legislation. Per se: An automatic breach of antitrust laws. Rule of reason: An action that breaches antitrust laws only if it has an anti-competitive impact.

23-2a The Sherman Act Price-Fixing Section 1 of the Sherman Act prohibits agreements that unreasonably restrain trade. The most common violation of this provision (and one of the most serious) involves horizontal price-fixing. When © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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competitors agree on the prices at which they will buy or sell products, their price-fixing is a per se violation of §1 of the Sherman Act. See the example in the test about Apple’s plans to introduce its first iPad for e-books, but its fear that it could not compete with Amazon’s price of $9.99 per book (at which price, Amazon was sometimes losing money.)

Resale Price Maintenance Resale price maintenance is also called vertical price-fixing. Resale price maintenance (RPM): A manufacturer sets minimum prices that retailers may charge.

Monopolization Under §2 of the Sherman Act, it is illegal to monopolize or attempt to monopolize a market. To determine if a defendant has illegally monopolized, we must ask two questions: 1. Does the company control the market? 2. How did the company acquire or maintain its control Possessing a monopoly is not necessarily illegal; using improper conduct to acquire or maintain one is. In the following case, a drug company took steps to extend its monopoly. Were these actions wrongful?

Case: New York v. Actavis PLC 787 F.3d 638, U.S. Ct. App. 2nd Cir (2015) Facts: Namenda IR is a drug used to treat Alzheimer’s disease (a devastating form of dementia). “IR” stands for “instant release,” meaning the drug has to be taken twice a day. Because Actavis had the patent on Namenda, it had the exclusive right to sell the drug for 20 years. As the end of the patent term neared, other companies developed generic alternatives. Actavis expected that, once these generics entered the market, it would keep only 30% of its annual $1.5 billion in sales. To protect its market, Actavis introduced a more convenient once-a-day pill, called Namenda XR (“extended release”). A year before generic IR became available, Actavis completely withdrew Namenda IR from the market, thereby forcing Alzheimer’s patients to switch to XR. Actavis estimated that this early removal of IR would enable it to keep 80 to 100 percent of the market. The nature of Alzheimer’s disease makes patients especially vulnerable to change sin routine, which means that doctors and caregiver s are reluctant to change a patient’s medication repeatedly. As a result, once forced to switch to XR, many patients would never go back to IR even after the generic version became available. The state of New York filed suit seeking an injunction against Actavis, for violating §§1 and 2 of the Sherman Act. The trial court granted an injunction and Actavis appealed. Issue: Did Actavis violate the Sherman Act? Decision: Yes, Actavis engaged in improper conduct that violated the Sherman Act. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Reasoning: Actavis’s patent granted it a monopoly of the Namenda IR market. As its patent was near expiration, the company developed a better version. As a general rule, courts are reluctant to hold that product design change harm competition because innovation generally benefits consumers. In this case, however, Actavis did not allow the market to determine whether the newer version of Namenda was worth the extra cost. By withdrawing the IR version from the market prior to the generic version becoming available, Actavis forced consumers to switch, knowing that a change back was highly unlikely for these patients. This forced switch was improper conduct that violated the Sherman Act. Question: Did the Defendant have monopoly power? Answer: Yes, because it had a patent on Namenda IR. Question: Knowing its patent was about to expire, what actions did Actavis take? Answer: First, it created a new product, Namenda XR, to replace the product with the patent. Knowing its time was coming to an end, and that generics could replace Namenda IR, Actavis created XR so that the generics could not be substituted for its product. Question: what did the court mean by “soft switch” and “hard switch?” Answer: Actavis first tried to persuade current customers to switch to the new medication, Namenda XR, by various means. It dropped all advertising for IR, and marketed XR extensively. It also charged a lower price for XR than for IR. This was the “soft switch.” But as the expiration of the patent drew closer, Actavis completely withdrew Namenda IR from the market, forcing Alzheimer’s patients to switch to XR. Actavis did this knowing that Alzheimer’s patients suffered when their routines were changed, and calculated that once the switch to XR was made, they would never go back to IR, or its generic substitutes. That was the “hard switch.” Question: Were these actions designed to retain as large a market share as possible? Answer: Yes, that was the goal. Actavis had estimated that when the patent expired, it would retain only 30% of the market, but with the soft switch and hard switch, it could retain 80 to 100 percent of the market.

Predatory Pricing Predatory pricing occurs when a company lowers its prices below cost to drive competitors out of business. To win a predatory pricing case, the plaintiff must prove three elements: 1. The defendant is selling its products below cost. 2. The defendant intends that the plaintiff go out of business. 3. If the plaintiff does go out of business, the defendant will be able to earn sufficient profits to recover its prior losses. A classic example is the case of a MegaGrocery against a Mom and Pop grocery store.

23-2b The Clayton Act Mergers The Clayton Act prohibits mergers that are anticompetitive.

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Tying arrangement: An agreement to sell a product on the condition that a buyer also purchase another, usually less desirable, product. Tying product: In a tying arrangement, the product offered for sale on the condition that another product be purchased as well. Tied product: In a tying arrangement, the product that a buyer must purchase as the condition for being allowed to buy another product. A tying arrangement is a rule of reason violation under the Clayton Act. It is illegal if:  Two products are clearly separate,  The seller requires the buyer to purchase the two products together,  The seller has significant power in the market for the tyi8ng product, and  The seller is shutting out a significant part of the market for the tied product.

23-2c The Robinson-Patman Act Under the Robinson-Patman Act (RPA), it is illegal to charge different prices to different purchasers if:  The items are the same, and  The price discrimination lessens competition. However, it is legal to charge a lower price to a particular buyer if:  The costs of serving this buyer are lower, or  The seller is simply meeting competition.

Chapter Conclusion In this chapter, you have learned about some of the important securities and antitrust laws that affect business. They can have a profound impact on your business – and on your life.

Matching Questions Match the following terms with their definitions: _____A. Securities Act of 1933 1. Prohibits price discrimination _____B. Section 16 2. Regulates companies once they have gone public _____C. Sherman Act 3. Prohibits price-fixing _____D. Robinson-Patman Act 4. Regulates the issuance of securities _____E. Securities Exchange Act of 1934 5. Requires an insider to turn over profits she has earned from buying and selling or selling and buying company stock in a sixmonth period Answers: ZZZ. AAAA. BBBB. CCCC.

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True/False Questions Circle T for true or F for false: (Correct answers are bolded) 109. T F Before permitting a company to issue new securities, the SEC investigates to ensure that the company has a reasonable business. 110. T F It is illegal to have a monopoly. 111. T F Horizontal price-fixing is legal as long as it does not have an anticompetitive impact. 112. T F Only the federal government regulates securities offerings; the states do not. 113. T F It is legal for a company to sell its product at a price below cost so long as it does not intend to drive competitors out of business.

Multiple Choice Questions 1. Under Regulation Crowdfunding: A. The issuer may sell to no more than 35 unaccredited investors. B. The issuer may advertise freely. C. The issuer is required to make disclosures, but only to unaccredited investors. D. The issuer may sell only through one online platform. Answer: D. 2. Foster is a reporter for the Daily Journal where he writes a column on wall Street gossip. His columns often affect the stock prices of the companies he writes about. He tells his friend, Ken, who is a stock broker, about some of his columns before they run. Ken trades on this information. Which of the following statements are true? I. Foster is guilty of misappropriation. II. Ken is guilty of misappropriation. A. Both of these are true. B. Only II C. Only I D. None of these is true. Answer: A.

To have an illegal monopoly, a company must:

Control the market.

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Have a market share greater than 50 percent. A. I, II, and III. B. I and II. C. II and III. D. I and III. E. Neither I, II, nor III.

Answer: B. 4. Are horizontal price fixing and vertical price fixing per se violations of the Sherman Act? A. Yes, Yes B. Yes, No C. No, Yes D. No, No Answer: B. 5. Reserve Supply Corp., a cooperative of 379 lumber dealers, charged that Owens-Corning Fiberglass Corp. violated the Robinson-Patman Act by selling at lower prices to Reserve’s competitors. It presented proof that these prices had harmed competition. Owens-Corning admitted that it had granted lower prices to a number of Reserve’s competitors to meet, but not beat, the prices of other insulation manufacturers. Is Owens-Corning in violation of the RPA? A. Yes, because the RPA requires that manufacturers charge all competitors the same price. B. Yes, because any difference in price is a per se violation of the RPA. C. Yes, because these price variations harmed competition. D. No, because a manufacturer is not liable under the RPA if it charges lower prices to meet competition. Answer: D.

Case Questions 1. You are the president of Turbocharge, Inc., a publicly traded company. You have been buying stock recently because you think the company’s product – a more efficient hybrid engine – is very promising. One day, you show up at work and find your desk in the hallway. The CEO has fired you. In a huff, you sell all your company stock. The only silver lining to your cloud is that you make a large profit. Or is this a silver lining? Answer: You are in violation of Section 16. Even though you acted without any bad intent, you must turn over all your profits to the company. 2. You’re in line at the movie theater when you overhear a stranger say: “The FDA has just approved Hernstrom’s new painkiller. When the announcement is made on Monday, Hernstrom stock will © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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take off.” Have you violated the law if you buy stock in the company before the announcement on Monday? Answer: This is how Investor’s Business Daily, Inc. answered: “In this case, you shouldn’t get into trouble. However, if that stranger happens to be talking to you and he is not a stranger at all, but a neighbor and XYZ’s president, watch out. Geanne Perlman Rosenberg, “When a Tip Becomes a Trap,” Investor’s Business Daily, Inc., June 14, 1995, p. AI. 3. Do you love ice cream? Here is an opportunity for you! For only $800, you can buy a cow from Berkshire Ice Cream. The company gets milk from the cow and you get to share in the profits from the sale of ice cream. Just last month, Berkshire mailed $32,000 worth of checks to investors—who are expecting a 20 percent annual rate of return. Are there any problems with this plan? Answer: This ice cream company is selling a security and must comply with both state and federal securities laws. Ellen Lahr, “Investor Milks Profits of Ice Cream Firm,” Boston Globe, July 30, 1995, p. 38. 4. It used to be that disposable contact lenses cost $169 a year. But then each of the five major manufacturers independently told retailers to charge at least $270 a year. Is this legal? Answer: Costco sued Johnson & Johnson over this pricing policy, alleging antitrust violations., but later dropped the suit after Johnson & Johnson announced it was discontinuing its unilateral pricing policy. Costco Wholesale Corp., v. Johnson & Johnson Vision Care Inc., Case No. 3:15-cv-00941, U.S. Dist. Ct., Northern Dist. Of California. 5. Businesses in Silicon Valley often struggle to recruit enough engineers and, as a result, salaries are highly competitive. Adobe, Apple, Google, Intel, Intuit, Pixar, Lucasfilm, and eBay entered into various agreements with each other not to recruit the other’s employees. Is this legal? Answer: After the DOJ filed suit against the firms alleging “facially anticompetitive” agreements, the parties entered into a settlement, and the anti-poaching agreements were terminated.

Discussion Questions 1. ETHICS To conceive a child, some infertile couples need an egg from a fertile woman. In this market, eggs from smart, pretty women are the most valuable. However, the American Society for Reproductive Medicine recommended that clinics cap any payments to donors at $10,000 per cycle. It was concerned that high prices might coerce some into donating, despite some risks to their health, or le3ad donors to conceal health issues that would make them ineligible to donate. Are these price limits legal? Ethical? Answer: A class action suit on behalf of women who donated eggs was brought against the American Society for Reproductive Medicine, alleging violations of the Sherman Act. When the class was certified, the suit was settled, and the price limits removed. Kamakahi v. American Society for Reproductive Medicine, et al, Case No. 11-cv-01781-JCS (2015).

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2. Federal security laws are based on the assumption that investors are knowledgeable enough to assess the quality of a stock so long as the issuer provides adequate disclosure. Many states take a different approach – they refuse to permit the sale of securities that they deem to be of poor quality. Should securities laws protect investors in this way? Answer: Answers will vary. 3. ETHICS David Sokol worked at Berkshire Hathaway for legendary investor Warren Buffett, who is renowned not only for his investment skills but also for his ethics. Bankers suggested to both Sokol and the ‘CEO of Lubrizol that the company might be a good buy for Berkshire. Sokol then found out that the CEO of Lubrizol planned to approach Berkshire about a possible acquisition. Sokol purchased $10 million worth of Lubrizol stock before recommending Lubrizol to Buffett. Sokol mentioned to Buffet “in passing” that he owned shares of Lubrizol. Buffet did not ask any questions about the timing or amount of Sokol’s purchases. Sokol made a $3 million profit when Berkshire acquired Lubrizol. Did Sokol violate insider trading laws? Did he behave ethically? What are Buffett’s ethical obligations? Answer: Was the information Sokol had material? Buffett defended the purchase by saying that Sokol had no way of knowing how Buffett would react to the purchase suggestion. Indeed, Buffett was originally skeptical. But Sokol was a top deputy often believed to be most likely to succeed Buffett as CEO. Sokol quit after the announcement of the purchase, but both he and Buffett said his departure was unrelated to Lubrizol. 4. Is Regulation Crowdfunding a good idea? Does it provide enough protection to investors? Answer: Answers will vary. 5. The Supreme Court decided that resale price maintenance is a rule of reason, not a per se violation, of the antitrust laws. Will this decision lead to higher or lower prices for consumers? Will it produce other benefits for consumers? Do you agree with the Supreme Court’s decision? Answer: Answers will vary. 6. ETHICS Clarice, a young woman with a mental disability, brought a malpractice suit against a doctor at the Medical Center. As a result, the Medical Center refused to treat her on a nonemergency basis. Clarice then went to another local clinic, which was later acquired by the Medical Center. Because the new clinic also refused to treat her, Clarice had to seek medical treatment in another town 40 miles away. Has the Medical Center violated the antitrust laws? Was it ethical to deny treatment to a patient? What Life Principles are at issue here? Answer: Clarice brought suit alleging that Medical Center had monopolized medical care in violation of §1 of the Sherman Act. The court denied the Medical Center’s motion for summary judgment. The case then went to trial to determine the relevant market and the defendant’s power in that market.

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Suggested Additional Assignments Research: IPOs Ask students to obtain a preliminary or final prospectus from a company that has recently been through an initial public offering (IPO). To obtain this document, they can call a company directly, a brokerage firm, or an investment bank. All SEC filings are also available on the Internet through its EDGAR system at http://www.sec.gov/edgar/searchedgar/webusers.htm .106 Students should prepare answers to the following questions:  Can you tell from reading the prospectus what type of commitment the underwriters have made–best efforts or firm commitment?  What risk factors did the company disclose? Are they “boilerplate” or do they specifically relate to the particular company?  Does the SEC consider this stock to be a good investment?  How many shares can company insiders sell under Rule 144?  Are there any questions about the company that the prospectus did not answer?

Chapter 24 – Consumer Protection* Chapter Overview Chapter Theme This chapter covers statutes that are designed to protect consumers. It also discusses the important role that the FTC plays in enforcing consumer rights.

Chapter 24-1 Introduction Some businesses are determined to separate consumers from their money, no matter what it takes. Both Congress and the states have passed statutes to protect consumers from these bad actors, and Congress has empowered two federal agencies to enforce consumer laws: 

Federal Trade Commission (FTC): It now regulates a wide range of business activities that affect consumers. The FTC can impose a fine or file suit on behalf of an injured consumer.

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Consumer Financial Protection Bureau (CFPB). The CFPB regulates consumer financial products and services, including mortgages, credit cards and checking accounts. Consumers can file complaints with the CFPB.

24-2 Sales Section 5 of the Federal trade Commission Act (FTC Act) prohibits unfair and deceptive acts or practices.

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24-1a Deceptive Acts or Practices Under the FTC Act, an advertisement is deceptive if it contains an important misrepresentation or omission that is likely to mislead a reasonable consumer.

Case: POM Wonderful, LLC v. FTC 777 F.3d 478, U.S. Ct. App. D.C. Cir (2015) Facts: Stewart and Lynda Resnick, who owned thousands of acres of pomegranate orchards, formed POM Wonderful, LLC, to make and sell pomegranate juice. POM spent more than $35 million on medical research, sponsoring at least 100 studies on the impact of pomegranate juice on heart disease, prostate cancer, and erectile dysfunction. POM might be wonderful, but, unfortunately, the results of the medical studies were not. Any health benefit was at best slight and obtained only in studies that were scientifically invalid. Despite the absence of scientific support, POM conducted national advertising campaigns trumpeting the benefits of pomegranate juice, such as: “POM Wonderful Pomegranate Juice can help prevent premature aging, heart disease, stroke, Alzheimer’s, even cancer.” The Federal Trade Commission charged the Resnicks and POM under the FTC Act for making false, misleading, and unsubstantiated statements. It ordered them to stop making health claims without scientific evidence. POM and the Resnicks appealed. Issue: Did the Resnicks and POM violate the FTC Act? Decision: Yes, they were in violation. Reasoning: POM ads used medical symbols, referenced medical journals, and reported that the company had spent substantial amounts on medical research. These factors were designed to make people believe that valid research supported the health claims. Sometimes the ads described research results as “hopeful,” “promising,” and “preliminary.” Although these words somewhat limited the health claims, they were not enough, by themselves, to make the ads accurate. Unless the ads included a disclaimer stating that “evidence in support of this claim is inconclusive,” reasonable consumers might wrongly believe in POM’s health benefits. To make health claims without such a disclaimer, POM must present supporting evidence from at least one scientifically valid study involving randomized and controlled human clinical trials. POM has already conducted several such trials which, unfortunately, did not support its claims. POM cannot use research showing no health benefits to support claims that there are. Question: What did the defendants claim that their POM wonderful juice could do? Answer: Defendants claimed their juice could treat, prevent or reduce the risk of incurring such conditions as heart disease, premature aging, stroke, Alzheimer’s, cancer, and erectile dysfunction. Question: Did the Defendants have medical proof of these claims? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No, although they had spent a great deal of money on medical research. But none of the studies was an RCT (randomized and controlled human clinical trial), which would establish a scientific basis for their claims. Question: What effect did POM’s reporting of the amount of money spent on medical research have on their liability? Answer: Because it suggested that the studies established medical benefits, it worked in favor of imposing liability. Statements such as POM is “backed by $34 million in medical research at the world’s leading universities,” tells the consumer that the benefits have been proven, although they have not. Question: Does it matter that defendants qualified their remarks with such phrases as “an initial study,” “hopeful results,” “preliminary study,” and “promising results.” Answer: No. The court found that such qualifications did not neutralize the claims made when the specific results were otherwise described in unequivocally positive terms. Question: What statement could the defendants have made in their ads to avoid liability under the FTCA? Answer: “The evidence in support of this claim is inconclusive.”

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Facts: Direct Marketing Concepts, Inc., broadcast an infomercial for Coral Calcium that featured a spokesperson named Robert Barefoot. In the ad, his claims were as bare as his feet. He asserted that virtually all diseases -- heart disease, cancer, lupus, multiple sclerosis, Parkinson’s -- are caused by a condition called acidosis. And that calcium derived from Okinawan coral cures these diseases by rendering the body more alkaline: “I’ve had 1,000 people tell me how they’ve cured their cancer. I’ve witnessed people get out of wheelchairs with multiple sclerosis just by getting on the coral.” To bolster his claims, Barefoot noted that unspecified articles from the Journal of the American Medical Association and the New England Journal of Medicine “said that calcium supplements reverse cancer . . . that’s a quote.” During an 18 month period, this infomercial generated $54 million in sales. The FTC filed suit against the company and its owners, alleging that the infomercials were deceptive. The trial court granted the FTC’s motion for summary judgment, ruling that the infomercials were misleading as a matter of law and, therefore, there was no need for a trial. The defendants appealed. Issue: Were these infomercials misleading as a matter of law? Excerpts from Judge Thompson’s Decision: When the FTC brings an action based on the theory that advertising is deceptive because the advertisers lacked a reasonable basis for their claims, the FTC must: (1) demonstrate what evidence would in fact establish such a claim in the relevant scientific community; and (2) compare the advertisers’ evidence to that required by the scientific community to see if the claims have been established.

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On the first prong, the FTC produced four expert declarations which demonstrated that the claims could be substantiated by double-blind, placebo-controlled human studies. To be sure, there may be other scientific evidence that could be sufficient. But the government established that some scientific evidence is required for substantiation, and thus satisfied the first prong. Because the Defendants neither produced nor pointed to any evidence to raise even the tiniest of fact issues, summary judgment was appropriate on the first prong. On the second prong, the FTC relied on the same four expert declarations, in which the experts compared the Defendants’ evidence to the available literature and concluded in each case that the Defendants’ evidence was woefully inadequate. The experts specifically opined that: (1) there was no evidence that calcium cures cancer; (2) there was some evidence that calcium might lower blood pressure but none that it cures heart disease; (3) there was no evidence whatsoever that calcium has any effect on autoimmune disorders; [and] (4) there has been no research published in the Journal of the American Medical Association or the New England Journal of Medicine indicating that calcium “reverses” cancer. The record contains a slew of documents, including excerpts from Barefoot’s books, excerpts from Barefoot’s deposition testimony, a number of popular science and pseudoscientific articles, and one preliminary study. Barefoot’s books present jumbles of quotes from scientists, scientific review articles, and scientific studies interspersed with references to Reader’s Digest and other general-consumption reductions of these studies. However, none of these scientists or studies supports the panacean claims made in the Coral Calcium infomercial. The Defendants therefore engaged in deceptive advertising as a matter of law. The Defendants attempt to head off the above analysis by asserting that their infomercials advanced no actual health claims but, instead, presented only puffery which was further attenuated by the presence of general disclaimers. However, specific and measurable claims are not puffery, and may be the subject of deceptive advertising claims. [T]he Defendants’ infomercials presented specific and measurable health claims. Disclaimers or qualifications in any particular ad are not adequate to avoid liability unless they are sufficiently prominent and unambiguous to change the apparent meaning of the claims and to leave an accurate impression. The disclaimers at issue here did nothing to affect the meaning of the infomercials’ health claims. The infomercial transcripts reveal only disclaimers that the infomercials are paid advertising. In contrast, the health claims were bold and straightforward, presented by supposed experts as testable observations backed up by clinical trials and studies. [W]e affirm the district court’s grant of summary judgment. Question: Did the court find that the FTC met the two requirements that the defendant lacked a reasonable basis for its claims? Answer: Yes, the FTC proved that the infomercials were misleading. Question: What was an argument that the defendants asserted? Answer: That their infomercials were puffery.

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Bonus Case: You Be The Judge: Federal Trade Commission v. Business Card Experts, Inc.108 Facts: Business Card Experts, Inc. (BCE) grossed over $16 million selling business-card dealerships. The prices of the dealerships ranged from $10,000 to $25,000. BCE recruited dealers through advertisements on the Internet and in newspapers and magazines. The ads claimed that dealers could earn $150,000 or more per year, when in fact only one or two people ever earned a third of that. Of the 1,300 people who purchased BCE dealerships, only about 300 were still ordering cards from BCE at the time of this suit. BCE sales representatives told potential dealers that they could not lose money on the dealerships, and they were sometimes offered what they described as “money back guarantees”, which meant dealers received free boxes of cards and those who sold all of the free boxes at the suggested retail price of $49.95 would recoup their initial investment. But only about three percent of dealers actually recouped their investment. When potential dealers asked for references, BCE sales reps lied and said they were independent dealers earning a living from selling business cards. The sales reps would offer prospective dealers exclusive territories knowing there were other dealers in the same areas, and one salesperson told an FTC investigator posing as a potential dealer that “We make over $200,000 a year net profit doing this business.” When in reality he had ordered only 5 boxed of cards in the prior three years. Another sales rep told and FTC investigator that he had fifteen people working for him and earned his investment back in three to four months, when in reality he sold less than $19,000 worth of cards in three years. Dealers did testify that the BCE website was helpful for ordering cards, the cards were good quality, and they were competitively priced. The court granted the FTC’s motion for a temporary restraining order. It enjoined BCE from selling dealerships, froze the company’s assets, and appointed a receiver to run the business. The FTC asked that the restraining order become permanent. You Be The Judge: Did BCE violate §5 of the FTC Act? If so, what is the proper remedy?

Holding: Yes, BCE violated the FTC Act and an injunction is the proper remedy. In this case, according to the court, in order to evaluate whether an injunction is the proper remedy, the Court need only consider the FTC’s likelihood of success on the merits of their case and the balance of any conflicting equities. Section 5 of the FTC Act prohibits “unfair or deceptive acts or practices in or affecting commerce.” According to the court, to establish liability under section 5, the FTC must prove that defendants made a material misrepresentation that was likely to mislead customers acting reasonably under the circumstances. Misrepresentations about expected profits from a business or returns from an investment violate section 5.

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The record contains ample evidence that BCE made material misrepresentations that could, and did, mislead reasonable consumers. BCE sales representatives told outright lies to the FTC investigator about their own and others’ experiences as BCE dealers. They falsely claimed to earn large incomes from selling business cards and to employ numerous people to sell business cards for them. BCE also disseminated materially misleading advertising about the potential for huge profits and the certainty of earning back initial investments. The FTC has shown an overwhelming likelihood that it will succeed on its claims. BCE does not dispute that it lacks sufficient assets to compensate the pool of potential victims. It is also clear that, in its current form as a receivership, BCE has or will soon become a money-losing operation. The status quo is therefore not sustainable. The Court has carefully balanced, on the one hand, BCE’s interest in maintaining BCE in its current form in case they ultimately prevail, against, on the other hand, the interests of potential victims and active BCE dealers. In light of the FTC’s very strong likelihood of success, the most important interest at stake is that of the potential victims. Thus, the FTC’s request for an injunction is allowed. Question: Is it reasonable for someone to believe that they could make $150,000 per year by selling business cards? Answer: Probably not. Question: Is it the role of the law to protect the silly and gullible? Answer: The law does not protect people from making bad investment decisions. However, it does require that sellers tell the truth. In this case, regardless of whether it was reasonable to expect to make $150,000 per year, the sales reps lied to potential dealers and to FTC investigators. As a result, even if a potential dealer were trying to determine whether it was reasonable to make $150,000 per year by selling business cards, BCE was not providing them with accurate and truthful information on which to base their decision. Question: Did BCE tell the truth? Answer: No, it lied about everything. Question: Were these business card dealerships a good investment? Answer: It appears not. Question: Was it legal to sell them anyway? Answer: It was perfectly legal to sell them, just not perfectly legal to lie about them.

24-2b Unfair Practices The FTC Act prohibits unfair acts or practices. Bonus Notes: A practice is unfair if:  It causes a substantial consumer injury  The harm of the injury outweighs any countervailing benefit, and  The consumer could not reasonably avoid the injury. In addition, the FTC may decide that a practice is unfair simply because it violates public policy, even if it does not meet these three tests.

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Research: Unfair or Deceptive Advertising If students’ located ads that they think are deceptive or unfair, ask them to show these ads to the class. General Questions:  What is deceptive or unfair about the ad?  What is the difference between deceptive and unfair?  Do you generally believe advertisements you see?  Should the FTC be more or less aggressive in its efforts to stamp out deceptive ads?

24-2c Abusive Acts The CFPB has the authority to take action against anyone committing “abusive acts.”

24-2d Bait-and-Switch Bait-and-switch: A practice whereby sellers advertise products that are not generally available but are being used to draw interested parties in so that they will buy other items. FTC rules prohibit bait-and-switch advertisements. A merchant may not advertise a product and then disparage it (or otherwise make it unavailable) to consumers in an effort to sell a different (more expensive) item.

24-2e Merchandise Bought by Mail, Telephone or Online The FTC has established the following rules for these types of sales:  Sellers must ship an item within the time stated, or, if no time is given, within 30 days after receipt of the order.  If a firm cannot ship the product when promised, it must send the customer a notice with the new shipping date and an opportunity to cancel. If the new shipping date is within 30 days of the original one and the customer does not cancel, the order is still valid.  If the firm cannot ship by the second shipment date, it must send the customer another notice. This time, however, the firm must cancel the order unless the customer returns the notice, indicating he still wants the item. 

24-2f Telemarketing The FTC prohibits telemarketers from calling or texting any telephone number listed on its do-not-call registry. You can list your home and cell numbers with the FTC. The Telephone Consumer Protection Act (TCPA) prohibits telemarketers from making autodialed and/or pre-recorded calls or texts to cell phones and pre-recorded calls to residential land lines unless the consumer unambiguously consents in writing.

24-2g Unordered Merchandise Under §5 of the FTC Act, anyone who receives unordered merchandise in the mail can treat it as a gift.

24-2h Door-to-Door Sales Consumers at home need special protection from unscrupulous salespeople. Also, it is difficult at home to compare products or process offered by competitors. Under the FTC door-to-door rules a © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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salesperson is required to notify the buyer that she has the right to cancel the transaction at any time before midnight of the third business day thereafter. Key Issue: Additional Sales Rules FTC rules prohibit bait and switch advertisements. They also regulate mail or telephone order merchandise, unordered merchandise, and door-to-door sales. Question: Have students ever been the victims of bait and switch sales practices? Have they noticed what some stores do to prevent charges of baiting and switching? Answer: If a sale item is sold out, many stores offer “rain checks,” which permit the consumer to return later for the sold-out item at the sale price. Question: Is this a satisfactory solution? Answer: It is better than nothing, but certainly not as good as getting the item the first time. Question: Many charities send out return address labels printed with the recipient’s name, hoping for a contribution in return. Does the recipient have a (legal) obligation to make a contribution if she keeps the labels? What if she uses them? Answer: Under FTC rules, anyone who receives unordered merchandise in the mail can treat it as a gift. General Questions: -Would you feel a moral obligation to make a donation if you used the address labels? -Have students received other free gifts? -Has any student ever worked as a door-to-door salesperson? -What do you think about the FTC rules regulating door-to-door sales? (Under the FTC door-to-door rules, a salesperson is required to notify the buyer that she has the right to cancel the transaction prior to midnight of the third business day thereafter.) -Have students had problems ordering merchandise from catalogs? Or do they find that almost all companies comply with FTC guidelines?

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24-3 Consumer Credit Bonus Notes: Historically, the practice of charging interest on loans was banned by most countries, and by Christianity, Islam and Judaism. But as the European economy developed, governments began to permit interest charges, but limited them to 6%. Even today, many states limit the maximum interest rate a lender may charge, but usury laws typically do not apply to credit card debt, mortgages, or to consumer leases or commercial loans. A major issue is that most lenders require that disputes be arbitrated, and arbitrators tend to favor lenders.

Most states limit the maximum interest rate a lender may charge consumers. ( However, usury laws typically do not apply to credit card debt, mortgages, consumer leases, or commercial loans.) Usury statutes: Laws that limit the maximum interest rate a lender may charge.

24-2a Payday Loans Payday loan: Small loans with high interest rates made to people who need money to make it to the next paycheck. Payday loans are made to desperate people who need money to make it to the next paycheck. These loans often carry exorbitant interest rates, with the result that the borrowers never manage to dig out from under their debt. These loans violate the usury laws in some states.

Example The newest controversy in consumer loans involves so-called “payday lending companies.” Ima Poor is living from paycheck to paycheck. She can pay all her regular expenses, barely, but has no savings. One broken arm later and she finds herself $500 in debt. How can she pay? She goes to a payday lending company, which agrees to give her $100 in cash on the spot. In return, she gives the company a check for $130, which they promise not to cash until her next payday two days later. Unfortunately, but predictably, she cannot afford to pay the loan when payday rolls around, so she asks the company to renew the loan again, which the company is happy to do–for another $30 fee. She then takes out another payday loan to cover accumulated fees on the first one. One of the checks she makes out to the lender bounces. That costs her $80 in fees from the bank and the lender. When the lender sues her over the bounced check, she has to pay treble damages, $150 in lawyers’ fees, and $60 for court costs. She ultimately pays $1200 on a total loan of $300. Question: What interest rate is Poor paying? Answer: A $30 fee on a two-week loan of $100 works out to an annual interest rate of 780 percent. Question: What other alternatives does she have? Answer: Not many. Most banks will not make loans for less than $1,000, and her credit rating may not be good enough to obtain a loan from a bank anyway. The $30 fee to the payday lender is probably cheaper than bouncing a check at the bank. Maybe she could pawn something, but that is inconvenient and may be embarrassing. Question: Isn’t this incredibly sleazy on the part of the payday lenders? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: They say that they are performing a vital service, helping out a segment of society that banks have traditionally ignored. If people need money to fill a prescription, where else can they turn? Besides, these companies argue, it is unfair to calculate an annual interest rate since borrowers pay off most loans within a couple of weeks. Question: Forget sleazy, isn’t this illegal, at least in states that have usury statutes? Answer: Yes, although these companies are so new that most states have not taken action against them. General Question: Can you see now the point of usury laws and the Truth in Lending statute?

24-3b Truth in Lending Act (TILA) Congress passed TILA to ensure that consumers receive adequate information about credit terms before entering into a loan. TILA does not regulate interest rates or the terms of a loan; these rule are set by state law. TILA simply requires lenders to disclose the terms of a loan in an understandable and complete manner. Bonus Notes: Applicability TILA applies to a transaction only if all of the following tests are met:  It is a consumer loan; that means a loan to an individual for personal, family, or household purposes, not a loan to a business.  The loan has a finance charge or will be repaid in more than four installments.  The loan is for less than $53,500, is secured by a mortgage on real estate, or is a private education loan.  The loan is made by someone in the business of offering credit Disclosure In all loans covered by TILA, the lender must:  Disclose all information clearly  Disclose the following facts: o The amount financed o The total of payments o The finance charge o The annual percentage rate (APR)

Bonus: Three TILA Cases 1. IN RE Pittman v. Allright.109 Allright Mortgage Company extended a loan to James Pittman. The loan documents contained a statement of the amount financed, finance charge, annual percentage rate, and total of payments. The terms “annual percentage rate” and “finance charge” appeared in the same type and in boxes identical to the ones in which the “amount financed” and “total of payments” were presented.

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2. Mars v. Spartanburg Chrysler Plymouth, Inc and First National Bank of South Carolina.110 When Mars purchased a car from Spartanburg Chrysler Plymouth, the defendant used the term “amount financed” instead of the required term “unpaid balance.” 3. Bonfiglio v. Nugent.111 After his divorce, a court ordered Bonfiglio to pay his wife’s legal fees, which were $6,385.00. Bonfiglio told the court that he could not afford a lump sum payment and asked to pay in installments instead. The court agreed that Bonfiglio could pay monthly installments of $250.00, without interest. As a result, the firm had to wait more than two years to receive all that Bonfiglio owed it. Bonfiglio wrote a letter to his ex-wife’s lawyer, expressing his thanks for the “extension of credit.” Twenty days later, he filed suit against the law firm for violating TILA. Question: Have these firms violated TILA? Answer:  In the first two cases, the courts held that the lenders had violated TILA, even though the technical violations did not harm the debtors.  In the third case, the court held that the law firm had not violated TILA because it was not in the business of offering credit. The loan also had no finance charge. Question: Note that if Bonfiglio had borrowed money from a bank to pay the law firm, the bank would have had to comply with TILA. Why should the bank have to comply and not the law firm? Answer: TILA is complex, with a great number of technical rules. Those not in the business of lending money would have a difficult time complying. Of course, a law firm could presumably figure out the rules, but, in this case, the firm was charging no interest and was essentially doing Bonfiglio a favor.

24-3c Home Mortgage Loans In the first decade of this century, the U.S. suffered through a bubble in housing prices, followed by a dramatic crash. Like all bubbles, this one began when prices rose and people began to believe they could not lose money. They thought they could always sell a house for more than they had paid for it. Lenders fueled this mania by giving out mortgages without first verifying the borrower’s income or assets; indeed, in some cases, encouraging loans that any reasonable observer would know the borrower could not repay. When the inevitable occurred and many homeowners were unable to pay back their loans, banks began huge numbers of foreclosures, which caused prices to fall further. Bleak tracts or abandoned houses stood across America. Congress amended TILA hoping to prevent another such crash. TILA prohibits unfair, abusive, or deceptive home mortgage lending practices. Qualified mortgage (QM): A mortgage that, according to the CFPB, complies with TILA. Under TILA, lenders: (1) must make a good faith effort to determine whether a borrower can afford to repay the loan, considering data such as income, assets, debt and credit history; (2) may not coerce or bribe an appraiser into misstating a home’s value; and (3) cannot charge prepayment penalties on adjustable rate mortgages. CFPB established the criteria for Qualified mortgages:  Limit all of a borrower’s debt (not just her mortgage) to 43% of her income  Limit up-front points and fees to 3 percent 110 111

713 F.2d 65 Court of Appeals for the Fourth Circuit, 1983 986 F.2d 1391, 1993 U.S. App. LEXIS 6524 Court of Appeals for the Eleventh Circuit, 1993 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Prohibit harmful features such as interest-only periods, balloon payments, and negative amortization

Bonus Notes: Home Equity Loans Both legitimate lenders and scam artists offer home equity loans. Congress amended TILA to provide additional consumer safeguards for home equity installment loans. If a home equity installment loan:  has an APR (interest rate) that is more than 10 percentage points higher than Treasury securities, or  the consumer must pay fees and points at closing that are higher than 8 percent of the total loan amount, then, 

at least three business days before the loan closing, the lender must notify the consumer that (1) he does not have to go through with the loan (even if he has signed the loan agreement) and (2) he could lose his house if he fails to make payments, and



loans that are for less than five years may not contain balloon payments (that is, a payment at the end that is more than twice the regular monthly payment).

Bonus Notes: Rescission Under TILA,. Consumers have the right to rescind a mortgage for up to 3 business days after signing (including Saturdays). However, if the lender does not comply with the disclosure provision of TILA, the consumer can rescind for up to three years from the date of the mortgage.

24-3d Plastic: Credit, Debit, and ATM Cards Bonus Notes: Credit, debit, and ATM cards are extremely important to most consumers, so Congress and the regulatory agencies have built in substantial protection.

Credit Cards Fees. Bonus Notes: In the absence of regulation, credit card companies were highly creative at finding ways to impose fees, changing the due date from month to month, setting the deadline in the middle of the day, or charging inactivity fees for failure to use a card. In response to the economic crisis that began in 2008, many consumers struggled to pay their credit card bills. In response, Congress passed the Credit CARD Act to prohibit unfair fees and to provide transparency so that consumers can compare the costs of different cards. These are the major provisions of the Credit CARD Act: 

Due dates must be disclosed. o Due dates must be set for the same time each month and occur at the end of a business day o The bill must be mailed at least 21 days ahead of time.

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Rates and fees

o During the first year, fees must be less than 25% of a card’s credit limit. o Increases in rates and fees:  Are not allowed on any charges already incurred (until a cardholder has missed two consecutive payments). © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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   

Are only permitted for future purchases and only if the credit card company provides 45 days’ notice to the consumer and permits cancellation of the card. Late payment fees are limited to $25 for first event and $35 thereafter. Payment must be applied to whichever debt on the card has the highest interest rate. Consumers have the right to set a fixed credit limit. People under 21 cannot obtain a credit card unless they have income or a co-signer.

Liability. If you lose a credit card, you are liable only for the first $50 in charges the thief makes before you notify the credit card company. If the thief steals just yo8ur credit card number, but not the card itself, you are not liable for any unauthorized charges.

Debit and ATM Cards Fees. Check cards: Another name for a debit card. In the case of ATM and debit cards, banks cannot overdraw an account and charge an overdraft fee unless the consumer signs up for an overdraft plan. Liability. When you lose a debit or ATM card:  If you report the loss before anyone uses your card, you are not liable for any unauthorized withdrawals  If you report the theft within two days of discovering it, the bank will reimburse you for all losses above $50.  If you wait until after two days, your bank will only replace stolen funds above $500.  If you wait more than 60 days after receipt of your bank statement, the bank is not responsible for any losses.  If an unauthorized transfer takes place using just your number, not your card, then you are not liable at all as long as you report the loss within 60- days of receiving the bank statement showing the loss. After 60- days, however, you are liable for the full amount.

Prepaid Debit Cards Fees. These cards may sound like debit cards, but they are different. The card is not linked to your bank account. Instead, these cards require that you pay in advance to load funds onto the card, and can spend only what is there. Traditionally, this type of card had minimal regulation, so issuers were highly creative in assessing fees and charges, including charges per month, to reload, for each transaction, to find out the balance, for inactivity, and to replace or cancel the card. To address this problem, the CFPB issued rules to protect prepaid card users:  Before consumers buy a card, issuers must clearly disclose key account information, such as all fees.  Issuers must make account information available for free by telephone, online, and in writing upon request.  If the card allows consumers to overdraw their accounts, they are entitled to the same protections as credit card holders under the CARD Act. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Liability When you lose a prepaid debit card: 

If you report the theft within two days of discovering it, the bank will reimburse you for all losses above $50.

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If you wait until after two days, the bank will only replace stolen funds above $500.

Bonus Case: Kruser v. Bank of America

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Facts: Mr. and Mrs. Kruser each had an ATM card for their joint account at the Bank of America. Mr. Kruser believed his card had been destroyed. It turned out, however, that someone used it to make an unauthorized withdrawal of $20 from the account in December, which the Krusers did not notice. Perhaps because, that same month, Mrs. Kruser underwent surgery and was hospitalized for 11 days. She then spent six or seven months recuperating at home. Her recovery underwent a nasty setback, however, when she discovered in September that someone had illegally withdrawn $9,020 from the account during July and August. The Bank refused to refund the money. The Krusers sued, but the trial court granted the Bank’s motion for summary judgment. The Krusers appealed. Issue: Did the Krusers’ failure to report the unauthorized withdrawal in December prevent them from recovering the much larger amount stolen in July and August? Excerpts from Judge Stone’s Decision: Appellants [that is, Mr. and Mrs. Kruser] contend the December withdrawal of $20 was so isolated in time and minimal in amount that it cannot be considered in connection with the July and August withdrawals. They assert the *lower+ court’s interpretation would have absurd results which would be inconsistent with the primary objective of the [statute]—to protect the consumer. They argue that if a consumer receives a bank statement which reflects an unauthorized minimal electronic transfer and fails to report the transaction to the bank within 60 days of transmission of the bank statement, unauthorized transfers many years later, perhaps totaling thousands of dollars, would remain the responsibility of the consumer. Here, although the unauthorized transfer of $20 occurred approximately seven months before the unauthorized transfers totaling $9,020, it is undisputed that all transfers were made by someone using Mr. Kruser’s card which the Krusers believed had been destroyed. *T+he Bank could have and would have canceled Mr. Kruser’s card had it been timely notified of the December unauthorized transfer. In that event Mr. Kruser’s card could not have been used to accomplish the unauthorized transactions in July and August. Appellants contend the facts establish that Mrs. Kruser, who was solely responsible for reconciling the bank statements, was severely ill when the December withdrawal occurred. Therefore, they claim they were entitled to an extension of time within which to notify the Bank. The evidence appellants rely upon indicates Mrs. Kruser left her house infrequently during the six or seven months while she was recuperating. [N]othing in the record reflects any extenuating circumstances which would have prevented Mr. Kruser from reviewing the bank statements. The understanding he had with Mrs. Kruser that she would review the bank statements did not excuse him from his obligation to notify the bank of any unauthorized electronic transfers. We affirm the judgment. Question: What is the time period within which one has to report an unauthorized electronic transfer? Answer: Within 60 days of transmission of the bank statement. Question: Mrs. Kruser, who was solely responsible for reconciling the bank statements, was severely ill during the time period of the unauthorized transfers. Why didn’t this fact help the Krusers? Answer: Nothing in the record reflected any extenuating circumstances which would have prevented Mr. Kruser from reviewing the bank statements.

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In the event of a dispute between a customer and a merchant, the credit card company cannot bill the customer if (1) she makes a good faith effort to resolve the dispute, (2) the dispute is for more than $50, and (3) the merchant is in the same state where she lives or is within 100 miles of her house.

Disputes with Credit Card Companies The FCBA provides that, if a consumer has a complaint about a bill and writes to the credit card company within 60 days of receipt of the bill, the company must acknowledge receipt of the complaint within 30 days and, then, within two billing cycles (but no more than 90 days) investigate the complaint and respond.

24-3e Electronic Funds Transfers Preauthorized transfer: Electronic fund transfer authorized in advance to recur at regular intervals. Preauthorized Transfers For these, the bank:  May not make preauthorized transfers without written instructions from the consumer.  Must allow the consumer to stop payment of the transfer by oral or written notice at least 3 business days before the scheduled date. Bonus Notes: Errors in Electronic Funds Transfers Your liability is limited, and the bank must take certain actions upon notification.

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Bonus Case: Broxton-King v. LaSalle Bank, N.A. Facts: Eunice Broxton-King paid $28 a month to belong to the YMCA. On the first day of each month, this sum was transferred automatically from her account at the LaSalle Bank to the YMCA. On August 31, Broxton-King went to the bank, paid an overdraft on her account, and then closed it. However, on September 1, the bank transferred $28 to the YMCA. Because there was no money in her account, the bank charged an overdraft fee of $22 and a service charge of $3. The overdraft totaled $53. On September 7, the bank sent Broxton-King a notice of this overdraft. She told the bank that her account had been closed on August 31, that the debit to the YMCA should be stopped, and the fees refunded. But on October 1, the bank again debited plaintiff’s checking account for the $28 YMCA fee and added an additional $27 in overdraft and service fees. Alleging that the bank had violated the EFTA, Broxton-King filed a pro se lawsuit.6 The bank filed a motion to dismiss. Issue: Did the bank violate the EFTA? Excerpts from Judge Gottschall’s Decision: Section 1693e of the EFTA provides that “*a+ consumer may stop payment of a preauthorized electronic fund transfer by notifying the financial institution orally or in writing at any time up to three business days preceding the scheduled date of such transfer.” Defendant argues that plaintiff failed to properly prevent the transfer of funds to the YMCA. Defendant contends that if plaintiff had wished to prevent the first transfer of funds in question (the one that occurred on September 1), plaintiff should have, pursuant to the EFTA, requested a stop to the funds transfer three days prior to the transfer date. Instead, defendant notes, plaintiff alleges that she closed her account and ended all transactions with her account on August 31: the day before the transfer date. As for the October 1 transfer of funds, defendant argues, it had properly allowed the funds transfer because plaintiff had failed to pay off the overdraft resulting from the first transfer of funds. Therefore, the account remained open during the time of the funds transfer. Defendant’s motion to dismiss is granted as to plaintiff’s EFTA claim regarding the September 1 transfer. Because the request happened less than three days prior to September 1, defendant is correct that plaintiff cannot sue under §1693e of the EFTA for the transfer that occurred on September 1. It appears, however, that under §1693e of the EFTA, the fact that plaintiff’s account was open is immaterial to whether plaintiff could stop a funds transfer from her account. Nowhere in the language of §1693e does the Act require that plaintiff have made the request to stop a funds transfer at a time when the account was closed, as defendant appears to argue. Defendant’s motion to dismiss is denied as to plaintiff’s EFTA claim regarding the October 1 transfer.

Question: Under the EFTA, if a consumer wants to stop payment of a preauthorized electronic fund transfer, what must they do?

Pro se is a Latin phrase meaning “on one‟s own behalf.” A pro se lawsuit is one in which the party represents herself instead of hiring a lawyer. 6

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Answer: Notify the financial institution orally or in writing at any time up to three business days preceding the scheduled date of such transfer. Question: What was the Court’s decision regarding the Defendant’s motion to dismiss? Answer: It was granted regarding the September 1 transfer and denied regarding the October 1 transfer. Question: Why the different outcome between the two transfers? Answer: Plaintiff did not give 3 days’ notice to the bank regarding the September 1 transfer, but did so for the October 1 transfer.

24-3f Credit Reports Accuracy of Credit Report Consumer reporting agencies: Businesses that supply consumer reports to third parties. These are governed by the Fair Credit Reporting Act. Under the Fair Credit Reporting Act (FRCA):  A consumer report can be used only for a legitimate business need.  A consumer reporting agency cannot report information that is more than seven years old (ten years for bankruptcies).  A consumer reporting agency cannot report medical information without the consumer’s permission.  An employer cannot request a consumer report on any current or potential employee without the employee’s permission.  Anyone who penalizes a consumer because of a credit report must reveal the name and address of the reporting agency that supplied the information.  Upon request from a consumer, a reporting agency must disclose all information in his file.  If a consumer tells an agency that some of the information in his file is incorrect, the agency must investigate. The consumer also has the right to report her side of the story. According to the FTC, 26% of consumers had errors in their credit report at one of the three major reporting agencies – Equifax, Experian, and TransUnion.

Access to Credit Reports and Credit Scores Credit score: A number that is supposed to predict your ability to pay your bills. Under FACTA, consumers are entitled by law to one free credit report every year from each of the three major reporting agencies. Consumer advocates recommend that you check your credit reports every year to make sure they are accurate, and that no one else has been obtaining credit in your name. If you find errors, notify the agency in writing and warn it that failing to make corrections is a violation of the law. You should also know your credit score (FICO sc0re, which ranges from 300-850. Research: Credit Reports If you asked students to obtain a credit report, you could now find out what they discovered. General Questions: Did anyone have any difficulty in obtaining a credit report? Did anyone find inaccurate information in his or her report? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Question: What can you do if your credit report contains inaccurate information? Answer: If a consumer tells an agency that some of the information in his file is incorrect, the agency must both investigate and forward the data to the information provider. The information provider must investigate and report the results to the agency. If the data are inaccurate, the information provider must so notify all national credit agencies. The consumer also has the right to give the agency a short statement on any adverse incident contained in the report. The agency must then include this statement with any credit report it provides.

24-3g Debt Collection The Fair Debt Collection Practices Act (FDCPA) is designed to protect consumers from abusive debt collection efforts. Three-quarters of debt collectors violate the law on contacting debtors. Under the FDCPA, collectors may not:  Call or write a debtor who has notified the collector in writing that he wishes no further contact  Call or write a debtor who is represented by an attorney  Call a debtor before 8 am or after 9 pm  Threaten a debtor or use obscene or abusive language  Call or visit the debtor at work if the consumer’s employer prohibits such contact  Imply that they are attorneys or government representatives when they are not or use a false name  Make any false, deceptive, or misleading statement  Contact acquaintances of the debtor for any reason other than to locate the debtor (and then only once)  Tell acquaintances that the consumer is in debt; or  Collect charges in addition to the debt unless permitted by state law or any contract the debtor has signed

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Case: Consumer Fin. Prot. Bureau v. Frederick J. Hanna & Assoc., P.C.. Facts: The Hanna law firm (the Firm) represented debt buyers, that is, companies that purchase portfolios of defaulted loans. Over a four-0year period, the Firm filed more than 35,000 (yes, 350,000 debt collection lawsuits. Yet the firm only had about a dozen lawyers.

The CFPB alleged that the Firm’s lawyers were not actually doing the legal work. How could they be? One attorney signed about 138,000 lawsuits in a two-year period. Assuming this one lawyer did nothing but review collection suits for eight hours a day, five days a week, every week of the year without vacation, he would literally have spent less than a minute on each lawsuit.

Instead of lawyers, the Firm used an automated system and support staff to decide which cases to file and then to draft the pleadings. The Firm also routinely filed affidavits asserting that the debts were valid. But these sworn statements were made by people with no knowledge of or connection to the cases. The CFPB filed suit alleging that the Firm had violated the Fair Debt Collection Practices Act. The Firm filed a motion to dismiss the complaint. Issue: Did the Firm violate the FDCPA? Should the motion to dismiss be granted? Decision: The Firm was in violation. The motion was denied. Reasoning: A letter from a lawyer can be a scary thing. Indeed, that may be its purpose. At a minimum, a consumer who gets a letter from an attorney knows the stakes are now higher. For this reason, courts have long held that, if a letter is signed by a lawyer, she must be meaningfully involved in drafting it. At a minimum, the lawyer must have first reviewed the recipient’s file. A debt collection lawsuit is even worse than a letter from a lawyer. Because the complaint was purportedly prepared by a lawyer, the defendant might view the document as a legally valid statement of his obligation. Such consumers might effectively be coerced into paying a debt that they do not owe. It is only fair that, if an attorney uses fear as a weapon, she must at the very least be professionally involved in the decision to file the lawsuit. Question: Was it possible for the law firm to have properly reviewed and filed as many lawsuits as it did? Answer: No, as the court pointed out, the lawyer who signed $138,0900 cases over two years, had he done nothing but work straight through the year, would have spent about 1 minute on each case, which would not be enough time to review the facts of the case, determine whether it appeared the debt was really owed, and drafted a lawsuit. Question: Why was it misleading that an attorney did not review each case before a lawsuit was filed? Answer: The impact of being sued, and served with a complaint filed by a lawyer is significantly more worrying that receiving a letter in the mail from a collection agency. Unsophisticated debtors may have thought they had no choice but to pay, whether they owed the debt or not. Question: Do you think other law firms conducted collection business this way? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Answers may vary, but they certainly did.

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Bonus Case: Bradley v. Franklin Collection Serv. Facts: When Melvin Bradley sought treatment at North Alabama Urology, P.C. (Urology) he signed a patient agreement, stating that: “In the event of non-payment . . . I agree to pay all costs of collection, including a reasonable attorney's fee." He then incurred a bill for $861.96, which he failed to pay. Urology referred his bill to Franklin Collection Service, Inc. and, in the process, added a $293.06 collection fee to Bradley's balance. The contract between Urology and Franklin provided that Urology would add 331/3 percent to a debt prior to transferring the account to Franklin and then Franklin was entitled to 30 percent of the total it collected. Bradley challenged this fee, alleging that it violated the FDCPA. Both parties moved for summary judgment. The district court granted Franklin's motion and Bradley appealed. Issue: Did Franklin violate the FDCPA when it tried to collect a percentage-based collection fee? Excerpts from the per curiam Decision:7 *The FDCPA+ specifically prohibits “collection of any amount (including any interest, fee, charge, or expense incidental to the principal obligation) unless such amount is expressly authorized by the agreement creating the debt or permitted by law.” Bradley argues that the collection fee he paid violates this section of the FDCPA because the fee was really liquidated damages rather than the actual cost of collection. 112 We agree. When Bradley signed Urology’s patient registration form, he only agreed to pay the actual costs of collection; his contractual agreement with Urology did not require him to pay a collection agency's percentage-based fee where that fee did not correlate to the costs of collection. Franklin failed to direct this Court to any evidence that the 331/3% “collection fee”—which was assessed before Franklin attempted to collect the balance due—bears any correlation to the actual cost of Franklin's collection effort. As such, the 331/3% fee breaches the agreement between Bradley and Urology, since, contractually, Bradley was only obligated to pay the “costs of collection.” Urology and Franklin cannot alter Bradley's obligations by the terms of their subsequent agreement. Because there was no express agreement between Urology and Bradley allowing for collection of the 331/3% fee, that fee violates the FDCPA. This is not to say that Bradley and Urology could not have formed an agreement allowing for the collection of the percentage-based fee. [Another court] suggested that the following contractual provision may allow the imposition of a percentage-based collection fee when a delinquent account was referred to a third-party collection agency: “You agree to reimburse us the fees of any collection agency, which may be based on a percentage at a maximum of 33% of the debt, and all costs and expenses, including reasonable attorneys’ fees, we incur in such collection efforts.” But, Bradley's contract with Urology was not like [this one]. We therefore hold that Franklin violated the FDCPA when it collected from Bradley a debt that included a 331/3% “collection fee” when Bradley only agreed to pay the actual costs of collection. Question: On what basis did the Court side with Bradley regarding the fee? 7

Per curiam is a Latin phrase that literally means “by the court.” In other words, the decision was unanimous and no individual judge signed the opinion. 112 You remember from Chapter 19 that a liquidated damages clause is used in a contract when it is difficult to prove how much damage the injured party will suffer. A liquidated damages clause solves this problem by stating in advance how much a party must pay if it breaches. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: He argued that under the FDCPA the fee was really liquidated damages rather than the actual cost of litigation. Question: What contractual language did the court suggest would allow for recovery of the fee against Bradley? Answer: “You agree to reimburse us the fees of any collection agency, which may be based on a percentage at a maximum of 33% of the debt, and all costs and expenses, including reasonable attorneys’ fees, we incur in such collection efforts.” Question: What does the FDCPA specifically prohibit? Answer: “collection of any amount (including any interest, fee, charge, or expense incidental to the principal obligation) unless such amount is expressly authorized by the agreement creating the debt or permitted by law.”

24-3h Equal Credit Opportunity Act The Equal Credit Opportunity Act (ECOA) prohibits any creditor from discriminating against a borrower because of race, color, religion, national origin, sex, marital status, age (as long as the borrower is old enough to enter into a legal contract), or because the borrower is receiving welfare.

You Be the Judge: Case: Treadway v. Gateway Chevrolet Oldsmobile Inc.9 Facts: Gateway Chevrolet Oldsmobile (GCO), a car dealership, sent an unsolicited letter to Tonja Treadway notifying her that she was “pre-approved” for the financing to purchase a car. Gateway did not provide financing itself; instead, it arranged loans through banks or finance companies. Treadway called the dealer to say that she was interested in purchasing a used car. With her permission, Gateway obtained her credit report. Based on this report, the dealer determined that Treadway was not eligible for financing. This was not surprising, given that Gateway had purchased Treadway’s name from a list of people who had recently filed for bankruptcy. Instead of applying for a loan on behalf of Treadway, Gateway told her that it had found a bank that would finance her transaction, but only if she purchased a new car and provided a co-signer. Treadway agreed to purchase a new car and came up with Pearlie Smith, her godmother, to serve as a co-signer. Concerned as it was with customer service, Gateway had an agent deliver papers directly to smith’s house to be signed immediately. If Smith had read the papers before she signed them, she might have realized that she had committed herself to be the sole purchaser and owner of the car. But she had no idea that she was the owner until she began receiving bills on the car loan. After Treadway made the first payment on behalf of smith, both women refused to pay more – Smith because she did not want a new car; Treadway because the car was not hers. The car was repossessed, but the financing company continued to demand payment. It appears that Gateway was running a scam. The dealership would lure desperate prospects off the bankruptcy rolls and into the showroom with promises of financing for a used car, and then sell a new car to their “co-signer”) who was, in fact, the sole signer). Instead of selling a used car to Treadway, Gateway sold a new car to Smith. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Treadway filed suit against Gateway, alleging that it had violated the ECOA by not notifying her that it had taken an adverse action against her. You Be the Judge: Did Gateway violate the ECOA? Argument for Treadway: One goal of the ECOA is to provide notice to credit applicants about why they have been denied credit. By failing to send Treadway’s application to any lender, Gateway effectively denied credit to Treadway. The result is the same whether the dealership or a lender makes the decision -0 Treadway does not get a loan. There is no logical reason why a denial of credit is an “adverse action” when done by a lender, but not by a dealership. The statute required Gateway to tell Treadway that it had failed to submit her application and why. Another goal of the statute is to prevent credit discrimination. If the dealership does not have to reveal to Treadway that it failed to send her credit application to a lender, she will never even know if she was the victim of discrimination. Under that interpretation of the statute, car dealers would be free to discriminate – they could throw the credit report of every minority applicant into the “circular file” and none would be the wiser. Argument for Gateway: The ECOA applies to “any creditor.” Its goal is to prevent discrimination in granting credit. Gateway is not a creditor, it is a car dealership. It did not deny Treadway credit for the simple reason that it is not in the credit business; it simply failed to send the application to a lender. Treadway could have applied for credit on her own, but elected not to. Gateway did Treadway a favor when it offered her another option for obtaining a vehicle – having her godmother sign the documents. Smith could have refused but, instead, signed without having even bothered to read the documents. No statute should protect her against her own negligence.

Holding: Judgment for Gateway reversed. The term, “adverse action” includes “a denial or revocation of credit.” By deciding not to send Treadway’s application to any lender, Gateway effectively denied her credit. Since Gateway did not tell Treadway of its decision not even to apply for a loan on her behalf, it would be difficult for her ever to determine that she was the victim of discrimination. Car dealers could throw the credit report of every minority applicant in the “circular file” and none would be the wiser. Question: Did Treadway ever file a loan application? Answer: No. Question: Then how could she claim that she had been denied credit? Answer: Gateway told Treadway it would apply for a loan on her behalf, but it never did. The court held that that was the same thing as denying credit. Question: Did the court rule that Gateway had discriminated? Answer: No, but it ruled that failing to tell her the truth was an “adverse action”. The statute requires creditors to explain why they have done so. The point of the EEOA is to protect against this type of secret activity on the part of lenders. It didn’t help Gateway’s cause that it was effectively running a scam. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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24-4 Magnuson-Moss Warranty Act The Magnuson-Moss Warranty Act applies to written warranties on goods (not services) sold to consumers. This statute does not require manufacturers or sellers to provide a warranty on their products. It does require the seller to disclose:  The terms of the warranty in simple, understandable language  Whether the warranty is full or limited  The name and address of the person to contact to obtain warranty service  The parts that are covered, and those that are not  What services the warrantor will provide, at whose expense, and for what period of time  A statement of what the consumer must do, and what expenses he must pay Full warranty: The seller must promise to fix a defective product for a reasonable time without charge.

Bonus Case: Muchisky v. Frederic Roofing113 Thomas Muchisky hired Frederic Roofing Company to re-roof his home. Their contract included a 12-year warranty guaranteeing the roof would be free from defects in workmanship and materials. The roofing job was unsatisfactory, and Muchisky sued for damages. If the Magnuson-Moss Warranty Act applied, then Muchisky was entitled to legal fees as well as damages. Issues: Does the Magnuson-Moss Warranty Act apply in this case? Is the re-roofing of a home a “consumer product” under the Act? Holding: The Act does not apply to purchases and sales of real estate, but it does apply to consumer products that become affixed to property, such as air conditioners and hot water heaters. The court concluded that the roofing was a consumer product and awarded attorney’s fees to Muchisky.

Question: Does the Magnuson-Moss Warranty Act apply to all warranties? Answer: No, it applies only to warranties on consumer products. Question: Is a house a consumer product? Answer: No, a house is real estate. Question: What about a product attached to a house, such as an air conditioner or hot water heater? Answer: Fixtures count as consumer products. Question: Is a new roof real estate or a consumer product? Answer: If Muchisky had hired Frederic to build an addition on his house, that would have been real estate. However, a roof by itself is a consumer product. Question: So where do you draw the line? What about new windows? Or a new carpet? Answer: They seem similar to a new roof and are probably consumer products, not real estate.

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838 S.W.2d 74, 1992 Mo. App. LEXIS 1287 Missouri Court of Appeals, 1992 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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24-5 Consumer Product Safety In 1969, the federal government estimated that consumer products caused 30,000 deaths, 110,000 disabling injuries, and 20 million trips to the doctor. Toys were among the worst offenders, injuring 700,000 children a year. The goal of the Consumer Product Safety Act of 1972 (CPSA) was to prevent injuries in the first place. Under the CPSC:  Manufacturers must report all potentially hazardous product defects within 24 hours of discovery  The Commission can impose civil and criminal penalties on those who violate its standards  Individuals have the right to sue for damages, including attorney’s fees, from anyone who knowingly violates a consumer product safety rule You can find out about product recalls or file a report on an unsafe product at the Commission’s website (www.cpsc.gov) or at saferproducts.gov .

Chapter Conclusion Virtually no one will go through life without reading an advertisement, ordering online, borrowing money, acquiring a credit report, or using a consumer product. It is important to know your rights.

Matching Questions Match the following terms with their definitions: _____A. EFTA 1. Requires lenders to disclose the terms of a loan _____B. FDCPA 2. Regulates credit reports _____C. FCRA 3. Regulates debt collectors _____D. ECOA 4. Prohibits lenders from discriminating based on race, religion, and sex _____E. TILA 5. Regulates electronic payments Answers: EEEE. FFFF. GGGG. HHHH. IIII. 1

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True/False Questions Circle T for true or F for false: (Correct answers are bolded) 114. T F A store is permitted to advertise a product, as long as it can obtain, within seven days, sufficient stock to meet demand. 115. T F The FTC telemarketing rules apply to calls but not texts. 116. T F Payday loans are illegal. 117. T F Under the Truth in Lending Act, it does not matter how the information is disclosed, so long as it is disclosed someplace on the first page of the loan document. 118. T F A consumer reporting agency has the right to keep information on its files secret from the consumer.

Multiple Choice Questions 1. If you receive a product in the mail that you did not order: A. you must pay for it or return it. B. you must pay for it only if you use it C. you must throw it away D. it is a gift to you. E. you must return it, but the company must reimburse you for postage. Answer: D. 2. Zach sells Cutco Knives door to door. Which of the following statements is false? A. The buyer has three days to cancel the order. B. Zach must tell the buyer of her rights. C. Zach must give the buyer a written notice of her rights. D. The seller can cancel orally or in writing. E. If the seller cancels, Zach must return her money within 10 days Answer: D. 3. Depending on state law, if a lender violates the usury laws, the borrower could possibly be allowed to keep_______. I. The interest that exceeds the usury limit II. All the interest III. All of the loan and the interest A. I, II, and III B. Only I C. Only II D. Only III E. Neither I, II, nor III Answer: A. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. Companies must obtain permission from a consumer before charging for overdrafts on_____. A. debit cards B. credit cards C. neither D. both Answer: D. 5. On the first of every month, your monthly rent is automatically deducted from your bank account. You are moving out and want to make sure the payments stop. What should you do? A. You must call the bank at least three days before the first of the month. B. You must write the bank at least three days before the first of the month. C. Either (a) or (b). D. You must have the landlord sign a form, which you then mail or deliver to the bank at least three days before the first of the month. Answer: C.

Case Questions 1. A company offered credit cards to consumers with low credit scores. These cards had a $300 limit, a $75 sign-up fee, a $6 per month participation fee, and a $5 monthly fee for paper billing. Despite the fees, 98,000 people signed up. Is there anything wrong with that? Answer: Answers will vary. 2. Synchrony (formerly known as GE Capital) offered a special deal providing that if credit card holders paid part of what they owed, it would write off the rest and the customer would never have to pay it. The company did not offer this deal to people who lived in Puerto or were native Spanishspeakers. Is there anything wrong with that? Answer: The CFPB ordered Synchrony to pay $225 million in consumer relief for deceptive and discriminatory credit card practices. 3. This post appeared on Instagram: khloekardashian Ever since I started taking two @sugarbearhair a day, my hair has been fuller and stronger than ever!! Even with all the heat and bleaching I do to it! #sugarbbearhair Is there anything wrong with that? Answer: Khloe Kardashian did not disclose that he was paid to endorse the product. The FTC gave her a week to amend her posting. 4. There you are on FindMeLove.com. You joined for free, but you have to upgrade to a paid version if you want to see full-size photos or send personalized messages. So far, you are fine with the free version. But then, a really attractive guy message you and wants to chat. To © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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respond, you have to upgrade. Once you do, you never hear from him again. Only later do you realize that his profile had a little “VC” in the upper corner. That meant he was ‘virtual cupid,” that is, not a real person. Is there anything wrong with that? Answer: Answers will vary. 5. ETHICS After TNT Motor Express hired Joseph Bruce Drury as a truck driver, it ordered a background check from Robert Arden & Associates. TNT provided Drury’s Social Security number and date of birth, but not his middle name. Arden discovered that a Joseph Thomas Drury, who coincidentally had the same birth date as Joseph Bruce Drury, had served a prison sentence for drunk driving. Not knowing that it had the wrong Drury, Arden reported this information to TNT, which promptly fired Drury. When he asked why, the TNT executive refused to tell him. Did TNT violate the law? Whether or not TNT was in violation, did its executives behave ethically? Who would have been harmed or helped if TNT managers had informed Drury of the Arden report? Answer: The Fair Credit Reporting Act required TNT to ask Drury’s permission before requesting a consumer report. Then, before firing him, TNT was required to give him a copy of the report and a description of his rights under this statute. Drury v. TNT Holland Motor Express, Inc., 885 F. Supp. 161, 1994 U.S. Dist. LEXIS 11583 (D.Ct. 1994).

Discussion Questions 1. Many people need a car to get to work, take care of their families, live their lives. But obtaining an auto loan can be difficult for those with a bad credit rating. Some finance companies are now willing to extend credit to people who are poor risks, on one condition: the company can install on the car tracking software that has the ability to disable the ignition if the debtor misses a payment. This procedure has left drivers stranded on highways and in dangerous neighborhoods. Is this practice unfair? Do the benefits of obtaining a loan outweigh the harm caused by this Answer: Answers will vary. 2. Processed cheese food slices must contain at least 51% natural cheese. Imitation cheese slices, by contrast, contain little or no natural cheese and consist primarily of water and vegetable oil. Kraft, Inc. makes Kraft Singles, which are individually wrapped processed cheese food slices. When Kraft began losing market share to imitation slices that were advertised as both less expensive and equally nutritious as Singles, Kraft responded with a series of advertisements informing consumers that Kraft Singles cost more than imitation slices because they are made from 5 ounces of milk. Kraft does use 5 ounces of milk in making each Kraft Single, but imitation slices contain the same amount of calcium as Kraft Singles. Are the Kraft advertisements deceptive? Answer: The court agreed with the FTC that Kraft’s ads were deceptive. Kraft, Inc. v. FTC, 970 F.2d 311, 1992 U.S. App. LEXIS 17575 (7th Cir. 1992). 3. ETHICS Should employers check an applicant’s credit report as part of the hiring process? Each year retailers lose $30 billion a year from employee theft and $55 million because of workplace © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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violence. Those who commit fraud are often living above their means but there is no evidence that workers with poor credit reports are more likely to steal from their employers, be violent, or quit their jobs. And refusing to hire someone with a low credit score creates a sad Catch-22: People have poor credit records because they are unemployed and because they have poor credit records they continue to be unemployed. What is the right thing for an employer to do? Answer: Answers will vary. 4. Go to youtube.com and watch the advertisements for freecreditreport.com. Although the characters repeat the word, “free” over and over, in fact the reports are not free unless the consumer signs up for the paid credit monitoring service. At the end of the ad, a voice quickly says, “Offer applies with enrollment in Triple Advantage.” Are these ads deceptive under FTC rules? Are they ethical according to your Life Principles? Answer: Answers will vary. 5. Advertisements for Listerine mouthwash claimed that it was as effective as flossing in preventing tooth plaque and gum disease. This statement was true, but only if the flossing was done incorrectly. In fact, many consumers do floss incorrectly. However, if flossing is done right, it is more effective against plaque and gum disease than Listerine. Is this advertisement deceptive? Answer: The court held that this advertisement was deceptive and did violate §5. McNeil, Inc, v. Pfizer Inc. 351 F. Supp. 2d 226; 2005 U.S. Dist. LEXIS 184 (2005).

Suggested Additional Assignments Research: Unfair or Deceptive Advertising Ask students to bring to class an ad that they think is deceptive or unfair. They could either clip an ad from a newspaper or magazine, or record one from television. Research: Credit Reports Ask students to order a credit report from one of the three national credit reporting agencies. They can obtain ordering information from the following websites:  Equifax (http://www.equifax.com)  Experian (http://www.experian.com)  TransUnion (http://www.transunion.com) Did the results surprise them? Was any of the report’s information false? Note: assign this research enough in advance of class to allow time for processing the request.

Chapter 25 – Environmental Law* Chapter Overview Chapter Theme The issue in environmental regulation is not, “Are you in favor of a clean environment?” Instead, the issues are:  Who will pay to clean up existing damage and to protect against current and future damage?  How can our society make environmental decisions that will provide maximum benefit while minimizing cost? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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25-1 Introduction Externality: When people do not bear the full cost of their decisions. The environment is a complex issue. Who will pay? Who will pay for past damage inflicted before we understood the harm that pollutants cause? Who will pay for current changes necessary to prevent damage in the future? Externalities prevent the market system from achieving a clean environment on its own.

25-2 Air Pollution Airborne contaminants cause a variety of harms:  Human health: Air pollution can cause or increase the severity of serious disorders such as asthma, bronchitis, cancer, dementia, emphysema, heart disease, and more.  The physical environment: Crops, forests, lakes, rivers, buildings, monuments and vehicles are damaged.  Animals: On land and in water, animals are injured and killed. The rate of extinction rises. The food chain is threatened.  Climate Change: During the last 100 years, the average temperature worldwide has increased between 0.5 and 1.1oF. If current trends continue, the world’s average temperature during the next 100 years will rise another 2-6oF, producing the warmest climate in the history of humankind. (By comparison, The planet is only 5-9oF warmer than during the last Ice Age) Air pollution is both a national and global issue with particularly acute externalities. In the U.S., prevailing west-to-east winds blow air pollution across country. Internationally, burning fossil fuels in the U.S. causes worldwide global warming. Air pollution from China creates smog in the U.S.

25-2a Clean Air Act Stationary source: Any building or facility that emits pollution BACT: Beset available control technology In the United States, air pollution is regulated by the Clean Air Act of 1963 (CAA). The EPA has authority to regulate both the total amount of existing air pollution and its ongoing production. It’s major provisions are:  National Standards  State Implementation Plans (SIPs)  Regulation of Stationary Sources  Prevention of Significant Deterioration (PSD) Program

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Case: Michigan v. EPA 135 S.Ct. 2699, U.S. Supreme Court (2015) Facts: In the Clean Air Act (CAA), Congress directed the EPA to study the impact of power plant emissions on public health and then to regulate power plants if the study indicated that regulation was “appropriate and necessary.” Twenty-three states and the National Mining Association challenged the EPOA’s decision to ignore costs when issuing these regulations. The Court of Appeals upheld the EPA’s decision. The Supreme Court granted certiorari. Issue: Should the EPA have considered cost when issuing power plant regulations? Decision: Yes, the EPA must consider costs. Reasoning: “Appropriate” is a very broad term that requires consideration of all r4elevant factors. Although the EPA certainly had flexibility in its interpretation of this word, it did not have the right to totally ignore an important aspect of the issue it was evaluating. It would not be “appropr8iate” or even rational to impose billions of dollars in e4conomic costs in return for a few dollars in health or environmental benefits. For example, one cost the EPA should certainly consider is the harm that regulation might do to human health or the e3nvironment. Yet, the EPA argued that if it found that the techno9logy to eliminate power plant emissions did even more damage to human health than the emissions themselves, regulation would still be appropriate. That conclusion is worn: No regulation is “appropriate” if it does significantly more harm than good. Furthermore, too much wasteful expenditure devoted to one problem may well mean considerably fewer resources available to deal effectively with other (perhaps more serious) problems. In that case, regulation would not be appropriate or necessary. Question: What was the cost of the proposed power plant regulations per year? Answer: It was $9.6 billion per year Question: What was the annual benefit from the modifications? Answer: Those that could be quantified were estimated at $4 to $6 million per year. But when the EPA considered other benefits, such as the impact on global warming and the reduction of the fine particulate matter, their benefit estimate increased to $37 billion to $90 billion. Question: Was the Supreme Court persuaded by those numbers? Answer: No; the court ruled that the EPA had decided to ignore costs, which was inappropriate. Question: What was the standard under which the EPA was to make its decision? Answer: The standard set by the statute was whether the regulation was “appropriate and necessary.” Question: Do the benefits of reducing the power plant emissions outweigh the costs? Answer: Answers will vary.

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You Be the Judge: Central Arizona Water Conservation District v. EPA114 Facts: In the Clean Air Act, Congress directed the EPA to issue regulations that would protect visibility at national landmarks. The Navaho Generating Station (NGS) is a power plant 12 miles from the Grand Canyon. The EPA ordered NGS to reduce its sulfur dioxide emissions by 90 percent. To do so would cost NGS $430 million initially in capital expenditures and then $89.6 million annually. Average winter visibility in the Grand Canyon would be improved by at most 7 percent, but perhaps less. The NGS sued to prevent implementation of the EPA’s order. You Be the Judge: Did the EPA act arbitrarily and capriciously in requiring the NGS to spend half a billion dollars to improve winter visibility at the Grand Canyon by at most 7 percent? Argument for NGS: This case is a perfect example of environmentalism run amok. Half a billion dollars for the chance of increasing winter visibility at the Grand Canyon by 7 percent? No rational person would choose to spend his own money that way, but the EPA is happy to spend NGS’s. Winter visitors to the Grand Canyon would undoubtedly prefer that NGS provide them with a free lunch rather than a 7 percent improvement in visibility. The EPA order is simply a waste of money. Argument for the EPA: Under the Clean Air Act, Congress instructed the EPA to protect visibility at national landmarks such as the Grand Canyon. How can NGS, or anyone else, measure the benefit of protecting a national treasure like the Grand Canyon? Even people who never have and never will visit it during the winter sleep better at night knowing that the Canyon is protected. NGS has been causing harm to the Grand Canyon, and now it should remedy the damage. Courts generally defer to federal agencies, whose experts deal with similar problems all the time. The EPA has greater expertise in these matters than either NGS or this court. Holding: No. The court acknowledged that the costs of the EPA order might outweigh its benefits. However, the Supreme Court held in a similar case that judicial review of EPA decisions should be “most deferential,” because the agency is “making predictions, within its area of special expertise, at the frontiers of science.” Therefore, the court supported the EPA’s decision. Question: How much would the Navaho Generating Station have to spend to comply with the EPA order to reduce its sulfur dioxide emissions? Answer: The initial cost would be $430 million for capital expenditures. Operating expenses would increase by $89.6 million annually. Question: What benefit would NGS and the public at large gain from this expenditure? Answer: NGS would gain no benefit. People who visited the Grand Canyon in the winter might see an improvement in visibility of 7 percent. Question: Without an order from the EPA, would NGS ever choose to reduce its sulfur dioxide emissions? Answer: No. This is one of the major problems with pollution. Often, those who pollute neither suffer the harm nor benefit from the cleanup. They have no economic reasons to avoid polluting. Question: How many visitors do you think there are to the Grand Canyon in the winter months? Answer: Typically, there are roughly 400,000 visitors during the months of December, January, and February. 114

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Question: What is the cost per visitor of the proposed EPA order? Answer: If amortized over all the visitors in one year, the initial capital expenditure of $430 million would cost $1075 per visitor. The annual expenditure of $89.6 million works out to $224 per visitor. General Questions:  Ignoring the cost of the initial capital expenditure, is it worth it to pay $224 annually per visitor for a chance at a 7 percent improvement in visibility? Would visitors rather have a free night at a hotel than a 7 percent improvement in visibility? How about a free $10 lunch?  Should the environment at the Grand Canyon be as clean as possible, without regard to cost?  How much would you be willing to pay personally to enhance visibility at the Grand Canyon?  Is it fair to impose these costs on NGS? Should all Americans bear this cost, through the tax system?

25-2b Climate Change Greenhouse gases or GHGs: Gases that trap heat in the Earth’s atmosphere, thereby causing global warming. The burning of fossil fuels produces gases—carbon dioxide, methane, and nitrous oxide—that create a greenhouse effect by trapping heat in the earth’s atmosphere. This global warming leads to significant climate change. The United Nations Intergovernmental Panel on Climate Change recently issued a report warning that, if governments fail to limit GHGs by 2030, profound global warming will be impossible to prevent using the technologies currently available. The report further warns that climate change will cause extreme storms, flooding, drought, landslides, air pollution, water and food shortages, the extinction of plants and animals, and an increase in refugees and poverty worldwide. Some of these effects will be seen this century. In just the past 30 years, climate change could lead to the displacement of as many as 200 million people. Sea levels are now rising at a faster rate than any time in the last 28 centuries. A bipartisan committee of American business leaders, politicians, and academics issued a report detailing the impact of climate change on the U.S. It predicts constant flooding along the coasts, and the destruction of important industries in the south, such as tourism and agriculture, as summers become too hot to grow crops – or even to be outside. Preventing climate change is a highly complex problem because any solution requires international political cooperation coupled with major behavioral changes. Finding a solution is even more challenging because, as the following ethics discussion illustrates, some powerful players have refused to accept its reality.

Paris Accord Paris Accord: An international agreement to prevent climate change by reducing GHGs In 2015, 195 countries entered into the Paris Accord. The Accord does not set specific standards. Instead, each country establishes its own goals and there are no penalties for countries that set low goals or who fail to achieve their set targets. Historically, the U.S. has produced more total GHGs than any other country. In 2015, the U.S. committed to cutting its GHJG emission by between 26 and 28 % by 2025, and issued CAA regulations that would have achieved at least part of this goal. However, these regulations were politically contentious because © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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they imposed high current costs in return for future benefits. In 2017, the Trump Administration overturned the regulations and withdrew from the Paris “Accord. However, more than 1,200 mayors, governors, and business leaders in the U.S. have promised to continue efforts to meet the Paris Accord standards.

Domestic Regulation The Supreme Court ruled that if GHGs endanger health or welfare, the EPA must regulate them. The Obama administration issued a Clean Power Plan to reduce GHG emissions, However, as with most environmental decisions, large externalities were at play: Costs and benefits were not born equally by everyone. Those who felt the costs were too high, such as power plants, sued to stop enforcement of the rules. The Trump administration then directed to EPA to revoke the Clean Power Plan. In addition, states are able to set their own standards for air pollution, so long as they are stricter than federal rules. California and ten eastern states have adopted a cap and trade plan for GHGs produced by electric utilities. In addition, more than half the states have established plans to increase renewable sources for electricity generation. Whether these limited plans can affect an international problem is uncertain. General Questions:  Is global warming a serious problem?  What should our own government, and other governments, do?  What should they do personally?  Are they willing to pay $2 more per gallon of gasoline or have their electricity bill double in cost?

25-2c Automobile Pollution Motor vehicles create more than 50% of the hazardous pollutants in the air. They also produce about 1/3 of the U.S’s GHGs. The Obama administration had imposed strict fuel economy rules to reduce pollution but car manufacturers complained that the cost of complying with these rules was too high. The Trump administration withdrew the Obama rules and began to work on new ones.

25-3 Water Pollution: The Clean Water Act Point sources: Discharges from a single producer. Nonpoint sources: Pollutants that have no single producer but result from events such as storm-water runoff or rain. Water pollution is harmful to:  Human health. Pathogens can cause a number of loathsome diseases, such as typhus, dysentery, and hepatitis. Chemicals are poisonous and can cause serious diseases such as cancer.  Animals. Fish, shellfish, dolphins, whales, and birds die or reproduce more slowly. The food chain is disrupted.  The physical environment. Damaged water systems are unable to support biodiversity in plants and animals. They are no longer attractive or useful for recreation purposes. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Sources of water pollution include:  Point source: Discharge from a single producer  Nonpoint source: Pollutants that have no single source, such as water runoff from city streets  Accidents. Such as an oil spill in the Gulf of Mexico and a chemical spill in West Virginia  Heat. When industrial plants use water as a coolant, they return it to the waterways at a high temperature that damages the ecosystem

In 1972, Congress passed a statute, now called the Clean Water Act (CWA), with two ambitious goals: (1) to make all navigable water suitable for swimming and fishing by 1983, and (2) to eliminate the discharge of pollutants into navigable water by 1985. The CWA’s goals have not, so far, been met.

25-3a Coverage The CWA governs all navigable Waters in the U.S. Traditionally, the courts had interpreted this term in a way that gave the EPA the right to regulate virtually all water polluters. But the Supreme Court dramatically narrowed the definition of navigable water, with the result that the EPA may no longer have the right to regulate one-third of the waterways that feed the nation’s drinking water.

25-3b Major Provisions Under the CWA: 

Point sources: Any discharge into navigable water from a point source is illegal without an EPA or state permit.

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Pollution limits: The EPA sets limits, by industry, on the amount of each type of pollution any point source can discharge.

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National water quality standards: The EPA must set national standards.

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State plans: Each state must develop plans to achieve these EPA standards.

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Water Use: States must identify how each body of water is used.

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Nonpoint sources. States, not the EPA, must develop a plan for nonpoint source pollution.

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TMDLs: For each body of water that does not meet water quality standards, the state is required to establish a set of TMDLs:

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TMDLs: Total maximum daily loads of permitted pollution

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Nonpoint Sources: States must develop a plan for nonpoint source pollution.

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Wetlands: Wetlands are the transition areas between land and open water. They may look like swamps (and may even be swamps) but their appearance should not disguise their vital role. They are natural habitats for many fish and wildlife. They also serve as a filter for neighboring bodies of water, trapping chemicals and sediments. They are an important aid in flood control. The CWA prohibits any discharge of dredge and fill material into wetlands without a permit.

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Wastewater: Sewer lines feed into publicly owned wastewater treatment plants (municipal sewage plant). A municipality must obtain a permit for any discharge from a wastewater © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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treatment plant, but must first reduce its toxicity. However, taxpayers have resisted the large increases in taxes or fees necessary to fund required treatments. Since the fines imposed by the EOA are almost always less than the cost of treatment, some cities have been slow to comply.

Bonus Notes: Cost-Benefit Analysis. In the case students read about the grand Canyon, the court dealt with the issue of cost-benefit analysis under the Clean Air Act. Until the case of Entergy Corp vs. Riverkeeper, Inc., the CWA had been interpreted generally to prevent the EPA from using cost-benefit analysis. The EPA was required to prevent pollution at any cost. However, in Entergy, the Supreme Court changed that interpretation of the CWA.

Bonus Case: Entergy Corporation v. Riverkeeper, Inc.115 Facts: Power plants generate lots of heat. To cool down, they flush vast amounts of water through a cooling system (called “cooling water intake structures”). In the process, aquatic organisms (fish, shellfish and plants) that live in this water get squashed against the screens (“impingement”) or in the cooling system itself (“entrainment”). Under the Clean Water Act, these cooling systems must use the “best technology available for minimizing adverse environmental impact.” It took the EPA three decades to issue regulations for these structures. For new power plants, the EPA required the best technology available, which would reduce fish mortality by 98 percent. But, for existing plants, the EPA permitted technology that reduced impingement by 80 to 95 percent and entrainment by 60 to 90 percent. The agency made this choice because the cost of converting existing plants to the better system would be $3.5 billion per year, which was nine times the cost of the cheaper version. In addition, the EPA reserved the right to reduce standards for specific plants if they demonstrated that the costs of compliance would be significantly greater than the benefits. Riverkeeper, Inc. an environmental organization, challenged these regulations. The appeals court ruled that the EPA could only consider costs in two circumstances: (1) determining if they could be ‘reasonably borne’ by the industry or, (2) if there were two ways to achieve the same goal, the EPA could mandate the cheaper option. The court said, however, that the EPA could not compare the costs and benefits of various methods, and choose the technology with the best net benefits. Nor could the EPA alter standards for specific sites based on cost-benefit analysis. The Supreme Court granted certiorari. Issue: Is the EPA permitted to use cost-benefit analysis when issuing regulations? Excerpts from Justice Scalia’s Decision:[The CWA] instructs the EPA to set standards for cooling water intake structures that reflect “the best technology available for minimizing adverse environmental impact.” The Second Circuit took that language to mean the technology that achieves the greatest reduction in adverse environmental impacts at a cost that can reasonably be borne by the industry. That is certainly a plausible interpretation of the statute. But “best technology” may also describe the technology that most efficiently produces some good. In common parlance one could certainly use the

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phrase “best technology” to refer to that which produces a good at the lowest per-unit cost, even if it produces a lesser quantity of that good than other available technologies. [Plaintiffs] contend that this latter reading is precluded by the statute’s use of the phrase “for minimizing adverse environmental impact.” Minimizing, they argue, means reducing to the smallest amount possible, and the “best technology available for minimizing adverse environmental impacts,” must be the economically feasible technology that achieves the greatest possible reduction in environmental harm. But “minimize” is a term that admits of degree and is not necessarily used to refer exclusively to the “greatest possible reduction.” It seems to us, therefore, that the phrase “best technology available,” even with the added specification “for minimizing adverse environmental impact,” does not unambiguously preclude cost-benefit analysis. [I]t was well within the bounds of reasonable interpretation for the EPA to conclude that cost-benefit analysis is not categorically forbidden. In the requirements challenged here the EPA sought only to avoid extreme disparities between costs and benefits. The agency limited variances from the national performance standards to circumstances where the costs are significantly greater than the benefits of compliance. And finally, the EPA’s assessment of the relatively meager financial benefits of the regulations that it adopted--reduced impingement and entrainment of 1.4 billion aquatic organisms, with annualized benefits of $83 million, when compared to annual costs of $389 million, demonstrates quite clearly that the agency did not select the regulatory requirements because their benefits equaled their costs. While not conclusive, it surely tends to show that the EPA’s current practice is a reasonable and hence legitimate exercise of its discretion to weigh benefits against costs. In the last analysis, even [plaintiffs] ultimately recognize that some form of cost-benefit analysis is permissible. They acknowledge that the statute’s language is “plainly not so constricted as to require EPA to require industry petitioners to spend billions to save one more fish or plankton.” This concedes the principle--the permissibility of at least some cost-benefit analysis--and we see no statutory basis for limiting its use to situations where the benefits are de minimis rather than significantly disproportionate. The judgment of the Court of Appeals is reversed. Question: Is the EPA now allowed to use a cost-benefit analysis under the Clean Water Act? Answer: Yes; the Supreme Court stated it is permissible for the EPA to weigh benefits against costs. Question: What would be the annual benefit cost? Answer: $83 million. Question: What would the annual costs be? Answer: $389 million! Question: Do the benefits of reducing the impingement and entrainment of 1.4 billion aquatic organisms outweigh the costs? Answer: Answers will vary. The following case demonstrates how complicated environmental issues can be. The EPA found a more efficient method for setting pollution standards. But should the court allow it? You be the judge.

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Bonus You be the Judge: Va. DOT v. United States EPA116 Facts: The Accotink Creek is a 25-mile long tributary of the Potomac River. After the Commonwealth of Virginia violated the CWA by failing to set TMDLs that would enable the Creek to meet water quality standards, EPA established its own set of TMDLs. The Creek was unhealthy because it had too much sediment from stormwater run-off. Sediment is a pollutant and, therefore, regulated by the CWA. However, it is difficult for scientists to measure and set daily pollution standards for sediment because its content varies and it is not always clear which components cause what problems and how the various ingredients react with each other. Stormwater run-off is easy to assess and measure but it is not technically classified as a pollutant. The EPA established TDMLs for the flow rate of stormwater into the Creek, but Virginia sued, alleging that the EPA had no right to regulate stormwater because it is not a pollutant. You be the judge. Does the EPA have the right to limit stormwater run-off (which is not a pollutant) because it carries pollutants? Argument for Virginia: The statute is very clear: The EPA has the right to regulate pollutants. Stormwater is not a pollutant. Therefore, the EPA cannot regulate it. Beginning and end of story. Argument for the EPA: Here is what we know: (1) how to measure and handle stormwater run-off, because civil engineers deal with it all the time; (2). how much stormwater will carry enough sediment to harm the Accotink Creek; (3) that to repair the Creek, Virginia has to limit stormwater run-off because that is how the sediment enters the water. What we do not know is how much of each pollutant will, on a daily basis, damage the Creek. Why spend huge amounts of time and money assessing each individual component of the sediment just to end up at the same result—limiting run-off? Remember that the goal of the CWA is to eliminate the discharge of pollutants into navigable water. We have come up with a reasonable methodology that is very much in keeping with the goals of the CWA. The court held Commonwealth of Virginia because the EPA had the authority to regulate pollutants not proxy measures of pollutants. Holding: Judgment for Virginia DOT. The court found as a matter of law that the “flow” of stormwater is not a pollutant under the Clean Water Act and could not be the basis of a TMDL. Question: Would the pollutants in this case be classified as a point source or non-point sources? Answer: Non-point sources because it is a pollutant with no single source, such as water runoff from agricultural land or city streets. Question: Do you agree with the court’s decision? Answer: Answers will vary.

Bonus Case: S. Fla. Water Management District v. Miccosukee Tribe of Indians117 Facts: Canals built throughout the 1900s to facilitate development in south Florida caused flooding and other problems. To solve these problems, the United States Army Corps of Engineers’ built a vast array of levees, canals, pumps, and water storage areas. This litigation focuses on the pumping of groundwater and rainwater from canal C-11 into a wetland area (called WCA-3). Before entering C-11, 116

541 U.S. 95; 124 S. Ct. 1537; 2004 U.S. LEXIS 2376 Supreme Court of the United States, 2004 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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the rainwater absorbs contaminants produced by human activities, including phosphorous from fertilizer used by farmers. When this phosphorous is pumped into WCA-3, it alters the balance of the WCA-3 ecosystem and stimulates the growth of algae and plants foreign to the Everglades. The Miccosukee Tribe of Indians was impatient with the pace of initiatives intended to restore the ecological integrity of the Everglades. The Tribe sued under the Clean Water Act to halt the pumping of water from C-11 into WCA-3. It alleged that C-11 was a point source and, therefore, could not discharge pollutants into WC-3 without a permit. The District argued that the canal was not a point source because it did not create the pollutants; it simply transported them. The Tribe filed a motion for summary judgment, which the trial court granted and the appellate court affirmed. The Supreme Court granted certiorari. Issue: Is a canal a point source when it transmits pollutants that it did not create? Holding: The Court held that the canal was a point source under the Clean Water Act. The Act defines point source as “any discernible, confined and discrete conveyance, such as a pipe, ditch, channel, or tunnel from which pollutants are or may be discharged.” A point source need not be the original source of the pollutant; it need only convey the pollutant. Question: Why did the tribe want C-11 defined as a point source? Answer: It wanted to protect the Everglades from further pollution. If C-11 was defined as a point source then, under the Clean Water Act, water could not be pumped from C-11 into the Everglades without a permit. Question: What was the District’s argument? Answer: It argued that C-11 was not a point source because it did not itself generate pollutants. C11 merely collected rainwater and groundwater containing pollutants produced elsewhere. Question: What did the Court rule? Answer: It ruled that C-11 was a point source, which, under the Act’s definition, includes pipes, ditches, tunnels, and conduits that merely transport water containing pollutants generated somewhere else. Question: The result in this case seems straightforward. Why did the District choose to litigate all the way to the Supreme Court? Wouldn’t its time and money have been better spent solving the pollution problem? Answer: Solving a pollution problem can take years and be enormously expensive. The District wanted to proceed on its own schedule, without pressure from the courts. ‘

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25-4 Waste Disposal In 1945, Hooker Chemical Co. disposed of 21,800 tons of 82 different chemicals by dumping them into Love Canal or burying them nearby. An internal memorandum warned that this decision would lead to “potential future hazard” and would be a “potential source of lawsuits.” The firm’s lawyer wrote that “children in the neighborhood use portions of the water for swimming,” and suggested that Hooker build a fence around the canal. They didn’t. Hooker disposed of the chemicals knowing that children swam in the canal and knowing of the danger and liability. Then, they sold the land to the local school board to build an elementary school. When the firm’s executive VP recommended against the sale, the firm inserted a clause in the deed to eliminate the firm’s liability. Schoolchildren tripped over drums of chemicals that worked their way to the surface, and were burned playing with hot balls of chemical residue that popped up through the ground (they called them “fire stones”). Homeowners noticed foul odors in their basements after heavy rains. Breast cancer, bladder cancer, throat cancer, convulsions and kidney failure, chromosomal abnormalities, epilepsy, respiratory problems and skin diseases resulted. Finally, a national health emergency was declared and 800 families relocated. The cleanup cost almost $400 million and took 21 years to complete. In its time, what Hooker did was not unusual. It is estimated that the cost of cleaning up existing waste will exceed $1 trillion.

25-4a Resource Conservation and Recovery Act (RCRA) This law focuses on preventing future Love Canals by regulating the production, transportation and disposal of solid wastes and ordinary garbage. Ordinary Garbage The disposal of nonhazardous solid waste has generally been left to the states, but they must follow guidelines set by the RCRA. Hazardous Wastes. Hazardous wastes must be (1) tracked from creation to final disposal and (2) disposed of at a certified facility.

25-4b Superfund Superfund: Another name for the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) The goal of the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA), more commonly known as Superfund is cleaning up hazardous wastes that were illegally dumped in the past. The philosophy of Superfund is “the polluter pays.” Therefore, under Superfund, anyone who has ever owned or operated a site on which hazardous wastes are found, or who has transported wastes to the site, or who has arranged for disposal of wastes that were released at the site is liable for:  The cost of cleaning up the site  Any damage done to natural resources, and  Any required health assessments Bonus Notes: All polluters are jointly and severally liable unless they can show they were only responsible for a portion of the damages. In practical terms, this means the EPA seeks full recovery from © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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whichever polluters are financially sound. But the trust fund for remediation was initially financed by a tax on the oil and chemical industries, which Congress refused to renew. Now, the EPA must rely on reimbursements from polluters and congressional appropriations. Discussion: Love Canal Congress passed Superfund legislation, at least partly, in response to Love Canal. Fittingly, Love Canal now serves as an illustration of what CERCLA can accomplish. In 1978, Love Canal was a major environmental disaster. In the early 1980s, the federal government bought 788 houses near Love Canal. It immediately tore down 238 of them. In 1988, it declared 360 of them to be habitable and, at the beginning of 1993, put them on the market at prices between $48,000 and $52,000. This was 15 percent below market price for equivalent houses in the area. To avoid speculation, purchasers were required to live in their houses for three years. Although the government had expected that it would take between 10 and 15 years to sell the houses, all but four sold within three and a half years. Ken Denman, the real estate agent at Love Canal (now called Black Creek Village), said that, despite the capped canal in the middle of the neighborhood, “You can’t find a Love Canal resident worried about 118 toxins.” Question: What arguments can you make that CERCLA should be reformed? Answer:  Joint and several liability is unfair. Every potential polluter is liable unless it can prove that it did not pollute, which means that a company that did only modest damage may be liable for enormous expenses.  It is unfair for potential polluters to be liable retroactively. Before Congress passed CERCLA in 1980, many companies did not keep accurate records and now cannot prove that they did not pollute.  Per site costs average more than $30 million and take more than 10 years. The law is clearly operating inefficiently. There must be a better way.  What about the story of the 84-year-old woman that began this chapter (text p. 1005)? She will be totally impoverished if forced to pay cleanup costs for the site that she owns. Is that fair?  Before CERCLA, we all paid less for goods because manufacturers did not pass along to consumers the cost of cleaning up pollution. If we all benefited, why shouldn’t we all pay (through higher taxes)? Question: What arguments can you make that CERCLA should not be amended (or at least not weakened)? Answer:  The polluters should have been paying these costs of cleanup all along. The fact that they have to pay them retroactively is fair. They were shirking their responsibility and cannot now complain.  If polluters do not pay the costs of cleanup, then taxpayers will. Why should people who did not in any way benefit from the lax pollution rules of the past pay the cost?  Love Canal demonstrates that even the most polluted property can be rehabilitated. Cleaning up is a much better choice than boarding up. Research: Superfund If students engaged in the Superfund research, now would be an appropriate point to ask them to report to the class with answers to these questions: 118

Evelyn Nieves, “Love Canal; Houses Sell Themselves,” New York Times, July 21, 1996, p. 21. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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How was the site created? Who is supervising its cleanup? Who is paying for the cleanup? How long has the process been going on? How long until it is completed? Has there been litigation over the cleanup?

25-5 Chemicals More than 85,000 chemicals are used in food, drugs, cosmetics, pesticides, and other products. Up to 3,000 new chemicals are introduced each year. Although consumers may think that these products have been safety tested, that is true for only a very small percent. Our regulatory system assumes that they are safe unless proven otherwise. Thus, after the Deep Horizon oil spill in the Gulf of Mexico, two million gallons of chemicals were used to disperse the oil slick, without evidence that this treatment was safe.119 The major provisions of the Toxic Substances Control Act (TSCA):  

Prohibits the use of new chemicals or old chemicals used in new ways until the EPA has determined they are safe. Requires that existing chemicals (which have not yet been tested) be tested at least 20 at a time by the EPA to determine their risk.

25-6 Natural Resources 25-6a National Environmental Policy Act EIS: Environmental impact statement. The National Environmental Policy Act of 1969 (NEPA) requires all federal agencies to prepare an environmental impact statement (EIS) for every major federal action significantly affecting the quality of the human environment. An EIS is a major undertaking – often hundreds, if not thousands of pages long The EIS requirement applies not only to actions undertaken by the federal government, but also activities regulated or approved by the government. The EIS process is controversial. But researchers have found that the EIS process generally has a beneficial impact on the environment. The mere prospect of preparing an EIS tends to eliminate the worst projects.

Ian Urbina, “Think Those Chemicals Have Been Tested?” The New York Times, April 13, 2013.

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Bonus Case: The Lands Council v. McNair120 Facts: The Forest Service was concerned about a section of the Idaho Panhandle National Forest that had old growth trees. Over time, the area had become overcrowded with younger trees. The increased density was harmful to all trees because they competed for moisture, sunlight, and nutrients, but was especially damaging to the older ones. The Forest Service decided to permit logging of some younger trees. The logging would generate 23.5 million board feet of timber. The Lands Council was opposed to cutting down trees but was also concerned about the collateral impact of logging, such as the creation of roads. The Lands Council sued to stop the project, claiming that the Forest Service had failed to develop an adequate EIS as required by NEPA. The district court denied Land Council’s motion for a preliminary injunction. A three-judge panel of the appeal’s court reversed the district court’s decision. The entire appeals court decided to rehear the case (sitting “en banc”). Issue: Did the Forest Service’s EIS comply with NEPA? Holding: Yes, the decision of the three-judge panel is reversed. According to the court, NEPA does not impose any substantive requirement on federal agencies, it ensures a process. NEPA requires agencies to take a hard look at the environmental consequences of their action by preparing an EIS for each major federal action significantly affecting the quality of the human environment. The EIS must provide full and fair discussion of significant environmental impacts so as to inform decision makers and the public of the reasonable alternatives which would avoid or minimize adverse impacts. NEPA does not require the Forest Service to affirmatively present every uncertainty in its EIS. To do so would be an onerous requirement given that experts routinely disagree, and such a requirement might prevent the Forest Service from acting due to the burden. Although the Forest Service must acknowledge and respond to comments by outside parties that raise significant scientific uncertainties and reasonably support that such uncertainties exist, the Forest Service does not have the burden to anticipate questions that are not necessary to its analysis, or respond to uncertainties that are not supported. Here, according to the court, the Forest Service did not ignore that there may be some adverse impact from logging. The Forest Service acknowledged possible short-term negative impacts, but explained based on its habitat sustainability model, that is actions would not decrease suitable habitat in the short-term and would enhance it in the long-term. While the Forest Service must explain its methodology, NEPA does not require the court to decide whether an EIS is based on the best scientific methodology available. Thus, the court concluded that the Forest Service took the requisite hard look at the environmental impacts of the project to satisfy the requirements of NEPA. Question: If NEPA does not impose and substantive requirements on federal agencies, what is the point of the law? Answer: The point of NEPA, according to the court, is to require all federal agencies to follow the same process for evaluating the environmental impacts of projects, and to provide full and fair 120

2008 U.S. App. LEXIS 13998, United States Court of Appeal for the Ninth Circuit, 2008. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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disclosure of significant environmental impacts so that decision makers and the public are informed of reasonable alternatives which would avoid or reduce and negative impacts from the project. Question: Given that purpose, how does the law protect natural resources and the environment? Answer: The law helps to protect natural resources and the environment because the process of preparing an EIS seems to eliminate the worst projects and litigation over the EIS eliminates the next weakest group.

25-6b Endangered Species Act Worldwide, 25 percent of mammals, 22 percent of reptiles, and 13 percent of birds are threatened with extinction. This threat is largely caused by humans. The ESA: 

requires the Department of Interior’s Fish & Wildlife Service (FWS) to prepare a list of species in danger of extinction, and to develop a plan to revive them.

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Requires all federal agencies to ensure their actions will not jeopardize an endangered species and avoid damage to habitat that is critical to their survival

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Prohibits sale or transport of these species, taking or capturing them, killing or harming them, or modifying their habitats in such a way that their population is likely to decline, and

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The taking of any endangered plant species on federal property.

Case: Gibbs v. Babbitt121 Facts: The red wolf used to roam throughout the southeastern United States, but development and hunting whittled its numbers over the years, making it into an endangered species. The FWS trapped the remaining red wolves, placed them in a captive breeding program, and then reintroduced them into wildlife refuges in North Carolina and Tennessee. Ultimately, the FWS reintroduced 75 wolves into the 120,000-acre Alligator River National Wildlife Refuge in eastern North Carolina and the Pocosin Lakes National Wildlife Refuge in Tennessee. About 40 red wolves wandered from these refuges onto private property. Richard Mann shot a red wolf that he feared might attack his cattle. Mann pled guilty to taking an endangered species without a permit. Two individuals and two counties in North Carolina filed suit against the U.S. government, alleging that the anti-taking regulation as applied to the red wolves on private land exceeded Congress’s power under the interstate Commerce Clause of the U.S. Constitution. Issue: Is the anti-taking provision of the ESA constitutional? Holding: Yes, the anti-takings provision of the ESA is constitutional. The red wolves had a substantial impact on interstate commerce – attracting tourists, promoting scientific research, supplying pelts to the fur trade, eating livestock, and protecting farms by killing other animals (raccoons, deer, and rabbits). Question: Who’s afraid of the big bad red wolf? 121

214 F.3d 483, 2000 U.S. App. LEXIS 12280 United States Court of Appeals for the Fourth Circuit, 2000 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Farmers and ranchers became angry when wolves killed their domestic livestock. Question: What legal claim did the plaintiffs make against the Secretary of the Interior (Bruce Babbitt)? Answer: The plaintiffs argued that the Commerce Clause of the Constitution did not apply because the wolves did not affect interstate commerce. Question: Do wolves affect interstate commerce? Answer: The court ruled that they do, for several reasons:  Wolves attract tourists.  They are also the subject of scientific research. This industry generates jobs.  A market for wolf pelts may develop.  Wolves have an impact on the farming industry (for better or worse, it’s not clear).  If wolves become extinct, there may result a permanent, though unascertainable, commercial loss. Question: How does this case reflect a general problem of environmental regulation? Answer: The people who pay the costs of environmental protection (in this case, farmers) don’t necessarily gain the benefit.

Chapter Conclusion (excerpts) Environmental laws have a pervasive impact on our lives. Their cost has been great, causing higher prices for everything.  Some argue that cost is irrelevant – a clean environment has incalculable value for its own sake.  Others insist on a more pragmatic approach.  The EPA estimates that the CAA has saved trillions of dollars by preventing lost work and school days, illness, and premature deaths.  Sixty (60%) percent of the nation’s’ waters are now safe for fishing and swimming. In 1972, when the Clean Water Act was passed, it was 30%. But we face intractable problems: global warming, chemicals and more. Many environmental laws are tangled in litigation. The EPA is over whelmed with its duties, while Congress cuts its budget.

Matching Questions Match the following terms with their definitions: _____A. EPA 1. Regulates the cleanup of hazardous wastes improperly dumped in the past _____B. ESA 2. Establishes rules for treating newly created wastes _____C. NEPA 3. Protects red wolves _____D. CERCLA 4. The agency that regulates environmental policy in the U.S. _____E. RCRA 5. Requires all federal agencies to prepare an environmental impact statement Answers: JJJJ. 4 KKKK. LLLL.

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True/False Questions Circle T for true or F for false: (Correct answers are bolded) 119. T F In establishing national standards under the Clean Air Act, the EPA need not consider the cost of compliance. 120. T F The Clean Water Act requires anyone discharging pollution into navigable water to obtain a permit from the EPA. 121. T F Any individual, business, or federal agency that significantly affects the quality of the environment must file an EIS. 122. T F The number of acres of wetlands in the U.S. has remained roughly constant over the past decade. 123. T F Violating the environmental laws can be a criminal offense, punishable by a prison term.

Multiple Choice Questions 1. Which of the following statements are true of Superfund? I. Anyone who has ever owned a site is liable for clean-up costs. II. Anyone who has ever transported waste to a site is liable for clean-up costs. III. Anyone who has ever disposed of waste at a site is liable for clean-up costs. A. Neither I, II, nor III B. I, II, and III C. I and II D. II and III E. I and III Answer: B. 2. The EPA _________ have authority to regulate greenhouse gases. The states ____________ impose their own standards for these gases. A. Does; can B. Does; cannot C. Does not; cannot D. Does not; can Answer: A.

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3. For purposes of the Clean Water Act, Farmer Brown’s fields ________ a point source. A canal that collects rainwater and discharges it into the Everglades ________ a point source. A. are/is B. are/is not C. are not/is D. are not/is not Answer: C.

4. Which of the following statements is true? I. The EPA sets national air quality standards. II. The EPA is not allowed to develop plans to meet air quality standards. III. States have no right to set their own air quality standards. IV. The states develop plans to meet air quality standards. A. II and III B. III and IV C. I and IV D. I, III, and IV E. I and II Answer: C. 5. The Toxic Substances Control Act: A. Requires manufacturers to test for safety all chemicals before they can be used in products. B. Requires the EPA to test for safety all chemicals before they can be used in products. C. Requires the EPA to test all chemicals although they are already being used in products D. Permits the EPA to require testing of a chemical only if there is evidence that it is dangerous. Answer: D.

Case Questions 1. Tariq Ahmad decided to dispose of some of his laboratory’s hazardous chemicals by shipping them to his home in Pakistan. He sent the chemicals to Castelazo (a company in the United States) to prepare the materials for shipment. Ahmad did not tell the driver who picked up the chemicals that they were hazardous,nor did he give the driver any written documentation. What law has Ahmad violated? What does this law require? What penalties might he face?

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Answer: Ahmad was convicted of transporting hazardous waste in violation of the Resource Conservation and Recovery Act. He was subject to criminal penalties under the Act. United States v. Ahmad, 1995 U.S. App. LEXIS 28350 (9th Cir. 1995).

You Be the Judge: WRITING PROBLEM The Lordship Point Gun Club operated a trap and skeet shooting club in Stratford, Connecticut, for 70 years. During this time, customers deposited millions of pounds of lead shot and clay target fragments on land around the club and in Long Island Sound. Forty-five percent of sediment samples taken from the Sound exceeded the established limits for lead. Was the Gun Club in violation of the RCRA? Argument for the Gun Club: The Gun Club does not dispose of hazardous wastes, within the meaning of the RCRA. Congress meant the statute to apply only to companies in the business of manufacturing articles that produce hazardous waste. If the Gun Club happens to produce wastes, that is only incidental to the normal use of a product. Argument for the plaintiff: Under the RCRA, lead shot is hazardous waste. The law applies to anyone who produces hazardous waste, no matter how. Answer: The court held that the Gun Club was in violation of the RCRA because it was disposing of lead shot that was clearly hazardous waste as defined by the statute. It ordered the Gun Club to clean up the site and to obtain a permit for the operation of a hazardous waste disposal site. Connecticut Coastal Fishermen’s Assoc. v. Remington Arms Co., 989 F.2d 1305, 1993 U.S. App. LEXIS 6424 (2nd Cir. 1993).

3. Before the Department of Agriculture issued regulations on genetically modified beets, what steps did it need to take under the environmental statutes? Answer: The Department had to conduct an EA (environmental assessment) to determine if an EIS (environmental impact statement) was necessary. 4. Rundy Custom Homes was building a subdivision of new houses next to a stream. During the building process, pipes on the property discharged storm water with sediment into the stream. Is this legal? What statute applies? Who would be liable? What if the EPA fails to act ? Answer: No, it is not legal. The Clean Water Act applies. Rundy would be liable. If the EPA fails to act, citizens may sue under the Clean Water Act.

5. The Navy wanted to conduct training exercises off the coast of California for sonar submarines. Scientists were concerned that the sounds emitted by the sonar would harm marine mammals, such as whales, dolphins, and sea lions. Environmental groups filed suit, asking that the Navy prepare an EIS. The Navy responded that these training exercises were important for national security and therefore it did not have to prepare an EIS. Was the Navy correct? Answer: The court ruled that the Navy did not have to file an EIS. The president—the commander in chief—determined that training with sonar was essential to national security. The courts do not have enough information to overrule him on national security issues. Winter v. Natural Resources Defense Council, Inc., 555 U.S. 7(S.Ct. 2008). .

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Discussion Questions 1. Life is about choices. Life is about choices—and never more so than with the environment. Being completely honest, which of the following are you willing to do? Why? 

Drive a smaller, lighter, more fuel-efficient car?

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Take public transportation or ride your bike to work?

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Vote for political candidates who are willing to impose higher taxes on pollutants?

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Insulate your home?

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Unplug appliances when not in use?

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Recycle your wastes?

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Pay higher taxes to clean up Superfund sites? Answer: Answers will vary.

2. The Commonwealth of Virginia refused to prepare TMDLs for polluted Accotink Creek. When the EPA prepared its own set of TMDLs, Virginia sued to avoid compliance. Should Virginia be allowed to determine how much pollution to permit in its own waters? Alternatively, is it ethical for Virginia to refuse to comply with the law and to prolong the dispute with litigation? Answer: Answers will vary. 3. ETHICS Externalities pose an enormous problem for the environment. Often, the people making decisions do not bear the full cost of their choices. And businesses tend to fight efforts to make them pay these externalities. For example, CropLife America lobbied against a bill that would support research on the effects of chemicals on children. On the other hand, Nike resigned its seat on the board of the United States Chamber of Commerce in response to the Chamber’s active lobbying against legislation that would regulate greenhouse gases. But Nike decided to remain a member of the group. What ethical obligation do American companies have to support environmental legislation that may impose higher costs? Do they have an obligation to look out for the greater good, or should they focus on maximizing their shareholder returns? What Life Principles would you apply? What would Kant and Mill say? Answer: Answers will vary. 4. The Supreme Court ruled that, under the CAA, the EPA may not consider cost while setting air quality standards to protect the public health. A bipartisan group of 42 of the country’s most respected economists filed a brief arguing that, from an economic perspective, it is wrong not to consider costs. Should the EPQ consider costs in all of its decision? Or are some decisions priceless?

Answer: Answers will vary.

5. Is cost-benefit analysis an effective tool in environmental disputes? How do we measure the costs and benefits? How do we know what benefits we might gain from saving endangered © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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species, or improving visibility at the Grand Canyon? In the Entergy case, how does the EPA calculate the benefits of not squashing fish against intake screens? Should you survey people to ask them how much it is worth? Or just think in terms of lives saved or sick days avoided? Or should we protect the environment regardless of cost? Answer: Answers will vary.

Suggested Additional Assignments Research: Superfund Sites Divide students into groups and ask them to contact the EPA to determine if there are any Superfund sites in a designated state. If there are, ask students to discover:  How the site was created  Who is supervising its cleanup  Who is paying for the cleanup  How long the process has been going on  How long until it is completed, and  Whether there has been litigation over the cleanup. Research: Global Warming Ask students to find out more about global warming and be prepared to discuss their conclusions in class. In particular, they should consider:  Is global warming a serious problem?  What should our own government, and other governments, do?  What should they do personally?

Chapter 26 – Accountants’ Liability* Chapter Overview Chapter Theme Accountants serve many masters and, therefore, face numerous potential conflicts. After the Arthur Andersen disaster, accountants, regulators and the public have begun to re-think the role of the accounting profession. Shareholders expected accountants to be more careful watchdogs than, in many cases, they were. How will accountants handle the inherent conflict of interest between shareholders and the managers who pay the bills?

26-1 Introduction 26-1a Sarbanes-Oxley (SOX) Public Company Accounting Oversight Board (PCAOB): The PCAOB regulates public accounting firms. Congress established the PCAOB to ensure that investors receive accurate and complete financial information. The board has the authority to regulate public accounting firms, establishing everything from audit rules to ethics guidelines. All accounting firms that audit public companies must register with © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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the board, and the board must inspect them regularly. The PCAOB has the authority to revoke an accounting firm’s registration or prohibit it from auditing public companies.

Reports to Audit Committee Traditionally, auditors reported to the senior management of a client. This relationship created obvious conflicts of interest. Auditors were reporting concerns to the very people who could be causing or benefiting from these problems. Under SOX, auditors must report to the audit committee of the client’s board of directors, not to senior management.

Consulting Services As we saw in the chapter opening, Enron paid Arthur Andersen more for its consulting servic3s than for its auditing efforts. SOX prohibits accounting firms that audit public companies from providing consulting services to those clients on topics such as bookkeeping, financial information systems, human resources, and legal issues (unrelated to the audit). Any consulting agreements must be approved by a client’s audit committee. Auditing firms cannot base their employees’ compensation on sales of consulting services to clients.

Conflicts of Interest An accounting firm cannot audit a company if one of the client’s top officers has worked for that accounting firm within the prior year, and was involved in the company’s audit. In short, a client cannot hire one of its auditors to ensure a friendly attitude.

Term Limits on Audit Partners After five years with a client, the lead audit partner must rotate off the account for at least five years. Other partners must rotate off an account every seven years, for at least two years. If students did the research project on Sarbanes-Oxley, this would be an appropriate time for them to report their results.

26-1b Consolidation in the Accounting Profession Bonus Notes: The top of the accounting industry has become very concentrated. Instead of the existing Big Four accounting firms, there used to be eight. These four remaining firms audit 98% of all companies in the U.S. with revenues over $1 billion. With such concentration, you would expect audit fees to rise. But instead, the audit fees that companies pay per dollar of revenue have declined, even as SOX requires auditors to do more work. Are they doing more work as they are supposed to? ? Or are they taking risks because they believe that regulators are afraid to kill a Big Four firm? Should the Big Four be broken into smaller firms to enhance competition?

26-1c Audits Audits are a major source of potential liability for accountants, so we need to know what an auditor does.

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Accountants serve two masters - company management and the investing public. Management hires the accountants, but investors and creditors rely upon them to offer an independent evaluation of the financial statements that management issues. Now, the auditor is an independent evaluator of the financial statements issued by management to investors and creditors. The audit report of a CPA firm is practically required for entry to the capital markets; investors will not invest without it. Accountants now serve two masters – company management and the investing public. When conducting an audit, accountants verify information provided by management. Because it is impossible to check each and every transaction, they verify a sample of various types of transactions. If these are accurate, they assume all are. To verify transactions, accountants use two mirror image processes – vouching and tracing. Vouching: Auditors choose a transaction listed in a company’s books and check backward for original data to support it. Tracing: An auditor takes an item of original data and tracks it forward to ensure that it has been properly recorded. GAAP: “Generally accepted accounting principles,” the rules for preparing financial statements. GAAS: “Generally accepted auditing standards,” the rules for conducting audits. IFRS: “International financial reporting standards,” an international alternative to GAAP.

Discussion: GAAP: Students who completed the GAAP assignment should present their results now. GAAP is the acronym for generally accepted accounting principles, the rules for preparing financial statements. GAAS is the acronym for generally accepted auditing standards, the rules for conducting audits. The SEC has proposed a set of rules that would ultimately require U.S. companies to use international financial reporting standards (IFRS) instead of GAAP. Question: What is the advantage of using GAAP? Answer: If everyone follows the same careful rules, investors have a better understanding of what the numbers really mean. If people develop their own accounting rules, the results do not mean much. Question: Is GAAP enough to protect investors? Answer: The text suggests that although auditing forms can serve two masters: the public and management, management pays the fees. General Question: Is there a solution to this problem? General Question: Would such a system work?

International Standards In 2007, the SEC began allowing foreign companies to use IFRS. The SEC is considering a proposal that would allow U.S. companies to supplement their GAAP fillings with IFRS information.

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Opinions When the audit is complete, the accountant issues an opinion that indicates how accurately the financial statements reflect the company’s true financial condition. The auditor has four choices:  Unqualified Opinion: Also known as a clean opinion, it indicates that company’s financial statements fairly present its financial opinion in accordance with GAAP. This is most favorable.  Clean opinion: An unqualified opinion, the most favorable report an auditor can give.  Qualified Opinion: This indicates that although the financial statements are generally accurate, there is an outstanding, unresolved issue. The issue may involve a violation of GAAP or something else whose resolution is uncertain.  Adverse Opinion: This opinion is definitely bad news. In the auditor’s view, the company’s financial statements do not accurately reflect its financial position.  Disclaimer of Opinion: An auditor issues this when it does not have enough information to form an opinion. Bonus Notes: But if the auditor knows that the statements are inaccurate, she cannot hide behind a disclaimer of opinion; she must issue an adverse opinion. Example: What Does “Material” Mean? W. R. Grace had an unusual problem–earnings in one of its units were too high. Grace executives knew that if they reported these numbers accurately, their bosses would set targets for the following year even higher. They feared they could not even match the current numbers, never mind an increase the next year. Their solution? They “parked” the excess earnings in a reserve account, intending to withdraw them when needed. Their accountant at PricewaterhouseCoopers LLP discovered the ploy but still issued a clean opinion, stating that the financials were “accurate in all material respects.” PricewaterhouseCoopers issued this opinion because the fake reserves were not material as part of the larger company; if this unit of Grace were stand-alone, the reserves would have been material. A PricewaterhouseCoopers spokesperson said that a clean opinion “doesn’t mean that the financial 122 statements are free from error or that the auditor agrees with everything.” Question: What does “material” mean? Answer: It means “important.” As a guideline, accountants often consider anything that would affect company earnings by 5 or 10% to be material. Question: What else could PricewaterhouseCoopers have done? Answer: It could have reported this issue to Grace’s audit committee, although one of the in-house auditors tried that and was first ignored and then fired. Now, under Sarbanes-Oxley, auditors for public companies must provide the audit committee with a description of any alternative options that the firm considered in preparing the financial statements. Question: What is the problem with this kind of manipulation? Answer: It undermines investor confidence in Grace and client confidence in PricewaterhouseCoopers. General Question: Should PricewaterhouseCoopers have refused to issue a clean opinion?

26-2 - Liability to Clients 26-2a Contract Engagement letter: A written contract by which a client hires an accountant.

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The contract contains both express and implied terms. The accountant expressly promises to perform a particular project by a given date, and also implies that she will work as carefully as an ordinarily prudent accountant would under the circumstances.

26-2b Negligence An accountant is liable for negligence to a client who can prove that:  The accountant breached his duty to the client by failing to exercise the degree of skill and competence that an ordinarily prudent accountant would under the circumstances, and  The accountant’s violation of duty caused harm to the client.

Case: Oregon Steel Mills, Inc. v. Coopers & Lybrand, LLP123 Facts: Oregon Steel Mills, Inc. was a publicly-traded company whose financial statements were audited by Coopers & Lybrand, LLP. When Oregon sold the stock in one of its subsidiaries, Coopers advised Oregon that the transaction should be reported as a $ 1 million gain. Two years later, Oregon began a public offering of additional shares of stock. It intended to sell these shares to the public on May 2. Shortly before Oregon planned to file the stock offering with the SEC, Coopers told the company that the sale of its subsidiary had been misreported and that it would have to revise its financial statements. As a result, the offering was delayed from May 2 to June 13. During this period of delay, the price of the stock fell. Oregon filed suit against Coopers, seeking as damages the difference between 2what Oregon actually received for its stock, and what it would have received if the offering had occurred on May 2 – an amount equal to approximately $35 million. You Be the Judge: Was Coopers’ liable for Oregon’s loss? Argument for Oregon: Coopers was negligent in giving advice4 to Oregon. As a result, Oregon had to delay its securities offering for six weeks. During this time, the market price of Oregon stock fell, with the result that the company sold the new stock for $35 million less than it would have received on the original sale date. Someone is going to suffer a $35 million loss. It should be Coopers, which caused the loss, rather than Oregon, which was blameless. Argument for Coopers: It is true that Coopers was negligent, the market price of the stock fell, and Oregon suffered a loss. However, to recover for negligence, the plaintiff must show that the loss was reasonably foreseeable. When Coopers made its error, no one could foresee that wo years later, Oregon’s securities offering would be delayed by six weeks and it would suffer a loss as a result. At the time of its mistake, Coopers did not know when the offering would take place, nor that one date would be more favorable than another. The decline in stock price was unrelated to Oregon’s financial condition or Cooper’s conduct. Coopers is not liable.

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Holding: Judgment for Coopers affirmed. The court concluded that the risk of a decline in Oregon’s stock price in June was not a reasonably foreseeable consequence of Coopers’ negligent acts. It is of course foreseeable that stock prices will fluctuate, and that an accounting firm’s negligence may harm a client by delaying its ability to raise capital, but Coopers did not cause the decline in Oregon’s stock price. Coopers knew that Oregon intended to enter the market and sell its securities, but at the time of Coopers’ wrongful conduct the schedule for that offering was known only in the most general sense. Also, there is no evidence in the record that Oregon expected market forces to be particularly favorable on May 2. Question: Was Coopers negligent in advising Oregon on the gain from the sale of its subsidiary? Answer: Yes. Question: Did this negligence cause a delay in Oregon’s public offering? Answer: Yes. Question: Did Oregon receive less money in the public offering because of the delay? Answer: Yes, Oregon’s stock price fell from $16 to $13.50. As a result, Oregon received $35 million less. Question: Is Coopers liable for this harm that resulted from its negligence? Answer: No. because Coopers’ negligence did not cause the harm. Question: What did cause Oregon’s harm? Answer: The decline in its stock price between May 2 and June 13. Question: What caused this decline? Answer: Market forces, not Coopers’ negligence. Question: I’m still confused. Could you give another example? Answer: If a professor lets class out late and one of the students is then hit by a falling brick as she leaves the building, it’s fair to say that the harm to the student resulted from the professor’s error. However, the professor did not cause the harm to the student and would not be liable.

26-2c Common Law Fraud Accountants are liable to their clients for fraud if (1) they makes a false statement of a material fact, (2) they either know it is not true or recklessly disregards the truth, (3) the client justifiably relies on the statement and (4) the reliance resulted in damages. For example, William deliberately inflated numbers in the financial statements he prepared for Tess so that she would not discover that he had made some disastrous investments for her. Because of these distortions, Tess did not realize her true financial position for some years. William committed fraud. A fraud claim is an important weapon because it permits the client to ask for punitive damages. In negligence or contract cases, a client is typically entitled only to compensatory damages. Punitive damages can be several times higher than a compensatory claim.

26-2d Breach of Trust Accountants occupy a position of enormous trust because financial information is often sensitive and confidential. Clients may put as much trust in their accountants as they do in their lawyers, clergy, or psychiatrists. Accountants have a legal obligation to (1) keep all client information confidential and (2) use client information only for the benefit of the client.

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Alexander Grant & Co. did accounting work for Consolidata Services, Inc. (CDS), a company that provided payroll services. The two firms had a number of clients in common. When Alexander Grant discovered discrepancies in CDS's client funds accounts, it notified those companies that were clients of both firms. Not surprisingly, these mutual clients fired CDS, which then went out of business. The court held that Alexander Grant had violated its duty of trust to CDS.

26-3 Liability to Third Parties No issue in the accounting field is more controversial than liability to third parties. Plaintiffs argue that auditors owe a duty to a trusting public (creditors, investors, etc.) that physicians and other professionals do not have. The job of the auditor is to provide an independent, professional source of assurance that a company’s audited financial statements are accurate. If the auditors do their job properly, they have nothing to fear. The accounting professional rebuts that if everyone who has ever been harmed even remotely by a faulty audit can recover damages, there will soon be no auditors left. Accountants are generally not liable to third parties in contract, as they are not in privity. Discussion: Liability to Third Parties: When conducting an audit, accountants serve three masters: the company’s officers, its board of directors, and its investors. Question: Who hires the accounting firm and pays its bill? Answer: Company officers. Question: What incentive does that create for the auditors? Answer: Not to be too tough on management. Question: Who, besides company officers, is concerned about the company’s financial health? Answer: The board of directors, investors, creditors, and suppliers. Investors, creditors, and suppliers consider a clean audit a green light to do business with the company. Question: What duty do the auditors owe to the board of directors? Answer: The board of directors, more than company officers, is really their client. Indeed, under Sarbanes-Oxley, auditors must report to the audit committee of the client’s board of directors, not to senior management. The accountants must inform the audit committee of any: significant flaws they find in the company’s internal controls; alternative options that the firm considered in preparing the financial statements; and accounting disagreements with management. Furthermore, under the Private Securities Litigation Reform Act, which Congress passed in 1995, auditors who suspect that a client has committed an illegal act that may have a material impact on the financial statements: Must ensure that the client’s board of directors is notified. If the board fails to act, the auditors must issue an official report to the board. If the board receives such a report, it must notify the SEC. If the auditors do not receive a copy of this notice, they must notify the SEC themselves. Question: What about the auditors’ liability to third parties such as investors and suppliers? Answer: Auditors face two sources of liability toward third parties: the common law rules of negligence and federal securities laws.

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Accountants who fail to exercise due care are liable to (1) anyone they knew would rely on the information and (2) anyone else in the same class.

Case: Ellis v. Grant Thornton124 Facts: For five years, the First National Bank of Keystone issued many risky mortgage loans on which borrowers defaulted. Keystone Management also lied about the value of the loans. When the Office of the Comptroller of the Currency (OCC) began to smell trouble, it required Keystone to hire a nationally recognized independent accounting form to audit its books. Keystone hired Grant Thornton (GT), who assigned Stan Quay as the lead partner on the account. As Quay was finishing up his audit, the board began talking with Gary Ellis about becoming president of the bank. Ellis already had a perfectly good job, so he was reluctant to move to a bank that the OCC was investigating. To reassure him, the Keystone board suggested he talk with Quay and look at the bank’s financials. Quay told Ellis that Keystone would receive a clean, unqualified opinion. Quay did ultimately issue a clean opinion reporting shareholder’s equity of $184 million, when in fact the bank was insolvent to the tune of hundreds of millions of dollars. The first page of the report stated: “This report is intended for the information and use of the Board of Directors and Management of the First National Bank of Keystone and its regulatory agencies and should not be used by third parties for any other purpose.” A week later, the Board voted to hire Ellis, who quit his job elsewhere to join Keystone. Five months later, the OCC declared Keystone insolvent and shut it down. Ellis was out of work. He filed suit against GT, seeking compensation for his lost wages. The district court ruled in favor of Ellis and granted him $2.5 million in damages. GT appealed. Issue: Was GT liable to Ellis for its negligence in preparing keystone’s financial statements? Decision: GT was not liable. Reasoning: GT prepared its audit for the benefit of Keystone and the OCC. Keystone did not pay GT to review the bank’s financial position with potential employees and, indeed, the accountants did not know about Ellis’s involvement until after it had decided to issue the clean opinion. GT was not aware that it might be held liable for Ellis’s lost wages. If the accountant is unaware of the risk, it cannot be held liable. Question: How is an accountant’s liability to third parties determined? Answer: An accountant who fails to exercise due care is liable to a third party if (1) it was foreseeable that the third party would receive financial statements from the accountant’s client, and (2) the third party relied on the statements.

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26-3b Fraud An accountant who commits fraud is liable to any foreseeable user of the work product who justifiably relied on it. This rule applies in all jurisdictions, even those that have adopted the Ultramares doctrine.

26-3c Securities Act of 1933 Due diligence: An investigation of a registration document. The Securities Act of 1933 requires a company to file a registration statement containing audited financial statements before offering securities for sale. Accountants will be liable if: 1. the registration statement contained a material misstatement or omission, and 2. the plaintiff lost money. However, auditors can avoid liability under §11 by showing that they made a reasonable investigation of the financial statements and had reasonable grounds to believe the statements did not contain material omissions or misstatements. This investigation is called due diligence.

26-3e Securities Exchange Act of 1934 A company that is subject to the 1934 Act must file with the SEC an annual report containing audited financial statements and quarterly reports with unaudited financials.

Fraud In these filings under the 1934 Act, an auditor is liable for making (1) a misstatement or omission of a material fact (2) knowingly or recklessly with the intent to deceive, manipulate, or defraud (3) that the plaintiff relies on in purchasing or selling a security. Accountants are liable under §10(b) only if they know their statement is wrong or they are reckless in checking the accuracy of their reports. This requirement is called scienter. Scienter: An action is done knowingly or recklessly with an intent to deceive, manipulate, or defraud. Because this concept is so important, we present two cases – one in which there was scienter and another one in which there was not. As you read the following case, you might ask yourself why Grant Thornton accountants were willing to do what they did.

Case: Gould v. Winstar Communs., Inc. 692 F.3d 148, U.S.Ct.App. 2nd Cir. (2011) Facts: Grant Thornton (GT) audited Winstar, a broadband communications company that provided businesses with wireless internet connectivity. Winstar was one of GT’s largest and most important clients, but only 12 percent of the company’s fees came from auditing, the rest were for consulting projects. Winstar asked that the partner in charge of its audit be replaced and also threatened to fire GT. In response, Winstar assigned two auditors who had no experience with telecommunications companies. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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When Winstar’s real revenues fell, it began to report fake ones. For example, at the end of the fiscal year, it reported that a large percentage of its revenue was from equipment sales to Lucent Technologies, a strategic partner. Equipment sales were not part of Winstar’s core business and there was little documentation that these sales had taken place. Winstar also engaged in round-trip transactions in which it overpaid other companies for goods and services and, in return, those companies bought unneeded equipment from Winstar. GT warned that the transactions were wrong, but issued an unqualified audit opinion. A year later, Winstar filed for bankruptcy protection and investors sued GT. Issues: Was GT liable to Winstar investors? Did it act with scienter? Decision: Yes, GT was liable because it acted with scienter. Reasoning: A finding of scienter requires evidence of deliberate illegal behavior. This standard is met (1) when conduct was so unreasonable that the defendant must have known it would cause harm or (2) when a defendant ignores obvious signs of fraud. The evidence that GT consciously ignored Winstar’s fraud goes beyond a mere failure to uncover wrongdoing. There was evidence that GT learned of and advised against the use of clearly deceptive accounting schemes, but eventually acquiesced in the schemes by issuing an unqualified audit opinion. GT argues that it should not be liable because its accountants had spent so much time and reviewed so many documents. But even great effort does not protect accountants who have nonetheless violated security laws. Question: What was the key issue in this case? Answer: Whether or not the defendants acted with scienter. Question: How would you define scienter? Answer: A defendant acts with scienter when an action is done knowingly or recklessly with an intent to deceive, manipulate, or defraud. Question: Why did the court find scienter in this case? Answer: the most damning evidence was that during the course of its audit, GT learned of and advised against the use of indisputably deceptive accounting schemes, but eventually went along with approving them, issuing a clean audit opinion. Question: Why do you think they did this? Answer: The case facts tell us that Winstar was one of GT’s largest clients, in particular in regards to consulting fees. As a result, GT might have been wary of raising concerns about Winstar because its own business relied so heavily on this client. Answers will vary.

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Case: Advanced Battery Techs., Inc. v. Bagell 781 F.3d 638, U.S.Ct.App. 2nd Cir. (2015) Facts: ABAT was a Delaware corporation that manufactured lithium batteries in China. It was required to file financial statements with both the U.S. Securities and Exchange Commission (SEC) and China’s Administration of Industry and Commerce (AIC). For four years, ABAT’s SEC filings reported increased revenues and profits while, at the same time, its AIC filings showed significant losses. When these discrepancies became public, the price of ABAT shares plunged. Shareholders sued ABAT’s auditors, Bagell, Josephs, Levine & Co., because the firm had issued clean audit opinions during this period. Issues: Was Bagell liable to ABAT investors? Did it act with scienter? Decision: No, Bagell was not liable because it had not acted with scienter. Reasoning: To show scienter, the plaintiff must present facts that constitute strong circumstantial evidence of conscious recklessness, that is, conduct that is highly unreasonable, representing an extreme departure from the standards of ordinary care and an actual intent to aid in the fraud being perpetrated by the audited company. Mere allegations of GAAP violations or accounting irregularities, or even a lack of due diligence, do not constitute securities fraud. The plaintiff argues that, when auditing ABAT’s SEC filings, Bagell should also have reviewed ABAT’s filings with AIC . However, neither GAAS nor GAAP requires an auditor to review a company’s foreign regulatory filings. The plaintiff also argues that the unusually high profit margins ABAT reported in its SEC filings triggered an obligation for Bagell to review the AIC filings. These profit margins might have triggered a duty to perform a more careful audit but they did not create an obligation to review the Chinese filings. Bagell’s failure to equate record profits with misconduct was not reckless. Question: What was the key issue in this case? Answer: Whether or not the defendants acted with scienter. Question: How would you define scienter? Answer: A defendant acts with scienter when an action is done knowingly or recklessly with an intent to deceive, manipulate, or defraud. Question: Was that proven in this case? Answer: No. The court said that the discrepancy between the securities filings in China and the U.S. was most likely explained by the fact that ABAT had two different sets of data, one for the U.S., and one for China, and that it provided its Bagell auditors with the set of U.S. data Question: What did Sanderson argue Bagell should have done? Answer: Sanderson argued that Bagell should have asked for the Chinese filings for confirmation, at which time, they would have discovered ABAT’s fraud. Question: Does the fact that they did not seek the Chinese filings or the data underlying it represent scienter? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No, the court determined that scienter required an active participation in the fraud, or circumstances that must have led the auditor to knowingly participate in the fraud. Question: Was that prove here? Answer: No. Nothing ABAT did demonstrated scienter of ABAT’s fraud. Note: That the judge who wrote the opinion finding scienter and not finding scienter is the same judge.

The following bonus case is famous for its landmark interpretation of §10(b) .

Bonus Landmark Case: Ernst & Ernst v. Hochfelder125 Facts: For 19 years, Ernst & Ernst audited a small brokerage firm, First Securities Company of Chicago (First Securities). Leston B. Nay was president of the firm and owned 92 percent of its stock. He convinced some customers to invest funds in “escrow” accounts that would yield a high rate of return. And, indeed, from 1942 through 1966, they did. The investments were unusual in that the customers wrote their checks to Nay personally, not to First Securities. None of these escrow accounts appeared in First Securities’ records. As you perhaps have guessed, there were no escrow accounts. Nay was spending the customers’ money on himself. The fraud came to light when Nay killed himself, leaving a note that described First Securities as bankrupt and the escrow accounts as “spurious.” In investigating the fraud, customers discovered that Nay had had a rigid rule prohibiting anyone else from ever opening mail addressed to him, even if it arrived in his absence. The customers alleged that if Ernst had done a proper audit, they would have found out about this mail rule which would have led to an investigation of Nay and discovery of the fraud. The customers filed suit against Ernst under §10(b). The accounting firm filed a motion for summary judgment, alleging that liability under §10(b) requires scienter, that is, an intent to deceive, manipulate, or defraud. Ernst admitted that it had been negligent but denied any intentional wrongdoing. The trial court granted Ernst’s motion, the Court of Appeals reversed and the Supreme Court granted certiorari. Issue: Was Ernst liable under §10(b) when it acted negligently but not intentionally? Excerpts from Justice Powell’s Decision: Section 10(b) makes unlawful the use or employment of “any manipulative or deceptive device or contrivance” in contravention of Commission rules. The words “manipulative or deceptive” used in conjunction with “device or contrivance” strongly suggest that § 10 (b) was intended to proscribe knowing or intentional misconduct. In view of the language of § 10 (b), which so clearly connotes intentional misconduct, and mindful that the language of a statute controls when sufficiently clear in its context, further inquiry may be unnecessary. We turn now, nevertheless, to the legislative history of the 1934 Act. The most relevant exposition of the provision that was to become § 10 (b) was by Thomas G. Corcoran, a spokesman for the drafters. Corcoran indicated: § 10 (b) says, “Thou shalt not devise any other cunning devices. The Commission should have the authority to deal with new manipulative devices.” It is difficult to believe that any 125

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lawyer, legislative draftsman, or legislator would use these words if the intent was to create liability for merely negligent acts or omissions. Holding: The judgment of the Court of Appeals is Reversed. Question: What was the result for Ernst? Answer: Ernst’s motion for summary judgment was granted. The Supreme Court said §10(b) prohibits “knowing or intentional misconduct.” Ernst did not act intentionally negligent. The above landmark case establishes the need for scienter.

Whistleblowing Auditors who suspect that a client has committed an illegal act must ensure that the client’s board of directors is notified. If the board fails to take appropriate action, the auditors must issue an official report to the board. If the board receives such a report from its auditors, it must notify the SEC within one business day and send a copy of this notice to the auditors. If the auditors do not receive this copy, they must notify the SEC themselves.

Joint and Several Liability Joint and several: All members of a group are liable. They can be sued as a group, or any of them can be sued individually for the full amount owing. But the plaintiff may not recover more than 100 percent of her damages. Congress has amended the 1934 Act to provide that accountants are liable jointly and severally only if they knowingly violate the law. Otherwise, the defendants are proportionately liable.

26-4 Criminal Liability Thus far, this chapter has focused on civil liability. The penalty for a civil offense is the payment of monetary damages. However, some offenses are criminal acts for which the punishment is a fine and imprisonment:  The Justice Department has the right to prosecute willful violations under either the 1933 Act or the 1934 Act.  The Internal Revenue Code imposes various criminal penalties on accountants for wrongdoing in the preparation of tax returns.  Many states prosecute violations of their securities laws. Returning for a moment to the opening scenario, this landmark case followed Arthur Andersen’s conviction.

Bonus Case: Arthur Andersen LLP v. United States126 Facts: Arthur Andersen audited Enron Corporation’s financial statements. When Enron’s financial and accounting problems began to surface at the beginning of August, a senior accountant at Enron told two 125 S. Ct. 2129; 2005 U.S. LEXIS 4348 Supreme Court of the United States, 2005 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Andersen partners that Enron could face severe accounting scandals. Shortly thereafter, the SEC opened an informal investigation. Early in October, Nancy Temple, a lawyer at Andersen, realized that an SEC investigation was highly probable. A few days later, at a general training meeting attended by 89 employees, including 10 from the Enron engagement team, Odom, an Anderson partner, urged everyone to comply with the firm’s document retention policy. He added: “If it’s destroyed in the course of the normal policy and litigation is filed the next day, that’s great . . . . We’ve followed our own policy, and whatever there was that might have been of interest to somebody is gone and irretrievable.” Three times that month, Temple reminded Andersen employees to follow the document retention policy. Andersen employees did indeed destroy a substantial number of paper and electronic documents. At a meeting on October 31, Duncan picked up a document with the words “smoking gun” written on it and began to destroy it, adding “we don’t need this.” On October 30, the SEC opened a formal investigation and sent Enron a letter that requested accounting documents. In November, the SEC served Enron and Andersen with subpoenas for records. Duncan’s assistant then sent an e-mail that stated: “Per Dave -- No more shredding . . . . We have been officially served for our documents.” Andersen was indicted for obstruction of justice, that is, intentionally persuading its employees to withhold documents from an official proceeding. A jury returned a guilty verdict. The Court of Appeals affirmed and the Supreme Court granted certiorari. Issue: Did Andersen employees commit a crime when they destroyed Enron documents? Holding: Conviction of Andersen reversed. Document retention policies are legal, even though they are designed to keep information from falling into the hands of others, including the government. To violate the law, Andersen had to know that what it did was illegal. Instead, the jury was told that, “even if [Andersen] honestly and sincerely believed that its conduct was lawful, you may find [Andersen] guilty.” And there also had to be some evidence that Andersen was aware of a particular proceeding, not just aware of the general possibility that there might be a proceeding. Question: What did Andersen do that upset government prosecutors? Answer: It destroyed documents that might have been useful in assessing the Enron accounting scandals. Question: Why did it destroy documents? Answer: Andersen was clearly concerned about potential liability for its work on Enron. Question: Did it know that the government would prosecute it or Enron? Answer: It did not know of any particular government case. Question: How did Andersen decide which documents to destroy? Answer: It urged its employees to comply with the firm’s “document retention policy.” Question: Is a document retention policy illegal? Answer: No. The court clearly states that such a policy is legal, even though the purpose is to keep documents out of the hands of the government. Question: What is illegal, then? Answer: It is illegal to destroy documents knowing that the government will want them in a particular lawsuit. There has to be some intention to “subvert” the government lawsuit. Question: Was this result important for Andersen? Answer: It was undoubtedly a relief to have the criminal conviction overturned, but the firm had already been destroyed by the original guilty verdict. Note also, that the court did not hold that © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Andersen was not guilty, it simply ruled that the jury instructions had been wrong. It was possible that Andersen would have been convicted in a retrial.

26-5 Other Accountant-Client Issues 26-5a The Accountant-Client Relationship SEC rules require accountants to maintain independence from the companies they audit. For example, an auditor or her family must not, for example, maintain a financial or business relationship with a client. SEC rules of practice specify that an accountant who engages in “unethical or improper professional conduct” may be banned from practice before the SEC.

26-5b Accountant-Client Privilege Traditionally, an accountant-client privilege did not exist under federal law. Accountants were under no obligation to keep confidential any information they received from their clients. In one notorious case, the IRS suspected that the owner of a chain of pizza parlors was underreporting his income. The agency persuaded the owner’s COPA to spy on him for eight years. (The IRS agreed to drop charges against the CPA who had not paid his own taxes for three years.) Thanks to the information the CPA passed to the IRS, his client was indicted on criminal charges of evading taxes. Then Congress passed the Internal Revenue Service Restructuring and Reform Act which provides limited protection for confidential communications between accountants and clients. That is the good news, the bad news is the word “limited.” This new privilege applies only in civil cases involving the IRS or the U.S. Government. It does not apply to criminal cases, civil cases not involving the U.S. government, or cases with other federal agencies such as the SEC. Nor does it apply to the preparation of tax returns. This new accountant-client privilege would not have protected the CPA’s client, because he was charged with a criminal offense. Some states recognize an accountant-client privilege, but it applies only to issues of state law, and provides no protection against federal charges. The following bonus case reveals some of the contours of this privilege.

Bonus Case: McNair v. The Eighth Judicial District Court127 A court in Nevada entered an award in favor of Mark and Janet Brandell for $435,066.82 against United Productions, Inc. (UP) and Harry R. Jones. When UP and Jones failed to pay the judgment, the court ordered both of them to appear and answer questions concerning their property. Neither obeyed the order. In an attempt to execute the judgment, the Brandells subpoenaed Sharon J. McNair, who had worked as an accountant for both UP and Jones for 15 years. McNair appeared but refused, on the grounds of accountant-client privilege, to answer the following questions:  In the course of your duties as an accountant for UP did you prepare tax returns?  What type of work did you do for UP from the mid-1980s to the present? 127

110 Nev. 1285, 885 P.2d 576, 1994 Nev. LEXIS 157 Supreme Court of Nevada, 1994 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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                  

What type of accountant work did you do for Jones from 1980 to the present? Do you have any tax returns for UP? Have you prepared tax returns for UP from the mid-1980s to the present? Do you have in your possession tax returns for UP from the mid-1980s to the present? What is the most recent tax return you prepared for UP? What is the most recent tax return you have prepared for Jones? Do you handle the banking for UP? Do you handle the banking for Jones? What documents do you have in your possession regarding accounting records of UP? Have you ever prepared any accounts receivable for UP? Have you ever prepared any accounts receivable ledgers for UP? Have you ever prepared any accounts receivable ledgers for Jones? Do you have in your possession any documents reflecting the sale of any assets of UP? Within the last five years to your knowledge has UP sold any of its assets? Is UP still in existence to your knowledge? Is Jackie Do Los Reyes still a stockholder of UP? Who are the stockholders of UP? Have you ever prepared any financial statements for UP? Have you ever prepared any financial statements for Jones?

The district court held McNair in contempt, and she appealed. Issue: Are the answers to any of these questions protected by the accountant-client privilege? Holding: The Nevada Supreme Court held that McNair was in contempt. The purpose of the accountant-client privilege is to ensure an atmosphere wherein the client will transmit all relevant information to his accountant without fear of any future disclosure in subsequent litigation. To claim this privilege, McNair had to show that the information was confidential and not accessible to the public, which she did not do. Most of the questions could have been answered by a simple “yes” or “no.” Question: What is the purpose of the accountant-client privilege? Answer: The purpose of the privilege is to ensure that the client will not be afraid to talk to his accountant out of fear that she will disclose information in subsequent litigation. Question: Does the accountant-client privilege mean that an accountant cannot disclose anything her client tells her? Answer: No, this privilege covers only information that is confidential and not accessible to the public. Question: To which of the questions in the case should the privilege extend? Answer: The court held that the privilege did not extend to any of the questions because none of them was based on confidential information that was inaccessible to the public.

Working Papers When working for a client, accountants use the client’s documents and also prepare working papers of their own. In theory, each party owns whatever it has prepared itself, but in practice, the client controls even the accountant’s working papers. The accountant: © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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1. cannot show the working papers to anyone without the client’s permission (or a valid court order) 2. must allow the client access to the working papers. Under SOX, accountants for public companies must keep all audit work papers for at least seven years.

Chapter Conclusion Accountants serve many masters. Clients, third parties, and the government all rely on their work. Privy to clients’ most intimate financial secrets, accountants must decide which of these secrets to reveal and which to keep confidential. The wrong decision may destroy the client, impoverish its shareholders, and subject its auditors to substantial penalties.

Matching Questions Match the following terms with their definitions: _____A. GAAS 1. Rules for preparing financial statements _____B. Tracing 2. When accountants check backward to ensure there are data to support a transaction _____C. Qualified opinion 3. Clean opinion _____D. GAAP 4. Rules for conducting audits _____E. Vouching 5. When accountants check a transaction forward to ensure it has been properly recorded _____F. Unqualified opinion 6. When there is some uncertainty in the financial statements Answers: OOOO. PPPP. QQQQ. RRRR. SSSS. TTTT.

4 5 6 1 2 3

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 124. T F Auditors are liable under the 1933 Act only if they intentionally misrepresent financial statements. 125. T F Auditors generally are not liable if they follow GAAP and GAAS. 126. T F Under the 1934 Act, accountants are liable for negligent behavior. 127. T F If auditors discover that company officers have committed an illegal act, they must always report this wrongdoing to the SEC. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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128. T F Under federal law, accounting firms may not provide any consulting services to companies that they audit.

Multiple Choice Questions 1.

To be successful in a suit under the Securities Act of 1933, the plaintiff must prove: Important mistake in the registration statement

Plaintiff lost money

Yes

Answer: D.

2. For an accountant to be liable to a client for conducting an audit improperly, the accountant must have: A. acted with intent. B. been a fiduciary of the client. C. failed to exercise due care. D. executed an engagement letter. Answer: C.

3. Which of the following statements about Sarbanes-Oxley is false? A. All accounting firms that audit public companies must register with the PCAOB. B. Auditors must report to the CEO of the company they are auditing. C. Auditing firms cannot base their employees’ compensation on sales of consulting services to clients. D. An accounting firm cannot audit a company if one of the client’s top officers has worked for that firm within the prior year and was involved in the company’s audit. E. Every five years, the lead audit partner must rotate off an audit account. Answer: B.

For a client to prove a case of fraud against an accountant, the following element is not required: 4.

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A. The client lost money. B. The accountant made a false statement of fact. C. The client relied on the false statement. D. The accountant knew the statement was false. E. The accountant was reckless. Answer: A. Dusty is trying to buy an office building to house his growing consulting firm. When Luke, a landlord, asks to see a set of financials, Dusty asks his accountant Ellen to prepare a set for Luke. Dusty shows these financials to a number of landlords, including Carter. Dusty rents from Carter. Ellen has been careless and the financials are inaccurate. Dusty cannot pay his rent and Carter files suit against Ellen. Which of the following statements is true? 5.

A. Carter will win because Ellen was careless. B. Carter will win because Ellen was careless and she knew that landlords would see the financials C. Carter will lose because Ellen did not know that he would see the financials. D. Carter will lose because he had no contract with Ellen. Answer: B. Ted prepared fraudulent financial statements for the Arbor Corp. Lacy read these statements before purchasing stock in the company. When Arbor goes bankrupt, Lacy sues Ted. 6.

A. Lacy will win because it was foreseeable that she would rely on these statements. B. Lacy will win because Ted was negligent. C. Lacy will lose because she did not rely on these statements. D. Lacy will lose because it is not foreseeable that she would rely on these statements. Answer: A.

Case Questions 1. After reviewing Color-Dyne’s audited financial statements, the plaintiffs provided materials to the company on credit. These financial statements showed that Color-Dyne owned $2 million in inventory. The audit failed to reveal, however, that various banks held secured interests in this inventory. The accountant did not know that the company intended to give the financial statements © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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to plaintiffs or any other creditors. Color-Dyne went bankrupt. Is the accountant liable to plaintiffs under the Restatement doctrine? Answer: The accountant was not liable. 356 S.E.2d 198 (Ga. 1987). 2. The British Broadcasting Corp. (BBC) broadcast a TV program alleging that Terry Venables, a former professional soccer coach, had fraudulently obtained a £1 million loan by misrepresenting the value of his company. Venables had been a sportscaster for the BBC but had switched to a competing network. The source of the BBC’s story was “confidential working papers” from Venables’s accountant. According to the accountant, the papers had been stolen. Who owns these working papers? Does the accountant have the right to disclose the content of working papers? Answer: Although, in theory, the accountant owns the working papers, he may not disclose confidential client information without the client’s permission. Ian Burrell and Adrian Levy, “Venables to Sue BBC Chief Over ‘Stolen’ Papers,” Sunday Times, July 16, 1995, Home News section. 3. Medtrans, an ambulance company, was unable to pay its bills. In need of cash, it signed an engagement letter with Deloitte to perform an audit that could be used to attract investors. Unfortunately, the audit had the opposite effect. The unaudited statements showed earnings of $1.9 million, but the accountants calculated that the company had actually lost about $500,000. While in the process of negotiating adjustments to the financials, Deloitte resigned. Some time passed before Medtrans found another auditor, and, in that interim, a potential investor withdrew its $10 million offer. Is Deloitte liable for breach of contract? Answer: Although a jury found for the plaintiffs, the court of appeals overruled, holding that an auditor does not breach the engagement letter if he resigns for good cause. National Medical Transportation Network v. Deloitte & Touche, 62 Cal. App. 4th 412, 1998 Cal. App. LEXIS 228. 4. A partnership of doctors in Billings, Montana, sought to build a large office building. When it decided to finance this project using industrial revenue bonds under a complex provision of the Internal Revenue Code, it hired Peat Marwick to do the required financial work. The deal was all set to close when It was discovered that the accountants had made an error in structuring the deal. As a result, the partnership was forced to pay a significantly higher rate of interest. When the partnership sued Peat for breach of contract, the accounting firm asked the court to dismiss the claim on the grounds that the client could only sue for the tort of negligence, not for breach of contract. Peat argued that it had performed its duties under the contract. The statute of limitations had expired for a tort case, but not for a contract case. Should the doctors’ case be dismissed? Answer: The jury found that Peat Marwick had breached its express or implied contract. The district court held that the allegations of the claims in this case could be stated either in tort or in contract, and the appeals court confirmed. Billings Clinic v. Peat Marwick Main, 797 P.2d 899 (Mont. 1990). 5. James T. Adams was a partner at Deloitte – a partner with a gambling issue. He ended up borrowing tens of thousands of dollars from a casino – a casino that he was in charge of auditing. Does he face any penalties? If so, what? Answer: Yes, Adams violated the auditor independence rules because he had a business relationship with an audit client. He was also guilty of improper professional conduct. The case was resolved by an Offer of Settlement in which Adams promised to cease and desist from committing any further violations. His privilege of appearing or practicing before the SEC was suspended for two © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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years, after which he could apply for reinstatement. In the Matter of James T. Adams, CPA, Admin Proceeding File No. 3-15876 SEC 6. An accounting team’s worst nightmare night be to wake up one morning and discover that a company for which it had repeatedly issued clean opinions did not really exist. In fact, the company had been stolen a few years earlier – its operations and related revenues all transferred away. Shareholders sued the auditors under §10(b) but the court granted the accountants’ request for summary judgment. Why? Answer: The court held there was no scienter because the plaintiffs had not alleged that the auditors had actual knowledge of the fraud but rather that they conducted an inadequate audit and missed red flags. That was not sufficient to establish scienter. In re Puda Coal Secs., Inc., 30 F.Supp.3d 230 (S.D.N.YH. 2014).

Discussion Questions ETHICS Pete, an accountant, recommended that several of his clients invest in Competition Aircraft. These clients passed this recommendation on to Arlene, who did invest. Unfortunately, Competition was a fraudulent company that pretended to sell airplanes. After the company went bankrupt, she sought to recover from Pete. Is Pete liable to Arlene? Whether or not Burnett faces legal liability, is it a good idea for accountants to recommend investments to clients? Does that practice create any potential conflicts of interest? 1.

Answer: An accountant may have liability for making investment recommendations to his client, but Arlene was not his client. He had no fiduciary relationship with her and, thus, no liability. 2. Should the IFRS be adopted in the United States? What result would be best for companies? For investors? Answer: Answers will vary. 3. Are the SOX rules on consulting services sufficiently strict? Should auditing firms be prohibited from performing any consulting services to companies that they audit? Answer: Answers will vary. 4. Some argue that investors have unrealistic expectations about what an audit can accomplish, especially at the prices companies are willing to pay their accountants. Critics respond that this view is just another way of saying: “Given how much money firms want to earn each year, they may not spend as much time as they should on an audit, especially in a complex situation..” Arthur Andersen got in trouble, in part, because of its desire to maintain high levels of profitability. Should the government create new regulations for audits, or are current rules sufficient? Answer: Answers will vary. 5. Under the 1934 Act, accountants are only liable if they act with scienter. Make an argument that they should be liable for negligence. What do you think is the right standard? Answer: Answers will vary. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Suggested Additional Assignments Interview Ask students to interview a certified public accountant who audits companies (as opposed to one who specializes in taxation). Students should ask the following:  Is the accountant concerned about increased liability?  Has she made any changes in the way she practices her profession as a result of concerns about liability?  What kind of liability insurance does she have?  Has she ever had an issue over the accountant-client privilege? Research: GAAP & GAAS Ask students to research and prepare a one-page report summarizing some recent changes or updates to generally accepted accounting principles (GAAP) or generally accepted auditing standards (GAAS) issued by the Financial Accounting Standards Board (FASB). They may want to start their research at the FASB website: http://www.fasb.org. Research: U.S. Accounting Standards v. International Accounting Standards Ask students to research the differences between U.S. accounting standards and International accounting standards. Have students include in the research the recent proposal by the Securities and Exchange Commission (SEC) to shift from US standards to international standards for many large multinational companies. Research: Sarbanes-Oxley Have students research the passage and implementation of the Sarbanes-Oxley Act of 2002 and address the following questions in a brief report:  What problems does the act address?  What must businesses and accounting firms do to comply with its requirements?  What are the costs of complying with Sarbanes-Oxley?  Can they find studies or commentary on whether Sarbanes-Oxley has been effective in achieving its goals?

Chapter 27 – Intellectual Property* Chapter Overview Chapter Theme Intellectual property is a major source of economic prosperity and individual wealth. New ideas increase both productivity and pleasure. Where would we be, as a society, without intellectual property–patented inventions, books, movies, computer software?

Chapter 27 For much of history, land was the most valuable form of property. Today, intellectual property (IP) is a major source of wealth. But land and intellectual property are fundamentally different:  The value of land lies in the owner’s right to exclude others.  But intellectual property has little economic value unless others use it. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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This ability to share intellectual property is both good news and bad news: The owner can produce and sell unlimited copies of, say, a song, but has no easy way to determine if someone is using the song for free; the high cost of developing intellectual property, combined with the low cost of reproducing it, makes it particularly vulnerable to theft The role of intellectual property law is to balance the rights of those who create intellectual property and those who would enjoy - or need it.

In this chapter, we examine four types of intellectual property: patents, copyrights, trademarks, and trade secrets.

27-1 Patents Patent: A patent gives an inventor the right to prevent others from making, using, or selling their invention for a limited time.

27-1a Types of Patents There are three types of patents:  Design patents. A design patent protects the appearance, not the function, of an item.  Plant patents. One who creates a new type of plant can patent it, provided that he is able to reproduce it through grafting.  Utility patents. When people use the word “patent” this is the kind they are speaking of. About 94% of all patents are utility patents. Utility patents are available to those who invent or significantly improve any of the following:

27-1b Requirements for a Utility Patent Novelty: An invention must be new to be patentable. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Nonobviousness: An invention must be unexpected to be patentable. Utility: An invention must be useful for its stated purpose to be patentable. To receive a patent, an invention must be:  Novel  Nonobvious  Utility  Patentable subject matter The Limits of Patentable Subject Matter: Living Organisms In 1980, the Supreme Court ruled that living organisms could be patented if they were different from anything found in nature and a product of human ingenuity. But the Supreme Court later clarified which were patentable; they did not include human genes.

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Case: Association For Molecular Pathology V. Myriad Genetics, Inc. Facts: Mutations in two genes known as BRCA1 and BRCA2 can dramatically increase the risk of breast and ovarian cancer. Myriad Genetics, Inc. (Myriad) obtained a number of patents on these genes. One patent gave Myriad the exclusive right to isolate an individual’s naturally occurring BRCA1 and BRCA2 genes. Another patent granted Myriad the exclusive right to synthetically create variants of BRCA1 and BRCA2 in the laboratory (cDNA). A group of researchers filed a lawsuit seeking a declaration that Myriad’s patents were invalid. The district court struck down the patents on the grounds that they covered products of nature. The appeals court reversed, holding that both DNA and cDNA were patentable. The Supreme Court granted certiorari. Issues: Is naturally occurring DNA patentable? Is manmade cDNA patentable? Decision: No, naturally occurring DNA is not patentable, but manmade cDNA is patentable. Reasoning: Laws of nature, natural phenomena, and abstract ideas are not patentable because they are the basic tools of science and technology. Allowing patents on what is found in nature would inhibit future innovation and would be at odds with the very point of patents, which is to promote creation. In this case, Myriad did not create anything. Yes, it did find an important and useful gene, but separating that gene from its surrounding genetic material is not an act of invention. Just because Myriad’s work was innovative, does not me4an that the genes were new creations. Myriad simply located what nature made, which is not enough for patent protection. cDNA is different because the lab technician creates something new when making cDNA. As a result, cDNA is not a “product of nature” and is patentable. In short, Myriad’s patent on DNA is invalid because DNA is a product of nature. However, its patent on cDNA is valid because this material is different from anything found in nature. Question: According to the Court, what is the purpose of patents? Answer: To promote creation. Question: Why is DNA not patentable, but cDNA is patentable? Answer: DNA is a natural phenomenon that is discovered, whereas cDNA is not naturally occurring.

27-1c Patent Application and Issuance To obtain a patent, the inventor must file a complex application with the PTO. If a patent examiner determines that the application meets all legal requirements, the PTO will issue the patent. If an examiner denies a patent application for any reason, the inventor can appeal that decision to the Patent © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Trial and Appeal Board in the PTO and from there to the Court of Appeals for the Federal Circuit in Washington. During the patent review process and for 9 months after a patent has been granted, third parties have the right to challenge it in the PTO rather than file suit in court.

Priority between Two Inventors. When two people invent the same product, the first to file a patent application has priority (not the first to invent or put to use. This is a change of preexisting law due to Congress’ passage of the America Invents Act (AIA) in 2013.

Prior Sale. An inventor must apply for a patent within 1 year of selling the product commercially. The purpose of this rule is to encourage prompt disclosure of inventions. It prevents someone from inventing a product, selling it for years, and then obtaining a 20-year monopoly with a patent.

27-1d Patent Infringement A patent holder has the exclusive right to make, use, or sell the patented invention during the term of the patent. A holder can prohibit others from using any product that is substantially the same, license the product to others for a fee, and recover damages from anyone who uses the product without permission. The PTO has set up a Track One system that permits inventors to buy their way to the front of the line by paying an additional fee of $4,800 for large companies, and $2,400 for small.

27-2e International Patent Treaties Bonus Notes: An inventor must apply for a patent in each country where patent protection is sought. This is no easy feat. Nevertheless, about half of all patent applications are filed in more than one country. This process used to be a logistical nightmare because almost every country had its own unique filing procedures and standards. Companies were reluctant to develop products based on technology that they were not sure they actually owned. Several treaties of the World Intellectual Property Organization now facilitate this process, although it is still not the one-stop (or one-click) effort that inventors desire. The Paris Convention for the Protection of Industrial Property (Paris Convention) requires each member country to accept and recognize all patent and trademark applications filed with it by anyone who lives in any member country. For example, the French patent office cannot refuse to accept an application from an American, as long as the American has complied with French law. Under this treaty, inventors who file in one country have up to one year to file elsewhere and still maintain patent protection. Under the Patent Cooperation Treaty (PCT), applicants are offered a single filing and streamlined review process. Upon filing an international patent application, inventors receive patent pending protection for 30 months in the 148 PCT member countries, so that they have time to pursue their application. Once a PCT application is filed, one of the major patent offices prepares an “international search report” and issues an opinion on whether the invention is patentable. This report, while nonbinding, helps applicants assess the patentability of their inventions and provides persuasive evidence to national patent offices. Inventors who wish to proceed internationally must then have the report translated and filed with applications and fees in whichever countries they want a patent.

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Bonus Notes: In addition to these treaties, any country that joins the World Trade Organization (WTO) must agree to trade-related aspects of intellectual property rights (TRIPS). This agreement does not create an international patent system, but it does require all participants to meet minimum standards for the protection of intellectual property. How individual countries achieve that goal is left to them.

27-2 Copyrights A copyright gives its creator the exclusive right to reproduce, distribute, and perform his original work for a limited time.  Abner Doubleday could have copyrighted a book setting out his particular version of the rules of baseball, but he could not have copyrighted the rules themselves, nor required players to pay him a royalty. In the following case, a celebrity yogi was incensed. Could copyright cool him down?

Case: Bikram ‘s Yoga College of India, L.P. v. Evolation Yoga, LLC 803 F.3d 1032, U.S. Ct. App. 9th Cir. (2015) Facts: Yoga is an ancient Hindu practice involving a combination of meditation, breathing exercises, and physical poses (called asanas). Bikram Choudhury was a lifelong student of a type of yoga known as Hatha. In the early 1970s, he developed a method of practicing yoga, which he called Bikram. It consisted of a sequence of 26 Hatha yoga asanas, arranged in an order designed to work the muscles optimally and practiced in a room heated to 105 degrees. Choudhury published and copyrighted a book that included detailed descriptions of Bikram Yoga. Many years later, two of Choudhury’s former students opened a yoga studio called Evolation where they taught Bikram Yoga. Choudhury sued Evolation for copyright infringement, claiming he deserved the exclusive right to teach Bikram Yoga. The district court granted summary judgment to Evolation, reasoning that a type of yoga could not be protected under copyright law. Issue: Was Bikram Yoga copyrightable? Decision: No, copyright law does not protect abstract ideas or systems, only their expression. Reasoning: Copyright does not prevent others from using the ideas or information revealed by the author’s work. It only protects the particular artistic form in which the author expressed concepts. In this way, it encourages people to build freely upon the ideas of others. The copyright for a work describing how to perform a process does not extend to the process itself. Recipes contained in a copyrighted cookbook are not entitled to copyright protection. Cooks are free to use them and experiment with new ingredients. To rule otherwise would be to prevent innovation, not promote it.

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Bikram Yoga is a system of yoga poses in a particular order. It is a method designed to alleviate physical injuries and illness. Just like a cookbook does not give its author the exclusive right to cook with its recipes. Choudhury’s copyright does not give him a monopoly over the practice of yoga. Question: Did the court find copyright infringement? Answer: No. Question: What is the idea/expression dichotomy? Answer: Every idea, theory, and fact in a copyrighted work becomes instantly available for public exploitation at the moment of publication. Question: Was the method Bikram created, promoted and memorialized in his book copyrightable? Answer: No. The only way he could have protected the Sequence was with a patent.

Unlike patents, the ideas underlying copyrighted material need not be novel.  Two movies are about friends who engage in a casual physical relationship and end up falling in love. The movies have the same plot, but there is no copyright violation because their expressions of the basic idea are different. The Copyright Act protects literature, music, drama, choreography, pictures, movies, recordings, computer programs and more. A work is copyrighted automatically once it is in tangible form.

In the following bonus case, more on recipes.

Bonus Case: Lapine v. Seinfeld 128 Facts: Missy Chase Lapine wrote a book called The Sneaky Chef: Simple Strategies for Hiding Healthy Foods in Kids’ Favorite Meals, which was about how to disguise vegetables so that children would eat them. Her strategy was to add pureed vegetables to food that children like, such as macaroni and cheese. (We are not making this up.) Four months later, Jessica Seinfeld, wife of comedian Jerry Seinfeld, published a book entitled Deceptively Delicious: Simple Secrets To Get Your Kids Eating Good Food which featured recipes involving pureed vegetables in (guess what?) macaroni and cheese and other kid-friendly foods. Lapine filed suit against Seinfeld, alleging violation of her copyright in the content of the book as well as her trademark in the name and cover design. The district court granted Seinfeld’s motion for summary judgment and Lapine appealed. Issue: Did Seinfeld violate Lapine’s copyright and trademark in The Sneaky Chef? Excerpts from the Decision of the Court: Copyright Infringement 128

375 Fed. Appx. 81; 2010 U.S. App. LEXIS 8778 UNITED STATES COURT OF APPEALS FOR THE SECOND CIRCUIT, 2010 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Plaintiffs assert that the two works are substantially similar in their unique and innovative expression of the idea of sneaking vegetables into children’s food by means of a cookbook containing comprehensive instructions for making and storing a variety of vegetable purees in advance, and then using the purees in specially created recipes for children’s favorite foods. We are not persuaded. Stockpiling vegetable purees for covert use in children’s food is an idea that cannot be copyrighted. In no case does copyright protection for an original work of authorship extend to any idea, procedure, process, system, method of operation, concept, principle, or discovery, regardless of the form in which it is described, explained, illustrated, or embodied in such work. It is a fundamental principle of our copyright doctrine that ideas, concepts, and processes are not protected from copying. Further, to the extent the two works have general and abstract similarities -- including their vaguely similar titles and inclusion of illustrations of prepared dishes, health advice, personal narrative, descriptions of how to make purees, instructions for preparing dishes, and language about children’s healthy eating -- the district court correctly concluded that these elements do not raise a fact issue for trial because they are “scenes a faire,” or unprotectable elements that follow naturally from the work’s theme rather than from the author’s creativity. Our independent comparison of the two cookbooks confirms that the total concept and feel of Deceptively Delicious is very different from that of The Sneaky Chef. Deceptively Delicious lacks the extensive discussion of child behavior, food philosophy, and parenting that pervades The Sneaky Chef. Unlike The Sneaky Chef, which uses primarily black, gray, and shades of brownish orange, Deceptively Delicious employs bright colors and more photographs. While The Sneaky Chef assumes greater familiarity with cooking, recommends thirteen methods for hiding healthy foods, and provides recipes for multiple-ingredient purees. Deceptively Delicious instructs readers about only single-ingredient purees and contains more basic instructions. Plaintiffs correctly note that no plagiarist can excuse the wrong by showing how much of her work she did not pirate. Like the district court, we nevertheless conclude as a matter of law that the two cookbooks lack the substantial similarity required to support an inference of copyright infringement. Trademark Infringement Having considered the overall impression on a consumer and the context in which the competing marks are displayed, we reach the same conclusion as the district court: the marks are not confusingly similar. Defendants’ depictions of a winking woman holding brownies near carrots or simply “shushing” are very different from plaintiffs’ considerably less detailed and less colorful image of a female chef winking and “shushing” while holding carrots behind her back. Further, defendants’ use of the famous “Seinfeld” name reduces any likelihood of confusion regarding the marks. In sum, like the district court, we conclude that dissimilarity of the marks is dispositive. Question: Did the court find copyright infringement and/or trademark infringement? Answer: No to both. Question: What were some of the courts reasons? Answer: Recipes for vegetable puree cannot be copyrighted and the look and feel of the two cookbooks was completely different (the colors used were difference, the amount of photographs were different, so there was no plagiarism).

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27-2a Copyright Term In England, copyrights were granted for 14 years, renewable for 14 more. Today, a copyright is valid until 70 years after the death of the work’s only or last living author, or in the case of works owned by a corporation, the copyright lasts 95 years from publication or 120 years from creation, whichever is shorter. Copyright term: The term for a copyright in the United States is the life of the author plus 70 years. Once a copyright expires, the work is said to be in the “public domain,” meaning that anyone may use it. Mark Twain died in 1910, so anyone may now publish Tom Sawyer. Bonus Notes: This change in law was brought about by a group of copyright holders led by Walt Disney who aggressively fought to lengthen the copyright period. Walt Disney wanted to protect its rights to Mickey Mouse.

27-2b Copyright Infringement and Fair Use Anyone who uses copyrighted material without permission is violating the Copyright Act. To prove a violation, plaintiff must present evidence that the work was original, and that either:  

The infringer actually copied the work, or The infringer had access to the original and the two works are substantially similar.

Damages can be substantial. Fair use doctrine: Permits limited use of copyrighted material without permission of the author.

The fair use doctrine is important because it permits limited use of copyrighted material without permission of the author. When copyrighted material is used for purposes such as criticism, parody, comment, news reporting, scholarship, research, or education, it is more likely to be a fair use. The following four factors determine whether a use is a fair one: 1. The purpose and character of the use 2. The nature of the copyrighted work. 3. the amount and proportion of the work that is used. 4. The effect of the use upon the potential market. The following bonus case may be of particular interest to students.

Bonus Case: Campbell v. Acuff-Rose Music, Inc., 129 Facts: Acuff-Rose filed suit against the members of a rap group, 2 Live Crew and their record company, claiming that 2 Live Crew’s song “Pretty Woman” infringed Acuff-Rose’s copyright in Roy Orbison’s song 129

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“Oh Pretty Woman.” The District Court granted summary judgment for 2 Live Crew holding that the song was a parody and thus a fair use of the copyrighted work. Acuff-Rose appealed and the appellate court reversed, holding that because the 2 Live Crew song was used for a commercial purpose, it is presumptively unfair, and because Campbell used so much of the original work in its work, the group had taken too much of copyrighted work. The United States Supreme Court granted certiorari. Issue: Is the parody a fair use of the original work? Decision: Appellate decision reversed and remanded. The Copyright Act of 1976 indicates that there are allowable fair uses of copyrighted work, such as uses for criticism, comment, news reporting, and teaching. The Act also states that four factors must be weighed in determining whether a use of a copyrighted work constitutes a fair use. The four factors are: 1. the purpose and character of the use; 2. the nature of the copyrighted work; 3. the amount of the copyrighted work used; and 4. the effect of the use on the market for the copyrighted work. According to the court, parody, like other comment and criticism may claim fair use. Under the first factor, the focus is on whether the new work merely replaces the original work, or whether the new work is a new “transformative” work, inserting new meaning and expression. The more transformative the new work, the less important the commercial nature of the new work is considered. For parody in particular, the heart of any parodist’s claim to quote from existing material is the use of some elements of an original work to create a new work that comments on that author’s work. Here, 2 Live Crew juxtaposes “the romantic musings of a man whose fantasy comes true” with degrading lyrics, a demand for sex, and relief from paternal responsibility. The words can be taken as a commentary of the original, as a rejection of its sentiment that ignores the “ugliness of street life and the debasement that it signifies.” This marriage of reference and ridicule is the hallmark of parody that traditionally has enjoyed fair use protection as a transformative work. According to the Court, the transformative nature of 2 Live Crew’s work should be balanced against the commercial use of the work. Commerciality does not mean a presumptively unfair use, to so hold would “swallow nearly all of the illustrative uses listed in the preamble” of the Act. The third factor asks whether the amount of the original work used is reasonable in relation to the purpose of the copying. The court agreed that the extent of the copying depends on the purpose of the copying. According to the Court, parody presents a difficult case because parody’s commentary stems necessarily from a recognizable reference to the original work. Thus, a parodist may use the most recognizable parts of the original in its own parody of that original, but the context of the use is important. According to the court, 2 Live Crew copied the characteristic opening bass riff of the original and the words of the first line of the original. However, although those are the most recognizable portions of the original, the group also departed significantly from the original lyrics, and otherwise produced distinctive sounds, and overlaying the music with solos in different keys. More facts When the owners of the Pretty Woman copyright sued 2 Live Crew, the group’s first inclination was to withdraw the parody. The Capitol Steps, however, wanted the courts to establish once and for all that parody is a protected form of speech. To persuade the Supreme Court to grant certiorari, the Capitol Steps prepared an audiotape history of political parody in the United States. There is some evidence that this tape was indeed influential in persuading the Supreme Court to grant certiorari.

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recording

the

Capitol

Steps

singing

God Bless My SUV is available here: https://www.youtube.com/watch?v=IyPhakY1mX0 . Both the Roy Orbison and the 2 Live Crew versions of Pretty Woman are available on https://www.youtube.com/watch?v=65GQ70Rf_8Y and can be purchased as singles from the iTunes Music Store. Also, Justice Souter attached the lyrics of both songs as appendixes to his majority opinion for the Court. As a result, both songs were reproduced in the United States Reports along with the rest of the opinion, and may now be found in every major law library in the United States. General Questions:  Did 2 Live Crew and the Capitol Steps make excessive use of the original recordings?  Did they harm the market for the original?  Should Roy Orbison be allowed (if he were alive) to prevent 2 Live Crew from using his material to mock women? What if he finds this material offensive?

27-2c The Digital Millennium Copyright Act. The Digital Millennium Copyright Act (DMCA) provides:  It is illegal to delete copyright information, such as the name of the author or the title of the article  It is illegal to circumvent encryption or scrambling devices that protect copyrighted works.  It is illegal to distribute tools and technologies used to circumvent encryption devices.  Internet service providers (ISPs) are not liable for posting copyrighted material as long as they are unaware that the material is illegal and they remove it promptly after receiving a “takedown” notice that it violates copyright law.

27-3 Trademarks Trademark: Any combination of words and symbols that a business uses to identify its products or services and distinguish them from others.

27-3a Ownership and Registration Under common law, the first person to use a mark in trade owns it. Registration with the federal government is not necessary, but the owner of a mark may register it under the federal Lanham Act, which has several advantages:   

Even if a mark has been used in only one or two states, registration makes it valid nationally. Registration notifies the public that a mark is in use because anyone who applies for registration first searches the Public Register to ensure that no one else has rights to the mark. The holder of a registered trademark generally has the right to use it as an internet domain name.

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To be valid, a trademark must be distinctive. The following are not distinctive, and cannot be trademarked:  Generic trademarks (for example, shoe or book)  Personal names  Similar to an existing mark (it would cause confusion in the mind of the public)  Scandalous, immoral, or disparaging trademarks BONUS ETHICS: For seventy years, the PTO refused to register marks that were considered offensive or disparaging. In 2014, the Trademark Trial and Appeal Board, the judicial arm of the PTO, canceled the trademark for the Washington redskins football team upon finding that the name offended some members of the Native American community. An Asian-American rock group called the “Slants” changed this law by insisting that they should be able to trademark the name, even though some night find it insulting. When the PTO refused to grant the band a trademark, the members appealed to the Supreme Court. In a case named Matal v. Tam, the Court held that the rule prohibiting insulting trademarks was unconstitutional: The First Amendment prohibits the government from silencing offensive words and messages - no matter how hurtful. As a result, the Slants were able to register their name and the Redskins will likely recover theirs. Do you agree with this outcome?

27-3c Trademark Infringement To win a trademark infringement suit, the trademark owner must show that the defendant’s trademark is likely to confuse customers about who has made the goods or provided the services. The following Landmark Case established the factors that determine trademark infringement.

Case: AMF Inc. v. Sleekcraft Boats 599 F.2d 341, U.S. Ct. App. 89th Cir. (1979) Facts: AMF sold recreational boats named “Slickcraft.” Unaware of this product, Bruce Nescher named his company’s boats “Sleekcraft.” When AMF notified Nescher of the alleged trademark infringement, Nescher added “Boats by Nescher” to its logo to distinguish his product. Both Slickcraft and Sleekcraft made sport, fiberglass boats of a similar size and price. However, Slickcraft boats were made and marketed for family recreation, such as fishing, while Sleekcraft boats were aimed at high speed racing enthusiasts. These uses did somewhat overlap. Both companies sold their boats nationally, advertised in magazines, and exhibited the product lines at the same boat shows. AMF sued Sleekcraft Boats for trademark infringement, arguing that its similar name was likely to confuse consumers. But the lower court decided that confusion was unlikely because the boats had different markets. AMF appealed. Issue: Was the use of Sleekcraft versus Slickcraft likely to confuse consumers? Decision: Yes, consumers are likely to be confused between Slickcraft and Sleekcraft boats. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Reasoning: To determine whether consumer confusion is likely, the following factors are relevant: 1. Strength of the mark: The more creative or arbitrary a mark, the stronger its protection. Because Slickcraft subtly connotes something about AMF’s boats, it is suggestive, which is protectable but weak. Thus, only if the marks are quite similar, and the goods closely related, will infringement be found. 2. Proximity of the goods: When goods are related, it is more likely that the public will be confused. The boats are extremely close in use and function. 3. Similarity of the marks: Courts look to the sight, sound, and meaning of the marks. The words Sleekcraft and Slickcraft are very similar. To the ear, they are almost the same. In meaning, slick and sleek are virtual synonyms. 4. Evidence of actual confusion: AMF introduced evidence that confusion had occurred both in the trade and in the mind of the buying public. 5. Marketing channels: Both AMF and Nescher advertise similarly, even though they target different submarkets. 6. Type of goods and purchaser care: In instances where the buyer can be expected to exercise greater care before purchasing, the risk of confusion is diminished. Boats are purchased only after thoughtful, careful evaluation of the product. 7. Intent: When the alleged infringer knowingly adopts a mark similar to another’s, courts presume that the purpose was to confuse consumers. Nescher was unaware of Slickcraft when he adopted the Sleekcraft name. 8. Likelihood of expansion: Evidence that either party may expand his business to compete with the other will weigh in favor of finding a likelihood of confusion. The evidence shows that both parties are diversifying their model lines. In conclusion, the court held that Nescher infringed the Slickcraft mark and issued an injunction prohibiting its use of Sleekcraft for boats. Question: What factors did the court consider in determining whether or not the mark was infringed upon? Answer: The strength of the mark, the proximity of the goods, the similarity of the marks, evidence of actual confusion, marketing channels, type of goods an d purchaser care, intent, and likelihood of expansion. Question: Of these, which leaned in favor of infringement of the Slickcraft mark? Answer: The proximity of the goods, the similarity of the marks, evidence of actual confusion, marketing channels, types of goods and purchaser care and likelihood of expansion. Question: Which factors leaned in favor of no infringement of the Slickcraft mark? Answer: The strength of the mark and intent. Question: Which factor did you find most compelling in proving infringement? Answer: Answers will vary. In the event of infringement, the rightful owner is entitled to: (1) an injunction prohibiting further violations, (2) destruction of the infringing material, (3) up to three times actual damages, (4) any profits the infringer earned on the product, and (5) attorney’s fees.

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Finding Names for New Products Companies complain that finding names for new products has become increasingly difficult, especially if the name must work in other languages, and also requires a corresponding Internet address. The classic example is the Chevrolet Nova, which might have been fine in the United States but did not work in Latin America, because “No va” means “Doesn’t go” in Spanish. Panasonic cancelled the campaign slogan for its Japanese Web browser that featured Woody Woodpecker: “Touch Woody–The Internet Pecker.” General Magic could not use “Regatta” or “Springboard” as a name for its digital assistant after discovering that the Web names were not available. The company ultimately went with “Portico.” Big Sky Brewing Company named its ale “Whistle Pig Red,” but then found out that two Whistling Pig microbrews were already on the market. (What an obvious name for a beer!) Big Sky then went with Moose Drool, only to be informed that another company owned the Moose family of names. No wonder that advertising agencies often turn over the job of developing names to specialized consulting firms. Research: If students performed the trademark name research assignment, ask them now to share the results of their search. Could they find names that were not already taken? Example Suppose that you are a Warner Bros. executive. The company is about to make a movie called Eraser that stars Arnold Schwarzenegger as an elite federal agent who “erases” the past lives of informers and relocates them to anonymous safety. Question: Would you be worried about trademark issues? Answer: In the script, a villainous computer company named Cyrex Corp. tries to kill Eraser. Warner Bros. says that, before shooting began, it did a search to make sure the movie was not infringing anyone’s trademark. Question: The trademark search revealed no similar names, so Warner was safe, right? Answer: Wrong. Cyrix Corp., a Richardson, Texas maker of microprocessors, filed suit, alleging trademark infringement. Executives were particularly concerned about a line in the film where co-star Vanessa Williams exclaims, “Cyrex and its co-conspirators will be put behind bars.” Investors began calling the company, wondering why Cyrix was cast in such an unsavory role. Question: What can Warner Bros. do now? Answer: It changed the name to Cyrec Corp. and ordered that 1,793 frames of the film–about two minutes’ worth–be edited out before the film opened. This included 84 scenes in which the name Cyrex Corp. was displayed on uniforms, hats, shirts, guns, and computer screens.

27-4 Trade Secrets Trade secret: A formula, device, process, method, or compilation of information that, when used in business, gives the owner an advantage over competitors. In determining if information is a trade secret, courts consider:  How difficult (and expensive) was the information to obtain? Was it readily available from other sources?  Does the information create an important competitive advantage?  Did the company make a reasonable effort to protect it? Most states have now adopted the Uniform Trade Secrets Act (UTSA) which provides remedies for trade secret holders. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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You Be the Judge: CDM Media USA, Inc. v. Simms 2015 U.S. Dist. LEXIS 37458,; 2015 WL 1399050, N.C. Ill (2015) Facts: Robert Simms worked for CEM Media USA, a marketing company focused on the technology industry. As CDM’s point person for social media, Simms created, controlled, and managed various social media groups and profiles to promote his employer. LinkedIn is a leading social media site for professional and business networking. The site’s user agreement informs its members that “your account belongs to you.” Through his personal LinkedIn account and on behalf of CDM, Simms launched a LinkedIn group called the CIO Speaker Bureau. This private online community sough to bring together technology executives interested in CDM’s services. Simms adopted LinkedIn’s strictest privacy setting, so the names of Bureau members and their communications were not available to the public at large. Over time, the group grew to 679 members and became a valuable source of clients for CDM. Four years later, Simms left to work for a technology company called Box, which was one of CDM’s largest clients. Upon departure, Simms refused to relinquish control of the LinkedIn group or to provide CDM with the group’s membership. CDM sued Simms for misappropriation, arguing that the LinkedIn members were a company trade secret. You Be the Judge: Is the list of members in a LinkedIn group a trade secret? Argument for Plaintiff: Trade secret law prevents departing employees form taking valuable information CMD spent significant time and money over four years to develop the Bureau. It was an exclusive group, with access limited by strict privacy settings and containing information extremely valuable to any CDM competitor. Although Simms used his personal LinkedIn account to create the group, he gathered this information as part of his job at CDM. He cannot take CDM’s secret client list to a new employer. Argument for Defendant: Membership of a LinkedIn group cannot be a trade secret for the simple reason that is not a secret. Although membership is not widely known, neither the existence of the group nor its composition is a secret. CDM announced the creation of the group through a press release. Members know each other and there is nothing confidential about their identities or interaction (which, after all, is the point of social networking!). Also, LinkedIn’s terms are clear: The account belongs to the individual user who created it, which in this case in Simms. If CDM was so interested in its client list, it should have taken other steps to protect it. Holding: No. While the private communications of the Bureau may have contained trade secrets, they were not trade secrets in themselves simply because they were private. Question: Is it correct to say that the Bureau list is not a secret because it was announced in CPM’s press release? Answer: Although the Bureau’s existence was announced, the press release did not reveal the names of the members of the Bureau, nor the substance of their private conversations. Question: Do you think Simms owns the Bureau group created by his LinkedIn account? Answer: Answers will vary. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Bonus Notes: Only civil penalties are available under the Uniform Trade Secrets Act. To safeguard national security and maintain the nation’s industrial and economic edge, Congress passed the Economic Espionage Act of 1996, which makes it a criminal offense to steal (or attempt to steal) trade secrets for the benefit of someone other than the owner, including for the benefit of any foreign government.

Bonus Case: Pollack v. Skinsmart Dermatology and Aesthetic Center P.C.7 Facts: Dr. Andrew Pollack owned the Philadelphia Institute of Dermatology (PID), a dermatology practice. Drs. Toby Shawe and Samy Badawy worked for PID as independent contractors, receiving a certain percentage of the revenues from each patient they treated. Natalie Wilson was Dr. Pollack’s medical assistant. Dr. Pollack tentatively agreed to sell the practice to Drs. Shawe and Badawy. But instead of buying his practice, the two doctors decided to start their own, which they called Skinsmart. They executed a lease for the Skinsmart office space, offered Wilson a job, and instructed PID staff members to make copies of their appointment books and printouts of the patient list. Then they abruptly resigned from PID. Ms. Wilson called patients to reschedule procedures at Skinsmart The two doctors also called patients and sent out a mailing to patients and referring physicians to tell them about Skinsmart. Dr. Pollack filed suit, alleging that the two doctors had misappropriated trade secrets. Issue: Did Drs. Shawe and Badawy misappropriate trade secrets from PID? Excerpts from Judge Cohen’s Decision: The right of a business person to be protected against unfair competition stemming from the usurpation of his or her trade secrets must be balanced against the right of an individual to the unhampered pursuit of the occupations and livelihoods for which he or she is best suited. For this reason, to qualify for protection, the information must be the particular secrets of the complaining employer, not general secrets of the trade in which he is engaged. Against this backdrop, it is clear the patient list is a trade secret, worthy of protection. As conceded by defendants, the confidentiality of patient information ensures that it remains unknown to those outside the practice and makes the patient list valuable. Through the substantial efforts of plaintiff, the patient list was compiled over numerous years, and contained 20,000 names with related information. PID spent money for computers, software, and employees to keep and maintain the patient list. Within the offices of PID, the information was not universally known or accessible. Not every staff member, including the practicing physicians, could pull the records. Wilson did not have access to them and the doctors relied on other PID employees to access the patient list. These same factors demonstrate that plaintiff sought to protect the secrecy of the information. The plaintiff must demonstrate that trade secret has value and importance to him and his business. As noted above, defendants acknowledge the value of the patient list to PID’s practice. In addition, plaintiff relied upon the patient list as the core component of his practice. To have the rights to the use of the trade secret, the plaintiff needs to show he either discovered or owned the trade secret. Plaintiff compiled the patient list over numerous years. The patient list was maintained on PID’s computers by PID’s employees. Plaintiff’s tax returns show that PID was owned © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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solely by the plaintiff. These facts establish plaintiff’s ownership of the patient list. Summary judgment is granted on the issue of liability against defendants Shawe, Badawy, and Wilson. Question: What did the defendants take from PID? Answer: A list of 20,000 patients compiled by Pollack over many years. Question: Can a list of patients be a trade secret? Answer: The court said that it can be because it provides a competitive advantage. Question: What did Pollack have to do to qualify his patient list as a trade secret? Answer: Two things: Spend significant time and resources gathering the information, and take reasonable steps to protect it. Question: Had Pollack done this? Answer: Yes, he had taken a lot of effort to develop the list and then he kept it private – even the other physicians in his office could not view the entire list. Bonus Example Lest students think that stealing trade secrets is not a serious matter, consider this example. Petr Taborsky, a former student research assistant at the University of South Florida, served seven months in prison, including two months on a chain gang, for stealing trade secrets. Taborsky was an undergraduate in chemistry and biology, working as a laboratory assistant at the College of Engineering when he took part in a research project to make sewage treatment cheaper and more efficient. The research was sponsored by Florida Progress Corporation, a utility holding company, which claimed that it had all rights to the research. Taborsky discovered a way to turn a clay-like compound similar to cat litter into a reusable cleanser of sewage, a process that has potentially valuable applications. The project leader maintains that Taborsky was part of a research team that made the discovery but the student claims he made the discovery on his own after the project had ended. A jury convicted Taborsky of grand theft of trade secrets. He was sentenced to a year’s house arrest, a suspended prison term of 3½ years, and probation for 11½ years, as well as 500 hours of community service. However, he was sent to prison when he violated the terms 8 of his probation by obtaining three patents related to the research.

Chapter Conclusion For many individuals and companies, intellectual property is the most valuable asset they will ever own. As its economic value increases, so does the need to understand the rules of intellectual property law.

Matching Questions Match the following terms with their definitions: _____A. Patent 1. Protects the particular expression of an idea _____B. Copyright 2. A word that a business uses to identify a product _____C. Trade secrets 3. Extends patent protection overseas _____D. Trademark 4. Grants the inventory exclusive use of an invention © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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_____E. Paris Convention

Answers: UUUU. VVVV. WWWW. XXXX. YYYY.

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5. Compilation of information that would give its owner an advantage in business

4 1 5 2 3

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 129. T F Once you have purchased a CD and copied it onto your iPod, it is legal to give the CD to a friend. 130. T F A provisional patent lasts until the product is used in interstate commerce. 131. T F In the case of corporations, copyright protection lasts 120 years from the product’s creation. 132. T F Under the fair use doctrine, you have the right to make a photocopy of a chapter of this textbook for a classmate. 133. T F The first person to file the application is entitled to a patent over someone else who invented the product first.

Multiple Choice Questions 1. To receive a patent, an invention must meet all of the following tests, EXCEPT: A. It has not ever been used anyplace in the world. B. It is a new idea. C. It has never been described in a publication. D. It is nonobvious. E. It is useful. Answer: A. 2. After the death of Babe Ruth, one of the most famous baseball players of all time, his daughters registered the name “Babe Ruth” as a trademark. Which of the following uses would be legal without the daughters’ permission? I. Publication of a baseball calendar with photos of Ruth II. Sales of a “Babe Ruth” bat III. Sales of Babe Ruth autographs A. Neither I, II, nor III B. Just I © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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C. Just II D. Just III E. I and III Answer: E. 3. To prove a violation of copyright law, the plaintiff does not need to prove that the infringer actually copied the work, but she does need to prove: I. The item has a © symbol on it II. The infringer had access to the original. III. The two works are similar. A. I, II, and III B. II and III C. I and II D. I and III E. Neither I, II, nor III Answer: B. 4. Eric is a clever fellow who knows all about computers. He: I. removed the author’s name from an article he found on the internet and sent it via email to his lacrosse team, telling them he wrote it II. figured out how to unscramble his roommate’s cable signal so they could watch cable on a second television III. taught the rest of his lacrosse team now to unscramble cable signals Which of these activities is legal under the Digital Millennium Copyright Act? A. I, II, and III B. Neither I, II, nor III C. II and III D. Just III E. Just I Answer: B. 5. Which of the following items cannot be trademarked? A. Color B. Symbol C. Phrase D. Surname E. Shape Answer: D. 6. Taylor Swift wanted to trademark her song lyrics: “And I’ll write your name.” She ____________. A. Can trademark it because it is a short phrase associated with her entertainment services B. Can trademark it only if it is in a tangible form C. Cannot trademark it because it is generic D. None of these because short phrases cannot be trademarked © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: A.

Case Questions 1. While in college, David invented a new and useful machine to make macaroni and cheese (he called it the “Mac ‘n’ Cheeser”). It was like nothing on the market, but David did not apply for a patent. At that time, he offered to sell his invention to several kitchen products companies. His offers were all rejected and he never sold the invention. Years later, he decided to apply for a utility patent. Is David entitled to a utility patent? Answer: No, while the Mac n’ Cheeser was new, useful, and nonobvious at the time it was invented, David’s disclosure to the kitchen products companies years before renders it not novel now. Inventors have a grace period of one year once disclosure is made to apply for a patent. That time lapsed. Patent rejected. 2. Rebecca Reyher wrote (and copyrighted) a children’s book entitled My Mother Is the Most Beautiful Woman in the World. The story was based on a Russian folktale told to her by her own mother. Years later, the children’s TV show Sesame Street televised a skit entitled “The Most Beautiful Woman in the World.” The Sesame Street version took place in a different locale and had fewer frills, but the sequence of events in both stories was identical. Has Sesame Street infringed Reyher’s copyright? Answer: The court held that Sesame Street had not infringed Reyher’s copyright because Reyher could not copyright the plot of a story, only her expression of the plot.130 3. In the documentary movie, Expelled: No Intelligence Allowed, there was a 15-second clip of “Imagine,” a song by John Lennon. The purpose of the scene was to criticize the song’s message. His wife and sons, who held the copyright, sued to block this use of the song. Under what theory did the movie makers argue that they had the right to use this music? Did they win? Lennon’s wife and sons originally won a preliminary injunction prohibiting further distribution of the movie. However, that decision was overturned. The court held that the movie producer’s use of the song was a fair use because the song was for purposes of criticism and commentary. Lennon v. Premise Media, 08-Civ. 3813 (SHS) United States District Court for the Southern District of New York. Answer:

Alice Randall wrote a novel entitled The Wind Done Gone, which retells the Civil War novel Gone with the Wind from the perspective of Scarlett O’Hara’s (imagined) black half-sister and slave. The novel does not use any of the names of the original, but clearly references the same characters, places, and plot lines. Randall was sued, but alleged fair use. Should she win? Answer: Answers will vary. But the appeals court expressed doubt that the infringement claim would be proven, after which, the case settled.

5. Sequenom developed a noninvasive prenatal diagnostic test to assess the risk of Down syndrome or

other chromosomal abnormalities in fetuses. The test analyzes DNA from the fetus that is 130

Reyher v. Children’s Television Workshop, 533 F.2d 87, 190 U.S.P.Q. (BNA) 387 (2d Cir. 1976). © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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found in the mother’s blood. Prior to this test, women had to undergo invasive tests that carried a slight risk of miscarriage. The PTO awarded Sequenom a patent on the test, but other diagnostic testing companies sued to invalidate the patent. Is Sequenom’s patent valid? Answer: In 2013, a California federal court invalidated Sequenom’s patent on the basis that it covered a natural phenomenon—the presence of DNA from the fetus in the mother’s blood. This was based on the Myriad precedent discussed in this chapter.

6. A man asked a question of the advice columnist at his local newspaper. His wife had thought of a clever name for an automobile. He wanted to know if there was any way they could trademark the name so that no one else could use it. If you were the columnist, how would you respond? Answer: Strategy: Recall that trademark registration requires a use – or bona fide intent to use – in commerce. Result: The couple could not trademark the name unless they had already or were intending to attach it to a product used in interstate commerce. So unless they had plans to manufacture a car, they could not trademark the name. 7. Frank B. McMahon wrote one of the first psychology textbooks to feature a light and easily readable style. He also included slang and examples that appealed to a youthful student market. Charles G. Morris wrote a psychology textbook that copied McMahon’s style. Has Morris infringed McMahon’s copyright? Answer: Strategy: McMahon cannot copyright an idea - only the expression of an idea. Result: The style of a textbook is an idea and not copyrightable. Thus, Morris could write a book with funny stories, just not the same stories told in the same was as in McMahon’s book. Morris did not infringe McMahon’s copyright.

Discussion Questions 1. ETHICS Virtually any TV show, movie, or song can be downloaded for free on the Internet. Most of this material is copyrighted and was very expensive to produce. Most of it is also available for a fee through such legitimate sites as iTunes. What is your ethical obligation? Should you pay $1.99 to download an episode of American Idol from iTunes or take it for free from an illegal site? What is your Life Principle? Answer: Answers will vary. 2. For much of history, the copyright term was limited to 28 years. Now it is as long as 120 years. What is a fair copyright term? Some commentators argue that, because so much intellectual property is stolen, owners need longer protection. Do you agree with this argument? Answer: Answers will vary.

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3. Music stars Beyoncé and Jay-Z named their newborn daughter Blue Ivy and then rushed to trademark the name, because they planned to use it in commerce. Their application was denied because a wedding planner in Massachusetts was already using “Blue Ivy” as the name of her business. Is this the correct outcome? Should people have priority in protecting personal names? Should a small business have priority over what would surely have been a much larger, more profitable use of this name? Answer: Answers will vary, however, this ruling did stand. The couple was able to secure a trademark for the child’s full name “Blue Ivy Carter”. 4. In New Orleans, Mardi Gras “Indians” are carnival revelers who dress up for Mardi Gras in costumes influenced by Native American ceremonial attire “Indians” often spend the entire year and thousands of dollars crafting their intricate designs with feathers, beads, and other decorations. As cultural icons in New Orleans, their images are often captured by photographers, who profit from the sale of these pictures. The Indians’ creations are not copyrightable because the law views costumes as functional, not aesthetic works. What are the Indians’ best arguments to change the law? Should cultural works be owned? Answer: Answers will vary. 5. The America Invents Act allows inventors to “guy” their way to the front of the line and expedite review of their inventions through a Track One application. This clearly favors those applicants who can pay. Do you agree with this practice? Why or why not? Answer: Answers will vary.

Suggested Additional Assignments Research: Patents Ask students to search the Patent and Trademark Office (PTO) database to locate two patented inventions, one worthwhile and one frivolous. Students should prepare a brief description of each item and explain why it is worthwhile or frivolous. The PTO’s searchable patent database is located at http://www.uspto.gov/patft/index.html. Research: Trademarks Ask students to make up a name for a hypothetical product and then search to see if anyone else has a trademark in that name. Their goal is to find a name that they could trademark. Searches are free on the PTO’s Website: http://www.uspto.gov/. How Recognizable is that Trademark Ask students to bring to class a trademark from a product they own. It could be a label from a water or soda bottle, a tag from a piece of clothing, or a label from a box, etc. Have the student cover up the brand name. See how many students recognize the mark without seeing the brand name. Research: Current Events Have students choose a current event about an intellectual property issue in the news and describe the issue to the class. What type of intellectual property is at the heart of the issue? Why is this issue newsworthy?

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Chapter 28 – Real Property and Landlord-Tenant Law* Chapter Overview Chapter Theme Real property law is ancient in origin and terminology, but every bit as potent as it was 1,000 years ago. Landlord-tenant law combines property, contract, and negligence principles into one important and fast-changing field.

28-1 Nature of Real Property Property falls into three categories: real, personal, and intellectual. Real property consists of:    

Land: The most common and important form of real property Buildings: Houses, office buildings, apartment complexes, and factories are included Plant Life: Plant life growing on land, whether naturally occurring or cultivated Fixtures: goods that have become attached to real property

Real property usually also includes anything underground (subsurface rights) and some amount of airspace above land ( air rights).

28-2 Concurrent Estates Concurrent estates: Two or more people owning property at the same time.

28-2a Tenancy in Common Tenancy in common: Two or more people holding equal interest in a property, but with no right of survivorship. A tenancy in common is the most common form of concurrent estate. Tenants in common have equal proportionate interest in the entire property: if there are two tenants in common, each has a 50% interest in the property; if there are 20 tenants in common, each as a 5% interest in the property. All cotenants have an absolute right to partition, or division of the property.

Partition Partition by Kind: A form of partition in which a property is divided among co-owners.

28-2b Joint Tenancy Joint tenancy: Two or more people holding equal interest in a property, with the right of survivorship. A joint tenancy gives the parties—joint tenants—proportionate ownership of the property, an absolute right to partition, and the right of survivorship. When one joint tenant dies, his interest passes automatically to the surviving joint tenants.

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28-3 Adverse Possession Adverse possession: Allows someone to take title to land without paying for it, if she meets four specific standards. The doctrine of adverse possession is analogous to easement by prescription. Under certain conditions, easement by prescription permits a person who makes use of land continuously to establish an easement for that use. Adverse possession goes even farther and allows someone to take title to land if she meets certain tests. In most states, to gain ownership of land by adverse possession, the user must prove:  Entry and exclusive possession  Open and notorious possession  A claim adverse to the owner, and  Continuous possession for a statutory period.

28-3a Entry and Exclusive Possession The user must take physical possession of the land, and must be the only one to do so.

28-3b Open and Notorious Possession The user’s presence must be visible and generally known in the area so that the owner is on notice that title is contested.

28-3c A Claim Adverse or Hostile to the Owner The user must clearly assert that the land is his. He does not need to register a deed or take other legal steps, but he must act as though he is the sole owner.

28-4d Continuous Possession for the Statutory Period State statutes prescribe a period of years for continuous use of the land. The trend has been to shorten the time period from 20 years to 10 years, or in some states, 5 years. Poet Robert Frost observed, “Good fences make good neighbors.” In the following case, the opposite was true. A fence unleashed a neighbor’s fury, and a claim of adverse possession.

Case: Medford v. Cruz 2016 WL 4439992, Court of Special Appeals of Maryland, 2016 Facts: Lots A and B were adjacent properties in a residential community near the Chesapeake Bay. Their only access to the beach was through a vacant tract of land – the Disputed Area – which was not part of either lot. Because the Disputed Area was a coastal buffer zone, state law prohibited its development. Dean Carter owned and lived on Lot A. For the prior 20 years every owner of Lot A had maintained the Disputed Area and treated it as their own. Carter built a fence around Lot A and the Disputed Area. Brigitte Cruz owned and lived on Lot B. When Carter erected the fence, she complained that it obstructed her access to the pier. Carter refused to remove it, but orally agreed to allow Cruz to reach the pier through a gate that opened from Lot B to the Disputed Area. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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After Carter died, Vicky Medford purchased his home. When Cruz attempted to use the Disputed Area gate, Medford kicked her out and accused her of trespassing. Medford then placed “No Trespassing” signs along the fence, but Cruz climbed it anyway. The neighbors sued each other to determine if Medford owned the Disputed Area by adverse possession. The trial court held that she did not, and Medford appealed. Issue: Did Medford acquire title to the Disputed Area by adverse possession? Decision: Yes, Medford owned the Disputed Area. Reasoning: To establish title by adverse possession, the claimant must show possession that is (1)( exclusive, (2) open add notorious, (3) hostile, and (4) continuous for 20 years. Exclusive. The owners of Lot A were the only ones to take physical possession of the Disputed Area. Open and Notorious. For years, the owners of Lot A treated the Disputed Area as their own. Since the land was a protected coastal buffer zone, the law prohibited its development. However, they rejected strangers, mowed the property, removed debris, and cut down dead foliage, which is sufficient evidence of occupancy. Hostile. All of Lot A’s owners claimed the exclusive right to the Disputed Area. Carter enclosed it with a fence; Medford put up “No Trespassing Signs.” Continuous for 20 years. To calculate the 20-year period, the court can tack on to Medford’s ownership the years when prior owners of Lot A (1) acted as if they owned the property and (2) intended to convey the Disputed Area when they transferred the deed to the property. Thus the possession was continuous for the 20-year period. Medford established title to the Disputed Area through adverse possession. However, she must give Cruz reasonable access to the jointly-owned pier. Question: Who won? Answer: Actually, both parties won. Medford established her ownership of the property through adverse possession, and Cruz established her right to access to their jointly owned pier. Question: Although Medford had only really lived on the property for a few years, she was able to establish adverse possession for a period of twenty years. How? Answer: By the use of tacking. Evidence was introduced about the adverse possession of the Disputed Area dating back to 1983, and the transfer of ownership of the adjacent property until the 2000s. Since each of the previous owners was in privity with the next, Medford gained the benefit of those years of open and notorious possession.

Bonus Case: Ray v. Beacon Hudson Mountain Corp.131 Facts: In 1931, Rose Ray purchased a cottage in a mountain-top resort town in the Adirondacks, agreeing to rent the land on which the structure stood. The long-term lease required her to pay the real 131

88 N.Y.2d 154, 666 N.E.2d 532, 1996 N.Y. LEXIS 676 Court of Appeals of New York, 1996 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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estate taxes and provided that when the tenancy ended, the landlord would buy back the cottage at fair market value. In 1960, the landlord terminated the lease of everyone in the town, so Ray and all other residents left. She died in 1962, without ever getting a penny for the cottage. The next year, Mt. Beacon Incline Lands, Inc. bought all rights to the abandoned 156-acre resort. Robert and Margaret Ray, the son and daughter-in-law of Rose Ray, reentered the cottage and began to use it one month per year, every summer from 1963 to 1988. They paid taxes, insured the property, installed utilities, and posted “no trespassing” signs. In 1978, Beacon Hudson bought the resort in a tax foreclosure sale. Finally, in 1988, the Rays filed suit, claiming title to the cottage by adverse possession. Beacon Hudson counter-claimed, seeking to eject the Rays. The trial court ruled for the couple. The appellate court reversed, stating that the Rays had been absent too frequently to achieve adverse possession. The Rays appealed to New York’s highest court. Issue: Did the Rays acquire title by adverse possession? Holding: Judgment for Rays affirmed. The requirement of continuous possession is satisfied when the adverse claimant’s acts of possessing the property are consistent with acts of possession that ordinary owners of similar properties would undertake. The plaintiffs’ actual summertime use for a full month each season, coupled with their repeated acts of repelling trespassers, improving, posting, padlocking and securing of the property in their absences throughout the statutory period, demonstrated their continuous dominion and control over, and thus possession of, the property. The Rays obtain title by adverse possession. Question: This case is based on the doctrine of adverse possession. What is that? Answer: Someone who simply uses land may ultimately be able to take title to the property, if she meets certain requirements. Question: What are the requirements? Answer: To gain ownership of land by adverse possession, the user must prove:  Entry and exclusive possession,  Open and notorious possession,  A claim adverse to the owner, and  Continuous possession for a statutory period. Question: This is crazy! Why should someone get title to land by cheating? Answer: The policy behind the adverse possession rule is to encourage and reward use of real estate and improvements on it. Question: This case perfectly proves the merit of the policy. How? Answer: For nearly 30 years, various corporations permitted a once-thriving resort community to deteriorate into a ghost town. Only one family seemed determined to sustain the property. The court is saying, “Good work. You win.” Question: But the rule requires the possessor to demonstrate continuous possession for the statutory period. This family only showed up in fair weather, for a month. Answer: This is a summer holiday home, and no one stays in such a house all winter. The court states that continuity of possession must be “consistent with acts of possession that ordinary owners of like properties would undertake”–in other words, the possessor only has to treat the property the way the real owner would.

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28-4 Land Use Regulation 28-4a Nuisance Law A nuisance is an unprivileged interference with a person’s use and enjoyment of her property. Common examples are offensive noise, odors, or smoke. A court will probably issue an abatement, that is, an order requiring the homeowner to eliminate the nuisance.

28-4b Zoning Zoning statutes: State laws that permit local communities to regulate land use. Local communities then pass zoning ordinances to control many aspects of land development.

28-4c Eminent Domain Eminent Domain: The power of the government to take private property for public use. Condemnation: A court order awarding title of real property to the government in exchange for just compensation. A government may need land to construct a highway, airport, etc., but the Fifth Amendment of the U.S. Constitution states that just compensation must be paid, a fair price. If the property owner refuses the government’s offer, the government will file suit seeking a condemnation of the land, a court order specifying what compensation is just, and awarding title to the government.

In the following Landmark case, a city used eminent domain to take property on behalf of private developers. Was this a valid public use? The Kelo decision was controversial, and in response, some states passed statutes prohibiting eminent domain for private development.

Case: Kelo v. City of New London, Connecticut 545 U.S. 469, U.S. Supreme Court, 2005 Facts: New London, Connecticut, was declining economically. The city’s unemployment rate was double that of the state generally, and the population was at its lowest point in 75 years. In response, state and local officials targeted a section of the city called Fort Trumbull for revitalization. Located on the Thames River, Fort Trumbull comprised 115 privately owned properties and 32 additional acres of an abandoned naval facility. The development plan included one section for a water front conference hotel and stores; a second one for 80 private residences; and one for research facilities. The state bought most of the properties from willing sellers. However, nine owners of 15 properties refused to sell, and they filed suit. The owners claimed that the city was trying to take land for private use, not public, in violation of the Takings Clause. The case reached the U.S. Supreme Court. Issue: Did the city’s plan violate the Takings Clause? Decision: No, the plan was constitutional. Affirmed. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Reasoning: The Takings Clause allows for some transfers of real property from one private party to another, so long as the land will be used by the public. For example, land may be taken to allow for the construction of a railroad even if private railroad companies will be the primary beneficiaries of the transfer. New London’s economic development plan aimed to create jobs and increase the city’s tax receipts. The Supreme Court had not previously considered this type of public use, but it now determined that economic development is a legitimate public purpose. New London did not violate the Takings Clause: Dissent by Justice O’Connor: Any public benefit in this case would be incidental and secondary. Under the majority’s opinion, the government can now take private property for any purpose. This case will most likely benefit those with inside access to government officials at the expense of small property owners. Question: Did the Court find the taking a constitutional exercise of eminent domain? Answer: Yes. The Supreme Court determined that as long as the property would be used by the public, it was constitutional to take it on behalf of private developers. Question: Did Justice O’Connor agree? Answer: No. She believed that the use of eminent domain in this circumstance was not constitutional. Question: What did she predict a municipality’s power would be in the future for the use of eminent domain? Answer: She believed that pursuant to this precedent, municipalities would be able to take private property for any purpose. Question: Do you believe she is correct? Answer: Answers will vary. Question: Do you think the city of New London was trying to improve the economic viability of the city? Answer: Yes. Question: Do you agree with the court’s decision? Answer: Answers will vary. Question: If the Supreme Court had ruled otherwise, what do you think the consequences would have been for the City of New London, or other cities in similar situations? Answer: Answers will vary.

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28-5 Landlord-Tenant Law The relationship between landlords and tenants involves three types of law: property, contract and tort law. Under Contract law, the Statute of Frauds generally requires that a long-term lease be in writing.

Freehold estate: The right to possess land for an undefined length of time. Landlord: The owner of a freehold estate who allows another person temporarily to live on his property. Tenant: A person given temporary possession of the landlord’s property. Leasehold interest: One party has the right to occupy the property for a given length of time. Reversionary interest: The landlord’s right to occupy the property at the end of the lease. Covenant: A promise or undertaking contained in a lese whose breach does not result in eviction. Condition: A promise or undertaking contained in a lease whose breach may result in eviction.

28-5a Types of Tenancy There are four types of tenancy. The most important feature distinguishing one from the other is how each tenancy terminates. In some cases, at tenancy terminates automatically, while in others, one party must take certain steps to end the agreement. Tenancy for years: A lease for a stated, fixed period. Periodic tenancy: A lease for a fixed period automatically renewable unless terminated. Tenancy at will: A tenancy with no fixed duration, which may be terminated by either party at any time. Tenancy at sufferance: A tenancy that exists without the permission of the landlord, after the expiration of a true tenancy.

Bonus Case: Elwell v. Minor132 Facts: Winfield Elwell orally agreed to rent Lucille Minor an apartment on a month-to-month basis. The rent was $575, and four years later was increased to $625, and the next year was increased to $650. Minor tendered $625 and included a letter explaining that she did not want to pay the increased rent for September or October. Elwell rejected the payment, Minor then tendered a check a second time, and Elwell returned it. Elwell told Minor to pay $650 or vacate. Minor did neither, so Elwell began eviction proceedings and served a Notice to Quit for non-payment of rent. At trial, Minor argued that non-payment of rent was an improper ground for evicting a tenant at sufferance, and asked the court to dismiss the case. Issue: May a landlord evict a tenant at sufferance for non-payment of rent?

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Holding: No, the court dismissed the action. During the months of September and October the communications between Minor and Elwell reveal a definite dispute, which precludes the formation of a new one-month lease. Because Minor remained in possession of the premise without a new monthly contract, she should be treated as a tenant at sufferance, a holdover occupying the apartment without the legal right to do so. Nonpayment of rent is not proper grounds for the eviction of a tenant at sufferance because a tenant at sufferance is not required to pay rent but only use and occupancy. The law treats a month-to-month lease as a series of individual leases which expire at the end of the month and are ordinarily renewed each month by implication, once the agreement expires, the tenant’s obligation to pay rent transforms into an obligation to pay a reasonable sum for the use and occupancy of the premise. Without an obligation to pay rent, there can be no eviction for nonpayment of rent. The proper basis for pursuing eviction proceedings against a tenant who failed to pay a reasonable sum for use and occupancy would be that the tenant originally had the right to occupy the premise but such right has terminated. Elwell’s second notice to quit is defective because it cites improper grounds for evicting a tenant at sufferance, and thus deprives the court of subject matter jurisdiction in the eviction proceeding. Question: What is a notice to quit? Answer: A notice to quit is the document that a landlord must serve on a tenant before beginning an eviction case. The significance of the paper is that it notifies the tenant that an eviction case, which can move very quickly, is about to begin, so that the tenant either prepares his defense or finds alternate digs. Question: Why did Elwell serve Minor with a notice to quit? Answer: Because she did not pay the increased rent. Question: Can a landlord begin eviction proceedings against a tenant for nonpayment of rent? Answer: Yes, a tenant has an obligation to pay rent. Question: If that is the case, why did the court dismiss the case? Answer: Because technically, because Minor had a month-to-month lease, once that lease expired, there was no lease in place. Ms. Minor was a tenant at sufferance once Elwell did not renew her lease by accepting her payment. The court stated that tenants at sufferance have no duty to pay rent, but they must pay a reasonable sum for use and occupancy. Because Elwell stated in his notice to quit that he was evicting Minor for nonpayment of rent, the notice to quit was defective. Question: What is “use and occupancy”? Answer: “Use and occupancy” is when a person is using and occupying a premise without a lease, the law imposes a duty on them to pay a reasonable amount for such use. Question: Isn’t that the same thing as rent? Answer: It looks like it. But the court in this case made it clear that Elwell can only seek eviction for nonpayment of rent if there were an actually lease between the parties. Because there is no lease and Minor is a tenant at sufferance, Elwell can only seek eviction for nonpayment of “use and occupancy”. Question: So, even though Minor did not pay her rent, or use and occupancy, Elwell’s case was dismissed? Answer: Yes. Question: How is this result fair? Answer: The court made it clear that the proper law must be followed. Although the issue is the same: a person living in a rented premise has not paid for living in that premise, the type of tenancy determines the legal rights of the parties. A tenant at sufferance has different rights than a tenant at will or a tenant with a month-to-month lease. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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28-5b Landlord’s Duties Duty to Deliver Possession The landlord’s first important duty is to deliver possession of the premises at the beginning of the tenancy. Bonus Notes:  The English rule obligates the landlord to remove the previous tenant in time for the new tenant to take possession.  The American rule is more favorable to the landlord (but this is the minority rule in the US). The landlord has no duty to deliver actual possession of the premises.

Quiet Enjoyment All tenants are entitled to quiet enjoyment of the premises, meaning the right to use the property without the interference of the landlord. Actual Eviction. If a landlord prevents the tenant from possessing the premises, he has actually evicted her. Constructive Eviction. If a landlord substantially interferes with the tenant’s use and enjoyment of the premises, he has constructively evicted her. For a constructive eviction to occur the landlord’s interference with the tenant’s use and enjoyment must be so substantial as to cause the tenant to leave the premises.

Duty to Maintain Premises In most states, a landlord has a duty to deliver the premises in a habitable condition and a continuing duty to maintain the habitable condition. Lease. The lease generally obligates the landlord to maintain the exterior of buildings and common areas. If not, state law may imply it. Building Codes. These mandate minimum standards for commercial and/or residential property. Implied Warranty of Habitability. This warranty requires that a landlord meet all standards set by the local building code, or that the premises be fit for human habituation. Duty to Return Security Deposit. In many states, a landlord must either return the security deposit or notify the tenant of damage and the cost of repairs. Duty to Mitigate. For a landlord, to mitigate damages is to keep losses to a minimum by promptly seeking another tenant. The common law rule did not require mitigation, that that rule evolved over time to require mitigation. Other Assignments: If students completed the research on the implied warranty of habitability, they should present their results now.

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Case: Harris V. Soley133 Facts: Nar Labor Day, Andrea Harris, Kimberly Nightingale, Karen Si8mard, and Michelle Dussault moved into a large apartment in the Old Port section of Portland, Maine. The apartment had been condemned by the city of Portland, but Joseph Soley, the landlord, assured the tenants that all problems would be repaired before they moved in. Not quite. When the women arrived, they found the condemnation notice still on the door, and the apartment an uninhabitable mess Soley’s agent told the tenants that if they cleaned the unit themselves, they would receive a $750 credit on their first month’s rent of $1,000. So the four rented a steam cleaner, bought supplies and cleaned the entire apartment. Unfortunately, their problems had only begun. The tenants suffered a continuous problem with mice and cockroaches, along with a persistent odor of cat urine. They ultimately discovered a dead cat beneath the floorboards. During October, the apartment had no heat. One tenant slept with blankets over her head, to keep heat in and bugs out. In November, the women submitted a list of complaints to Soley, including a broken toilet, an inoperable garbage disposal, and a shattered skylight, as well as a leaking roof and cockroach infestation. Snow began to fall into the living room through the skylight. Soley made no repairs, and the women stopped paying the rent. He phoned them several times, aggressively demanding payments. The tenants found another place to li8ve, but before they had moved, Soley’s agents broke into the apartment and took many of their belongings. The tenants located Soley at the restaurant he owned and asked for their possessions back, but he refused to return the belongings unless they paid him $3,000. He threatened them by saying that he knew where their families lived. The tenants sued, claiming breach of contract, conversion (wrongful taking of property), intentional infliction of emotion al distress, wrongful eviction, and wrongful retention of a security deposit. Soley refused to respond to discovery requests, and eventually the trial court gave a default judgment for the plaintiffs. The judge instructed the jury that all allegations were deemed true, and their job was to award damages. The jury awarded damages for each of the claims, including $15,000 to each tenant for emotional distress and a total of $1 million in punitive damages. Soley appealed. Issue: Were the tenants entitled to such large damages. Decision: The tenants are entitled to all damages. Affirmed. Reasoning: Soley argues that the identical awards to all four tenants indicates the verdict is a result of irrational thinking, passion, and prejudice. However, the jury could reasonably have found that the emotional distress suffered by each tenant deserved comparable compensation, even if the harm was not identical to each. Among the factual findings from the trial court was this statement: The plaintiffs were shaken up, infuriated, violated intimidated, and in fear for their physical safety. The conduct of [Soley] was so extreme and outrageous as to exceed all possible bounds of decency. Defendant acted intentionally, knowingly, willfully, wantonly, and with malice. 133

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The jury was entirely justified in awarding substantial punitive damages. The tenants had to endure insect and rodent infestation, dead animals, and falling snow. Soley refused to repair conditions that made the apartment unfit for human habitation, violently removed the tenants’ property, destroyed some of their belongings, and threatened the young women. His conduct was utterly intolerable, and the verdict is reasonable. Question: How can the landlord be defaulted when in fact he was in court, arguing the case? Answer: The landlord answered the complaint but then failed to cooperate with discovery requests. The plaintiffs served motions to compel and the court ordered the defendants to respond but they never did. This is a drastic remedy, which courts try to avoid, but here the trial court was convinced that nothing less was fair. Question: Name some or all of the rules of law that this landlord broke. Answer:  Quiet enjoyment. The landlord interfered with the tenants’ quiet enjoyment by failing to provide a livable apartment.  Constructive eviction. The apartment was in such terrible shape that a reasonable tenant would feel forced to move out. That is a constructive eviction.  Conversion. The landlord had his agents take some of the tenants’ personal property while they were in the process of moving elsewhere.  Duty to maintain premises. Maine, like most states, requires a landlord to deliver an apartment in clean and sanitary condition and maintain it in a habitable condition.  Building codes. Maine, like most states, has a building or occupancy code which prohibits these kinds of conditions.  Implied warranty of habitability. This is an implied condition in all residential leases in Maine (and most states).  Failure to return security deposit. Because he constructively evicted the tenants, the landlord was obligated promptly to return their security deposit.  Threats. The landlord apparently made criminal threats, implying that he might harm the tenants or their families. Question: Other than that, was the landlord a pretty decent guy? Answer: Yeah, right.

28-5c Tenant’s Duties Duty to Pay Rent Rent is the compensation the tenant pays for use of the premises, and paying the rent is the tenant’s foremost obligation. Landlord’s Remedies for Nonpayment of Rent. There are several. The landlord is entitled to apply the security deposit to the unpaid rent, and may sue the tenant for nonpayment of rent, including costs of collection and interest. The landlord may also evict a tenant who has failed to pay rent. Duty to Mitigate. For a landlord, to mitigate damages is to keep losses to a minimum by promptly seeking another tenant. The common law rule did not require mitigation, that that rule evolved over time to require mitigation. [NOTE: ALTHOUGH THIS PARAGRAPH APPEARS UNDER TENANT’S DUTIES IN THE TEXT, IT HAS BEEN COPIED TO LANDLORD’S DUTIES. AS THIS IS A DUTY OF THE LANDLORD.] © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Duty to Use Premises Properly A lease normally lists what a tenant may do in the premises and prohibits other activities. A tenant may not use the premises for any illegal activity, such as gambling or selling drugs.

28-6 Change in the Parties Sometimes the parties to a lease change.

28-6a Sale of the Property Generally, the sale of leased property does not affect the lease but merely substitutes one landlord, the purchaser, for another, the seller.

28-6b Assignment and Sublease Assignment: Process under which the original tenant transfers all of his rights and duties to a new tenant. Note, however, the original tenant remains liable to the landlord unless the landlord explicitly releases him, which the landlord is unlikely to do.

28-7 Liability of Landlords and Tenants 28-7a Tenant’s Liability A tenant is generally liable for injuries occurring within the premises she is leasing, whether that is an apartment, a store, or something else.

28-7b Landlord’s Liability Historically, the common law held a landlord responsible only for injuries that occurred in the common areas, or those due to the landlord’s negligence. But increasingly, the law holds landlords liable under the normal rules of negligence law.

28-7c Crime Landlords may be liable in negligence to tenants or their guests for criminal attacks that occur on the premises. Courts typically decide by looking at four factors: 1. 2. 3. 4.

Nature of the crime: How did it occur? Reasonable person standard: What would a reasonable landlord have done? Foreseeability: Was it reasonably foreseeable? Prevalence of crime in the area: If the area has a high rate of crime, courts are more likely to hold landlord responsible.

In the following case, the court held that a landlord was required to take reasonable steps to protect a tenant, even when some of the threats occurred in cyberspace. Should the landlord be responsible?

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Case: Lindsay P. v. Towne Properties Asset Management Co., Ltd. 2013-Ohio-4124, Court of Appeals of Ohio, 2013 Facts: Lindsay134 and her young daughter lived above Rhonda Schmidt, in an apartment complex operated by Towne Properties (TP), where Courtney Haynes, Schmidt’s boyfriend often stayed, though not on her lease. They often blared rap music and fought loudly, often waking Lindsay’s child; Lindsey complained to TP. In retaliation, Haynes banged on Lindsay’s door and threatened her. Terrified, Lindsay reported Haynes to TP and they suggested she file a police report so they would have the documentation necessary to “take care of it.” Late one night, Haynes sent Lindsay a Facebook message. It read: “you will really like having a friend so close that can satisfy you in so many great ways” and had a link to a pornographic website. Lindsay immediately told TP managers and begged them to let her out of her lease. TP refused, but offered to move her to an available first-floor unit, where they assured her she would be safe. TP promised to “keep an eye” on Haynes for Lindsay. Meanwhile, TP advised Schmidt that since Haynes was not on her lease, he would have to leave. In response, Schmidt insisted on adding him to the lease, and TP agreed. In the process, TP divulged that Lindsay was moving to another unit. A few days later, Haynes broke into Lindsay’s new apartment and raped her. Lindsay sued TP, alleging that it was negligent. The trial court dismissed the case, reasoning that TP had no duty to protect Lindsay from a random criminal act. Lindsay appealed. Issue: Could the landlord liable for the tenant’s injuries? Decision: Yes. The evidence suggests that TP did not take reasonable steps to protect its tenant. Reversed. Reasoning: Generally, landlords do not have a duty to protect their tenants from third party criminal acts. However, such a duty exists when the landlord should have reasonably foreseen the criminal activity and failed to take reasonable precautions to prevent it. Haynes’ criminal activity was certainly foreseeable. TP was aware of his dangerous propensities and his menacing behavior toward Lindsay. It knew that Lindsay had good reason to feel threatened by Haynes. It also reassured Lindsay, telling her it was “taking care of it,” promising to “keep an eye on” Haynes, and guaranteeing it was taking precautions.

<FTN>134The court refers to Lindsay by her first name alone to protect her privacy.</FTN> © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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But it did not take such precautions. TP did not let Lindsay out of her lease. It moved her to a first-floo9r apartment even though she expressed concern for her safety. It even informed Haynes that Lindsay was moving and began the process of adding him to Schmidt’s lease.

Question: What is the general rule in Ohio regarding landlord liability to protect their tenants from criminal acts of third parties? Answer: Landlords do not have a duty to protect tenants from the criminal acts of third parties. Question: Why does this particular case not follow the general rule above? Answer: Foreseeability. The landlord should have reasonably foreseen Haynes’ criminal activity.

Chapter Conclusion Real property law is ancient but forceful. Although real property today is not the dominant source of wealth that it was in medieval England, it is still the greatest asset that most people will ever possess and is worth understanding. When property is rented, a special relationship exists between the landlord and tenant. Each has numerous obligations to the other. The current trend is clearly for expanded landlord liability, but how far that will continue is impossible to divine.

Matching Questions Match the following terms with their definitions: _____A. Constructive eviction 1. A landlord’s substantial interference with a tenant’s use and enjoyment of the premises _____B. Adverse possession 2. Goods that have become attached to real property _____C. Fixture 3. A tenancy without fixed duration, which either party may terminate at any time _____D. Tenancy at will 4. A method of acquiring ownership of land without ever paying for it _____E. Tenancy at sufferance 5. A tenant remains on the premises after expiration of a true tenancy Answers: ZZZZ. AAAAA. BBBBB. CCCCC. DDDDD.

1 4 2 3 5

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134. T F If one joint tenant dies, his interest in the property passes to surviving joint tenants, not to his heirs 135. T F The federal government has the power to take private property for public use, but local governments have no such power. 136. T F A landlord could be liable for a constructive eviction even if he never asked the tenant to leave. 137. T F A nonrenewable lease of a store, for six months, establishes a tenancy for years. 138. T F A landlord may charge a tenant for normal wear and tear on an apartment, but the charges must be reasonable.

Multiple Choice Questions 1. CPA QUESTION Quick, Onyx, and Nash were deeded a piece of land as tenants in common. The deed provided that Quick owned one-half the property and Onyx and Nash owned one-quarter each. If Nash dies, the property will be owned as follows: A. Quick 1⁄2, Onyx 1⁄2. B. Quick 5⁄8, Onyx 3⁄8. C. Quick 1⁄3, Onyx 1⁄3, Nash’s heirs 1⁄3. D. Quick 1/2, Onyx 1/4, Nash’s heirs 1/4 Answer: D 2. Marta places a large, prefabricated plastic greenhouse in her backyard, with the steel frame bolted into concrete that she poured specially for that purpose. She attaches gas heating ducts and builds a brick walkway around the greenhouse. Now, the town wants to raise her real property taxes, claiming that her property has been improved. Marta argues that the greenhouse is not part of the real property . Is it? A. The greenhouse is not part of the real property because it was prefabricated. B. The greenhouse is not part of the real property because it could be removed. C. The greenhouse cannot be part of the real property if Marta owns a fee simple absolute. D. The greenhouse is a fixture and is part of the real property. Answer: D 3. CPA QUESTION Which of the following forms of tenancy will be created if a tenant stays in possession of leased premises without the landlord’s consent, after the tenant’s one-year written lease expires? A. Tenancy at will B. Tenancy for years C. Tenancy from period to period D. Tenancy at sufferance Answer: D

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4. CPA QUESTION A tenant renting an apartment under a three-year written lease that does not contain any specific restrictions may be evicted for: A. counterfeiting money in the apartment B. keeping a dog in the apartment C. failing to maintain a liability insurance policy on the apartment D. making structural repairs to the apartment Answer: A 5. Michael signs a lease for an apartment. The lease establishes a periodic tenancy for one year, starting September 1 and ending the following August 31. Rent is $800 per month. As August 31 approaches, Michael decides he would like to stay another year. He phones the landlord to tell him this, but the landlord is on holiday and Michael leaves a message. Michael sends in the September rent, but on September 15, the landlord tells him the rent is going up to $900 per month. He gives Michael the choice of paying the higher rent or leaving. Michael refuses to leave and continues to send checks for $800. The landlord sues. Landlord will A. win possession of the apartment because the lease expired. B. win possession of the apartment because Michael did not renew it in writing. C. win possession of the apartment because he has the right to evict Michael at any time, for any reason. D. win $1,200 (12 months times $100). E. lose. Answer: E.

Case Questions 1. Lisa Preece rented an apartment from Turman Realty, paying a $300 security deposit. Georgia law states: “Any landlord who fails to return any part of a security deposit which is required to be returned to a tenant pursuant to this article shall be liable to the tenant in the amount of three times the sum improperly withheld plus reasonable attorney’s fees.” When Preece moved out, Turman did not return her security deposit, and she sued for triple damages plus attorney’s fees, totaling $1,800. Turman offered evidence that its failure to return the deposit was inadvertent and that it had procedures reasonably designed to avoid such errors. Is Preece entitled to triple damages? Attorney’s fees? Answer: The court held the defendant liable for $900 (treble damages) and an additional $900 in attorney’s fees. The rationale for treble damages is that, historically, landlords often willfully refuse to refund security deposits, knowing that most tenants would not bother to sue. That was obviously unethical. By trebling the damages, state legislatures have given landlords a financial incentive to be fair. By permitting attorney’s fees, such laws ensure that injured tenants have access to court and a remedy. Preece v. Turman Realty Co., Inc., 228 Ga. App. 609, 492 S.E.2d 342, 1997 Ga. App. LEXIS 1216 (Ga. App. 1997). Philip Schwachman owned a commercial building and leased space to Davis Radio Corp. for use as a retail store. In the same building, Schwachman leased other retail space to Pampered Pet, a dog 2.

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grooming shop. Davis Radio complained repeatedly to Schwachman that foul odors from Pampered Pet entered its store and drove away customers and workers. Davis abandoned the premises, leaving many months’ rent unpaid. Schwachman sued for unpaid rent and moved for summary judgment. What ruling would you make on the summary judgment motion? Answer: The court denied summary judgment. Davis Radio is raising a constructive eviction defense to the tenant’s nonpayment of rent. Davis argues that the odors were so strong as to interfere with its quiet enjoyment of the premises. If Davis can convince the jury that the interference seriously interfered with normal use of the premises, it owes no rent. Schwachman v. Davis Radio Corporation, Mass. Lawyers Weekly, No. 12-360-94 (Mass. Super. Ct. 1994).

You Be the Judge: WRITING PROBLEM Frank Deluca and his son David owned the Sportsman’s Pub on Fountain Street in Providence, Rhode Island. The Delucas applied to the city for a license to employ topless dancers in the pub. Did the city have the power to deny the Delucas’ request? Argument for the Delucas: Our pub is perfectly legal. Further, no law in Rhode Island prohibits topless dancing. We are morally and legally entitled to present this entertainment. The city should not use some phony moralizing to deny customers what they want. Argument for Providence: This section of Providence is zoned to prohibit topless dancing, just as it is zoned to bar manufacturing. There are other parts of town where the Delucas can open one of their sleazy clubs if they want to, but we are entitled to deny a permit in this area. Answer: Yes, the city could use its zoning powers to deny the license. Earlier zoning ordinances had allowed topless dancing in the section of the city where the pub was located, but the current ordinance prohibited such dancing in that section. The city had no obligation to grant a variance for the Delucas and denied the request. Jonathan Saltzman, “License Is Denied for Topless Dancing at Downtown Pub,” Providence Journal-Bulletin, July 11, 1995, p. 2C.

4. Angel and Linda Mendez bought a home next door to Rancho Valencia, a fancy hotel on 45 acres of land. The house was about 600 feet from the site where the hotel held outdoor wedding receptions and parties. Even though the Rancho Valencia had installed noise0abating equipment, the Mendezes could still hear music and announcements from its sound system for about 8 hours a month., mostly during the evenings. These noise levels complied with the applicable county noise ordinances. On what theory could the Mendezes sue Rancho Valencia? Will they succeed? Answer: The Mendezes sued claiming nuisance, but lost at the trial court and on appeal. The 8 hours per month of noise did not violate the noise statute. Mendez v. Rancho Valencia Resort Partners, 3 Cal.App.5th 248, Court of Appeals of California, Fourth District, Division One, 2016. 5. In 1931, ‘Rose Ray purchased a cottage in the Adirondacks. Although the home was hers, the land belonged to a landlord, who agreed to give her a long-term lease. In 1960, the landlord terminated the land lease and sole the entire area to a developer. In 1963, Ray’s son and his wife re-entered the cottage and began to use it one month a year, for 25 years. They paid property taxes, bought insurance, installed utilities, and posted “No Trespassing” signs. Years later, a new owner took over the land and sought to eject the Rays. The Rays filed suit, claiming title to the cottage by adverse possession. Who wins and why? Answer: The Rays win. They did acquire title by adverse possession. Defendants argued that the Rays did not occupy the property continuously. But the court held that the requirement of © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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continuous possession is satisfied when the adverse claimant’s acts of possessing the property are consistent with acts of possession that ordinary owners of similar properties would undertake. The Rays not only occupied the property one month per year, but also repelled trespassers, made improvements, padlocked and secured the property, paid the real estate taxes, and generally demonstrated their continuous dominion and control over the property. Ray v. Beacon Hudson Mountain Corp., 88 N.Y.2d 154, 666 N.E.2d 532, 1996 N.Y. LEXIS 676 Court of Appeals of New York, 1996.

Discussion Questions 1. ETHICS During the Great Recession, home foreclosures hit an all-time high. In many instances, banks ended up as landlords and property managers, a job for which they were ill-prepared. As a result, many homes were abandoned for long periods. Some people who knew a little bit about adverse possession decided to take advantage of this ancient common law doctrine: They shamelessly occupied vacant homes, claiming them as their own, changing locks, and purchasing electricity. The new residents argued that they were not hurting anyone and acting within the bounds of the law. In response, some states lengthened the time period necessary for adverse possession. Examine the squatters’ ethics. What do you think of their behavior? Does your opinion vary if the squatters were the home’s former owners? What if the banks were ignoring the home? What would Kant and Mill say? Answer: Answers will vary. 2. Leslie buys a house from Jamal. Consider the following items in the house. -A ceiling fan -A bathtub -The carpeting -A floor lamp -A dishwasher -A television Which of the above are Jamal’s personal property? Which are real property? Which will Jamal get to take when he moves, and which will Leslie own? Answer: personal property: the floor lamp and the television (Jamal takes with him.). Real property: ceiling fan, bathtub, carpeting, dishwasher (these stay with the house and become Leslie’s property.) 3. Donny Delt and Sammy Sigma are students and roommates. They lease a house in a neighborhood near campus. Few students live on the block. The students do not have large parties, but they often have friends over at night. The friends sometimes play high-volume music in their cars, and sometimes speak loudly when going to and from their cars. Also ,departing late night guests often leave beer cans and fast food wrappers in the street. Neighbors complain about being awakened in the wee hours of the morning. They are considering filing a nuisance lawsuit against Donny and Sammy. Would such an action be reasonable? Do you think Donny and Sammy are creating a nuisance? If so, why? If not, where is the line- what amount of late night noise does amount to a nuisance? Answer: Answers will vary. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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4. The Estates is a suburb outside of Los Angeles. Local zoning ordinances require that lots be “at least one acre in size”. Al owns a one acre lot in The Estates which has never been developed. He needs cash and wants to sell the property. Al finds a potential buyer, who offers him $100,000 for the acre. But, he also finds a pair of interested buyers who each offer him $75,000 for half of his acre. Al is furious that he cannot divide his acre and sell it to two buyers. “I need that extra $50,000,” he rants. “It’s my land, and I should be able to do what I want with it!” Do you sympathize with Al, or do you think the zoning restriction is reasonable? Answer: Answers will vary. 5. Imagine that you sign a lease and that you are to move into your new apartment on August 15. When you arrive, the previous tenant has not moved out. In fact, he has no intention of moving out. Compare the English and American rules. Should the landlord in charge of getting rid of the old tenant, or should you have the obligation to evict him? Answer: Presumably, most will agree that the English rule is better for an incoming tenant, and an incoming tenant should not have the obligation to evict a previous tenant. 6. When landlords wrongfully withhold security deposits, they can often be sued for three times the amount of the security deposit. Is this reasonable? Should a landlord have to pay $3000 for a $1000 debt? What if you fail to pay a rent on time? Should you have to pay three times the amount of your normal rent? If your answers to these two questions are different, why is that? Answer: Answers will vary.

Suggested Additional Assignments Research: Zoning Students should use the Internet to find an article that addresses some unique uses of zoning laws, such as trying to prevent a large retailer from opening in a small town, or trying to prevent an adult entertainment business from opening, or trying to prevent a large residential and/or commercial development. What is the real reason people oppose the project? Does it have anything to do with zoning? Is it fair to use these laws to prevent “undesirable” businesses from locating in the area?

Research: Lease Terms Ask students to read their leases carefully, noting the following things in particular:  What, if any, warranties does the landlord make as to the unit’s condition?  What does the lease say about quiet enjoyment?  What obligations does the lease impose on the student?  Under what circumstances may the landlord evict the student?  What steps must the landlord take before commencing an eviction action?  What, if anything, does the lease say about liability for personal injuries suffered in the apartment? In the common areas? Students should then bring the leases into class, and discuss the clauses referring to these issues. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Research: Lease Law Students should go to the Web site http://www.rilin.state.ri.us/statutes/title34/34-18/INDEX.HTM where they will find a typical state landlord-tenant statute, conveniently labeled and easy to navigate. Students should check the provisions of the statute that correspond to the issues raised in the Lease Terms research exercise above. For example, as to the landlord’s warranties, students should see what the statute demands of the landlord and then compare the statutory requirements with the lease provisions. Students should do this for each of the topics indicated. How do the two differ? Are any provisions illegal or inadequate under the law? Based on the statute, students should draft what they regard as a neutral, fair lease. Field Work: Interviews Divide students into small working groups, whose job is to learn more about the relationship between landlord and student-tenant by interviewing the respective parties. The groups should interview as many landlords and students as possible. Ask the landlord questions such as:  What are the good things that happen when you rent property to students?  What are the worst problems that occur when you rent property to students?  Describe the ideal tenant.  Describe the nightmare tenant.  What change in the landlord-tenant law would you like to make, and why?  Have you ever had to go to court against a student tenant?  In your view, what is the reputation of landlords locally? Good, bad, indifferent? Is the reputation justified or unfair? Why? Ask the students analogous questions. Research: Implied Warranty of Habitability Have students research their state’s law regarding a landlord’s warranty of habitability in residential tenancies. Does state law imply this warranty in all residential leases, whether stated in the lease or not? What is the legal standard to determine whether the landlord has breached the warranty? What rights does a tenant have if the landlord has breached this warranty? Can the tenant use a self-help remedy such as withholding rent?

Chapter 29 – Personal Property and Bailment* Chapter Overview Chapter Theme This chapter is about property – both real and personal – and the rights and duties that each carries. Real property involves interests in land and things firmly attached to it, including buildings and trees. Personal property means all tangible property other than real property – a toothbrush, a share of stock, a 1961 Ferrari 250 GT California.

29-1 Acquiring Personal Property 29-5a Gifts Gift: A voluntary transfer of property from one person to another, without consideration. Donor: A person who gives property away. Donee: A person who receives a gift of property. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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A gift involves three elements: 1. The donor intends to transfer ownership of the property to the donee immediately, 2. The donor delivers the property to the donee, and The donee accepts the property.

Intention to Transfer Ownership The donor must intend to transfer ownership to the property right away, immediately giving up all control of the item. Revocable gifts: Are not gifts at all because the donor can take them back.

Delivery The donor must deliver the property to the donee, either physically or constructively. Physical Delivery. The donor must deliver the property to the donee. Constructive Delivery. A donor makes constructive delivery by transferring ownership without a physical delivery.

Inter Vivos Gifts and Gifts Causa Mortis Inter vivos gift: A gift made during the donor’s life, with no fear of impending death. Gift causa mortis: A gift made in contemplation of approaching death.

Acceptance The donee must accept the gift. If the donee should refuse a gift, then change her mind, there is no gift. The following case involves the age-old question: Who keeps the engagement ring when a relationship sours?

Case: Estate of Lowman v. Martino 2016 R. I. Super. LEXIS 4; 2016 WL 197267, Superior Court of Rhode Island, Providence, 2016 Facts: David Lowman and Sarah Martino had an on-again, off-again romance. Their relationship was at its peak when Lowman proposed to Martino with a $15,000 engagement ring on Valentine’s Day. But years later, the relationship was on the rocks -0 and Lowman was dying. Martino told Lowman that she would not marry him because he could not afford the house she wanted. She rarely visited him and threatened to take him off her health insurance. Martino refused to return his calls, much less the ring. Lowman sued Martino for the return of the engagement ring. When he died, his estate took over as plaintiff. It argued that the ring was a gift conditioned upon a marriage, which never happened. Issue: Was Martino entitled to keep the engagement ring? Decision: No. Martino had to return the ring.

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Reasoning: The law in most states classifies engagement rings as conditional gifts. That is, if a couple does not marry, the donee must return the ring to the donor, no matter who was to blame for the break-up. In this case, Martino argued that the ring was hers because the engagement ring was still on when Lowman died. But the evidence tells a different story. Martino had clearly broken up with Lowman and had even threatened to revoke his health insurance while he was dying. She neither visited him nor returned his calls. Lowman asked for the ring back. Because the ring is considered a conditional gift, the donor is entitled to its return. Martino may give the ring to Lowman’s estate or reimburse it for the full value, which is $15,000. Question: Did the court believe Ms. Martino when she said she should keep the ring because the engagement was still on at the time of Lowman’s death? Answer: No, the court found her testimony to be not credible, and cited Mr. Lowman’s testimony in his deposition, as well as Ms. Martino’s actions. Question: What did the court decide? What rule of law did it adopt? Answer: The court decided, citing the modern trend in a majority of states, that an engagement ring was a gift conditional upon a marriage, and since no marriage had occurred, the gift should be returned. Question: What options was Ms. Martino given? Answer: She could either return the ring to Lowman’s estate, or pay the estate the value of it, which was $15,000. In a similar case, below, the bride-to-be got to keep the ring. Why?

Bonus You Be The Judge: Albinger v. Harris135 Facts: Michelle Harris and Michael Albinger lived together in a stormy relationship, marred by alcohol abuse and violence, on and off for three years. When they announced their engagement, Albinger gave Harris a $29,000 diamond ring, but the couple broke off their wedding plans because of emotional and physical turmoil. Harris returned the ring. Later, they reconciled and resumed their marriage plans, and Albinger gave his fiancée the ring again. This cycle repeated several times over the three years. Eventually they ended their affair, and Harris moved to Kentucky, with the ring. Albinger sued for the value of the ring. The trial court found that the ring was a conditional gift, made in contemplation of marriage, and ordered Harris to pay its full value. She appealed. The Montana Supreme Court had to decide, in a case of first impression, whether an engagement ring was given in contemplation of marriage. (In Montana, and many states, neither party to a broken engagement may sue for breach of contract, because it is impossible to determine who is responsible for ending the relationship.) You Be The Judge: Who owns the ring?

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Holding: Michelle Harris gets to keep the ring. The court was unwilling to create a new type of conditional gift. The court discussed the history of anti-heart balm statutes, the history of ring giving, and other issues. Some excerpts of the decision follow. Abolition of Breach of Promise Actions

By the mid-1930’s, several state legislatures questioned the efficacy of court “interference with domestic relations” and passed statutes barring actions for breach of promise to marry, alienation of affections, criminal conversation and other inappropriate conduct of the “private realm.” Engagement Ring Symbology

The custom of giving expensive engagement rings is largely a mid- to late 20th Century phenomenon. The six-prong gold or platinum setting holding a raised, brilliant-cut diamond, which has become the classic engagement ring style, was created by Tiffany’s in the 1870s. DeBeers’ launched its national advertising campaign in 1939 that promised: “A diamond is forever.” To cultivate a no-return custom in America, the cartel threatened to cut off supply to dealers who bought diamonds back from purchasers. An interesting correlation exists between the mid-20th Century increase in demand for costly diamond engagement rings and the statutory changes by state legislatures to abolish the breach of promise action. After the Second World War, expensive rings became not just symbols of love, but tangible economic commitments in themselves, and appear to have gained significance as other economic incidents of marriage were in flux. Conditional Gift Theory

According to Montana law, “a gift is a transfer of personal property made voluntarily and without consideration.” The essential elements of an inter vivos gift are donative intent, voluntary delivery, and acceptance by the recipient. Another essential element of a gift is that it is given without consideration. A purported “gift” that is part of the inducement for “an agreement to do or not to do a certain thing,” becomes the consideration essential to contract formation. An exchange of promises creates a contract to marry, albeit an unenforceable one. When an engagement ring is given as consideration for the promise to marry, a contract is formed and legal action to recover the ring is barred by the abolition of the breach of promise actions. Albinger maintains he held a reversionary interest in the gift of the engagement ring grounded in an implied condition subsequent. Since actions stemming from breach of the contract to marry are barred by our “anti-heart balm” statute, Albinger urges the Court to adopt a conditional gift theory patterned on the law relevant to a gift in view of death. Under Montana law, no gift is revocable after acceptance except a gift in view of death. While some may find marriage to be the end of life as one knows it, we are reluctant to analogize gifts in contemplation of marriage with a gift in contemplation of death. This Court declines the invitation to create a new category of gifting by judicial fiat. Gender Bias

Article II, Section 4 of the Montana Constitution recognizes and guarantees the individual dignity of each human being without regard to gender. This Court and the Montana State Bar have recognized the harm caused by gender bias and sexual stereotyping in the jurisprudence and courtroom of this state. Conditional gift theory applied exclusively to engagement ring cases, carves an exception in the state’s gift law for the benefit of predominately male plaintiffs. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Engagement Ring Disposition

To preserve the integrity of our gift law and to avoid additional gender bias, we decline to adopt the theory that an engagement ring is a gift subject to an implied condition of marriage. Question: If you think that Michelle Harris should win, please answer these questions:  Intent is an element of a gift. Wasn’t Albinger’s intent to give Harris the ring only if the couple married?  If you took a poll of 10,000 Americans, wouldn’t most agree that the former fiancée should return an engagement ring if the relationship ends?  Harris gave back the ring each time they ended their unhappy affair. Doesn’t that indicate she knew it was only conditionally hers?  Although Montana has no law declaring these rings as conditional gifts, isn’t that because there has been no need of such a law – because everyone understood that the ring had to be returned? Question: If you think that Michael Albinger should win, please answer these questions:  Why should a court help someone who beat up his girlfriend?  If Albinger did not want Harris to keep the ring, why did he keep giving it to her?  Doesn’t Harris’s returning of the ring indicate simply that she voluntarily decided to give it to Albinger – not that she thought she owed it to him?  There is no such thing as a conditional gift – why should this court create one?  Typically, the man gives the ring to the woman, and typically, the woman’s family bears the expense of preparing for and hosting the wedding. Wouldn’t the proposed “conditional gift” mean that the man gets back his money but the woman’s family does not?

29-1b Found Property The primary goal of the common law has been to get found property back to its proper owner. Abandoned property: Property that the owner has knowingly discarded because she no longer wants it. Lost property: Property accidentally given up. Mislaid property: Property the owner has intentionally placed somewhere and then forgotten.

Landmark Case: Armorie v. Delamirie 93 ER 664, Middlesex, 1722

Facts: Before Parliament banned the practice in l840, many English chimney sweeps forced young children to climb the narrow flues and do the cleaning. Armorie was one such boy. But fortune smiled on him, and he found a jeweled ring. To discover its value, he carried the ring to a local goldsmith. Armorie handed the ring to the goldsmith’s apprentice, who removed the jewels from the ring and pretended to weigh it. He called out to the goldsmith that the ring was worth three halfpence. The goldsmith then offered that amount to Armorie.

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Not being a fool, Armorie refused the offer and demanded that the ring be returned. The apprentice gave him the ring, but without the jewels. Issue: Did the chimney sweep boy have a legal right to retain possession of the found jewels? Decision: Yes, he had a right to the jewels. Reasoning: Someone who finds property has a right to keep it unless the true owner claims it. In this case, the chimney sweep found the jewels, so they belonged to him. The goldsmith wrongfully withheld the stones from Armorie. The judge instructed the jury to award damages and to assume that the missing stones had been of the highest quality. Question: What kind of found property did the court classify the ring under? Answer: Lost property and the finder has rights superior to the entire world except the true owner.

29-2 Bailment Bailment: The rightful possession of goods by one who is not the owner, usually by mutual agreement between the bailor and bailee. Bailor: The one who delivers the goods. Bailee: The one who possesses the goods. Involuntary bailment: A bailment that occurs without an agreement between the bailor and bailee.

29-2a Control To create a bailment, the bailee must assume physical control of the bailor’s property with intent to possess.

Case: de Csepel v. Republic of Hungary136 Facts: Baron Herzog was a Hungarian who had amassed one of Europe’s largest private art collections. But the Herzog family was Jewish, and during World War II, the Hungarian government worked with the Nazis to confiscate all the property of Hungarian Jews. The government turned many pieces in the Herzog collection over to Hungarian museums; others were sent to Germany. The Herzog family was forced to flee or face extermination. At the end of the war, the Herzog heirs were dispersed all over the world. They claim that, at that time, they arranged for Hungary to retain possession of the collection so that the works could stay in Hungary. But when the Herzogs requested the collection’s return, Hungary refused.

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The Herzogs sued Hungary for return of the art. They argued that the postwar arrangement formed a bailment, whereby Hungary promised to safeguard their property and return it to them on demand. Hungary denied that such a deal existed. It asked the court to dismiss the lawsuit. The district court denied the motion, and Hungary appealed. Issue: Did the parties create a valid bailment agreement? Decision: Yes, there is enough evidence to suggest that the parties formed a bailment. Reasoning: The question is whether the postwar agreement created a valid bailment contract. If such a bailment was created, Hungary was merely the keeper, not the owner, of the artwork during the time of the family’s exile. If there was no such agreement, Hungary has a claim of ownership in the expropriated collection. Hungary argues that there was no bailment agreement because one of the key elements to bailment formation was absent: consent. Since the Herzogs were under duress when they made the postwar deal, a valid bailment could not have been created. The court disagreed. If there was duress, then the contract would be voidable by the Herzogs (who suffered the duress) not by Hungary. It is up to the Herzogs to decide whether or not to enforce the bailment contract, and they have decided to do so. Question: Why did Hungary’s argument, that the Herzogs’ consent was induced by duress, fail? Answer: If Hungary’s claim in this regard was valid, it would only allow the Herzog family to disclaim the agreement. It would not invalidate the agreement. Question: Why was the Judge reluctant to conclude that the Herzog family’s consent was induced by duress? Answer: The dispute has not been argued at trial yet, it is at the motion to dismiss stage. Question: Given the facts of this case, what level of due care is owed? Answer: This depends upon who receives the benefit of the bailment. The facts do not appear to give rise to a bailment for the sole benefit of the bailee or a bailment for the sole befit of the bailor. Rather this appears to be a case of mutual benefit. Thus, the bailee would need to use ordinary care with the property.

Bonus Case: Mitchell v. Bank of America National Association137 Facts: Donna and Timothy Mitchell rented a safe deposit box from a Dallas branch of the Bank of America. The lease agreement stated that the bank “had no possession or custody of, nor control over, the contents of the Box, and the Lessee [the couple] assumes all risks in connection with the depositing of such content.” The lease also permitted the bank to remove the box’s contents if the rental fee went unpaid.

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Bank officers, believing the Mitchells were behind in their rental fees, drilled into the box and removed the contents, which they inventoried and sent to a central vault elsewhere. The Mitchells expressed their displeasure and, a week later, the bank returned the contents to the Dallas branch. The couple placed the contents into a bag under the front seat of their car. Shortly after leaving the bank, the Mitchells had a flat tire. A stranger offered assistance. While they were all changing the tire, the bag disappeared. The Mitchells sued the bank, claiming that its negligence enabled bank employees to learn of the box’s contents, orchestrate the flat tire, and steal the bag. The trial court gave summary judgment for the bank, finding that the contract language quoted above meant that there was no bailment, and no possible negligence. The Mitchells appealed. Issue: Was there a bailment? Holding: Summary judgment for the Bank reversed. Common law negligence principles generally govern liability in bailment relationships. Parties to a bailment can alter the law of bailment by agreeing to contract terms that clearly vary the liability imposed by law. To the extent the lease agreement clearly addressed the duties and liabilities of the Bank for the Mitchells’ property, the lease agreement controls. To establish a bailment, there must be a delivery of personal property from one person to another for a specific purpose. The lease clearly provides that so long as the contents of the box remained in the box, there was no delivery of the property to the Bank. Accordingly, no bailment occurred due to the deposit of the Mitchells’ property into the box. However, the lease authorized the Bank to remove the contents of the box for non-payment of rent. The lease thus contemplated a delivery of the property to the Bank under certain circumstances and did not change the duties imposed by law once the Bank exercised its right to take control of the property. The trial court thus erred in granting summary judgment for the Bank on the grounds the Mitchells’ common law cause of action for breach of bailment was superseded by the written contract. Question: What law governed the Mitchells’ lease of the safe deposit box from the Bank? Answer: Contract law, because initially the terms of the box-rental agreement established their relationship. Question: How did the box-rental agreement deal with the parties’ liability? Answer: It stated that the Mitchells assumed all risks in connection with depositing contents into the safe deposit box. Question: Why do the Mitchells argue that there was a bailment? Answer: Because if the box-rental agreement controlled, the Bank as a matter of law is entitled to judgment that it is not liable for the Mitchell’s loss. If there was a bailment, then the Mitchells could attempt to convince the trial court that the Bank breached its duty of due care. Question: Why? Answer: Because if there was a bailment, the Bank’s duties with respect to the contents of the safe deposit box changed. Question: The box-rental agreement said the Bank had no possession, custody, or control over the contents of the box. Since bailment requires that the bailee exercise control over the property, how can there be a bailment? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: The no-bailment terms controlled the relationship as long as the contents remained in the safe deposit box. However, once the bank took possession and control of the contents by removing them from the box—which it had the right to do in the event of non-payment of box-rental fees— there was a bailment relationship between the parties. Question: Viewed as a bailment relationship, which party is liable for the loss? Answer: The court did not determine who was liable. It ruled that the Bank was not entitled to judgment as a matter of law that it was not liable.

Bonus Case: Sealey v. Meyers Parking System138 Facts: Sharon Sealey parked her Nissan Pulsar in Meyers’s parking garage. She locked the car and took the keys with her. When she returned that evening, she found that vandals had stolen her radio and severely damaged the car. She sued. Meyers argued that there was no bailment and hence no liability. Issue: Did the parties create a bailment? Holding: Judgment for Sealey. There was a bailment and Sealey is entitled to damages for the full cost of repairs. This was a park and lock facility, but nonetheless the garage exercised control of Sealey’s car. An attendant controlled egress at the gate; a driver was not free simply to drive away. The garage also had a security guard. Question: Why are the parties arguing about whether there was a bailment? Answer: If there was a bailment, the garage is liable for damage to her car. If there was no bailment, there is no basis for liability. Question: What was the key factor in deciding whether the parties had created a bailment? Answer: Whether the garage had control of the car. Question: The court ruled that the garage did have control. Why? Answer: The court said two factors indicated control:  Controlled egress—the only exit had a gate and an attendant  Security guard—the presence of a guard demonstrates control Question: Describe a garage in which there is no bailment. Answer: A park and lock garage in which there is no security guard, the driver pays upon entering, the driver retains her keys, and the driver exits freely without encountering a gate or attendant.

29-2b Rights of the Bailee The bailee’s primary right is possession of the property. Anyone who interferes with the bailee’s rightful possession is liable to her. The bailee is typically, though not always, permitted to use the property.

29-2c Duties of the Bailee The bailee is strictly liable to redeliver the goods on time to the bailor or to whomever the bailor designates. Strict liability means there are virtually no exceptions. The bailee is obligated to exercise due care. The level of care required depends upon who receives the benefit of the bailment. 138

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Due Care The level of care required depends upon who receives the benefit of the bailment. There are three possibilities:  Sole benefit of bailee. The bailee is required to use extraordinary care with the property.  Mutual benefit. The bailee must use ordinary care with the property.  Sole benefit of bailor. The bailee must use only slight care. This kind of bailment is called a gratuitous bailment, and the bailee is liable only for gross negligence.

Burden of Proof Once the bailor has proven the existence of a bailment and loss or harm to the goods, a presumption of negligence arises and the burden shifts to the bailee to prove adequate care.

Bonus You Be the Judge: Johnson v. Weedman 5 Ill. 495, Supreme Court of Illinois, 1843 Facts: Johnson left his horse with Weedman, paying him to board and feed the animal. Johnson did not grant Weedman permission to ride the horse. Nonetheless, Weedman took the horse for a 15-mile ride. Later that day, the horse died. However, the trial court found that Weedman had not abused the animal and that the ride had not caused the horse’s death. The court did not grant damages to Johnson, and Johnson appealed. You Be the Judge: Should Weedman pay for Johnson’s dead horse? Argument for Johnson: Your honor, Weedman was in possession of my client’s horse only to feed him and see to his basic needs. My client did not give him permission to take the horse out of the pasture. Weedman made personal use of my client’s property when he took a 15-mile ride that was in no way necessary. The trial court’s finding that Weedman did not abuse the horse during the ride is irrelevant. My client must be compensated for the loss of his animal. Argument for Weedman: My client had a legal right to possession of the horse. Riding the horse was not a substantial abuse of his rights as bailee. The horse was returned to the pasture in good condition. It was not abandoned and was not devalued in any way by the ride. The plaintiff is therefore not entitled to any compensation. The coincidental death of the horse does not change that fact. Holding: Judgment for Weedman. In this case, a young lawyer named Abraham Lincoln convinced the court that his client’s ride on the horse was not culpable. Although his client had made an unauthorized use of the bailed chattel, the ride in no way injured the horse, although it sided later form other causes and could not be returned. Lincoln convinced the court that although the ride was a breach of contract and a tort, it was not a conversion because it was not a sufficiently serious invasion of the plaintiff’s rights as bailor. Question: What was the issue in this case? Answer: The issue was whether the bailee was responsible for the loss of the bailor’s property. Question: Was Weedman authorized to ride the horse? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: No, he wasn’t. Question: Then why do you think the court did not rule against him? Answer: As a bailee, Weedman had the right to possession of the horse, and the court did not believe that his taking the horse for a ride was so far outside the scope of his rights that it was culpable. Question: Did Weedman breach the contract? Answer: Yes, but not in such a manner as to cause liability. Question: Why do you think the horse died? Answer: Answers will vary.

29-2e Liability for Defects If the bailment is for the sole benefit of the bailee the bailor must notify the bailee of any known defects. In a mutual-benefit bailment, the bailor is liable not only for known defects, but also for unknown defects that the bailor could have discovered with reasonable diligence.

29-2f Common Carriers and Contract Carriers Common carrier: A company that transports goods and makes its services regularly available to the general public. Generally, a common carrier is strictly liable for harm to the bailor’s goods. Contract carrier: A company that transports goods for particular customers. A contract carrier does not incur strict liability.

29-2g Innkeepers Hotels, motels, and inns frequently act as bailees of their guests’ property. Most states have special innkeeper statutes that regulate liability. Hotel patrons often assume that anything they bring to a hotel is safe. But some state innkeeper statutes impose an absolute limit on a hotel’s liability. Other statutes require guests to leave valuables in the inn’s safe deposit box. A state statute might require the guest to register the nature and value of the goods with the hotel. If a guest fails to follow the statutory re2quirements, he receives no compensation for any losses suffered.

Chapter Conclusion Personal property law plays an almost daily role in all of our lives. The manager of a parking lot, the finder of lost property, and the operator of an airport security system must all realize that they may incur substantial liability for personal property, whether they intend to accept that obligation or not. Understanding personal property can be worth its weight in gold … or Ferraris, art, or jewels.

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Matching Questions Match the following terms with their definitions: _____A. Extraordinary care 1. A gift made with no fear of death, cannot be revoked _____B. Inter vivos gift 2. Required level of care in a bailment made for the sole benefit of the bailee _____C. Ordinary care 3. A gift made in contemplation of approaching death, can be revoked _____D. Gift causa mortis 4. Required level of care in a bailment made for the mutual benefit of the bailor and bailee _____E. Slight care 5. Required level of care in a bailment made for the sole benefit of the bailor Answers: EEEEE. FFFFF. GGGGG. HHHHH. IIIII. 5

2 1 4 3

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 139. T F A gift is unenforceable unless both parties give consideration. 140. T F A gift causa mortis is automatically revoked if the donor dies shortly after making it. 141. T F A bailee always has the right to possess the property. 142. T F A finder of lost property generally may keep the property unless the true owner comes forward. 143. T F A common carrier is strictly liable for harm to the bailor’s goods.

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CPA QUESTION Which of the following requirements must be met to create a bailment? I. Delivery of personal property to the intended bailee II. Possession by the intended bailee III. An absolute duty on the intended bailee to return or dispose of the property according to the bailor’s directions A. I only B. II only C. Both I and II D. None of the above Answer: C.

Martin is a rich businessman in perfect health. Monday morning he tells his niece, Stephanie, “Tomorrow I’m going to give you my brand new Ferrari.” Stephanie is ecstatic. That afternoon, Martin is killed in a car accident. Does Stephanie get the car? A. Stephanie gets the car because this is a valid inter vivos gift. B. Stephanie gets the car because this is a valid gift causa mortis. C. Stephanie gets the car because there is no reason to dispute that Martin made the promise. D. Stephanie gets the car unless Martin left a wife or children. E. Stephanie does not get the car. Answer: E

Margie has dinner at Bill’s house. While helping with the dishes, she takes off her Rolex watch, and forgets to put it back on when she leaves for the night. Bill finds the watch in the morning and decides to keep it. 3.

A. This is abandoned property and Bill is entitled to it. B. This is lost property and Bill is entitled to it. C. This is lost property and Margie is entitled to it. D. This is mislaid property and Bill is entitled to it. E. This is mislaid property and Margie is entitled to it. Answer: E. 4. Arriving at a restaurant, Max gives his car keys to the valet. When the valet returns the car three hours later, it has a large, new dent. The valet says he did not cause it. Max sues the valet service. A. The burden is on the valet service to prove it did not cause the dent. B. The burden is on Max to prove that the valet service caused the dent. C. The valet service is strictly liable for harm to Max’s car. D. The valet service has no liability to Max, regardless of how the dent was caused. E. The valet service is only liable for gross negligence. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: A. 5. Car Moves hauls autos anywhere in the country. Valerie hires Car Moves to take her Porsche from Chicago to Los Angeles. The Porsche arrives badly damaged, because the Car Moves truck was hit by a bus. The accident was caused by the bus driver’s negligence. If Valerie sues Car Moves for the cost of repairs A. Valerie will win. B. Valerie will win only if she can prove Car Moves was partly negligent. C. Valerie will win only if she can prove that Car Moves agreed to strict liability. D. Valerie will lose because Car Moves did not cause the accident. E. Valerie will lose because this was a bailment for mutual benefit. Answer: A

Case Questions 1. While in her second year at the Juilliard School of Music in New York City, Ann Rylands had a chance to borrow for one month a rare Guadagnini violin, made in 1768. She returned the violin to the owner in Philadelphia, but telephoned her father to ask if he would buy it for her. He borrowed money from his pension fund and paid the owner. Ann traveled to Philadelphia to pick up the violin. She had exclusive possession of the violin for the next 20 years, using it in her professional career. Unfortunately, she became an alcoholic, and during one period when she was in a treatment center, she entrusted the violin to her mother for safekeeping. At about that time, her father died. When Ann was released from the center, she requested return of the violin, but her mother refused. Who owns the violin? Answer: Ann does. Ann’s father made a valid inter vivos gift of the violin while Ann was still a student. He intended to transfer ownership to her immediately, and made delivery by permitting her to pick up the violin. From that point on, Ann owned it. Rylands v. Rylands, 1993 Conn. Super. LEXIS 823 (Conn. Super. Ct. 1993). 2.

Eileen Murphy often cared for her elderly neighbor, Thomas Kenney. He paid her $25 per day for her help and once gave her a bank certificate of deposit worth $25,000. She spent the money. Murphy alleged that shortly before his death, Kenney gave her a large block of shares in three corporations. He called his broker, intending to instruct him to transfer the shares to Murphy’s name, but the broker was ill and unavailable. So Kenney told Murphy to write her name on the shares and keep them, which she did. Two weeks later Kenney died. When Murphy presented the shares to Kenney’s broker to transfer ownership to her, the broker refused because Kenney had never endorsed the shares as the law requires, that is, signed them over to Murphy. Was Murphy entitled to the $25,000? To the shares? Answer: Murphy gets the $25,000. There was delivery, acceptance, and adequate evidence that Kenney intended the items as gifts. Murphy is not entitled to the shares, though, because without the endorsement there is no delivery, an essential element. Kenney lived for two weeks after instructing Murphy to write her name on the shares and during that time should have endorsed © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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them to her, or caused a broker to do so. IN RE Estate of Kenney, 1993 Ohio App. LEXIS 2481, Ohio Ct. of App., 1993). 3. Artist James Daugherty painted six murals on the walls of the public high school in Stamford, Connecticut. Many years later, the city began to restore its high school. The architect and school officials agreed that the Daugherty murals should be preserved. They arranged for the construction workers to remove the murals to prevent harm. By accident, the workers rolled them up and placed them near the trash dumpsters for disposal. A student found the murals and took them home, and later notified the federal government’s General Services Administration (GSA) of his find. The GSA arranged to transport the murals to an art restorer, named Hiram Hoelzer, for storage and eventual restoration, when funds could be arranged. Over 19 years went by before anyone notified the Stamford School system where the murals were. In the meantime, neither the GSA nor anyone else paid Hoelzer for the storage or restoration. By 1989 the murals were valued at $1.25 million by Sotheby’s, an art auction house. Hoelzer filed suit, seeking a declaration that the murals had been abandoned. Were they abandoned? What difference does it make? Answer: Abandonment is a vital issue because if Stamford abandoned the murals, Hoelzer probably owns them. An owner abandons property only by deliberately relinquishing all right in it. A court will never presume abandonment. Here, the court concluded that Stamford had never intended to abandon ownership, largely because the city did not know where the murals were. Stamford still owned them. Hoelzer v. City of Stamford, Conn., 933 F.2d 1131, 1991 U.S. App. LEXIS 10830 (2d Cir. 1991). 4. The Louisiana Civil Code limits an innkeeper’s liability for stolen property to $500 and only covers cash, jewelry, rare art items, furs, cameras, and negotiable instruments. While staying at the New Orleans Hilton, Allen Chase was drugged by a woman he met at the hotel bar. He woke up the next morning to find that his gold watch, wallet, credit cards, passport, business papers, and camera were gone As a result of the drug, Chase suffered health problems, which seriously affected his business. Believing that the hotel bartender had helped the woman who drugged him, Chase sued Hilton for negligence in the amount of $575,000. Who wins and why? Answer: The court limited Chase’s recovery to $500 per the statute. Allen Chase v. Hilton Hotels, 682 F.Supp. 316 (1988)

ETHICS Famous artists Georgia O’Keefe and Alfred Stieglitz donated 101 artworks to Fisk University in the 1940s. But the gift had two conditions: The pieces could not be sold and they had to be displayed as one collection. Over 50 years later, Fisk could not pay to maintain the collection and decided to sell two of the pieces. Proceeds of the sale would go to restore its endowment and build a new science building. The Georgia O’Keefe Foundation sued to stop the sale, arguing that the artists would have opposed it. Should the law permit this sale? Do you agree with Fisk’s actions? What duties do gift recipients have to donors? What would Kant and Mill say? Answer: Answers will vary. Based on Georgia O’Keefe Foundation v. Fisk University, 312 S.W.3d 1 (2009).

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Discussion Questions 1. Ann is Becky’s best friend. Tomorrow, Ann will move across the country to start a new job. Feeling sentimental on a night of good-byes, Becky gives Ann a necklace that has been in Becky’s family for 50 years. “You’ve always liked this, and I want you to have it,” she says. Ann accepts the necklace. Early the next morning, Becky reconsiders. She finds Ann at the airport, and sees her wearing the necklace. “Ann, my grandmother gave me that necklace. I’m sorry, but I want it back,” she pleads. “You know,” Ann replies with a smile, “I think I’m going to keep it.” Is Ann legally required to return the necklace? Is she ethically required to return the necklace? Answer: Ann is not legally required to return the necklace, because all elements of a gift have been met. One can debate her ethical requirements, but most would agree that in this situation, she should return it. 2. “Finders keepers, losers weepers” is a common children’s rhyme. Does the law mirror its sentiment? Answer: Answers will vary. 3. Historically, the law has viewed animals as personal property. As a result, when a pet is wrongfully killed, its owner can only recover the cost of replacing the animal. Some groups have challenged this view, arguing that animals are fundamentally different from other forms of personal property. Do you agree? How should the law address the ownership of animals? Answer: Answers will vary. 4. After a baseball game, Randy cannot find his car in the stadium parking lot. For the life of him, he cannot remember where he parked. He wanders down row after row for an hour, and then another hour. Eventually, he gives up and calls a cab. Is Randy’s car lost, abandoned, or mislaid? If Randy never returns to reclaim the car, who owns it? Answer: Although in a conventional sense Randy has “lost” his car, it has actually been mislaid because he intentionally placed it in its parking place and then forgot its location. The baseball team will own the car if Randy never returns. 5. If there has been no account activity for an extended period of time, state laws require banks to turn the customers’ property over to the state. State treasurers or comptrollers are responsible for holding the abandoned or lost property, which often includes money, watches, jewelry, and coins from abandoned safe deposit boxes. What rules should govern this property? How long should citizens have to claim it? What should the government do with unclaimed property? Answer: Answers will vary.

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Suggested Additional Assignments Research: Gifts Students should find the website of a nonprofit organization that solicits gifts, such as the World Wildlife Foundation at http://worldwildlife.org/how_to_help. In a one-page paper, students should summarize the many different ways to donate to the organization, and should clarify which are true gifts and which are testamentary disposals. Research: Bailment Dispute On the Internet, students should find an article discussing a current bailment dispute. They should submit brief written answers to these questions:  How was the bailment created–by contract, informal agreement, or constructively?  Did the bailee assume physical control of the property?  Who received the benefit of this bailment (bailee, bailor, or both parties)?  What level of care does the law impose in such a bailment?  What is the dispute about?  Who has the burden of proof?  Were any exculpatory clauses involved? If so, were they enforceable?  Did any statutes govern this type of bailment, such as an innkeeper or common carrier law? Action Learning: Itemized Bailments Ask students to make a list of bailments in which they have been involved during the last year, as either bailor or bailee. For example, borrowing a parent’s car, lending a book to a friend, checking a coat in a restaurant, etc. Offer a prize for the most unusual bailment.

Chapter 30 – Estate Planning* Chapter Overview Chapter Theme Most people do not like to think about death, especially their own. And they particularly do not want to spend time and money thinking about it in a lawyer’s office. However, responsible adults understand how important it is not to leave their financial affairs in chaos when they do eventually die.

Food for Thought Despite having a large group of feuding heirs, Picasso died without a will.

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30-1 Introduction to Estate Planning There is one immutable law of the universe: “You can’t take it with you.” But you can control where your assets go after your death. Or you can decide not to bother with an estate plan, and leave all in chaos behind you.

30-1a Definitions Estate planning. The process of giving away property after (or in anticipation of) death. Estate. The legal entity that holds title to assets after the owner dies and before the property is distributed. Decedent. The person who has died. Testator or testatrix. Someone who has signed a valid will; Testatrix is the female version (from the Latin). Intestate. To die without a will. Heir. Technically, the term heir refers to someone who inherits from a decedent who died intestate. Devisee means someone who inherits under a will. However, common parlance and many courts use heir to refer to anyone who inherits property, and we follow that usage here. Issue. A person’s direct descendants, such as children and grandchildren. Probate. The process of carrying out the terms of a will. Executor or Executrix. A personal representative chosen by the decedent to carry out the terms of the Will. An executrix is a female executor. Administrator or administratrix. A personal representative appointed by the probate court to oversee the probate process for someone who has died intestate (or without appointing an executor). As you can guess, an administratrix is a female administrator. Grantor or settlor. Someone who creates a trust. Donor. Someone who makes a gift or creates a trust.

30-1b Purpose Estate planning has two primary goals: to ensure that property is distributed as the owner desires and to minimize estate taxes.

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30-1c Probate Law The federal government and many states levy estate taxes, but only the states have probate codes to regulate the creation and implementation of wills and trusts. These codes vary from state to state, so this chapter speaks only of general trends among the states.

30-2 Wills Will: A legal document that disposes of the testator’s property after death. It can, in most instances, be revoked or altered at any time until death. Virtually every adult, even those with modest assets, should have a will to: 

Ensure that their assets are distributed in accordance with their wishes.

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Provide guardians for minor children. If parents to not appoint a guardian before they die, a court will.

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Select a personal representative to oversee the estate. If the decedent does not name an executor in a will, the court will appoint an administrator.

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Avoid unnecessary expense.

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And to say what you really think?

30-2a Requirements for a Valid Will Generally speaking, a person may leave his assets to whomever he wants. However, the testator (male) or testatrix (female) must be:  Of legal age (which is 18).  Of sound mind. That is, she must be able to understand what a will is, more or less what she owns, who her relatives are, and how she is disposing of her property.  Acting of her own free will. Undue influence means that one person has enough power over another to force him to do something against his free will. Key Issue: Making a Will Question: Virtually everyone needs a will. Why? Answer: Almost everyone has assets–whether trinkets with just sentimental value or employee pension plans. Without a will, your property goes according to intestacy laws, which may not be what you want to have happen. If you have children who are minors, you need to appoint a guardian for them. Joint property is not a substitute for a will. If you and your spouse both die simultaneously in a car accident, then where does the property go? It is important to select an executor. General Questions: How many students in the class have a will? Students often think that they do not need a will. Did this discussion change their minds? Do any of these reasons apply to them? Will Drafting Exercise: If students completed the suggested will-drafting exercise, this is a good opportunity to look at some of their efforts. Question: Have they been sure to: Include everyone important–spouse, children, parents, siblings (where appropriate), Appoint a guardian for minor children (and check with the proposed guardian first!), Name an executor, and comply with all the required technicalities–witnesses, etc.? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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You Be the Judge: Cresto v. Cresto 302 Kan. 820, Kansas Supreme Court, 2015 Facts: Francis Cresto was married three times over a 50-year period. He had three biological children with his first wife; a stepdaughter, Lauri, with his second wife; and seven stepchildren with his third wife, Kathleen. At the time of his death, Francis and Kathleen lived in Kansas and the numerous family seemed to get along well. Francis owned a large stock portfolio, part of a family farm, and valuable family heirlooms. Prior to meeting Kathleen, he executed an estate plan (both a will and a trust) prepared by his long-time lawyer, Edward White. This plan gave the family farm and heirlooms to his children, while dividing the stock portfolio among his three children and his stepdaughter, Lauri. A few years later, Francis tweaked this estate plan, but the primary result was the same – everything went to his three children and Lauri. Shortly after marrying Kathleen, Francis asked White to re-draft his estate plan to give Kathleen the income from his assets during her lifetime. At her death, everything went to his three children and Lauri. Four years later, Francis called Patricia Hackett, an Indiana lawyer, to ask for her help in revising his estate plan. Hackett was in a romantic relationship with Kathleen’s daughter Rita. Hackett agreed, but told Francis he would need a Kansas lawyer to review the plan to ensure that it was valid in that state. Although White was available, Hackett suggested another Kansas lawyer, James Logan, who had been a federal judge. The estate plan that Hackett drafted left everything to Kathleen. But if she died before Francis, her children would receive all of his personal property (including the family heirlooms), plus$25,000 each, and the rest would go to several charities. Hackett sent the documents to Logan for review, but did not disclose her relationship with Kathleen’s daughter. When Francis went to Logan’s office to execute the documents, they spent 30 minutes discussing his assets and his reasons for the change in his estate plan. Logan testified that, although Kathleen was present, Francis was competent and in charge. Francis had said that his children were successful business people and did not need the money. He wanted to take care of Kathleen. Eighteen months later, Francis was diagnosed with dementia. H died the following year. His children sued to overturn his estate plan, alleging that Kathleen had exercised undue influence over him. You Be the Judge: Did Kathleen exercise undue influence? Was Francis’s estate plan valid? Argument for Francis’s Children: Before meeting Kathleen, Francis had always used Edward White, a lawyer who knew the family well. With White’s help, Francis had made three estate plans that left all of his assets to his children and Lauri. Even after he married Kathleen, the plan drafted by White provided for her in her lifetime, but then gave everything to his children and Lauri. Then Francis fired White and went to Hackett, who was out of state and the romantic partner of one of Kathleen’s children. Hackett clearly had a conflict of interest, which she did not disclose to Logan before he helped Francis execute the documents. Undue influence cases often begin with the firing of a long© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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time, trusted legal adviser. Also, Kathleen was in the room when Francis signed the documents. Suddenly he left everything to her, including family heirlooms and farm. Even if he outlived Kathleen, his assets would go to charity rather than his children. This act, this sudden change of heart, does not reflect Francis’s free will. Moreover, eighteen months after making this plan, Francis was diagnosed with dementia. He could well have had diminished capacity when he signed his final estate plan. Argument for Kathleen: Francis and Kathleen had a happy marriage. But he was not that close to his children. Moreover, his children were all well-off, she was not. It made senses for him to take care of his wife. Francis switched to Hackett because he liked her, she knew the family well, and was likely to outlive him. Logan, an impartial lawyer, interviewed Francis extensively before he signed the documents. This was an experienced, objective lawyer who had no prior relationship with either Hackett or Francis. He took his fiduciary obligations seriously and would not have participated in a scheme that looked to him like undue influence. Holding: Judgment for Francis’s children. The court found that Kathleen, through the actions of her daughter’s paramour, had exerted undue influence over Francis resulting in the estate plan that, for the first time in his life, disinherited his own children, even to the extent to giving away family heirlooms. Previously, when Francis had remarried, he had added the children from the new marriage to his own children in his estate plan. This time, all children were disinherited in favor of Kathleen and her children. Question: Was there direct evidence of undue influence? Answer: No, there rarely is in cases of undue influence. Usually the evidence is circumstantial. Question: What circumstantial evidence supports the claim of Francis’s children? Answer: First, Francis for the first time, disinherited his own children, and his stepchildren who had been previously included. Second, for this new estate plan, he abandoned his long-time trusted legal advisor in favor of someone recommended by Kathleen. Third, she did not tell Francis that she was romantically involved with Kathleen’s daughter.

Bonus You Be the Judge: In re Estate of Ulrich139 Facts: Wayne Ulrich had lived his whole life on his family farm. His only relatives were his brother, Raymond (who lived on the farm next door) and Raymond’s two adult daughters and their children. Wayne saw and talked on the phone with them fairly regularly, but was not particularly close to them. When he was 68, he signed a will leaving his property to his nieces and their children. He then met Susan Sorenson, who was a customer at his farm. Ten years after he met her, he suddenly broke off all communication with his brother and closest friends, because he thought they had stolen items from his home while he was in the hospital. His list of missing items included dish towels and a canister of dried prunes. There was no evidence that they had taken anything.

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Wayne began to rely on Sorenson to help him with household chores and personal grooming. He attended many Sorenson family events and began to look upon her as a daughter. He also had daily help from a home healthcare assistant. Two years later, when Wayne was 80 years old, he asked his lawyer to draft a power of attorney giving Sorenson authority over his affairs and a will leaving everything to her. He told the lawyer that Sorenson would not accept a power of attorney unless it gave her the right to control his money. He believed that she would take care of him and keep him out of a nursing home. The lawyer refused to draft the documents. Sorenson recommended a different law firm, although she herself was not a client there. She drove him to his appointment but did not attend his meetings. Because Wayne’s request was so unusual, the lawyer insisted that he meet privately with two other attorneys at the firm to assess his competence and any undue influence. Wayne explained that Sorenson was like family to him and his nieces would inherit from their father. All three lawyers stated that Wayne was a competent, very strong-willed person who made his own decisions and who was not likely to be unduly influenced. Wayne signed both a will and a power of attorney. Three years later, Wayne entered a nursing home. Sorenson visited, took him on excursions, and bought what he needed. During the last five years of his life, Sorenson wrote herself $256,000 worth of checks from Wayne’s accounts. She said they were gifts from Wayne. Bette Schmidt, one of Wayne’s nieces, sued, alleging that Wayne’s will was invalid because of Sorenson’s undue influence. Sorenson moved for summary judgment, which the trial court granted. Schmidt appealed. You Be the Judge: When Wayne altered his will, was he acting under undue influence? Argument for Schmidt: When Wayne Ulrich changed his will, he was a confused old man, isolated from his family and long-time friends. Did he really think someone had stolen a canister of prunes from him? He had lived on his farm his entire life. When he asked for the power of attorney and the new will, he was clearly afraid of having to go into a nursing home. He was depending on Sorenson to keep him at home. (Not that she did.) Sorenson refused to accept a power of attorney unless it gave her the right to take money from Wayne. And take she did—hundreds of thousands of dollars. Wayne’s request for the power of attorney and will was so unusual that the first lawyer refused to draft it for him. Then Sorenson helpfully found another lawyer and even drove him to his appointment. Three lawyers said he was competent, but of course they had an incentive to say so. And competence is not the same thing as acting with free will. How could they assess, in one visit, her influence over him? Argument for Sorenson: No one has alleged that Wayne was demented or unaware of what he was doing. And when he changed his will, he was not isolated—home healthcare aides visited him regularly. At that point, Sorenson had taken care of him for more than a decade. She continued to care for him afterward—visiting him at the nursing home and taking him on excursions. He considered her his family and, indeed, she acted like a daughter. As for his biological family, he knew that his brother would be able to provide for his nieces and their children. There is no evidence that Sorenson told him to change his will or make the power of attorney. She was not in the room when he met with the lawyers. Three of them interviewed him before allowing him to sign the documents. If anything, Wayne was the opposite of confused or persuadable: He was a hardheaded man who had the right to change his will. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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It is easy to see why the nieces are disappointed at being left out of their uncle’s will. No one likes being disinherited. But the money and the farm were Wayne’s to do with as he pleased. Holding: Judgment for Sorenson affirmed. Because decedent left his estate to Sorenson, the district court concluded that Schmidt does not have a property interest in decedent’s estate and therefore lacks standing to assert a claim. We agree. The district court did not err in granting summary judgment to Sorenson on this claim. Question: According to Schmidt, which of the three elements of a valid will appears to be lacking? Answer: Acting without undue influence. Sorenson is clearly of legal age and, according to the attorneys who interviewed him, of sound mind. Question: What is a power of attorney? Answer: A document that permits the attorney-in-fact (Sorenson) to act for the principal (Ulrich).

A testator must comply with the legal requirements for executing a will:  It must be in writing,  The testator must sign it or direct someone else to sign it for him, if he is too weak.  Generally, two witnesses must also sign the will. Under the UPC, a notarized will does not require any witnesses, but only a few states have passed this provision.  No one named in the will should also serve as a witness because, in many states a witness may not inherit under a will.

Holographic Will Holographic will: A will that is handwritten and signed by the testator, but not witnessed. Some states recognize a holographic will. A holographic will must be in a testator’s own handwriting – it cannot be typed or written by someone else.

Nuncupative Will Nuncupative will: An oral will. A few states also accept a nuncupative will for personal property but not for real estate. But for the will to be valid:  The testatrix must know she is dying  There must be two witnesses, and These witnesses must know they are listening to her will.

30-2b Spouse’s Share In community property states, a spouse can override the will and claim one0half of all marital property acquired during the marriage, except property the testator inherited or received as a gift. In most non-community property states, a spouse can override the will and claim some percentage of the decedent’s estate (which varies by state).

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30-2c Children’s Share Pretermitted child: A child who is left nothing under the parent’s will. Parents are not required to leave assets to their children—even minors whom the testator was obligated to support while alive. They may disinherit their children for any reason (in most states, even if they are minors). But the law presumes that a pretermitted child was omitted by accident unless a parent clearly indicates in a will that he has omitted the child on purpose.

Case: In re Estate of Josiah James Treloar, Jr.140 Facts: Josiah Treloar’s first will left his estate to his wife unless she died before he did, in which case one piece of land was to go to his daughter, Evelyn, another to his son, Rodney, and the rest of his estate was to be divided equally among Evelyn, Rodney and another daughter, Beverly. After his daughter Evelyn died, Josiah executed a new will. To help his lawyer in preparing this document, Josiah gave him a copy of the old will with handwritten changes, including Evelyn’s name crossed out. The new will left the land to Rodney and the remainder of the estate to Rodney and Beverly equally. Evelyn’s husband and children got nothing although Evelyn’s husband, Leon, was named as executor. The will stated: “I hereby nominate and so far as I legally may appoint as Executor of this will, my son-in-law, Leon Merrill of Concord, New Hampshire.” Under New Hampshire law, all issue (including children and grandchildren) can qualify as pretermitted heirs. The law assumes that if the testator does not leave anything to his issue or does not refer to them in his will, it is because he has forgotten them. They are therefore entitled to a share of his estate. If Josiah had mentioned Evelyn then the assumption would be that he had not forgotten her or her children. Evelyn’s children argued that they were pretermitted heirs and, therefore, were entitled to a share of Josiah’s estate. Josiah’s attorney was serving as executor (not Leon). When he refused to pay the children, they sued. Issue: Are Evelyn’s children entitled to a share of Josiah’s estate? Decision: Yes, Evelyn’s children are entitled to a share of the estate. Reasoning: Most people leave their money to their children and grandchildren. Therefore, when a parent omits one or more of these heirs from his will, the law in New Hampshire assumes that it was a mistake unless he clearly specifies in the will that he had left them out on purpose. In this case, it seemed that Josiah had not forgotten Evelyn or her children. After all, he had crossed her name out of the old will he had given his lawyer to use as a basis for the new document. He also listed her husband, Leon, as executor. Presumably, he remembered that Leon was married to Evelyn. Nonetheless, it is not the court’s job to try to figure out what Josiah did or did not remember. The law is clear – indirectly alluding to the children or grandchildren is not sufficient. Because Josiah did not 140

151 N.H. 460; 859 A.2d 1162; 2004 N.H. LEXIS 177 Supreme Court of New Hampshire, 2004 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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specifically refer to Evelyn or her children within the four corners of the will, it is presumed he forgot them, and therefore they are entitled to a share of his estate. Question: What is a pretermitted heir? Answer: A pretermitted heir is a child who is left nothing in the parents’ will. Question: Is a child entitled to inherit something? Answer: No, a child has no automatic right to inherit. A parent can leave a child out on purpose, but not by accident. Answer: How can courts tell if a child is left out by accident? Answer: They can’t really. But if children are not named in the will, courts assumed they have been forgotten by accident. Question: What must a parent do then if he doesn’t want to leave money to a child? Answer: He must explicitly state in the will that he is leaving her nothing (or a nominal amount). Question: Why does the law presume that a child who is left nothing has been forgotten? Answer: Because children are the natural object of a parent’s bounty. To overcome this presumption, the law requires proof that the parent intended to omit the child from the will. Question: What happens to the pretermitted heir? Answer: The child is generally entitled to the same share she would have received if her parent had died intestate. Question: How much is that? Answer: Each state has its own intestacy statutes, establishing how the estate of a person who dies without a will is distributed. Question: In this case, did Josiah forget Evelyn? Answer: It seems that he did not. He crossed her name out of the prior will and he referred to her husband in the current will. Question: Why did the court ignore his clear intent? Answer: Wills are so important they must comply with the technicalities. Courts will not guess what a testator meant. Question: What should Josiah have done? Answer: He should have explicitly stated that he was leaving Evelyn out. Or he could have left her heirs $1.

Issue: A person’s direct descendants, such as children and grandchildren. Per stirpes: Each branch of the family receives an equal share. Per capita: Each heir receives the same amount. In drafting a will, lawyers use the term issue instead of children, meaning all direct descendants, so that if one child dies before the testator, that child’s children will inherit his share. The will must also indicate whether issue are to inherit per stirpes or per capita.

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30-2d Digital Assets The rules on the inheritance of digital assets are based on: Service provider policies: Google has set up an Inactive Account Management System Facebook now takes a similar approach Statutes: Almost half of the states have adopted the Uniform Fiduciary Access to Digital Assets Act, which permits a decedent to specify in his will who will inherit his digital assets.

30-2e Amending a Will Codicil: An amendment to a will. A testator can generally revoke or alter a will at any time prior to death.

30-2f Intestacy When someone dies intestate, the law steps in and determines how to distribute the decedent’s property.

Research: Key Issue: Intestacy If you asked your students to do the Suggested Additional Assignment in which they looked up the intestacy laws in your state, this would be a good time to let the students report the results of their research. General Questions: Where would their assets go if they:  Have a spouse and children  Have a spouse but no children  Have children but no spouse, or  Are single?

30-2g Power of Attorney Power of attorney: A document that allows one person to act for another. Attorney-in-fact: The person who has the authority under a power of attorney to act for the principal. Durable power: A power of attorney that remains valid even if the principal becomes incapacitated. A power of attorney is a document that permits the attorney-in-fact to act for the principal. (An attorney-in-fact need not be a lawyer.) Typically, a power of attorney expires if the principal revokes it, becomes incapacitated or dies. But a durable power is valid even if the principal can no longer make decisions for herself.

30-2h Probate The testatrix appoints an executor to implement the estate, typically a family member, lawyer, or close friend. If no executor is appointed, the probate court appoints an administrator.

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A will does not control the distribution of retirement, life insurance, or most joint property. Property held in joint tenancy automatically passes to the surviving owner.

30-2j Anatomical Gifts The demand for transplants of organs is much greater than the supply. You can register to be an organ donor:  Under the Uniform Anatomical Gift Act (UAGA), by putting a provision in your will or by signing an organ donation card in the presence of two witnesses,  By using a smartphone app such as DonateLives or Organ Donor ECard, or,  In some states, by signing up when you apply for or renew a driver’s license. The UAGA provides that unless a decedent has affirmatively indicated her desire not to be a donor, family members have the right to make a gift of her organs after death.

30-2k End of Life Health Issues Living Wills or advance directives: In the event that a person is unable to make medical decisions, this document indicates her preferences and may also appoint someone else to make these decisions for her. Health care proxy: Someone who is authorized to make health care decisions for a person who is incompetent. Physician-assisted death or assisted suicide: When a doctor prescribes a lethal dose of medication at the request of a terminal patient who is suffering intolerably.

Interview If you asked your students to talk with their parents or guardians about whether they have living wills, now would be an opportune moment to ask the results of their interviews. General Questions: Did they find out something that surprised them? Do they have (or plan to have) their own living will? Do they have objections to the concept of a living will?

Example For the last four years, Brenda Young has spent her days in torment, rhythmically screaming and thrashing in her mother’s modest house in Flint, Michigan. Since a seizure at age 34, Ms. Young has needed total care. She must be fed, bathed, diapered, and, at night, tied into bed so she does not push herself over the padded bed rails. Sometimes she manages a few intelligible words: “Water” or “Bury me.” But mostly she screams, over and over, for five and six hours at a time. Her father, unable to stand it, abandoned his wife after more than 30 years of marriage. Her mother has tried to find a convalescent home for her, but none has been willing to cope with the screaming. Young’s situation was predictable. For some time she had been suffering seizures that were becoming increasingly severe. Her doctor had warned her that she would ultimately become profoundly disabled. A month before the seizure that left her so disabled, Young signed an advance directive giving her mother a power of attorney to stop treatment if she became incapacitated. But to no avail: after her next seizure, the hospital put Young on a ventilator and tube-fed her during a two-month coma, despite her mother’s insistence that Young did not want life support. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Divide students into three groups, one to represent each side in this case, and one to serve as jury. Question: Should Young and her mother be able to recover damages from the hospital that treated Young against the instructions of her mother? On what legal theories might Young and her mother base their claims? Answer: This type of lawsuit is typically based on: Negligence, Intentional infliction of emotional, physical, and financial distress, and/or Battery. Question: What arguments might the hospital make? Answer: The hospital made the following arguments: Young’s doctors believed they were doing what was best for her. No one could have predicted how disabled she would be. It is often difficult to predict whether an emergency intervention will improve the patient’s quality of life or consign her to a painful, prolonged death. Keeping someone alive against her will is not a tort–wrongful death is a tort, not wrongful life. Saving a life should never be against the law. The decision had to be made very quickly, and the doctors did the best they could under the circumstances. Doctors instinctively think that if they do not act quickly and the patient dies, they will be liable. Question: If you were on the jury, what would you decide? Answer: In this case, the jury awarded Young and her mother $16.5 million. This is apparently the first award of its kind, but there is a new wave of lawsuits seeking to hold hospitals, nursing homes, and doctors liable for ignoring advance directives.141

Bonus Case: You Be the Judge: Washington v. Glucksberg Facts: The plaintiffs comprise a coalition of three terminally ill patients, five physicians who treat terminally ill patients, and Compassion in Dying, an organization that provides support to mentally competent, terminally ill adults considering suicide. Jane Roe (she and the other patients used pseudonyms) is a 69-year-old retired pediatrician who has suffered for six years from metastatic cancer. Although she underwent chemotherapy and radiation, she is now in the terminal phase of her disease. She has been almost completely bedridden for a year and is in severe pain despite the use of pain medication. She also suffers from swollen legs, bed sores, poor appetite, nausea, and vomiting, impaired vision, incontinence of bowel, and general weakness. John Doe is a 30-year-old artist dying of AIDS. Since his diagnosis three years ago, he has experienced two bouts of pneumonia, chronic, severe skin and sinus infections, grand mal seizures, and extreme fatigue. He has already lost 70 percent of his vision to a degenerative disease that will end in blindness and rob him of his ability to paint. James Poe is a 69-year-old retired sales representative who suffers from emphysema. He is connected to an oxygen tank at all times and takes morphine regularly to calm the panic reaction associated with his constant feeling of suffocating. Poe also suffers from heart failure related to his pulmonary disease, which obstructs the flow of blood to his extremities and causes severe leg pain. He is in the terminal

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Tamer Lewin, “Ignoring „Right to Die‟ Directives, Medical Community Is Being Sued,” New York Times, June 2, 1996, p. 1 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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phase of his illness. [This medical information about the patients is from the appeals court decision.142 It was omitted from the Supreme Court opinion, but is included here to help students understand the issues better.] All three patients are mentally competent and wish to commit suicide by taking physician-prescribed drugs. They are prevented from doing so by a statute in the state of Washington that makes it a felony to help another person attempt suicide. You Be the Judge: Does a state have the right to punish those who assist the terminally ill to commit suicide? Holding: The trial court held the statute was unconstitutional. A three-judge panel of the court of appeals overturned the trial court. The full appeals court agreed to rehear the case en banc. By a vote of 8-3, the en banc appeals court agreed with the trial court that the statute was unconstitutional. The opinion stated that preservation of life is an important state interest but, “when patients are no longer able to pursue liberty or happiness and do not wish to pursue life, the state’s interest in forcing them to remain alive is less compelling.” However, the Supreme Court overruled the appeals court, holding that the right to assistance in committing suicide is not a fundamental liberty interest. Further, the state’s assisted suicide ban is reasonably related to the promotion and protection of a number of the state’s important and legitimate interests. Question: What is the difference between this case and the Cruzan case or the Brenda Young case discussed above? Answer: In the Cruzan and Young cases, the issue was whether life support could be withheld. In this case, the issue is whether a doctor can affirmatively help a patient commit suicide. Question: Why does the state care if someone wants to commit suicide? Answer: States have traditionally taken the view that any killing is bad, even the killing of oneself. Indeed, traditionally, a suicide attempt was against the law and could be punished with a prison sentence (although this is generally not the case now). Question: Why did the patients in this case want a physician to help them commit suicide? Answer: They were too ill to commit suicide on their own. Question: If the doctor and patient are willing, then why shouldn’t the patient be allowed to seek help in killing herself? Answer:  The American Medical Association is firmly opposed to physician-assisted suicide because it believes that doctors should concentrate on curing patients. If they have a choice between curing patients and killing them, they may decide that it is easier to kill patients than to find new methods for treating them.  The poor and the elderly may be pressured by relatives and doctors into asking for suicide.  There is evidence that people want to die only if their pain is unbearable. Even the terminally ill will almost always choose to live if their pain is controlled.  In an era of managed care, doctors may have a financial incentive to assist patients in committing suicide rather than ordering expensive treatments. Question: Why should patients be allowed to ask for help from doctors to kill themselves? Answer: 142

Compassion in Dying v. Washington, 79 F.3d 790, 1996 U.S. App. LEXIS 3944 Court Appeals for the Ninth Circuit, 1996 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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

The courts increasingly recognize a broad right to privacy. To live or to die is a fundamentally private, personal decision. Ultimately, shouldn’t the individual have the right to make this decision herself?  There is no real difference between a right to refuse life-saving treatment and the right to kill oneself.  In some illnesses, the pain cannot be controlled. Patients are forced to bear intolerable pain, as evidenced by the plaintiffs in this case. Question: What did the courts decide? Answer: The courts were very split, as one might expect with such an emotional issue:  The trial court held that the statute was unconstitutional.  A three-judge panel of the appeals court overturned the trial court.  By a vote of 8-3, the en banc appeals court agreed with the trial court that the statute was unconstitutional.  By a vote of 5-4, the Supreme Court overturned the appeals court, holding that the right to assistance in committing suicide is not a fundamental liberty interest. Further, the state’s assisted suicide ban is reasonably related to the promotion and protection of a number of the state’s important and legitimate interests. The five justices in the majority were Rehnquist, O’Connor, Scalia, Kennedy, and Thomas.

30-3 Trusts Trust: An entity that separates legal and beneficial ownership. Grantor: Someone who creates and funds a trust, also called a settlor or donor. Trustee: Someone who manages the assets of a trust. Beneficiary: Someone who receives the financial proceeds of a trust.

Bonus Notes: There are four requirements for establishing a trust: 1. Legal capacity. The grantor must be of legal age and sound mind. 2. Trustee. The grantor must appoint at least one trustee (who may be the grantor). 3. Beneficiary. A trust must have specific beneficiaries. 4. Trust property. The grantor must transfer specific assets to the trust, although these can be nominal. The Uniform Trust Code (UTC) has been adopted by about half the states.

30-3a Advantages and Disadvantages Advantages:  Control  Caring for children  Tax savings  Privacy  Probate  Protecting against creditors  Domestic Asset Protection Trusts (DAPTs): Creditors cannot reach the assets that a donor has placed in a DAPT. Disadvantages: The major disadvantage of a trust is expense. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Example: William S. Paley and Steven J. Ross were both wealthy, well-connected men. Paley, 89, was chairman and a major shareholder of CBS, Inc. Ross, 65, was chairman and co-chief executive of Time Warner, Inc. Paley’s will was 135 pages long with seven executors, including Henry Kissinger. It mentioned scores of charities. By contrast, Ross’s will was four pages long. He had transferred most of his assets to a living trust before he died. Question: Why did these two men–both rich and famous–treat their assets so differently at death? Answer: Ross had younger children. By putting his assets in a revocable trust, he accomplished these goals: He kept his children’s financial information private. Trusts are private documents; wills are not. Because his assets were in a trust at the time of his death, they did not go through probate, so his children could have immediate access to his assets after his death. By keeping his assets in a trust, he was able to maintain more control over them after his death—again, more of an issue with younger children.

30-3b Types of Trusts Living trust or Inter vivos trust: A trust established while the grantor is alive. Revocable: A trust that can be terminated or changed at any time. Testamentary trust: A trust that goes into effect when a grantor dies. Depending upon the goal in establishing a trust, a grantor has two choices. Living Trust Also known as an inter vivos trust, a living trust is established while the grantor is still alive. In the typical living trust, the grantor serves as trustee during his lifetime. He maintains total control over the assets and avoids a trustee’s fee. If the grantor becomes disabled or dies, the successor trustee, who is named in the trust instrument, takes over automatically. All of the assets stay in the trust and avoid probate. Most (but not all) living trusts are revocable, meaning that the grantor can terminate or change the trust at any time. Testamentary Trust A testamentary trust is created by a will. It goes into effect when the grantor dies. Naturally, it is irrevocable because the grantor is dead. The grantor’s property must first go through probate, on its way to the trust. Living trusts are particularly popular with older people because they want to ensure that their assets will be properly managed if they become disabled. Younger people typically opt for a testamentary trust because the probability they will become disabled any time soon is remote. Also they want to avoid the effort of transferring their assets to the trust while they are still alive.

30-3c Trust Administration The primary obligation of trustees is to carry out the terms of the trust. They may exercise any powers expressly granted to them in the trust instrument and any implied powers reasonably necessary to

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implement the terms of the trust, unless that power has been specifically prohibited. In carrying out the terms of the trust, the trustees have a fiduciary duty to the beneficiary. This fiduciary duty includes:  A duty of loyalty. In managing the trust, the trustees must put the interests of the beneficiaries first.  A duty of care. The trustee must act as a reasonable person would when managing the assets of another. (This is a higher standard than requiring a trustee to act as a reasonable person would when managing his own affairs.)

30-3d A Trust’s Term There are three possible outcomes for a trust: Decanting. This means pouring the assets out of one trust into another. Termination. A trust ends (1) on the date indicated by the grantor, (2) if the trust is revocable, when revoked by the grantor, (3) when the purpose of the trust has been fulfilled. Perpetual Trusts. About half of the states now permit dynasty trusts Rule against Perpetuities: A trust must end within 21 years of the death of some named person who was alive when the trust was created. Perpetual or dynasty trusts: Trusts that last forever.

Chapter Conclusion Most people do not like to think about death, especially their own. And they particularly do not want to spend time and money thinking about it in a lawyer’s office. However, responsible adults understand how important it is not to leave their financial affairs in chaos when they do eventually die.

Matching Questions Match the following terms with their definitions: _____A. Executrix 1. Someone who inherits assets _____B. Intestate 2. An amendment to a will _____C. Codicil 3. Children and grandchildren _____D. Administrator 4. Dying without a will _____E. Heir 5. A personal representative appointed by the court to oversee the probate process _____F. Issue 6. A personal representative chosen by the decedent to carry out the terms of a will Answers: JJJJJ. 6 KKKKK. 4 LLLLL. 2 MMMMM. 5 NNNNN. 1 OOOOO. 3 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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True/False Questions Circle T for true or F for false: (Correct answers are bolded) 144. T F There is no need to have a will unless you have substantial assets. 145. T F A holographic will does not need to be witnessed. 146. T F A nuncupative will does not need to be witnessed. 147. T F All states permit an executor access to the decedent’s digital assets. 148. T F A trustee must obtain approval from the beneficiaries before decanting a trust.

Multiple Choice Questions 1. CPA QUESTION A decedent’s will provided that the estate was to be divided among the decedent’s issue, per capita and not per stirpes. If there are two surviving children and three grandchildren who are children of a predeceased child at the time the will is probated, how will the estate be divided? (a) 1⁄2 to each surviving child (b) 1⁄3 to each surviving child and 1⁄9 to each grandchild (c) 1⁄4 to each surviving child and 1⁄6 to each grandchild (d) 1⁄5 to each surviving child and grandchild Answer: D.

Hallie is telling her cousin Anne about the will she has just executed. “Because of my broken arm, I couldn’t sign my name, so I just told Bertrand, the lawyer, to sign it for me. Bertrand was also the witness to the will.” Anne said, “You made a big mistake: I. You should have made at least some sort of mark on the paper.” II. The lawyer is not permitted to witness the will.” III. You did not have enough witnesses.” Which of Anne’s statements is true? (a) I, II, and III (b) Neither I, II, nor III (c) Just I (d) Just II (e) Just III Answer: E. 3. Owen does not want to leave any money to his son, Kevin. What must he do to achieve this goal? I. Nothing. If he dies without a will, Kevin will inherit nothing. II. Make a will that leaves nothing to Kevin. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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III. Leave Kevin $1 in his will. A. I, II, or III. B. II or III. C. Just I. D. Just II. E. Just III. Answer: E.

Lauren a resident of Kansas appointed her husband to be her health care proxy. Now that she is dying of cancer and suffering terribly,she is begging her husband and her doctors to kill her. Which of the following statements is true? 4.

If she goes into a coma, her husband has the right to direct her doctors to withhold treatment.

II.

Her doctor has the right to give her an overdose of pills that will kill her.

III.

Her husband has the right to give her an overdose of pills that will kill her. A. I, II, and III. B. Neither I, II, nor III. C. Just I. D. Just II. E. Just III.

Answer: C. 5. Blake tells his client that there are five good reasons to set up a trust. Which of the following is not a good reason? A. To pay his grandchildren’s college tuition if they go to the same college he attended. B. To save money, since a trust is cheaper than a will. C. To make sure the money is properly invested. D. To avoid probate. E. To safeguard his privacy. Answer: B.

Case Questions 1. If your grandparents were to die leaving a large estate and all of their children were also dead, would you prefer a per stirpes or per capita distribution?

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Answer: Answers will vary. It depends on the number of siblings you have in relation to the number of children in each of the other branches of the family. For example, if the decedents had two children, under per stirpes distribution, they would each inherit half the estate. If the children were dead, their children (the grandchildren of the decedents) would split the parents’ portions. So, if you were an only child, you would get half the estate. If you had three siblings, you would get ¼ of half, or 1/8 of the estate. In the same example, but under per capita, each grandchild would get 1/5 of the estate. So, per stirpes is better if you have few siblings; per capita is better if your sibling group is larger than the average sibling group in the extended family. 2. Kevin Fitzgerald represents the down-and-out Mission Hill and Roxbury Districts in the Massachusetts House of Representatives. A priest alerted him that Mary Guzelian, a street person who roamed his district, had trash bags in her ghetto apartment stuffed with cash, bonds, and bank books. Fitzgerald visited the apartment with his top aide, Patricia McDermott. Two weeks later, Guzelian signed a will, drafted by one of Fitzgerald’s acquaintances, that left Guzelian’s $400,000 estate to Fitzgerald and McDermott. Fitzgerald claimed not to know about the will until Guzelian’s death four years later. Guzelian, 64, suffered from chronic paranoid schizophrenia and severe health problems. Would Guzelian’s sister have a claim on Guzelian’s estate? Answer: The probate court overturned Guzelian’s will and ordered Fitzgerald and McDermott to pay the entire estate to Guzelian’s sister. The lawyer who drafted the will was suspended from practice for three years. Patricia Nealon, “Probate Judge Orders Rep. Fitzgerald, Two Others to Repay Guzelian Estate,” Boston Globe, November 9, 1994, p. B1. 3. When Bill died, he left all of his property in a trust to take care of his wife, Dorris, for the rest of her life. On her death, the money would go to their son, Rob. The Bank of Tulsa was the trustee of this trust. Fifty years later, Rob needed money, so he began writing checks out of Dorris’s checking account. She knew about the checks but could never say no to him. At the rate at which Rob was spending her money, the trust funds would all be gone within a couple of years. What was the bank’s responsibility? Was it obligated to let Dorris have as much money as she wanted? Answer: As the trustee, the bank’s obligation was to take care of Dorris. They could not let her spend so much that her welfare was at risk. The bank had to do what was best for her, even if it wasn’t what she wanted. 4. When Sheryl founded a Silicon Valley company, she placed half of her stock in a trust for her children. They were entitled to the assets in the trust when they turned 21. The company has just gone public, and the stock in the trust is now worth $150 million. She does not want her children, who are 12 and 10 years old, to have that much money when they turn 21. Is there anything she can do? Answer: She can ask the trustee to decant the assets into a different trust that would place limits on the children’s income. 5. When Gregg died, his will left his money equally to his two children, Max and Alison. Max had died a few years earlier, leaving behind a widow and four children. Who will get Gregg’s money? Answer: Alison will inherit everything. His grandchildren would inherit only if his will said “to his issue” or if the will named the grandchildren explicitly.

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Discussion Questions 1. ETHICS Is an asset protection trust right? Should wealthy people be able to avoid paying legitimate creditors? What about perpetual trusts that avoid estate taxes forever? Legislators pass such laws to attract trust business from out of state. Trusts generate billions of dollars in fees each year. If you were a state legislator, how would you vote when this legislation came up for approval? If you had substantial assets, would you put them in such a trust? What Life Principles apply here? Answer: Answers will vary. 2. Should you have a will? Do you have one? Answer: Answers will vary. (Short answer: yes, you should have one!) 3. Billionaire Warren Buffett said that children should inherit enough money so that they can do anything but not so much that they can do nothing. Is it good for people to inherit money? How much? At what age? How much would you like to leave your children? Answer: Answers will vary. 4. The rules on wills are very exact. If the testator does not comply precisely, then the will is invalid. Suppose a man discovers that his daughter has broken virtually every law in this book – she has engaged in insider trading, price-fixing and fraud, to name a few. At his birthday party, the man says to the videographer, in front of 100 witnesses, “I have an appointment with my lawyer tomorrow but, in the meantime, you should know that I want all of my assets to go to the Home for Little Wanderers, the orphanage that raised me.” On his way home that night, he dies in a car accident. Under his will, his daughter inherits all. A court would undoubtedly enforce the will despite all the evidence about the man’s real wishes. Is that right? Courts are often called upon to make difficult decisions about facts. In the case of disputed wills, why not let the courts decide what the decedent really wanted? Answer: Answers will vary. 5. What should intestacy laws provide? To whom would most people want their assets to automatically go? Answer: Answers will vary.

Suggested Additional Assignments Research: Intestacy Ask students to look up the intestacy laws in their state. Where would their assets go if they had a spouse and children? Had a spouse but no children? Had children but no spouse? Were single? In South Carolina, for instance, a spouse inherits half the estate if there are children and everything if there are not. When a single person dies without children, parents inherit everything. To find this information for South Carolina, the authors went to the state code section of LEXIS and typed in “heading (intestate).” © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Drafting Exercise: Wills Ask students to try their hand at drafting their own will. Advice on drafting a will is available on the Internet.

Interview: Living Wills Have students talk with their parents or guardians about whether they have living wills and what their preferences would be if they were facing a terminal illness or permanent coma. Students should also think about whether they want a living will themselves. A sample living will is available from the Caring Connections Web site at http://www.caringinfo.org.

Chapter 31 – Insurance* Chapter Overview Chapter Theme Life is risky for people and their businesses. Insurance can help plan for the unknown future.

Food for Thought If he applies for life insurance, should he admit to being a social smoker?

31-1 Introduction to Insurance We are all subject to risk. We seek insurance against it. Insurance has its own terminology:       

Person. An individual, corporation, partnership, or any other legal entity. Insurance. A contract in which one person, in return for a fee, agrees to guarantee another against loss caused by a specific type of danger. Insurer. The person who issues the insurance policy and serves as guarantor. Insured. The person whose loss is the subject of the insurance policy. Owner. The person who enters into the insurance contract and pays the premiums. Premium. The consideration that the owner pays under the policy. Beneficiary. The person who receives the proceeds from the insurance policy.

The beneficiary, the insured, and the owner can be, but are not necessarily, the same person.

31-2 Insurance Contract An insurance policy must meet all of the common law requirements for a contract.

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31-2a Offer and Acceptance Binder: A short document acknowledging receipt of an application and premium for an insurance policy. It indicates that a policy is temporarily in effect. The purchaser of a policy makes an offer by delivering an application and a premium to the insurer. The insurer can accept or reject the offer. It can accept by oral notice, by written notice, or by delivery of the policy. It may also accept by a written binder.

31-2b Limiting Claims by the Insured The law has created a number of rules to protect insurance companies from fraud and bad faith on the part of insureds.

Insurable Interest An insurance contract is not valid unless the owner has an insurable interest in the subject matter of the policy—that is, if she would be harmed by the danger that she has insured against.

Rules governing insurable interests:  Definition: A person has an insurable interest if she would be harmed by the danger that she has insured against.  Amount of Loss: The insurable interest can be no greater than the actual amount of loss suffered.  Life Insurance: A person always has an insurable interest in his own life and the life of his spouse or fiancée. Parents and minor children also have an insurable interest in each other.  Work Relationships: Business partners, employers, and employees have an insurable interest in each other if they would suffer some financial harm from the death of the insured. Key person life insurance: Companies buy insurance on their officers as compensation were they to die. In the follo9wing case, one family entity owned properties, while a different family company managed them. When a hurricane blew, who had an insurable interest? You be the judge.

Case: You Be the Judge: Banta Props. v. Arch Specialty Ins. Co.143 Facts: The Banta family controlled a complex network of companies. One family company owned three apartment complexes in Florida. A different family business, Banta Properties, Inc., managed these three complexes in return for 4 percent of the gross income. Banta Properties purchased $11 million in property insurance on the three complexes from Arch Specialty Insurance. Two months later, Hurricane Wilma badly damaged all three. As a result of the hurricane damage, the apartments lost approximately $39,000 in rents. Banta Properties’s share of those rents was about $1,600. Banta Properties filed an insurance claim for $6.1 million, which was the cost to repair the damage that Wilma had caused to the apartments. Arch 143

2014 U.S. App. LEXIS 1419;2014 WL 274478 United States Court of Appeals for the Eleventh Circuit, 2014 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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refused to pay, claiming that Banta Properties had no insurable interest in the complexes because it did not own them. Florida law defines an insurable interest as a “substantial economic interest” in keeping the property “free from loss, destruction, or pecuniary damage or impairment.” You Be the Judge: Did Banta Properties have an insurable interest in the three apartment complexes? Argument for Properties: Yes, Banta Properties meets the Florida definition of insurable interest because it had “a substantial economic interest” in keeping the property free from damage. If the properties were out of commission, Banta Properties lost substantial management fees. Also, Banta Properties paid premiums on the full value of the apartments. It is only fair for it to receive what it paid for. This situation is different from, say, fire insurance, where the insured may be tempted to burn down a building. No one can cause a hurricane, thus Banta Properties had no adverse incentives. Arch is just being a poor loser – it was unlucky and is trying to avoid paying what it owes. Argument for Arch: An insurable interest is the amount of the insured’s potential loss. Banta Properties’s only loss was its management fees which, in this case, was $1,600. But Banta Properties is claiming $6.1 million in damages, completely out of proportion to what it actually lost. The Banta family, with its complicated ownership structure, needed to be more careful when purchasing insurance to ensure that only those entities with an insurable interest actually bought the policies. Excerpts from the Per Curiam Decision: 144 Arch argues that the amount of Banta Properties’ insurable interest is limited to its revenue stream from the complexes, namely 4 percent of gross income. Banta Properties argues the Banta Family's ownership interest in the complexes covered by the insurance policy allows it to recover for physical damage to all of the properties. Under Florida law, property insurance contracts are enforceable only where the insured has an insurable interest in the covered property at the time of the loss. An insured does not need to own property to have an insurable interest. Instead, Florida law defines an insurable interest as an “actual, lawful, and substantial economic interest in keeping the property “free from loss, destruction, or pecuniary damage or impairment.” In sum, the measure of an insurable interest is the loss the insured might suffer from damage to the property. Banta Properties actually had no property rights in the apartment complexes whatsoever. The only right Banta Properties had at the time of loss was the contractual right to receive 4 percent of gross income in exchange for its service as property manager. The sole injury Banta Properties could have suffered from the impairment or destruction of the apartment complexes was the loss of revenue from that contractual right. We conclude that Florida law thus limits the extent of Banta Properties’ insurable interest to the potential loss of that revenue. The Banta Family created numerous business entities to manage its business ventures. Consequently, they are bound to both the benefit and burden of the limited liability and interests of the entities. The 144

Per curiam is a Latin phrase that literally means “by the court.” In other words, the decision was unanimous and no individual judge signed the opinion. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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only plaintiff in this suit is Banta Properties, a company that obtained insurance for buildings it never owned, only managed. The sole injury Banta Properties suffered to its insurable interest due to Hurricane Wilma was $1,600, its 4 percent share of $39,000 in business interruption. The judgment of the district court is reversed, and the case is remanded for entry of a judgment in favor of Arch. Question: Under Florida law, what does “insurable interest” mean? Answer: An “actual, lawful, and substantial economic interest: in keeping the property “free from loss, destruction, or pecuniary damage or impairment.” Question: What is Banta Properties insurable interest in this case? Answer: $1,600, its 4 percent share of $39,000 in business interruption that it suffered. Question: Arch filed a motion asking that the jury’s verdict be overturned. What type of motion is this? Answer: a judgment non obstante verdict (JNOV), meaning a judgment notwithstanding the verdict.

Bonus Case: Tim’s Food, Inc. v. Fireman’s Fund Insurance

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Edith and Tim York operated a grocery business in Florence, Wisconsin, under the name “Tim’s Food.” Tim’s leased, with an option to purchase, the building in which it operated. The owners of the building, Loretta and Daniel Baker, were required by the lease to maintain fire insurance on the building. Despite this lease provision, the Yorks, acting on the advice of an insurance agent for Fireman’s Fund, purchased a fire insurance policy on the building in the amount of $175,000. After a fire destroyed the building, Fireman’s refused to pay the Yorks on the grounds that the Bakers owned the building and, thus, the Yorks did not have an insurable interest. Question: Did Tim’s have an insurable interest in the building? Answer: Yes, Tim’s had a right to purchase the leased property and that was an insurable interest. The court stated, “Generally speaking, a person has an insurable interest in property whenever he would profit by or gain some advantage by its continued existence and suffer loss or disadvantage by its destruction.”

Misrepresentation Insurers have the right to void a policy if, during the application process, the insured makes a material misstatement or conceals a material fact. Material: important to the insurer’s decision to issue a policy or set a premium amount.

Bonus Case: Cummings v. American General Life Insurance Co.

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Facts: During a visit to a hospital emergency room for a gunshot wound, John Cummings tested positive for cocaine use. Six months later, Cummings applied for life insurance, naming his mother as beneficiary. On the application for the insurance Cummings was asked if he had, within the prior five 145 146

152 Wis. 2d 404, 449 N.W.2d 336, 1989 Wisc. App. LEXIS 922 Court of Appeals of Wisconsin, 1989 2008 U.S. Dist. LEXIS 37157, District Court for the Eastern District of Pennsylvania, 2008. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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years, used any controlled drugs without a prescription by a physician. Mr. Cummings answered “No.” Four months later, when completing the application, Mr. Cummings was asked “have you ever (b) used cocaine, marijuana, heroin, controlled substances, or any other drug except as legally prescribed by a physician?” Mr. Cummings answered “No.” During the required medical exam, Mr. Cummings did not test positive for illegal drug use. Mr. Cummings was issued a life insurance policy for $91, 351. Mr. Cummings died a year later from a gunshot wound to the head. In investigating his death, the insurance company obtained medical records from the emergency room that treated Mr. Cummings before he applied for life insurance. These records indicated that he had tested positive for cocaine, opiates, and benzodiazepine. The doctor’s notes stated, “COCAINE ABUSE-CONTINUOUS.” American General rescinded Cummings life insurance policy claiming he had made a material misrepresentation on the application. His mother filed suit seeking payment under the policy and American General filed a motion to dismiss. Issues: Is Mr. Cummings policy void because he made a material misrepresentation? Holding: Yes, the insurance policy is void and American General is entitled to summary judgment. Under Pennsylvania law, an insurance policy is void for misrepresentation when the insurer establishes three elements: (1) that the representation was false; (2) that the insured knew that the representation was false when made or made it in bad faith; and (3) that the representation was material to the risk being insured. American General has established the first element of the test; the representation was false. Considering the second prong of the test, there is evidence that the drug abuse by Mr. Cummings occurred during the time periods covered in the life insurance applications, therefore his repeated denials of past drug use were made in bad faith. Regarding whether the representation was material to the risk being insured, Ms. Cummings argues that Mr. Cummings’ drug use was not a material fact because “it would seem that having been shot would present a greater underwriting risk (especially in light of the fact that that was how he died), than an allegation of cocaine use, where the insured’s test results were negative for any drug use in [the] paramedical exam.” However, according to the court, Mr. Cummings’ prior gunshot wounds and his ultimate death from a gunshot are irrelevant to the analysis of his denial of drug use. According to the court, a misrepresentation does not have to be related to the eventual claim for which benefits are sought in order to be “material” for legal purposes. American General presented evidence that had it known of Mr. Cummings’ past drug use, the company would not have issued any life insurance policy to him within three years of the use of cocaine. Any misrepresented fact is material if, had the insurer known it would have refused the risk or demanded a higher premium to insure the risk. Thus, the court concluded that the undisputed facts lead to the conclusion that Mr. Cummings’ past drug use would have led American General to deny Mr. Cummings’ insurance coverage and, thus, is a material fact. Question: Why do you think Mr. Cummings did not admit his drug use on the life insurance application? Answer: He probably knew that he would not get a policy otherwise. Question: What did Ms. Cummings mean when she said that her sons’ drug use was not a material fact because “it would seem that having been shot would present a greater underwriting risk © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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(especially in light of the fact that that was how he died), than an allegation of cocaine use, where the insured’s test results were negative for any drug use in [the] paramedical exam.”? Answer: She meant that being shot is a greater risk for insurance companies because the likelihood of dying and paying a claim is greater from a gunshot wound that it is from cocaine use. Question: Why did the court say that such a conclusion is irrelevant to her argument? Answer: The court said that the fact that Mr. Cummings actually died from a gunshot wound and not cocaine use was irrelevant because the issue before the court is the statements made on the application, not how Mr. Cummings died. The insurance application is a contract, and making a misrepresentation of a material fact on the application is grounds for rescission, regardless of how the insured died.

Bonus Case: New York Life Insurance Co. v. Johnson147 Kirk Johnson applied for life insurance with New York Life. On the application, he stated that he had not smoked in the past 12 months and that he had never smoked cigarettes. In fact, he had smoked for 13 years and during the month he applied for the policy, he was smoking approximately 10 cigarettes per day. Had New York Life known about his smoking it would still have issued the policy, but it would have charged a substantially higher premium. Johnson died two years later of causes unrelated to smoking. New York Life denied the claim and rescinded the policy. Question: Was Johnson’s misrepresentation material? Answer: Yes, the court held that it was. Question: Did his lie affect the insurance company’s risk? Answer: The lie affected the company’s risk, but not its liability. In other words, Johnson’s risk of dying during the term of the policy was higher because he was a smoker. However, he ultimately died of causes unrelated to smoking. His smoking did not affect the company’s ultimate liability because he would have died regardless of his smoking. Question: What is the appropriate remedy? Johnson’s father (and beneficiary) argued that he should pay the company the difference between the low premium of a non-smoker and the higher premium the company would have charged if it had known that Johnson smoked. Do you agree? Answer: The court held that a policy is void if the insured makes a misrepresentation. This is true even in a case such as this where the insurance company, if it had known the truth, would still have issued a policy, but with a higher premium. Question: What is the moral of this story? Answer: Do not lie on insurance applications! The insurer might smoke out the truth. Additional Fraud Cases If students completed the insurance fraud research, this would be a good time for them to report their findings to the class. General Questions: Do the students detect any particular patterns? Are some types of insurance more subject to fraud than others? How are the culprits typically caught? What gives them away? 147

923 F.2d 279, 1991 U.S. App. LEXIS 42 Court of Appeals for the Third Circuit, 1991 © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Do the students know anyone personally who has committed insurance fraud?

31-2c Bad Faith by the Insurer Insurance policies often contain a covenant of good faith and fair dealing. Even if the policy itself does not explicitly include such a provision, an increasing number of courts imply this covenant. An insurance company can violate its covenant of good faith and fair dealing by: 1. fraudulently inducing someone to buy a policy, 2. refusing to pay a valid claim, or 3. refusing to accept a reasonable settlement offer that has been made to an insured. When an insurance company violates the covenant of good faith and fair dealing, it becomes liable for both compensatory and punitive damages.

Fraud In recent years, some insurance companies have paid serious damages to settle fraud charges involving the sale of life insurance.

Refusing to Pay a Valid Claim Consumers complain that insurance companies too often act in bad faith by: refusing to pay legitimate claims; making unreasonably low settlement offers; or setting claims quotas that limit how much their adjusters can pay out each year, regardless of the merits of each individual claim. Damage in these cases are often sizeable, as the following case illustrates.

Case: Berg v. Nationwide Mut. Ins. Co. 2014 Pa. Dist. & Cnty. Dec. LEXIS 543, Common Pleas Court of Berks County, Pa, 2014 Facts: Sheryl Berg was in a serious accident while driving her Jeep Grand Cherokee. Luckily, she was not injured; unluckily, she had to deal with her insurance company, Nationwide Mutual. A Nationwide appraiser determined that the Jeep was damaged beyond repair and recommended that the company pay her the value of the car, which was $25,000. In response, Nationwide brought in a second appraiser who decided the car should be repaired, which would cost only $12,500. Although the car was in the shop for four months, Nationwide only provided a replacement car for the first month. After that, the Berg family had to travel in Mer. Berg’s panel truck, with their son sitting on the floor in the back. Even after four months, the car was not safe to drive: The frame was crooked and neither the headlights nor the airbags worked. Berg repeatedly returned the car to the repair shop, but it was never fixed. Despite her many requests for help, Nationwide did nothing until Berg’s lease expired two years later. It then paid $18,000 to buy the car from the bank that had held her lease. Nationwide had the Jeep destroyed because it was worried about its liability if the bank sold the defective car to someone who © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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was then injured. In short, Nationwide could have fairly settled with Berg for $25,000 but opted instead to pay over $30,500 ($12,500 for bad repairs, $18,000 to the bank, plus disposal fees) and risk Berg driving a dangerous car for two years. In the past, it had been Nationwide’s written policy to fight lawsuits at all cost. Even in cases where it made economic sense to settle, the company’s goal was to be so unreasonable as to discourage other wronged customers from suing. A court in a prior case had ordered the company to end this policy. The Bergs sued Nationwide for damages. During this litigation, Nationwide repeatedly hid evidence and violated discovery orders by refusing to turn over documents. It dragged out the litigation for 16 years, in the process spending more than $3 million in legal fees. (And also lying to the court about the amount of these fees.) Berg then filed this suit alleging that Nationwide had acted in bad faith. She also sought punitive damages. Issues: Did Nationwide act in bad faith? Should it pay punitive damages? Decision: Nationwide did act in bad faith and must pay punitive damages. Reasoning: Nationwide could have settled this case in the beginning for $25,000. Instead, it spent two years ignoring Berg’s reasonable requests, leaving her to drive a dangerous car. In the end, the company paid more than $30,500 – a worse result for both parties. When Berg was reasonably upset by this behavior, Nationwide elected to spend 16 years and millions of dollars in legal fees to torment her further. During this process, it lied to the court and violated numerous court orders, including an order from a prior court that it stop its official policy of refusing to pay reasonable claims. The burden on a plaintiff in a bad faith case is high. It is not enough to show mere negligence or bad judgment on the part of the insurer. Rather, the plaintiff must prove that the insurer: (1) did not have a reasonable basis for denying benefits, (2) knew of or recklessly disregarded its lack of reasonable basis, and (3) breached its duty of good faith and fair dealing through a motive of self0interest or ill will. In addition, the insured must prove its case by clear and convincing evidence, a higher burden than by [a] preponderance of the evidence. In this case, Nationwide strong-armed its own policy-holder rather than negotiating in good faith. The company engaged in numerous examples of bad faith in refusing to disclose vital information to its policyholder and violating the court’s rules. Nationwide’s goal was to send this ultimate message to Berg, her attorney, and other lawyers: (1) do not mess with us if you know what is good for you, (2) you cannot run with the big dogs, (3) there is no level playing field to be had in your case, (4) you cannot afford it, (5) we can get away with anything we want to, and (6) you cannot stop us. Sadly, Defendant did wear down Berg, who will never receive her due justice. After years of fighting for her life against the ravenous disease of cancer, she died just las month. Nationwide clearly thought that its delay and harass strategy was cost-effective. This court must make clear that it is not. Nationwide paid its lawyers $3 million. Berg’s lawyers took this case on contingency which means that they have received no payment for 16 years and have had to fund all the costs © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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themselves. If they lost the case, they would get nothing. It seems only fair that they be paid as much as Nationwide’s lawyers, who bore no financial risk, lost the case, and behaved badly in the process.

This court awards the following damages:  Interest on the amount of the claim from the date it was made in an amount equal to the prime rate of interest plus 3 percent.  Punitive damages in the amount of $18 million.  Court costs and attorney fees of $3 million. Question: what was the issue in this case? Answer: The issue was whether Nationwide acted in good faith in handling the claim of its insured, Sheryl Berg. Question: What did the court rule on that issue? Answer: The court ruled that Nationwide breached its duty of good faith and fair dealing. Question: What are some of the ways that Nationwide breached its duty of good faith? Answer: First, although the initial appraiser assessed the jeep as a total loss and recommended payment of its value of $25,000, a second appraiser was brought in who contradicted that assessment, ruling that the car should be repaired at a cost of $12,500. Second, after the Bergs sued, Nationwide hid evidence from the court and from the plaintiffs, in violation of discovery rules. Question: Was the jeep ever repaired? Answer: No. Although it was brought back to the repair shop repeatedly, it was never safe to drive. Question: What was Nationwide’s written policy regarding lawsuits under its insurance policies? Answer: Its policy was admittedly to fight litigation at all costs. In a previous case, a judge ordered Nationwide to abolish that policy. Question: Does it sound to you as though they did abolish that policy? Answer: No. Question: Nationwide declined to pay Sheryl Berg $25,000, the value of her totally damaged vehicle. What did they pay instead? Answer: Nationwide paid $12,500 for repairs, $18,000 to buy the car from the bank that held her lease, plus disposal fees. Question: How long did the litigation take? Answer: Sixteen years. Question: What did plaintiffs have to prove in a bad faith case? Answer: The insured must prove that the insurer did not have a reasonable basis for denying benefits under the policy, and that the insurer knew or recklessly disregarded its lack of reasonable basis in denying the claim. Question: Did the court agree Sheryl Berg had proven bad faith? Answer: Yes. The court awarded:  Interest on the amount of the claim from the date the claim was made in an amount equal to the prime rate of interest plus 3%  Punitive damages in the amount of $18 million  Court costs and attorney fees of $3 million Question: In its verdict, what did the court note about plaintiff’s attorneys? Answer: That they took the case on a contingency fee basis, had received nothing for their services to date, that they had funded the lawsuit for more than sixteen years at astonishing cost, risk and expense. Question: Did the court award Plaintiff’s attorneys any attorneys’ fees? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Answer: Yes. The court awarded to plaintiff’s attorneys the same amount Nationwide had paid to their attorneys to fight the lawsuit – the sum of $3 million. Question: You know the ad jingle. Do you think Nationwide is on your wide? Answer: Answers will vary.

Bonus Case: Goodson v. American Standard Insurance Co. of Wisconsin148 Facts: Dawn Goodson and her two children were in an automobile accident while driving a car owned by Chet Weber. He was insured by American Standard Insurance Company of Wisconsin. To treat injuries that she and her children suffered in the accident, Goodson sought care from a chiropractor. She submitted these bills, totaling about $8,000, to American Standard. The insurance company offered a number of erroneous reasons why it should not pay the claims: that the chiropractor was not a member of American Standard’s preferred provider organization; that Weber’s policy was not in effect at the time of the accident; and that Goodson and her children needed to undergo an independent medical evaluation to determine whether their injuries were related to the accident and whether their medical treatment was reasonable and necessary. In the end, American Standard did pay Goodson’s bills, but it took 18 months to do so. Goodson filed suit against American Standard, alleging that it had engaged in a bad faith breach of the insurance contract. Although the company’s delay in payment had not caused Goodson any economic damage, it had caused her substantial emotional distress. The jury awarded Goodson and her children $75,000 in actual damages and an additional $75,000 in punitive damages. The appeals court overturned the verdict. Goodson appealed to the state Supreme Court. Issue: Can Goodson recover damages for emotional distress without showing any economic loss caused by American Standard’s delay in paying her claim? Holding: Judgment for American Standard reversed, trial court verdict reinstated. To establish that the insurance company breached its duties of good faith and fair dealing, the plaintiff must show that a reasonable insurer would have paid the claim. The insured may recover for non-economic losses such as emotional distress; pain and suffering; inconvenience; fear and anxiety; and impairment of the quality of life. Goodson proved to the jury that she suffered emotional distress worrying about whether she would have to pay the bills herself. The whole point of buying insurance in the first place is to avoid such anxiety. The fact that an insurer finally pays in full does not erase the distress caused by the bad faith conduct. Question: Would a reasonable insurer have behaved as American Standard did? Answer: No, a reasonable insurance company would not have offered so many false excuses. Nor would it have waited a year and a half to pay the bill. Question: But American Standard did in the end pay all the bills in full. What is Goodson’s claim against the company? Answer: She asked for compensatory damages for the emotional distress the company caused, as well as punitive damages to prevent the company from behaving that way in the future. Question: Are these reasonable claims? 148

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Answer: The court thought so. Paying the bill reluctantly, after a year and a half of foot-dragging was not part of the deal. The company made Goodson suffer unreasonably. In the end, it had to pay for the harm it caused.

Refusing to Accept a Settlement Offer An insurer also violates the covenant of good faith and fair dealing when it wrongfully refuses to settle a claim. Example: Dmitri has a $100,000 auto insurance policy, but after he injures Tanya in a car accident, she sues him for $5 million. Dmitri’s insurer defends him against Tanya’s claim, and she offers to settle for $100,000, the policy limits. But the insurer refuses because it only has $100,000 at risk anyway, and it may get lucky with the jury. Instead, a jury comes in with a $2 million verdict. The insurance company is only liable for $100,000, but Dmitri must pay $1.9 million. A court might well find that the insurance company violated its covenant of good faith and fair dealing and require it to pay the full amount.

31-3 Types of Insurance Insurance is available for virtually any risk. Most people, however, get by with six different types of insurance: property, life, health, disability, liability, and automobile.

31-3a Property Insurance Also known as casualty insurance, it covers physical damage to real estate, personal property or inventory.

31-3b Life Insurance Really, death insurance; provides for payments to a beneficiary upon the death of the insured.

Term Insurance Simplest, cheapest option; purchased for a specific period; if the insured dies during that period, the insurance company pays.

Whole Life Insurance Also called straight life insurance; designed to cover the insured for his entire life. It forces people to save, but has some significant disadvantages.

Universal Life A flexible combination of whole life and term; the owner can adjust the premiums over the life of the policy; options are complex.

Annuities The owner makes a lump sum payment to an insurance company in return for a fixed annual income for the rest of her life. Annuities: Provides payment to a beneficiary during his lifetime. Deferred annuity contract: The owner makes a lump=sum payment now, but receives no income until a later date.

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Pay for service plans: The insurer pays for whatever treatments a doctor orders. Managed care plans: Health insurance plans that limit treatment choices to reduce costs. Health maintenance organization (HMO): Generally, patients can only be treated by doctors who are employees of the organization. Value-based care: Payment to medical providers is based on patient outcomes, not quantity or complexity of services provided.

31-3d Disability Insurance Disability insurance: Replaces the insured’s income if he becomes unable to work because of illness or injury.

31-3e Liability Insurance Liability insurance: Reimburses the insured for any liability she incurs by accidentally harming someone else. Personal liability insurance covers tort claims. Business liability policies may protect against:  Professional malpractice  Product liability for injury caused by a company’s products  Employment practices liability insurance Business liability policies may also protect against other sorts of claims.

31-3f Automobile Insurance These are the basic types of coverage:  Collision covers the cost of repairing or replacing a car damaged in an accident  Comprehensive covers fire, theft, and vandalism  Liability covers harm the owner causes to other people or their property.  Personal injury protection pays the medical expenses and lost wages of the owner, his passengers, anyone living in his house or authorized to drive the car  Uninsured motorist covers the owner and anyone else in the car who is injured by a driver without insurance

Research: Insurance If students investigated the purchase of an insurance policy, now would be a good time to determine the results of their research. Divide students into groups according to the type of policy they investigated. Can they tell who got the best deal? How do the policies differ? They should notice, for instance, how different the premiums are for whole life rather than term insurance. They will also probably find that the prices for house insurance vary greatly.

Chapter Conclusion Life is a risky business. Cars crash, people die, and houses burn. So what can we do? Buy insurance, and get on with our lives, knowing that we have prepared as best we can. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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Matching Questions Match the following terms with their definitions: _____A. Insured 1. The person who issues the insurance policy _____B. Insurer 2. The person who receives the proceeds from the insurance policy _____C. Owner 3. If the person who takes out the policy would be harmed by the danger that she has insured against _____D. Beneficiary 4. The person who enters into the policy and pays the premiums _____E. Insurable interest 5. The person whose loss is the subject of an insurance policy Answers: PPPPP. QQQQQ. RRRRR. SSSSS. TTTTT.

5 1 4 2 3

True/False Questions Circle T for true or F for false: (Correct answers are bolded) 149. T F If the insured makes any false statement in the application process, the insurance policy is voidable. 150. T F Even after an insurance company issues a binder, it can still revoke the policy. 151. T F You should primarily buy insurance to protect against harm that you cannot afford. 152. T F You are more likely to die before 65 than to become disabled before 65. 153. T F An annuity is simply a type of life insurance.

Multiple Choice Questions 1. Lucas has bought the following insurance this week: I. A life insurance policy on his brother. II. A life insurance policy on the partner in his accounting practice. III. A fire insurance policy on the fitness club he belongs to so that if it burns down, he will receive a large enough payment to enable him to join a different club. © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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In which of these policies does he have an insurable interest? A. I, II, and III. B. Neither I, II, nor III. C. I and II. D. I and III. E. II and III. Answer: E. 2. If Chip helps out his daughter Sarah by buying a policy to insure her apartment, then ________is the insured, ____ is the beneficiary, and ____ is the owner. A. Sarah, Sarah, Sarah B. Chip, Chip, Chip C. Sarah, Chip, Chip D. Sarah, Sarah, Chip Answer: D. 3. If you are a smart consumer, you will: I. Insure against as many different kinds of risks as you can so that no matter what happens, you will be protected. II. Select as low a deductible as possible so that no matter what happens, you will not have to pay large sums out of pocket. III. Buy flight insurance when you take long airplane flights so that your family will be protected if your plane crashes. A. I, II, and III. B. Neither I, II, nor III. C. I and II. D. Just I. E. Just II. Answer: B.

4. An insurance company does not violate its covenant of good faith and fair dealing if it: A. charges elderly customers higher premiums than it charges younger customers. B. tells potential customers that their premiums will decline when that is not true. C. tells potential customers that their returns on a whole life policy are certain to be higher than an equivalent amount invested in the stock market. D. refuses to pay a valid claim until after four years of litigation. E. refuses to accept a settlement offer on behalf of an insured that was reasonable, but not in the company’s best interest. Answer: A. 5. Which of the following policies are you likely to need in your lifetime? © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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A. B. C. D. E. Answer: D.

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I. Service plan on an appliance II. Whole life insurance III. Disability insurance IV. Health insurance All of the above None of the above II, III, and IV III and IV IV

Case Questions 3.

You Be the Judge: WRITING PROBLEM Linda and Eddie had two children before they were divorced. Under the terms of their divorce, Eddie became the owner of their house. When he died suddenly, their children inherited the property. Linda moved into the house with the children and began paying the mortgage that was in Eddie’s name. She also took out fire insurance. When the house burned down, the insurance company refused to pay the policy because she did not have an insurable interest. Do you agree? Argument for the Insurance Company: Linda did not own the house; therefore, she had no insurable interest. Argument for Linda: She was harmed when the house burned down because she and her children had no place to live. She was paying the mortgage, so she also had a financial interest. Answer: Linda had an insurable interest because she had made a substantial financial contribution by paying the mortgage. Also, the house was owned by her children and as their guardian, she had an insurable interest in the house. Motorists Mutual v. Richmond, 676 S.W.2d 478 (Ky. Ct. App. 1984).

2. Armeen ran a stop sign and hit the Smith’s car, killing their child. He had $1.5 million in insurance. The Smiths offered to settle the case for that amount, but Liberty State, Armeen’s insurance company, refused and proposed $300,000 instead. At trial, the jury awarded the Smith’s $1.9 million, which meant that Armeen was liable for $400,000 rather than the zero dollars he would have had to pay if Liberty had accepted the Smith’s offer. What is Liberty’s liability? Under what theory? Answer: Liberty acted in bad faith. An insurance company is supposed to negotiate a settlement as if the policy had no limits. Here, Liberty made a lowball offer—$300,000 was not close to what the jury ultimately awarded. Liberty is liable for the full $1.9 million.

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3. Dannie Harvey sued her employer, O. R. Whitaker, for sexual harassment, discrimination, and defamation. Whitaker counter-claimed for libel and slander, requesting $1 million in punitive damages. Both Whitaker and Harvey were insured by Allstate, under identical homeowner’s policies. This policy explicitly promised to defend Harvey against the exact claim Whitaker had made against her. Harvey’s Allstate agent, however, told her that she was not covered. Because the agent kept all copies of Harvey’s insurance policies in his office, she took him at his word. She had no choice but to defend against the claim on her own. Whitaker mounted an exceedingly hostile litigation attack, taking 80 depositions. After a year, Allstate agreed to defend Harvey. However, instead of hiring the lawyer who had been representing her, it chose another lawyer who had no expertise in this type of case and was a close friend of Whitaker’s attorney. Harvey’s new lawyer refused to meet her or to attend any depositions. Harvey and Whitaker finally settled. Whitaker had spent $1 million in legal fees, Harvey $169,000, and Allstate $2,513. Does Harvey have a claim against Allstate? Answer: Harvey sued Allstate for a violation of the covenant of good faith and fair dealing. A jury awarded her $94,000 plus attorney’s fees. Harvey v. Allstate Insurance Co., 1993 U.S. app. LEXIS 33865 (10th Cir. 1993). 4. Clyde received a letter from his automobile insurance company notifying him that it would not renew his policy that was set to expire on February 28. Clyde did not obtain another policy, and, in a burst of astonishing bad luck, on March 1, at 2:30 a.m., he struck another vehicle, killing two men. Later that day, Clyde applied for insurance coverage. As part of this application, he indicated that he had not been involved in any accident in the last three years. The new policy was effective as of 12:01 a.m. on March 1. Will the estates of the two dead men be able to recover under this policy? Answer: No, the insurance company had the right to cancel the policy because Clyde had made material misstatements on the application. Auto-Owners Insurance Co. v. Johnson, 209 Mich. App. 61, 530 NW.2d 485, 1995 Mich. App. LEXIS 66 (Mich. Ct. App. 1995). 5. Jackson lived in an apartment with Miri, to whom he was not married. When he applied for homeowners insurance, the form asked their marital status. He checked the box that said “married.” Later, the apartment was robbed, and Jackson filed a claim with his insurance company. When the company discovered that Jackson and Miri were not married, it refused to pay the claim on the grounds that he had made a material misrepresentation. Jackson argued that the misrepresentation was not material because the insurance company would have issued the policy no matter how he answered that question. Is Jackson’s policy valid? Answer: This representation was material because it would have changed the amount of the premiums Jackson had to pay. The policy is invalid.

Discussion Questions 1. Suzy Tomlinson, 74, met a tragic end – she drowned, fully-clothed, in her bathtub after a night out partying with 36-year-old J.B. Carlson. He had taken her home at 1 a.m. and was the last person to see her alive. The two were not only party buddies, Suzy was on the board of directors of a company J.B. had started. Her family was stunned to find out that she had a $15 million life insurance policy, with the proceeds payable to a company J.B. controlled. He said it was a key man policy. He wanted © 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

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to protect the company if she died because she had frequently introduced him to potential investors. Is the life insurance policy valid? Answer: Did Carlson have an insurable interest? The court denied the insurance company’s motion for summary judgment in its suit seeking a declaration that Carlson did not have an insurable interest. That was in 2010 and there have been no further proceedings, which indicates the case may have settled. There was lots of suspicious evidence, however. Tomlinson’s children say that she never took baths. When she applied for insurance, she claimed assets of $47 million. In fact, she had virtually no assets. Carlson had taken out a loan at 17% interest to pay the premiums and the loan was about to come due. Am. Gen. Life Ins. Co. v. Germaine Tomlinson Ins. Trust, 2010 U.S. Dist. LEXIS 103730 (S.D. Ind. Sept. 30, 2010) 2. Tomlinson’s family sued the insurance company, claiming that the policy was valid, but that they were the beneficiaries, not J.B. Is the family entitled to the proceeds of the policy? Should they be? Answer: If JB is deemed not to have an insurable interest then the policy is invalid and the family is not entitled to the proceeds. But maybe they should be entitled to the proceeds if Tomlinson paid the premiums. She had indicated that she wanted her family to benefit from the policy. The evidence however, is that JB had paid the premiums. It seems that this is a scam and that, at best, the insurance company should return the premiums, but to whom?

3. ETHICS Most people who rent cars do not need to buy the extra coverage that the rental agencies offer because credit cards already provide this type of insurance. However, this coverage is very profitable for the rental companies. If you were the manager of a car rental agency, how aggressive would you be in encouraging your agents to sell these policies? Would you pay them a commission or base their salaries on the number of policies they sold? Train them to remind customers that their credit card company might provide coverage? Answer: Answers may vary.

4. ETHICS Donna and Carl Nichols each bought term life insurance from Prudential Insurance Company of America. These policies contained a provision stating that if the insured became disabled, the premiums did not have to be paid and the policy would still stay in effect. This term is called a waiver of premium. Carl became totally disabled, and his premiums were waived. Some years later, two Prudential sales managers convinced the Nicholses to convert their term life insurance policies into whole life policies. They promised that, once Carl made the conversion, he would only have to pay premiums on the new policy for a six-month waiting period. They even wrote “WP to be included in this policy” on the application form. “WP” stood for waiver of premium benefit. Only after the new policy was issued did the Nicholses learn that Prudential would not waive the premium. The Nicholses had exchanged a policy on which they owed nothing further for a policy on which they now had to pay premiums that they could not afford. Do the Nicholses have a claim against Prudential? Regardless of the legal outcome, did Prudential have an ethical obligation to the Nicholses? Answer: The court held for Prudential. The two Prudential sales managers were not authorized to execute policies, only the home office was. Nor did they have the right to determine if premiums could be waived on a policy. Moreover, the application form specifically stated that: “No agent can

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make or change a contract, or waive any of Prudential’s rights or needs.” Nichols v. Prudential, 851 S.W.2d 657 (Mo. 1993). 5. Jason applied for a homeowner’s policy through CPM Insurance Services, Inc. An employee of CPM filled out the application form using information provided by Jason’s housemate, Tricia. The twopage form asked: “Does applicant or any tenant have any animals or exotic pets?” The CPM employee checked an adjacent box stating that the answer was “No.” At the time, Jason owned two dogs, a Doberman and a German shepherd. Although Jason had not read this part of the form, he nonetheless signed the application attesting that he had read it and that the answers were true. When Jason was sued by someone who claimed to have been bitten by one of his dogs, CPM rescinded his policy for material misrepresentation. In his defense, Jason said that the question about pets was confusing. He thought it applied only to exotic animals, not dogs. Also, he had not filled out the form. Is Jason’s policy with CPM valid? Answer: No. He should have read the form before signing it. If he was confused about the question, he should have asked for clarification. 6. ETHICS Life insurance policies place the burden on beneficiaries to notify the insurance company when an insured dies. The company itself has no obligation to hunt down the heirs of dead customers. But sometimes beneficiaries do not know that their relative had a policy. Some state authorities are now requiring insurance companies to run a list of their policy owners through a database of people who have died. But the insurance companies are objecting because, they say, they priced the policies originally on the assumption that a certain percentage of them would never be paid. What is the ethical choice for insurers? What would Kant or Mill say? Answer: Answers will vary.

Suggested Additional Assignments Research: Insurance Ask each student to investigate the purchase of $100,000 of insurance on his or her life or $300,000 in house insurance. They should obtain a quote for annual premiums and also a copy of the proposed policy. Students can obtain quotes either from an insurance agent or on the Internet at http://itechusa.com, or http://quickquote.com/.

Research: Insurance Fraud Ask students to go to http://www.insurancefraud.org and read the “Fraud Case of the Month.” They should be prepared to give a report in class on at least one of these cases.